Regulatory Equivalence in Blockchain Systems: The Role of Public Values and Legitimacy

Abstract

In this chapter, we develop the concept of ‘regulatory equivalence’. As opposed to functional equivalence, used to extend the scope of existing legal frameworks to new technological arrangements, regulatory equivalence refers to the use of technological guarantees to serve the same purpose as traditional legal formalities. This approach goes beyond the use of technology to execute certain legal formalities, but involves analysis of the equivalence between the values undergirding legal rules and the affordances of technological artifacts. This chapter draws on the distinct properties of blockchain-based systems, such as notarization systems, Decentralized Autonomous Organization (DAO)s, and privacy pools, to demonstrate the opportunities and challenges they present to establishing regulatory equivalence. Public actors, however, are hesitant to recognize regulatory equivalence, due to competing perceptions of legitimate governance between participants within these systems and external actors such as regulators. We explore this tension before concluding that this challenge can be overcome through co-regulatory engagement between public authorities and actors within blockchain-based systems, and public authorities more explicitly stating the values they seek to promote within blockchain-based systems.

Funding: This research is funded by the European Research Council under the European Union’s Horizon 2020 Research and Innovation Programme (Grant Agreement No. 865856).

1 Introduction

In 2014, one of the co-founders of the Ethereum blockchain, Gavin Wood, argued that a blockchain system is intrinsically “alegal” because it “cannot care […] as to whether its actions might be interpreted as legal or illegal”.¹ Yet, almost a decade later, with the growing adoption of blockchain technology, many actors are now seeking to make blockchain applications regulatorily compliant or, at least, ‘regulatorily equivalent’. Regulatory equivalence builds on the concept of functional equivalence, a term that is well-established in the legal literature.² Functional equivalence allows the establishment of equivalence between two artifacts, one that is already covered within the realm of a legal rule and another that is not (yet) encompassed by it (e.g., written signatures and electronic signatures). Regulatory equivalence goes further by striving to establish the equivalence between the policy objectives of specific legal provisions, and the implications of adopting a particular technological artifact as an alternative way to achieve regulatory objectives.³

This new trend is due in large part to the spectacular bankruptcies (e.g. FTX) and scams (e.g. OneCoin, BitConnect) that have brought actors within the blockchain space in direct confrontation with law enforcement authorities and regulators, but also to a growing interest in pro-actively cultivating the legitimacy of blockchain networks to ensure their long-term sustainability.⁴ To the extent that blockchain applications want to interface with the legal or administrative systems of existing nation states, they must comply with their rules. Regulatory compliance, however, is not always a viable option. Indeed, it can sometimes be challenging to reconcile the demands of the legal system (designed for legacy institutions) with the distinctive properties of blockchain technologies (in terms of e.g. decentralization, transparency, immutability and irreversibility), in ways that do not undermine their basic technological guarantees or their legitimacy within blockchain (‘Web3’) communities.

Regulatory equivalence can be regarded as an alternative way to achieve regulatory compliance, by establishing equivalence between the objective of existing legal formalities and the technological guarantees provided by a new technological artifact. For instance, the COALA DAO Model law discussed in this chapter proposes regulatory equivalence between a variety of requirements for corporate formation and the technological design of specific blockchain-based decentralized autonomous organizations (DAOs). These organizations are not governed by traditional by-laws (i.e. legal and contractual rules) but rather by smart contracts (i.e. technological rules encoded as a computer program on a blockchain network). As such, their rules of operation will be enforced by the underlying blockchain infrastructure, regardless of their compliance with the law.

At times, technological design can provide equivalent (if not superior) guarantees to traditional legal formalities. For instance, blockchains make it possible to achieve real-time auditing of transactions, thereby reducing the need for third-party audits and period reports. Yet, these technological guarantees may fall short of satisfying some of the motivations that underpin public values, particularly those that are implicit and have not been expressly articulated in the law. Think, for instance, about the public value of transparency, which, in the context of financial transactions, has been explicitly articulated in regulations against money laundering and counter-terrorism financing. Yet, these regulations have been claimed to also be motivated by a more general desire of surveillance by regulatory authorities, with a view not only to prevent illegitimate financial activities, but also to monitor and scrutinize legitimate ones.⁵ Moreover, regulatory equivalence threatens the functions of existing regulatory authorities. For instance, if DAOs were to secure regulatory equivalence with the filing and registration requirements by simply posting their formation and disclosure documents on a secure public forum, at least notionally they could bypass the need for the imprimatur of state authorities like a business registry. This might entail a loss of sources of revenue for the state (e.g., filing and incorporation fees). Consequently, lawmakers and regulators might be reluctant to recognize this type of regulatory equivalence.

At the same time, while blockchain technology continues to develop, these authorities are left facing a regulatory dilemma: curbing the technology’s negative effects, without excessively stifling innovation. This has led to regulatory experimentation to support the development of the crypto-industry (e.g., regulatory sandbox regimes, legislation that enables the creation of limited liability DAOs) as well as regulations that curb its perceived risks (e.g., tailoring anti-money laundering and counter-terrorism financing rules to crypto-assets). In the process of drafting these new regulations, it has become necessary for national and global (e.g., the Financial Action Task Force) regulators to articulate the “public values” that they want to promote. This revealed a potential tension between values such as financial privacy and other public values like financial scrutiny and oversight.⁶ The question we are now faced with is whether the technological guarantees afforded by blockchains fulfill public values in a manner that is considered legitimate by society and relevant regulatory bodies?

In theory, if properly implemented, regulatory equivalence can establish greater confidence among all relevant stakeholders than traditional legal formalities and enhance the legitimacy of actors operating in the blockchain space. However, if not properly implemented, reducing the role of publicly accountable trusted intermediaries can lead to accusations that regulatory equivalence creates new publicly unaccountable intermediaries (e.g., miners, token holders, or other blockchain stakeholders), thereby undermining confidence, legitimacy, and legal certainty. Ultimately, to ensure that regulatory equivalence is recognized, we need to guarantee that the underlying governance is robust, and that there is enough accountability at the governance level.

This chapter starts by elucidating the principles of functional equivalence (Sect. 2.1) and regulatory equivalence (Sect. 2.2) by providing a series of examples to illustrate the distinction between the two. While the former has largely been recognized by regulators as a useful tool to extend the scope of regulations to novel technologies without having to undertake extensive legislative reforms, the latter is a more contentious principle whereby regulation can recognize alternative ways to achieve regulatory compliance by leveraging the specific characteristics of novel technologies. The chapter continues by presenting the unique opportunities (Sect. 3.1) and challenges (Sect. 3.2) that regulators must face in the process of establishing regulatory equivalence in the context of blockchain systems. Drawing from selected examples (e.g. notarization systems, DAO Model Law, and privacy pools), it is shown that while there are tangible benefits in recognizing the use of technological guarantees as an alternative means for blockchain systems to achieve regulatory compliance, such approach is not devoid of challenges, in particular when the technological guarantees fulfill some, but not all, of public values—whether these are explicitly or implicitly enshrined within the law.

Finally, the chapter tackles the issue of legitimacy in the blockchain systems, and the need to resolve the tension between endogenous legitimacy (i.e. how the operations of these systems are perceived by the system’s participants) and exogenous legitimacy (i.e. how these systems are perceived by external actors, including regulators and society at large). On the one hand, regulators will only recognize regulatory equivalence to systems that are perceived as legitimate by societal actors; on the other hand, blockchain systems will only try to implement technological guarantees to implement specific regulatory objectives which are perceived as legitimate by the system’s participants. The chapter concludes with the claim that, in order for regulatory equivalence to be properly implemented by blockchain actors and effectively recognized by regulators, it is crucial for public authorities to more explicitly state the values they are ultimately seeking to promote, as well as the activities they are seeking to repress. Only then does it become possible for blockchain developers and practitioners to properly understand the policy objectives that the systems they are building need to satisfy in order to qualify for regulatory equivalence.

2 Functional Equivalence and Regulatory Equivalence

In this section, we will first define our usage of specific terms: functional equivalence and regulatory equivalence. Each concept is illustrated with examples and respectively distinguished from technological neutrality and regulation by design. We show how regulatory equivalence represents an evolution of functional equivalence, prefiguring a future regulatory environment in which public policies and technological innovation coexist more harmoniously than at present.

2.1 Functional Equivalence

We first turn to the notion of functional equivalence. Certain artifacts, such as paper documents, hand-written signatures, and physical seals of wax, rubber or steel, have for centuries been used for the execution of contracts and deeds. Across the various legal systems of the world, these artifacts are recognized as having legal effects and are required for the valid execution of a wide range of transactions For instance, the law traditionally prescribes that the creation and disposal of interests in land (e.g., the sale of land) and the preparation of wills must be in writing.⁷ While oral contracts are common, in written contracts a signature by the contracting parties (and in some cases witnesses)⁸ is necessary for contracts to be finalized and to enter into force, unless agreed otherwise. In the case of agreements that have a public dimension or involve foreign transactions, such as a land transfer or marriage, a third party—such as a land registry,⁹ notary, and/or (other) state authority—must also affix their seal(s) to the document. Dalgetty,¹⁰ for instance, observes that in England and Wales every “practicing notary has their own unique seal embossed on a document which can only be used by him or her when completing a notarial act. This must be in the form of a ‘tamper proof’ document, and is usually sewn with a ribbon and sealed”.¹¹ In short, these physical artifacts have significant implications for the validity of legal documents and are designed with certain public interests in mind, such as transaction security and fraud protection.

With the development of electronic media and commerce in the latter half of the twentieth century, new digital artifacts have emerged that can serve the same functions as analogue physical artifacts while protecting public interests such as transaction security and fraud protection, provided that certain legal and technical requirements are met. For instance, the introduction to the UNCITRAL Model Law for Electronic Commerce (1996) mentions that electronic records can provide at least the same degree of security as a paper document.¹² In addition, electronic records can be widely legible, tamper-proof, reproducible, authenticated by a signature, and submitted to public authorities. They can even fulfill some of these functions more expeditiously and reliably than ordinary paper documents. In the following years, the use of electronic documents has become commonplace. For instance, under English law, the electronic conveyance of land has become possible, and an electronic document can be legally deemed to be a land deed.¹³ Similarly, under the UNCITRAL Model Law, a ‘data message’ can be deemed to be equivalent to certain signatures, if the following conditions are met: (1) there is a method for identifying the person sending the data message, (2) there is a method for showing that a person approved the information in the message, and (3) the method is reliable under the circumstances.¹⁴ UNCITRAL acknowledged that there are different types of signature requirements (e.g., additional seals, or witness signatures) for various transactions and further functional equivalents may need to be developed to accommodate them.¹⁵ Indeed, various ‘levels’ of electronic signatures and electronic seals are recognized under EU law. Following the passage of the EU’s eIDAS Regulation, all Member States recognized the validity of three types of electronic seals as being equivalent to comparable physical seals.¹⁶ As such, they have been recognized by the law as having the same function or effects as the corresponding physical artifacts—thereby acknowledging their functional equivalence.

In short, functional equivalence is the legal recognition that an artifact not encompassed by the law can fulfill the same functions as an artifact that is already encompassed by the law, thereby extending the variety of artifacts encompassed by the law. As explained by UNCITRAL, a functional equivalence analysis involves first analyzing the functions that a paper-based method serves before establishing whether another technology can fulfill the same functions. If such equivalence can be determined, a new rule can be drafted that encompasses this artifact.¹⁷

Blockchain artifacts can potentially be functionally equivalent to earlier digital and physical artifacts. For instance, jurisdictions like Delaware and Vermont in the United States and Poland in the European Union already permit companies to maintain their share registers on blockchain-based systems,¹⁸ treating them as being functionally equivalent to other non-distributed types of share registers subject to limited statutory requirements. However, a functional equivalence analysis may have unintended, even adverse, consequences for persons and organizations developing blockchain artifacts. Take, for example, the classification of tokens issued by blockchain protocols as (unregistered) securities in the United States. At first glance, the application of an investment contract classification test (i.e., the Howey test) to crypto tokens, which were originally applied to interests in orange groves, can be seen as an example of functional equivalence. Under this perspective, the crypto tokens recorded on a blockchain network are deemed to be equivalent to the paper documents that traditionally comprise an investment contract.¹⁹ However, this is not an example of functional equivalence but rather an example of the law’s use of analogical reasoning and adherence to neutrality of technology.

While functional equivalence has occasionally been equated with neutrality of technology, they are distinct concepts.²⁰ Neutrality of technology is broadly concerned with ensuring that the effects of online and offline acts are treated in the same way. The law is thereby “indifferent” to the technology used.²¹ For instance, the act of defamation should be subject to the same legal treatment irrespective of whether the defamatory act is committed online on a chat forum or offline in a print newspaper. In the US, under the Howey test, it appears that in determining the existence of an investment contract, the technological medium is irrelevant. However, the results of such an assessment are not self-evident in the European Union, as EU law does not have an equivalent of the Howey test. The functional assessment of whether crypto assets are ‘transferable securities’ under the EU’s Markets in Financial Instruments Directive (MiFID II), though quite similar, is not identical to the Howey test.²² This may lead to a crypto asset being classified differently in the EU compared to the United States.

The application of analogical reasoning and neutrality of technology can be seen in recent US cases concerning the classification of unregistered decentralized autonomous organizations (DAOs). As such DAOs have not made a formal entity choice and there is no legal framework specifically tailored to unregistered DAOs, courts have drawn legal analogies with other legal forms, most notably general partnerships.²³ Again, the focus of courts thus far has been on the substantive factual relationship between human parties in the DAO, rather than the technologies that are used for distributed coordination and/or automation of operations and governance processes.

In both instances, laws and regulations that were designed for centralized systems are being applied to decentralized systems. This can have unintended consequences. For instance, deeming unregistered DAOs to be general partnerships can lead to the joint and several liability of all members of the DAO,²⁴ leaving those members in the jurisdiction of the court that made such determination especially vulnerable. This creates uncertainty, places considerable financial and non-financial risk on DAOs members, and stymies technological innovation. Arguably, such an approach also anchors DAOs and crypto tokens to “outdated characteristics and properties” rather than recognizing their emergent and innovative features.²⁵

Some technologically progressive jurisdictions like England and Wales have come to appreciate these difficulties and have tailored solutions that are suited to decentralized systems. An example of this is the service of notice of legal proceedings and other legal documents and orders using non-fungible tokens (NFTs). English courts have long permitted a variety of mediums for valid service, but recognizing the challenges that the pseudonymity and non-hierarchical nature of blockchain networks present, courts have recently begun deeming the sending of an NFT containing such documents and orders to blockchain addresses to be valid service.²⁶ This has been possible as the civil procedure rules of English courts already recognized electronic methods of service and, when presented with a sufficiently novel and significant case, this was capaciously interpreted to include NFT airdrops of legal documents. In other words, this new blockchain artifact was deemed to be functionally equivalent to earlier digital artifacts such as email.

2.2 Regulatory Equivalence

Blockchain technology introduces a unique set of challenges when it comes to complying with existing legal provisions crafted for centralized institutions.²⁷ In particular, several difficulties emerge due to the need to accommodate the demands of the legal system with the fundamental properties of blockchain technology.²⁸ Indeed, traditional legal frameworks, established over decades to regulate centralized operators and their platforms, are generally ill-equipped to account for the decentralized and disintermediated nature of blockchain networks.²⁹

Blockchain networks operate on a worldwide scale, with transactions occurring across borders without reliance on centralized operators. The absence of a central governing body creates potential jurisdictional challenges, making it difficult to determine which jurisdiction has authority in case of legal disputes.³⁰ Traditional legal frameworks, designed around national boundaries, may therefore struggle to assert authority over decentralized blockchain platforms with an international user base.³¹

Besides, legal systems traditionally presuppose a set of identifiable entities that can be held accountable for the services they provide to their users.³² Yet, blockchain networks operate in a peer-to-peer manner, as transactions are processed and verified by network participants rather than by a central authority.³³ The pseudonymity inherent in these networks also challenges traditional legal norms, making it difficult to identify parties in case of disputes or wrongdoing.³⁴ Striking a balance between privacy expectations of blockchain users and the identification requirements of legal authorities is a delicate task that requires careful consideration.³⁵

Integral to many blockchain applications are smart contracts, i.e., software used to facilitate social and economic transactions through deterministic computation.³⁶ These applications challenge the enforcement and adjudication of contractual disputes because,³⁷ independently of the decision of a judge, no one has the power to unilaterally influence, or even stop the execution of a smart contract.³⁸ This stands in contrast with conventional legal doctrines of contractual interpretation which rely on the human interpretation of natural language to define the nature and scope of any contractual relationship.³⁹ This adds a new layer of complexity to regulatory efforts seeking to govern the operations of blockchain systems.⁴⁰

At the same time, blockchain technology brings new opportunities for regulatory compliance.⁴¹ Traditional legal systems often emphasize the need for more transparency and traceability in centralized institutions. These features, which are inherent in many blockchain networks, provide a significant degree of accountability and verifiability.⁴² As such, they could potentially contribute to, rather than jeopardize, the ability of blockchain systems to comply with existing regulatory requirements.⁴³ Hence, while traditional legal frameworks struggle at adapting to the new challenges and opportunities offered by blockchain technology, blockchain practitioners can fill up the regulatory gap, through the introduction of technological guarantees intended to fulfill specific policy objectives. The applications deployed on blockchain networks can evolve rapidly, driven by technological advancements and community-driven updates that by far outpace the legislative process of traditional legal frameworks.⁴⁴

The increased adoption of blockchain technology in various sectors has enabled new forms of experimentation,⁴⁵ using blockchain technology as a regulatory technology in ways that differ from traditional notions of regulatory compliance centered solely on the fulfillment of existing legal formalities. This is what we refer to as ‘regulatory equivalence’.⁴⁶ Rather than seeking strict adherence to established legal formalities, regulatory equivalence seeks alignment with the overarching policy objectives embedded within specific legal provisions. This is grounded on the fact that, while the distinctive properties of blockchain technology may not easily conform to existing legal norms, they might nonetheless be instrumental to achieving identical policy goals—albeit via different means.⁴⁷ The emphasis on policy objectives allows for a more flexible interpretation of regulatory requirements, enabling regulators to evaluate the effectiveness of blockchain technology in fulfilling overarching policy goals through technological guarantees,⁴⁸ without strictly adhering to predefined legal formalities.

Regulatory equivalence goes beyond acknowledging technological guarantees as mere substitutes for legal formalities;⁴⁹ it endeavors to establish an actual and meaningful equivalence between the purpose of the legal formalities and implications of these technological guarantees. This requires a comprehensive evaluation of how the adoption of these technological guarantees aligns with the intended policy outcomes of existing legal provisions.⁵⁰ For instance, the transparency and tamper-resistance of a blockchain introduce new opportunities for real-time auditing,⁵¹ which can be regarded as an effective alternative to traditional third-party audits,⁵² potentially streamlining compliance processes.⁵³ The adoption of technological guarantees as an alternative means to comply with specific policy objectives and regulations (instead of complying with traditional legal formalities) forms the basis of regulatory equivalence.⁵⁴ Indeed, identifying these technological guarantees makes it possible to leverage the intrinsic capabilities of blockchain technology without compromising the integrity of traditional regulatory frameworks.⁵⁵

As such, regulatory equivalence can be regarded as a proactive response to the inherent challenges faced by blockchain applications seeking integration with traditional legal and administrative systems. Regulatory equivalence stands in contrast to other concepts, such as regulation by design and compliance by design, which involve the ex ante implementation of specific legal requirements in technological design.⁵⁶ Rather than viewing compliance as a rigid adherence to predefined legal steps, regulatory equivalence encourages a forward-looking approach that explores innovative ways to achieve regulatory objectives in ways that simply could not have been foreseen at the time in which legislation was drafted.

Overall, this represents a shift towards a more dynamic and policy-oriented approach to regulation, fostering an environment where technological innovation and public policy can coexist harmoniously.⁵⁷ Yet, the pursuit of regulatory equivalence necessitates an intricate understanding of the relationship between technology and established legal frameworks. It underscores the need for greater legal flexibility and regulatory adaptability in the face of rapid technological advancements, recognizing that new technologies may offer alternative means to comply with policy goals. By focusing on policy objectives, regulators could assess the compatibility of blockchain technology with existing legal frameworks, ensuring that the transformative potential of these emergent technologies are harnessed to support, rather than violate the law.⁵⁸ Failure to address these dynamics may not only impede the legal compliance of blockchain applications but also risk stifling the innovative potential of this technology.

3 Opportunities and Challenges of Regulatory Equivalence for Blockchain

Having explained the concepts of functional and regulatory equivalence, this section presents the main opportunities and challenges of recognizing regulatory equivalence, using examples of blockchain-based notarization processes, DAOs, and privacy pools. The section concludes by considering the main obstacles to regulatory equivalence being recognized by regulators.

3.1 Opportunities

The pursuit of regulatory equivalence presents a series of opportunities for both regulators and regulated entities alike, who might benefit from the identification of new means of achieving public policy and legal objectives.⁵⁹ Yet, it also introduces a host of challenges stemming from the need to reconcile overarching policy objectives with the unique guarantees offered by emergent technologies.⁶⁰ In the realm of blockchain technology, achieving regulatory equivalence requires understanding the technological properties of blockchain systems, in terms of decentralization and disintermediation. One key challenge lies in the reconciliation of existing policy objectives with the requirements of pseudonymity, immutability, and tamper-resistance endorsed by many of these systems.⁶¹ This requires finding the right balance to ensure that such reconciliation does not compromise the fundamental principles of the legal system, nor the technological guarantees of blockchain technology.

Blockchain technology offers a series of technological guarantees that can potentially fulfill functions associated with traditional legal formalities. One interesting example of this is the undertaking of notarization processes with blockchain systems, where decentralized and cryptographic mechanisms could replace the need for a centralized trusted authority.⁶² Regulatory equivalence in this context requires establishing a comparable level of confidence, predictability, and security through technological means. This hinges on a few technological guarantees provided by blockchain technology. First, each block in a blockchain contains a timestamp and a cryptographic hash that links to the previous block, thereby producing an immutable and chronological chain of transactions, with cryptographic primitives ensuring the authenticity and integrity of all data recorded therein.⁶³ Recording the hash of a digital document into a blockchain transaction thus provides tamper-resistant proof that such a document or transaction existed at a specific point in time.⁶⁴ Second, because users employ cryptographic signatures to validate their transactions, the mere act of recording the hash of digital files into a blockchain transaction constitutes a secure and non-repudiable means of validating the source or provenance of these digital documents.⁶⁵

Third, the transparent nature of a public blockchain allows all participants to view and verify the recorded transactions. This transparency ensures that the information recorded on the blockchain always remains accessible to relevant parties, creating a shared and publicly verifiable record. This transparency can be regarded as equivalent to public record-keeping functions traditionally associated with notary services.⁶⁶ Combined with the technological guarantees provided by blockchain technology (in terms of cryptographic security, immutability, tamper-resistance, non-repudiability, as well as public timestamping), a blockchain can be regarded as achieving equivalent functions as traditional notary services, concerning document certification and fraud prevention, with at least an equivalent level of assurance and legal certainty.⁶⁷

Blockchain technology also offers a set of technological guarantees that can fulfill functions analogous to legal formalities required for traditional corporate entities. This can be illustrated through the example of DAOs.⁶⁸ As discussed above, unregistered DAOs do not enjoy the same benefits as traditional corporate entities and are generally assimilated to a simple form of general partnership.⁶⁹ The challenge here is to establish regulatory equivalence by aligning the policy objectives of legal provisions governing corporate formations with the unique technological guarantees of blockchain-based DAOs. The DAO Model Law⁷⁰ attempts to address this problem with regulatory equivalence, claiming that the transparency and immutability intrinsic to blockchain technology can fulfill, under specific conditions, the registration formalities that traditional corporations are legally required to abide by.⁷¹ First, a DAO is operated via smart contracts, i.e., self-executing code deployed on a blockchain. Once deployed, these contracts are executed by the blockchain network as a whole, meaning they cannot be unilaterally altered or tampered with.⁷² These smart contracts are therefore, to some extent, akin to legal documents associated with traditional corporate formalities, such as articles of incorporation, that do not have to be updated often.⁷³

Second, DAOs often use tokens to represent ownership and voting rights, where token holders participate in decision-making processes in proportion to their token holdings.⁷⁴ This mirrors the governance structures inherent in traditional corporate entities, where decisions are often made through shareholder voting or board resolutions.⁷⁵ Thus, token-based ownership and voting mechanisms can be regarded as a technological evolution of the paper and electronic share system in traditional corporations. Third, all transactions and decisions within DAOs are recorded on a public blockchain, acting as a transparent and publicly accessible record. This aligns with the policy objectives of corporate law, concerning disclosure requirements. The public accessibility of DAO records guarantees that stakeholders have relevant insights into the governance processes of a DAO, analogous to the transparency requirements in traditional corporate entities.⁷⁶ Finally, the immutability of a blockchain ledger functions as an additional technological guarantee to achieve regulatory equivalence, by maintaining a clear record of governance actions, that cannot be unilaterally altered or manipulated.⁷⁷

Privacy Pools provide another interesting example of an attempt at achieving regulatory equivalence. Privacy Pools represent an innovative approach that leverages cryptography and the technological guarantees of blockchain technology to strike a balance between maintaining user privacy in financial transactions while fulfilling analogous policy objectives as those underpinning the transparency requirements imposed by law concerning financial transactions.⁷⁸ Privacy Pools implement confidential transaction protocols that obfuscate the link between incoming and outgoing transactions. These protocols typically rely on ring signatures and anonymity sets, making it challenging to attribute transactions to specific individuals within the pool.⁷⁹ Yet, they also incorporate selective mechanisms that allow users to control the inclusion or exclusion of specific wallets in the pool.⁸⁰ This functionality is particularly relevant in the context of meeting the regulatory objectives of laws, for instance focused in Counter-Terrorism Financing (CTF), where users may seek to prevent association with wallets linked to criminal activities. Some privacy pools may offer users the ability to create and manage a whitelist of specific wallets that they trust or consider as legitimate counterparts. Others may offer a mechanism to exclude wallets associated with illicit or criminal activities by maintaining a blacklist.⁸¹ This feature enables users to proactively distance themselves from wallets linked to unlawful activities, aligning with regulatory objectives and contributing to a more secure and trustworthy environment within the privacy pool. Moreover, Privacy Pools can also incorporate mechanisms allowing for the selective disclosure of transaction details to specific entities (e.g., regulatory authorities), if desirable by the parties who took part in the transaction.⁸² Instead of a binary choice between complete transparency (as in the case of most public blockchains) or complete anonymity (as in the case of traditional cryptocurrency tumblers), selective disclosure mechanisms enable regulated entities to disclose specific transaction information, while still preserving the overall privacy of transactions.

3.2 Challenges

Despite their benefits, none of the technological artifacts described above have, thus far, benefited from regulatory equivalence. The lack of recognition for regulatory equivalence in these three examples can be attributed to multifaceted challenges that extend beyond the technological domain. Even if—technically speaking—blockchain solutions do implement some of the technological guarantees necessary to address a particular policy objective, a variety of factors have to be taken into account when establishing regulatory equivalence, including, but not limited to legal, economic, and sociopolitical considerations. Thus, even though the pursuit of regulatory equivalence presents opportunities for both regulators and regulated entities eager to promote and facilitate regulatory compliance, new challenges arise from the difficult reconciliation of overarching policy objectives with the distinctive properties of blockchain technology.

Despite early attempts by countries like Estonia to implement new forms of blockchain-based notarization within its e-residency program,⁸³ embracing regulatory equivalence in the context of public and permissionless blockchain systems is limited by three important challenges. First, while blockchains can provide tamper-resistant proofs and non-repudiable means of validating digital documents, challenges persist in verifying the identity of pseudonymous parties involved in transactions and ensuring that the parties have, indeed, properly understood the terms of the transaction.⁸⁴ Second, one must ensure that the blockchain network on which notarization services are provided is sufficiently secure not to compromise the robustness of technological guarantees, e.g., as a result of a 51% attack.⁸⁵ Third, and perhaps most importantly, recognizing regulatory equivalence for notarization services through disintermediated blockchain-based systems could be perceived as detrimental to public institutions due to the potential loss of revenue generated from traditional notary fees and services.⁸⁶

When it comes to the legal recognition of DAOs, the challenge lies in aligning the policy objectives of legal provisions governing corporate formations with the unique technological guarantees of blockchain-based systems. The DAO Model Law is an attempt to establish regulatory equivalence by showing that the deployment of smart contracts governing a DAO on a publicly accessible, transparent and immutable system can be assimilated to traditional registration formalities.⁸⁷ Yet, two important challenges remain. First, it is crucial to precisely stipulate the criteria for a DAO to qualify for legal recognition and how to ensure that these conditions remain true over time, even when the membership of the DAO—and therefore its governance—has changed.⁸⁸ Second, foregoing registration may be seen as disadvantageous for public institutions as it may result in a reduction of revenue typically generated through state registration processes for corporate entities, including fees for filing and incorporation.

Privacy Pools also encounter challenges in achieving regulatory equivalence due to the delicate balance between user privacy and transparency requirements. While privacy pools leverage cryptographic techniques to obfuscate transaction details while maintaining a certain degree of control over who can transact with whom,⁸⁹ challenges emerge in determining how these privacy features can coexist with the information disclosure needed for legal compliance, such as anti-money laundering laws.⁹⁰ The selective disclosure mechanisms must strike the right balance to satisfy both user privacy concerns and regulatory transparency mandates.

In sum, the reluctance of regulators to recognize regulatory equivalence in the field of blockchain technology can be attributed to various factors. One of the primary concerns is the perceived threats to the public institutions responsible for upholding and enforcing laws. The use of blockchain technology as a new mechanism for regulatory compliance may diminish the supervisional powers traditionally held by regulatory authorities and legal intermediaries.⁹¹ Indeed, the decentralization and disintermediation inherent in many blockchain systems, along with their self-executing and decentralized governance structures, may alter the dynamics of regulatory control, shifting decision-making power from centralized authorities to a distributed network of non-identified participants.⁹² This challenges the traditional hierarchical structure of law enforcement,⁹³ contributing to the reluctance of regulators to recognize the regulatory equivalence of blockchain artifacts to the policy objectives of existing legal frameworks.

A further concern with the recognition of blockchain technology as a means of regulatory compliance is the potential loss of revenue for public administrations. Existing regulatory processes often involve fees, taxes, and other revenue sources collected by public institutions. If blockchain technology can streamline or circumvent these processes, it could generate a direct financial loss for public services. This may further contribute to the hesitancy of regulators to acknowledge blockchain-based regulatory equivalence.

Finally, this hesitancy might also stem from the difficulty of ensuring that blockchain-based systems correspond to and uphold liberal democratic values.⁹⁴ The decentralized and pseudonymous nature of blockchain technology, while offering unique advantages, may conflict with principles of fairness, equality, accountability, and public scrutiny inherent in liberal democracies.⁹⁵ Regulators may be concerned that recognizing regulatory equivalence in blockchain systems could inadvertently lead to the creation of new, non-publicly accountable intermediaries within the blockchain ecosystem—such as miners, validators, token holders, or other relevant stakeholders. We discuss this further in the section below, by expanding on the legitimacy of blockchain-based guarantees in the context of regulatory equivalence.

These challenges show that establishing regulatory equivalence in the blockchain landscape requires striking a delicate balance. Regulators must carefully weigh the benefits of a blockchain’s technological guarantees against the potential threats to established authorities, democratic values, and existing revenue models. This requires a nuanced understanding of the interplay between the explicit policy objectives recognized by the law, and the more implicit political and economic considerations underpinning these laws. Those advocating for regulatory equivalence must therefore engage in careful consideration to demonstrate how a blockchain system is not only an analogous (or advantageous) alternative to existing legal formalities but also provides economic and political equivalents to the functions traditionally served by these legal formalities.

4 Public Values and Legitimacy of Blockchain Technology

In the preceding section we explained the opportunities and challenges of recognizing the technological guarantees of blockchain systems as being regulatorily equivalent to the objective enshrined in existing laws and regulations. In addition to the complexities inherent in understanding the technological properties and consequences of blockchain artifacts, public authorities may also be concerned that recognition of regulatory equivalence for these artifacts would not be seen as legitimate, to the extent that doing so would be contrary to public values. In this section, we evaluate the extent to which the technological guarantees provided by blockchain-based systems can conform to public values and thereby be considered as legitimate means of achieving specific regulatory objectives. Subsequently, we consider reforms that, in the spirit of co-creation and co-regulation,⁹⁶ would enhance the legitimacy of these technological guarantees and consequently enable the recognition of regulatory equivalence in blockchain systems.

Public values are at the heart of several definitions of the concept of legitimacy. In Max Weber’s famous articulation of the concept, the authority of a political system is considered to be legitimate if the exercise of power is congruent with the values of the people that are being governed by the system.⁹⁷ Similarly, Talcott Parsons acknowledged that consistency between the values of governors and the governed can help generate legitimacy within a political system.⁹⁸ As such, the legitimacy of power arises from powerholders exercising power in conformity with what is perceived as being proper or desirable in a broader, socially constructed value system.⁹⁹ Margaret Levi expands on this further, by adding that beyond the governors and the governed sharing higher-order values and moral principles, there need to be mechanisms for the governed to have a voice in governance.¹⁰⁰ Naturally, public values differ across societies. What may be deemed to be legitimate in one society, may not be deemed to be legitimate in another due to differing value systems. Values that are deemed to be important in liberal democratic political systems, may not always be considered appropriate or desirable in the context of blockchain systems (‘Web3 ecosystems’).¹⁰¹ Relatedly, there are dramatic differences in the ways in which various systems enable input into governance processes, and the weight they give to different forms of input.

The topic of legitimacy has long been discussed in political science and legal theory, but it has also generated considerable interest in the Web3 ecosystem following the publication of Ethereum co-founder Vitalik Buterin’s blog post ‘The Most Important Scarce Resource in Blockchain: Legitimacy’ in 2021.¹⁰² As coercion is more difficult in public permissionless blockchain-based systems relative to traditional political systems (given the ease with which it is possible to exit these systems and the opportunities there are to contribute to the development, maintenance and governance of these open-source technologies), the conditions for the existence of legitimacy also differ. For Buterin, legitimacy in the Web3 ecosystem emerges from a community’s acceptance of a blockchain system, which can be indicated by the continued usage of the system and the capital mobilized into the system. Indeed, in an ecosystem where participation is voluntary, legitimacy acts as a social glue that keeps users loyal to the system and helps generate the network effects necessary for the system to be viable.¹⁰³ There are various ways in which legitimacy can be established in a blockchain system—from the exercise of force by a charismatic authoritarian ruler to broad-based participation—but their appropriateness will be determined by the values of that system. “Brute force”, for instance, is unlikely to be desirable, or even feasible, in a Web3 ecosystem that values “freedom”, “decentralization”, and credible neutrality¹⁰⁴

So far, we have discussed legitimacy in Web3 ecosystems in terms of endogenous legitimacy, i.e., the perceptions of communities within those ecosystems. However, exogenous legitimacy, i.e., how Web3 ecosystems are perceived by external actors, such as the state, has not yet been addressed. The perception of external actors turns on the type of legitimacy they are concerned with. Dimitropoulos,¹⁰⁵ for instance, explains that the use of blockchain technologies for humanitarian purposes by international organizations may be perceived as being legitimate by the public from a substantive and output-oriented view, to the extent that they can improve the efficiency of aid disbursement processes and promote certain ideals such as upholding human rights. However, this use may be perceived as being illegitimate by the public in terms of input and procedural legitimacy, given the potential lack of meaningful input from vulnerable groups and public actors when designing the system.¹⁰⁶ This shortcoming is increasingly present in humanitarian projects where international organizations have begun using private, permissioned blockchains—thereby inhibiting who can contribute to and decide on their development.

However, even if humanitarian applications were built on public, permissionless blockchains, there may still be concerns about the extent to which the views of vulnerable groups and public actors are given consideration, relative to those of private actors in Web3 ecosystems, such as software developers and (at least indirectly) miners and validators.¹⁰⁷ Reinsberg concedes that blockchain systems could entrench existing power asymmetries but is more optimistic than Dimitropoulos about their input and procedural legitimacy, especially when it comes to global climate governance.¹⁰⁸ According to him, the use of blockchain-based systems could not only broaden the number of people who can read or record blockchain transactions, but also diversify the sources of data to directly include local, marginalized communities affected by climate change (e.g., through the use of oracles). This can contribute to more democratic legitimacy and accountability of global climate governance, and more broadly, prefigure a “more liberal” global governance system.¹⁰⁹

Accordingly, the extent to which the use of blockchain-based systems by organizations is viewed as exogenously legitimate clearly depends on multiple factors. The examples mentioned above are, at least ostensibly, designed for beneficial social purposes, thereby benefiting from more positive perceptions about their substantive and output legitimacy. In contrast, the various speculative financial applications of blockchain technology, through which many people have lost their savings, may not be perceived in the same way by external actors as they are by those who voluntarily take on the risks of such transactions.

As a general rule, the existence of both input and procedural legitimacy appears to be a common requirement for both endogenous and exogenous legitimacy. Yet, the values underlying endogenous legitimacy and exogenous legitimacy may differ.

Take, for example, the concept of credible neutrality. Buterin refers to the concept of credible neutrality as describing a situation where a large, heterogeneous group of people are convinced that a technical system does not discriminate for or against anyone. He provides the example of private property as a credibly neutral mechanism, because, in his view, it is a right enjoyed by all, and its existence “solves a lot of problems in society”.¹¹⁰ He then goes on to provide a set of principles for designing credibly neutral mechanisms, which are largely procedural in nature: e.g., not writing specific people or outcomes into the mechanism, being open source, publicly verifying the execution of the software, keeping the mechanism simple, and not changing the technical rules of the mechanism very often—which he considers to be important features of blockchain-based systems.¹¹¹

In the political domain, neutrality, and the related concept of impartiality, are important public values necessary for the realization of the rule of law and the administration of justice. In that sense, the use of blockchain-based systems can help uphold rule of law principles.¹¹² However, other principles, such as equity—including the idea of equitable access and representation—are also important public values in many liberal democracies. In addition to civil rights legislation that prohibits discrimination on the grounds of race, nationality, skin color, religion, sex, and sexual orientation (e.g., US Civil Rights Act of 1964),¹¹³ there are many laws that seeks to empower traditionally disadvantaged and marginalized groups by positively discriminating in their favor (e.g., the Constitution of India allows the State to reserve civil service jobs for scheduled castes, tribes, and other “backward class of citizens”).¹¹⁴ The social and economic development of all citizens can thus be considered a public value, which allows for the meaningful use of equal opportunities—itself another key liberal public value. Consequently, for a state that practices positive discrimination, the fair outcome from the use of a blockchain-based application may not necessarily be to treat everyone equally—as Buterin argues—but may rather require favoring certain groups. More broadly, we can conclude that political systems and Web3 ecosystems may have different criteria for determining the existence of input and procedural legitimacy, due to their differing value systems. Indeed, as Brummer has recently pointed out that in setting policies for financial regulation states may have conflicting policy goals (e.g., market integrity, financial innovation, and financial inclusion),¹¹⁵ all of which may not be able achievable at the same time. This clash or incompatibility in values can contribute to an unwillingness on the part of regulators and policy makers to recognize the regulatory equivalence of blockchain artifacts.

Moreover, there may be latent public values that have yet to be explicitly articulated. Accountability, for instance, is a public value that is central to public governance.¹¹⁶ However, the type of accountability that is typically discussed presupposes the existence of a trusted authority that can be held to account, such as a particular organ or entity of the state in the case of public governance. This understanding of accountability is difficult to transpose to a distributed network in which trusted authorities are eliminated, and in which holding network participants (e.g., core developers) individually account for harms arising from the operations of a technological system can lead to unjust outcomes.¹¹⁷ The vast majority of regulatory efforts targeted at the Web3 ecosystem have sought to identify and regulate the network participants that act as chokepoints (e.g., crypto-asset service providers in the EU’s Markets in Crypto-Assets Regulation), or, when there are no apparent chokepoints, they have held some entities to be trusted authorities on weak grounds (e.g., the US OFAC sanction against the purported ‘organization’ behind the Tornado Cash software system).¹¹⁸ While this regulatory approach may be effective in deterring certain malevolent actors and transactions, it casts a wide net which could also inhibit socially and economically beneficial activities (e.g., open-source software development) due to the increased costs of compliance and risks of penalties.

As regulators typically have a difficult time mapping the myriad participants involved in a public, permissionless blockchain system, and identifying their particular roles in this system, they often treat them with suspicion. There is, therefore, a natural hesitation to recognize new ways of achieving public policy objectives through blockchain technology.

Take, for instance, the implementation of the DAO Model Law in the state of Utah in the United States. While Utah’s DAO Act, for the most part, closely adheres to the text of the model legislation, there are certain key differences. One of these changes is the requirement that DAOs appoint a registered agent in the state of Utah to receive service of legal documentation and other communication from the State.¹¹⁹ Such a registered agent acts as an intermediary between the state and a legal entity, while also drawing local income from newly recognized DAOs. This choice reflects the need for state governments to identify an intermediary, and their desire for corporate entities to use local public and private services. In other words, the DAO Model Law provisions describing how blockchain technology could provide a technological equivalent of a registered agent requirement, for instance through direct service and notice to the DAO online, were not seen by legislators as being regulatorily equivalent to the public policies that animate the need to have registered agents. To uphold the public value of accountability, in the traditional conception of the term, a local physical connection between the DAO and the state had to be maintained.

In order to maximize the opportunities for regulatory equivalence to be recognized, one must not perceive the Web3 ecosystem to be in conflict with the political system, but rather in a competitive discovery process for facts that were previously unknown,¹²⁰ most notably concerning the public values that public actors seek to uphold but have not before been explicitly specified. As earlier literature critiquing the use of blockchain technologies in public administration has pointed out, there is a need for widely accessible forums of public debate to deliberate on major updates and developments,¹²¹ as there is in other domains of public administration (e.g., building new highways). Such forums could help prevent the development of this technology (and the interpretation of laws relating to it) being guided by technical or domain experts but encourage the participation and input of laymen and policymakers who may be otherwise hesitant to comment on technical issues.¹²²

The discovery and explicit articulation of these values could strengthen co-regulatory efforts in the path towards achieving regulatory equivalence. Indeed, in response to a clearer understanding of public values, it becomes possible to improve the technological design of blockchain systems in order to provide more advanced technological guarantees. Moreover, explicit public values can help shape the endogenous social norms within Web3 ecosystems, translating into voluntary (yet coordinated) efforts by web3 practitioners and industry players to address these public values through technological design.¹²³ For instance, in an effort to achieve both procedural and input legitimacy, Web3 ecosystems may develop Web3-native forms of accountability, which are more suitable to these new types of technological artifacts. Similarly, blockchain-based systems could be designed to incorporate rules that further human liberty and agency—values that are cherished in both traditional political regimes and Web3 systems.¹²⁴ Good faith efforts in this regard are likely to encourage more public authorities to see the merits of recognizing regulatory equivalence.

5 Conclusion

In this chapter, we first explained the concepts of functional equivalence and regulatory equivalence, distinguishing them from the notions of technological neutrality and regulation by design respectively. We then turned to the opportunities and challenges presented by blockchain artifacts as a means to achieve regulatory equivalence, noting that official recognition of this regulatory equivalence by lawmakers and public authorities is currently very challenging. The following section showed the centrality of public values to many major conceptions of legitimacy, drawing on various conceptions of legitimacy—as well as the interplay between endogenous and exogenous legitimacy—to show how the political system of public authorities and the Web3 ecosystem may have both convergent and divergent values. While substantive values are more likely to differ, both systems consider that procedural and input legitimacy should be attained. However, there may be differences in how such legitimacy should best be attained based on contrasting sets of values. The examples of ‘credible neutrality’ versus ‘positive discrimination’ were provided as potentially conflicting values between the Web3 ecosystem and liberal political systems. Similarly, different understandings of the concept of accountability across coercive centralized systems and non-coercive distributed systems might impinge upon the recognition that the Web3 ecosystem can also guarantee a degree of accountability. This clash of values can lead to inappropriate, even unjust, forms of regulation and foil attempts at having regulatory equivalence recognized.

Thus, for the full potential of blockchain technology and Web3 systems to be realized, there needs to be an ongoing dialogue between public authorities and the Web3 ecosystem. Indeed, the interplay between these two can be seen as a process for discovering and articulating implicit values that are not explicitly enshrined into the law, thereby contributing to enhancing mutual understanding and ideally bridging the gap between these divergent value systems.

Ultimately, recognizing the legitimacy of blockchain systems requires both sides to adapt: lawmakers must be open to new forms of accountability and transparency, while the Web3 community must strive to meet regulatory standards without compromising their foundational principles. Regulators providing more guidance on how Web3 communities can be made exogenously legitimate can enhance efforts from Web3 practitioners at finding ways to design blockchain-based systems in ways that would provide better regulatory equivalence. Only through this cooperative approach will it be possible to develop a regulatory framework that respects the innovative nature of blockchain technology while ensuring it aligns with broader societal values.