19 Sep 2023
by Khillan Gohil, Paul Nightingale, Prakash Kerai

Innovation vs regulation - Web3

Guest blog by Prakash Kerai, Paul Nightingale and Khillian Gohil at Shoosmiths. Part of techUK's #SuperchargeUKTech Week 2023.

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At a Web 3.0 Symposium hosted by the Digital Regulation Cooperation Forum (“DRCF”) in October 2022, one of the questions posed was “how can we best encourage responsible innovation in relation to decentralisation and / or distributed ledger technology applications?” Encouraging “responsible innovation” in Web 3.0 and metaverse technologies is a thornier topic for regulators than it might at first appear. Building trust among stakeholders and the general public needs an effective and transparent regulatory framework that helps protect individuals while fostering innovation in a safe and sustainable manner. Getting to this point, however, poses many challenges. This article explores why regulation of the Web 3.0 and metaverse spaces is required, and looks at the risks around implementing a regulatory regime that could be too prescriptive or too flexible. 

Navigating Regulatory Challenges 

The Role of the Regulator 

Regulators are tasked with setting participant-agnostic policy, while monitoring and enforcing standards in a particular area. The DRCF notes how the role of the regulator is changing amid developments in technology: “our roles as regulators are becoming increasingly important to ensure that consumers’ and citizens’ interests are at the heart of digital innovation”. In the context of Web 3.0 and metaverse technologies, regulators need to create frameworks that strike a balance between preserving the flexibility for innovation and minimising the potential risks.  

Regulation is required 

While a flexible regulatory approach is often welcomed by developers, the success of emerging technologies depends on consumers and stakeholders having sufficient trust in the markets. Recently we have seen how this trust can be eroded. For example, the FTX collapse (termed by Damian Williams as “one of the biggest financial frauds in American history”) resulted in a significant loss of confidence in emerging digital markets and reduced appetite for investment. This scandal highlighted the need for regulators to consult with stakeholders to develop effective regulatory frameworks. Without consultation, regulators risk creating frameworks which are not fit for purpose, or which negatively impact confidence in emerging technologies. Conversely, if following consultation stakeholders wish for markets to be unregulated, they must accept the risk that without effective regulation they will not be afforded protection in another scenario like the FTX collapse. If scandals become more frequent, trust in emerging technologies will continue to be eroded. 

Although the FTX collapse negatively impacted trust around digital markets, it did accelerate the idea that greater regulatory oversight may be required.  Sir John Cunliffe of the Bank of England noted that, while crypto technologies have the potential to improve efficiency, functionality, and reduce risk in the financial system, they “will only be… adopted at scale when they sit within regulatory frameworks that can effectively manage their risks”. The need for regulation is true of the metaverse as well as crypto – in a 2023 survey by BCS, the UK’s Chartered Institute for IT, 81% of respondents believed that the metaverse would create new regulatory challenges, and over two-thirds said they were concerned about safety issues. 

To build trust and confidence in these technologies, then, regulators must implement and maintain adaptable frameworks. Below, we discuss the merits of various approaches.  

Can regulation be too prescriptive? The response to the European Union Artificial Intelligence Act. 

Historically, regulation has struggled to keep pace with emerging technologies. The EU’s AI Act, proposed in April 2021, aims to establish a comprehensive framework for governing artificial intelligence (AI), with one of its stated goals being to strike a balance between safeguarding fundamental rights and fostering innovation. However, the Act’s initial draft failed to anticipate the rapid rise of large language AI models (LLMs), such as OpenAI's ChatGPT, and the Act was subsequently revised. It now imposes obligations on LLM developers, such as requiring them to register their products, undergo risk assessments, and meet transparency requirements around copyright.  

In an open letter to the EU, over 150 executives from Europe’s largest companies expressed concern about the AI Act’s potential to “jeopardise Europe’s competitiveness and technological sovereignty”, arguing that the Act will “lead to highly innovative companies relocating their activities to non-European countries as well as investors withdrawing their capital from the development of… European AI in general.”   

This highlights how well-intentioned efforts to regulate transformative technologies can face resistance from the very industry players they seek to reassure. The uncertainty around what was to be an all-encompassing Act risks creating friction between regulators and technology companies in the short term and having even more damaging effects on innovation in the long term. This is potentially instructive for regulators dealing with other emerging technologies like Web 3.0 and the metaverse. 

Flexibility is key. The response to the Digital Securities Sandbox (DSS) 

The UK’s consultation for its DSS (the first financial market infrastructure sandbox delivered under the Financial Services and Markets Act (FSMA) 2023) takes a different regulatory approach. The DSS is designed to temporarily disapply and/or modify existing legislative frameworks, with the prospect of such modifications later becoming permanent. Participating entities can test and scale their technologies, while regulators are provided with the flexibility to set requirements that can be adapted as activities within the sandbox evolve. So, instead of being an all-encompassing legislative framework at the outset, the DSS provides a controlled framework in which to test emerging technologies and modify legislation as and when appropriate.   

This flexibility is available to UK regulators due to a fundamental difference between the UK and the EU legislative frameworks: FSMA 2023 gives the Financial Conduct Authority (indirectly) the power to codify its statutory agenda without amendments to primary legislation, which would take years to agree at a political level, and enables the UK court system to interpret the existing rules as they stand; the EU institutions do not have this luxury. 

Stakeholders have welcomed the DSS’s flexibility as a “significant potential strength”. In its response to the DSS consultation paper, UK Finance called the flexibility a key differentiator to the EU’s own distributed ledger technology pilot scheme, and questioned whether the EU’s prescriptive approach can “truly support innovation”.  

The DSS highlights the importance of implementing regulatory frameworks that encourage and facilitate innovation. This does not, however, mean adopting a laissez-faire approach. In the absence of robust regulatory frameworks, there is a risk that the digital markets created by Web 3.0 and metaverse technologies become a “Wild West” where criminal activities such as fraud and social-engineering scams flourish and the severity of hate speech and misinformation escalates. 

Conclusion  

Regulating emerging technologies like those in Web 3.0 and the metaverse is crucial, but doing so in an effective manner presents a tricky balancing act. As the FTX collapse shows, rules are needed to deter “bad actors” from exploiting new technologies to engage in illicit or criminal activities that could cause financial harm to unwitting users. However, overly strict regulations can spook developers and investors and potentially restrict innovation. 

More flexible approaches, like the one taken by the DSS, seem to strike a better balance. However, it remains to be seen whether the actual implementation of the sandboxes under the DSS will garner the same positive support. We are hopeful this will be the case. 

Ultimately, for Web 3.0 and the metaverse to take off as viable technologies at scale, it is essential that developers, regulators, and other stakeholders are able to build a sufficient level of trust in them. This will require effective, adaptable regulation that both adequately protects the public and continues to encourage innovation. Finding the right balance is challenging but vital for the safe and sustainable growth of Web 3.0 and Metaverse technologies in the UK and beyond. 

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Authors

Khillan Gohil

Khillan Gohil

Associate, Shoosmiths

Paul Nightingale

Paul Nightingale

Principal Associate, Shoosmiths

 Prakash Kerai

Prakash Kerai

Partner, Shoosmiths