What might the “carrot” of crypto regulation look like?

tl;dr: if you can’t read a thousand words then you’re ngmi

When looking at the regulation of crypto, saying that the SEC has favoured the “stick” over the “carrot” approach is almost an understatement. It would probably be more accurate to say that the SEC has taken the “piñata” approach. Taking ostensibly completely random enforcement actions against randomly selected market participants, with no prior warning, no guidance, no collaboration with the industry, and no attempt to justify either their choice of targets or their actions against them.

This has fed into existing anti-regulatory sentiment within the crypto space and resulted in a pretty hostile mutual relationship between crypto builders/users and the various regulatory agencies that are claiming to have jurisdiction over them. The most salient flashpoints of this tension have come up in the actions against Tornado Cash, the arrest (still without formal charge) of Tornado Cash representative Alexey Pertsev, and accusations against Sam Bankman Fried (and his empire) of working behind the scenes with government to undercut rivals, hobble DeFi and fix his centralised businesses in positions of power and influence.

In short, things have been pretty acrimonious recently between crypto idealists and government regulators. But is this an inevitable consequence of crypto’s permissionless and open nature, or is there a way that regulatory control could actually be embraced by crypto users. In other words, is there a “carrot” way to get crypto users to willingly adopt regulation?

There is a convergence of various technological components that leads me to believe that such a carrot is possible. These factors are non-transferable tokens (Vitalik’s “soulbound” tokens), privacy preserving attestations (DECO) and the inevitable integration of decentralised systems with tradfi.

But instead of boring you to death with the details of those technologies, I will focus instead on what using them might look like. It would be something like this: You provide all your KYC information to an entity, it might be a central government solution or it might be a decentralised identity solution like CanDID. In return for “proving” that you are you, you get a non-transferable KYC token transferred to your wallet.

This “KYC token” doesn’t reveal your personal information to anyone that you don’t want it to, and it doesn’t have to reveal all of your information all at once. Think of it like a locked ZIP file on your computer that has completely customisable access. If you want more details on how this actually works, Dahlia Malkhi’s recent SmartCon presentation on DECO is one of the most seminal and revolutionary steps forward in privacy preserving technology in years, and I think it’s criminal that it still has fewer than 4,000 views.

So basically you get this token in your wallet that can’t be transferred, that contains your personal info, and that can be used in a customisable way to “prove” various things about yourself to various smart contracts. So if it proved your nationality, for example, it could be used to access smart contracts that are limited in terms of the nations that are legally allowed to access them.

If you’re a crypto purist you might look at this and wonder why you would opt in. Under the current system you can access any smart contract without restriction, why would you voluntarily dox yourself in a way that is only going to limit you from engaging in some crypto behaviours that you might otherwise want access to?

I think this is where the integration with tradfi is going to come in. The inevitable convergence of legacy and Web3 systems will allow for new products that will be, quite simply, awesome. An example of this would be, say, keeping a certain amount of money in a Web3 automated yield farming strategy (like YEARN) where the interest earned on your initial is automatically directed to pay off a mortgage you have gotten from a legacy banking institution. So your crypto interest goes to pay off your mortgage, and there is no friction where you have to “jump” between legacy and Web3 (or between “normal money” and crypto) because that distinction has been abstracted away.

But the only way that such an integration is possible is if the relevant governments have assurances that the people accessing and interacting with those tradfi products are who they say they are. And by far the best way for you to have a doxxed wallet is to do so in a way that actually protects your privacy to some degree. It’s worth noting that this isn’t just pie in the sky speculation. Recent EU guidance on DeFi regulation alludes to this exact thing (see bottom of page 45 here):

https://op.europa.eu/en/publication-detail/-/publication/f689e5b2-4f55-11ed-92ed-01aa75ed71a1/language-en/format-PDF/source-272370364

So at the start most crypto purists won’t want to go through the process of getting this KYC token, and I think it would be severely misguided for governments to pursue a “stick” approach to this (for example: Get a KYC token or we will fine you).

The carrot approach will be much more effective. “If you get the KYC token, and it can show you are who you say you are, then you will have access to an entirely new playground of financial products that move seamlessly across the tradfi/Web3 boundary. Use your blue chip NFTs as collateral for a car loan. Pay for half your house with Bitcoin and get a mortgage for the rest that pays automatically from the yield earned from staked Ethereum, etc.”

This sort of “look what you’ll be able to do while still generally preserving your privacy” incentive is much more powerful than a hostile and retroactive regulatory regime, it’s a carrot so tempting that it would cause the vast majority of DeFi users (who are generally, after all, neither North Korean hacker or criminals) to adopt this system. Whether there is large-scale consumer support for such a solution really comes down to how well people understand the trade-offs, what they lose by KYCing themselves vs what they stand to get. At any rate, it’s a good idea to start thinking about it.