The role of regulators in accelerating Web 3 innovation

Financial institutions see the potential that Web 3 technologies can bring to their industry but are seeking regulatory guard rails before they have the confidence to invest in Web 3.

The lack of a regulatory framework in some scenarios could be viewed as a golden opportunity for players in the financial services world – an industry that typically sees heavy guardrails, controls and reporting (albeit for valid reasons). However, given the somewhat ‘wild west’ perception of Web 3 the industry is keen to see some bold steps being taken by regulators to help forge the path and enable real progress to be made with investments into Web 3. Our clients have spoken to us about the excitement Web 3 technology brings but also their hesitancy to commit resource to it considering the lack of regulatory steer.

Web 3 is fundamentally a ‘standing on the shoulders of giants’ endeavour. Exciting foundations have been laid and undoubtedly create a world of opportunity within banking. But encouraging commitment to innovation and sandbox development requires regulators to provide direction.

Regulation will help cement industry confidence in the potential of Web 3

The response of global regulators to Web 3 is mixed. Some countries have stronger frameworks than others, but most regulators are still trying to grasp the implications of new Web 3 technologies, with many reaching for their existing playbooks. The pattern seems to be defining cryptocurrency assets in such a way where they fall under existing rules and then bolstering existing regulations. For instance, since 2020, businesses seeking to deal in cryptoasset activity in the UK need to be registered with the FCA under the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017. Existing regulations for financial products are expanded to incorporate new digital assets.

These existing regulatory playbooks are designed for a highly centralised, controlled economy and Web 3 represents economic freedom and the ability to interact directly, anywhere, seamlessly. To ensure a resilient market when incorporating digital assets into regulatory guardrails regulators will need to address three key issues.

1. New players on the scene

Web 3 involves a very different set of players. There will be no centralised counterparty who has access to funds and the ability to rehypothecate them. Instead, users will interact and contract with networks.

Existing regulatory frameworks do not translate effectively when a network is owned, maintained, developed, and governed by a community of pseudonymous individuals. The lack of a clear counterparty to engage with, and no direct channel to enforce compliance action raises several challenges.

2. Creation of a global standard

Web 3 is, by definition, borderless and key players are likely to be distributed across the globe. At a minimum, this increases the need for a global standard and consistent regulation across bodies. Any potential for regulatory arbitrage must be avoided – given the Web 3 ecosystem, a fragmented regulatory structure could give way to this opportunistic behaviour. Jurisdictions must work in conjunction with global exchanges, decentralised finance protocols and organisations such as Global Digital Finance to define a new standard.

3. The need for agility

Composability (i.e. the ability for a developer to consume parts of other developer’s applications) has been compared to compounding (according to Einstein, the ‘eighth wonder of the world’) due to the exponential opportunities to be created. The use cases we primarily see today will be vastly different to the use cases of the future. Regulators will need to ‘see around corners’ or at least be able to lay relevant guardrails down to enable responsible innovation.

To design an effective framework, regulators must work with the industry (and each other) more than they ever have and must be open to new ways of working. The technology is evolving fast and will redefine the concept of ownership – building a smart and prudent set of regulation will be no small feat.

The common thread of Web 3 related regulation globally has centred around the protection of consumers, arguably a strong but safe place to start. This doesn’t help lay foundations for banks to invest in the most transformative elements of this disruptive technology. In turn, this means society only sees surface level or hypothetical benefits of a Web 3 world.

It is true that understanding of Web 3 is still developing. This opens the door for risk to consumers, partially why we’ve seen global focus on cryptocurrency marketing and advertising, ensuring digital assets are subject to disclosure guidelines and custody requirements. Whilst we believe that the consumer protection angle will (and should) continue to receive focus, there also needs to be thought around tokenisation, real time flows and permissionless assets. Regulators must provide comfort to the industry that they understand the full stack of technology enough to continue to protect the market.

There is an equal and opposite requirement to innovate and push the boundaries of technology, just as there is a need to form clear rules of engagement. But there is a risk that the solution to solving regulator challenges will come at the cost of the benefits that the technologies being offered. The regulators that manage to balance this and embrace the promise of technology will deliver most value to the industry.

The time is now for a new evolution of regulation in the Web 3 space

A shift in Web 3 regulation will enable the environment to become one far more attractive to invest in. There is a golden opportunity to take advantage of the ground-breaking elements of Web 3 to introduce a new regulatory paradigm. One that embraces this new innovation to realise industry benefits whilst ensuring market and consumer protection. The sooner we see something bold and with clear direction, the sooner banks can start to operate with intent and action, ultimately benefiting everyone.

To find out more about how we can help you understand the Web 3 regulatory landscape, please get in touch with us.