Polygon Labs’ Response to the OSTP RFI Seeking Comments on Digital Assets Research & Development

March 3, 2023 

For additional information about this response, please contact: 

Policy Team 

Polygon Labs 

policy@polygon.technology

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About Polygon Labs 

Polygon Labs is a software development company that builds blockchain network scaling solutions and complementary software to enhance the user experience in a blockchain-based Internet (also referred to as “web3”). Our mission is to provide more efficient and open blockchain infrastructure on which developers and the community can build and bring web3 to billions globally. 

Over the last several years, Polygon Labs invested significant time and resources into promising early stage technologies that improve Ethereum by increasing transaction speeds and decreasing transaction costs. To date, these efforts have been able to reduce blockchain transaction costs to the point where transactions on the Polygon network typically cost less than one cent (cf. the average Ethereum transaction), and Polygon Labs continues to build on and improve these technologies. 

The builder and user community has shown great receptivity to the benefits of the Polygon network. As of the end of 2022, developers had deployed countless applications on top of the Polygon network. These applications span various fields and industries, including healthcare, education, social media as well as decentralized finance (“DeFi”).

Although the technology is still at an early stage and may present some risks and limitations, research and development (“R&D”) efforts from the U.S. government - like that of the Office of Science & Technology Policy (“OSTP”) through the “Request for Information: Digital Assets Research and Development” (“RFI”) - will provide additional insight and assist with building evergreen legislation relating to blockchain technology. We agree with the RFI that “[r]esponsible innovation in digital assets could provide significant benefits for the American people” and believe open dialogue with industry will facilitate innovation while ensuring the technology’s safety and soundness, especially as it relates to the users.

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Introduction and Recommendations 

As the RFI recognizes, web3 – an Internet powered by blockchains – has the potential to transform the economy. Although the Internet has already made great strides in bringing more individuals and businesses into the U.S. (and global) economy, a blockchain-enabled Internet will further reinforce this trend. Digital assets coupled with the broad ecosystem of blockchain technology and attendant applications built thereon will enable this innovation to add value to the U.S. economy. For that reason, Polygon Labs’ response to the RFI (the “Response”) focuses on blockchain-enabled applications – many of which are powered by digital assets – and not solely on digital assets themselves. 

Web1 (1980s-2005) gave us the core infrastructure (“protocols”) on which the current Internet is based and is freely accessible by anyone (“open”). In web2 (2005-2020), large technology companies built proprietary, closed protocols on top of the open Internet infrastructure and monetized these business models. This made them the “gatekeepers” of the Internet and gave them an ability to “commoditize users” — i.e., requiring users to relinquish control over personal data, intellectual property, and choice to access basic websites.

Web3 (2020+) is a return to the web1 ethos, with a determination to avoid the centralization of web2. It cultivates an ecosystem of projects that use open blockchain infrastructure for building and connecting. Rather than promoting predatory big tech intermediaries, a blockchain-enabled internet allows users to be stewards of their rights, including over their personal data, personally identifiable information, intellectual property, and financial well-being. Whereas this period seems to have kicked off in earnest in 2008 with the publication of the Bitcoin Whitepaper, the development of web3 infrastructure and applications has proliferated exponentially, particularly over the last five years. 

Now, instead of simply blockchain networks, web3 comprises blockchain infrastructure solutions (“layer 2 networks” or “scaling solutions”), DeFi, decentralized social media, gaming, and other applications. Since 2018, monthly active developers have increased +297% (now averaging 23,000 monthly developers), and this accounts for the drop in overall value of the market within the past year.

The significant growth can develop further in an economic and regulatory environment that seeks to foster innovation, while protecting users and ensuring market integrity.

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Questions Posed in the RFI 

(1) Goals, sectors, or applications that could be improved with digital assets and related technologies. 

A blockchain-enabled Internet can improve significant aspects of our society. Many of these improvements have been discussed at length over the past decade – e.g., financial inclusion, efficiency in transactions, etc. 

One of the more recent innovations with blockchain technology is the advent of “web3 social” – social media and networking protocols that return autonomy to users over all aspects of their social media experience. For that reason, the Response highlights the ways in which web3 social will positively impact individuals’ social media experience. 

In the current web2 world, users must relinquish their rights – over personally identifiable information and intellectual property – to receive access to interact with a website. Blockchain-enabled applications – whether they utilize digital assets or not – will return control over these valuable rights to users, increasing autonomy over their digital footprint and presence. 

Limitations in current web 2 social and networking applications. 

Big Tech tracks user data through browsing history, location, emails, among other means – whether covertly (e.g., search engines) or overtly (e.g., forced acceptance of “cookies” for most websites). Technology companies then use and sell (for profit) this data for advertising, marketing, or personalizing the browsing experience. In certain instances, this data collection may produce some benefit to users (e.g., better suggestions for shopping), but this benefit is only a byproduct of technology companies seeking to maximize their revenues. One study found that when looking at iPhone applications that may appeal to children, two thirds of those apps harvested data on how children interacted with the app and sent that information to the advertising industry. This may explain why in 2021, the estimate for children’s advertising in the U.S. grew to $2.9 billion and is expected to reach $21.1 billion by 2031.

Outside of tracking personal data, Big Tech also exercises similar amounts of control over a user’s generated content (“UGC”). Many individuals contribute reviews and other types of UGC to a variety of sites like social media, crowd-sourced reviews platforms, personal blogs, among others. UGC allows users to create a “database” of content (whether visual or written) while simultaneously garnering an audience and building an online presence and reputation. However, a user’s online presence is tied to a specific platform because both the UGC and following are non-transferable to other platforms. 

This helps Big Tech companies to build a user base through network effects (the more users join the platform, the more appealing the platform becomes, and the more users join) while maintaining control of this user base by “locking in” users to their platform. In this sense, Big Tech exercises ownership over all the user’s UGC while also leveraging the user as a personal, profit-generating tool without offering any compensation. 

The same is true as it applies to a user’s intellectual property. Online, two forms of intellectual property come into play: “formal” and “informal.” In the formal system, different types of IP (e.g., trademark, patent) require different types of legal frameworks, making the system fragmented and complicated. The informal system relates to UGC, in which no legal frameworks or recognized rights exist. This allows Big Tech to “own” all a user’s content, following, and therefore, the user’s entire presence on a given platform. 

Where blockchain provides benefits in web2 social applications. 

In blockchain-based/web3 social or networking internet applications, users reclaim control over their internet experience: data, content, and following. Users do not relinquish their personal data; instead, when the user wants to engage with the Internet, they connect their personal, self-hosted wallet to any application. These self-hosted wallets are pseudonymous – meaning that they are identified only by a string of letter and numbers – and do not necessarily contain any personal data, unless the user intentionally has included a type of digital asset (e.g., non-fungible tokens (“NFTs”)) with such information or which represents such information. 

Blockchain-enabled social applications also reshape the idea of ownership and UGC. In 2021, YouTube had total revenue of $15 billion with 37 million channels and paid out an average of $405 per channel whereas total NFT sales totaled $3.9 billion with 22,400 creators, and the creators made an average of $174,000.

NFTs allow a new way for creators to monetize their contributions. In the web3 world, users own their content, while allowing others to engage with or collect it. Instead of only consuming content as with the web2 space, consumers can become active participants in the career of creators, either investing in projects directly, voting on future content, or becoming collectors, making them personally invested in the success of the creator. 

Blockchains allow users to hold their intellectual property through NFTs or otherwise. Instead of relying on paperwork and documents, an individual can have digital ownership or representations of ownership tied to their identity online. This system could work both in the formal and informal contexts. In relation to the formal context, NFTs would allow individuals to obtain IP rights quickly and more efficiently, while also allowing for easier tracking and transfer of ownership. In the informal context, an individual would own all his or her contributions on a platform and could take this UGC to other parts of the Internet. If an individual has the right to “pack up and leave” a social media site in web2, the company will have to continually innovate and offer incentives for the user to stay. This reallocates power from Big Tech to the users. 

(2) Goals, sectors, or applications where digital assets introduce risks or harms. 

While we draw attention to the significant benefits that blockchains present for both individual users and the economy, we acknowledge that there are risks associated with emerging technologies. In particular, we are mindful of the concerns voiced by regulators domestically and globally regarding the decentralized finance system. 

Notably, regulators have focused on financial stability risks, as the DeFi system grows and becomes more interconnected with current, established systems. Specifically, we acknowledge concerns connected to the price volatility of digital assets held by users and the deployment of digital assets throughout the DeFi system - such that if digital assets are used as collateral or otherwise back transactions, this may amplify selling behavior and cause compounded user losses in periods of market stress. 

However, DeFi systems differ from traditional financial and “CeFi” systems - centralized, financial platforms for digital assets - where intermediaries control users’ assets in times of market stress. In a DeFi system, volatility may impact the assets held by users, but these users remain empowered to take control over their own holdings rather than relying on an intermediary.

(3) Federal research opportunities that could be introduced or modified to support efforts to mitigate  risks from digital assets. 

Classifications of digital assets. 

In the U.S., there has long been a debate over whether digital assets are commodities as defined by the Commodities Exchange Act, falling under the jurisdiction of the Commodities Future Trade Commission, or securities as defined by the Securities Act of 1933, falling under the jurisdiction of the Securities Exchange Commission. This divide has hindered the ability to create a thorough regulatory regime on digital assets in the United States. Therefore, we recommend for the OSTP to research classifications of digital assets across the globe to inform the U.S. approach. 

Other jurisdictions have undertaken various classifications of digital assets that recognize the realities of the technology and the nuances in different types of assets:

• The European Union’s Markets in Cryptoasset Regulation (“MiCA”) has created a classification of digital assets as follows: “asset-referenced tokens” (a digital asset that is not an electronic money token and that purports to “maintain a stable value by referring to the value of several fiat currencies that are legal tender, one or several commodities or one or several crypto-assets, or a combination of such assets”); “e-money tokens” (digital assets that purport “to maintain a stable value by referencing to the value of one official currency”), and all other tokens (including utility tokens, defined as “a type of crypto-asset which is only intended to provide access to a good or a service supplied by the issuer of that token”);
• The Swiss Financial Market Supervisory Authority (“FINMA”) categorized digital assets based on the following breakdown: “payment tokens” (tokens intended as “a means of payment for acquiring goods or services or as a means of money or value transfer”); “utility tokens” (tokens that “provide access digitally to an application or service by means of a blockchain-based infrastructure”); and “asset tokens” (tokens that represent assets like debt or equity claims on the issuer and include tokens that “enable physical assets to be traded on the blockchain”).
• On February 1, 2023, the UK’s HM Treasury issued a consultation and call for evidence entitled, “Future financial services regulatory regime for cryptoassets” (the “UK Consultation”) in which they posit a “glossary” for various types of “cryptoassets” that expands significantly on the framework presented by MiCA and FINMA. For example, the UK Consultation defines “utility tokens” as “cryptoassets which provide digital access to a specific service or application . . . and use a technology such as DLT to support the recording or storage of data”; defines NFTs as “cryptoassets which confer digital ownership rights of a unique asset (e.g., a piece of digital art), using a technology such as DLT to support the recording or storage of data . . .”; and define “crypto-backed tokens” as a “subset of asset-referenced tokens which reference their value in relation to other cryptoassets.” The UK Consultation glossary also includes exchange tokens, security tokens, stablecoins, commodity-linked tokens, algorithmic tokens, governance tokens and others.

MiCA, FINMA classifications, and the UK Consultation all recognize that digital assets take many forms, not all can be classified as financial instruments, and certain digital assets may have characteristics of both a financial instrument and something entirely not financial. 

To build a robust and appropriately-tailored regulatory regime for digital assets, understanding the extent and ways in which digital assets function – and the ways that other jurisdictions have been classifying digital assets as they build their own legislation – will be important to ensuring the U.S. can build regulation that protects users, provides market stability, and promotes innovation. 

DeFi risk mitigation. 

There are significant benefits to a financial system based upon or buttressed by DeFi and its ecosystem. We understand that other responses to the RFI will address these benefits and refer the OSTP to those responses. We recognize, however, that there are risks that may arise in the DeFi system. 

Financial stability risk. A number of technological solutions may be deployed to mitigate against financial stability risk, including implementing systems and controls. For example, creating a control designed to mitigate the risk of leverage and liquidity mismatches. This could include a protocol that uses indicators of available capital within a liquidity pool to calibrate liquidity risk and optimize utilization, which impact interest rates that could also be calibrated to address a variety of digital assets and their respective levels of risk. Other measures could include protocols that provide additional liquidity during times of stress or volatility, create siloed assets (restriction on borrowing to isolated stablecoins), or implement caps (upper bounds for reducing exposure to certain assets). 

Cyber risk. DeFi systems may face cyber risks, including economic exploits by bad actors (e.g., hacks). And, because DeFi is an emerging technology, code errors and bugs may occur, posing technological risk. However, continual improvements are being made to the code underlying such systems, meaning they are becoming increasingly more secure from technological risks. The most critical tool for mitigating these risks is the creation of uniform code audit and cyber-security standards for the deployment of DeFi protocols (i.e., a set of pre-deployment standards). The OSTP’s research into the way code audits are conducted, how to standardize such audits, and the benefits of a disclosure regime relating to such audits will benefit the DeFi ecosystem and its users. In addition to this, the OSTP could consider how the concept of self-regulatory organizations (SROs) could fit in the context of decentralized technology. Although other jurisdictions have developed digital asset related SROs (see e.g. Japan's Crypto Asset Trading Association), the U.S. is uniquely positioned to support and assist in developing SROs. For example, FINRA and NFA provide robust examples of SROs with regulatory authority that form a basis for standard setting regimes across the digital asset sector.

(4) R&D that should be prioritized for digital assets.

Benefits to the U.S. Economy. Blockchain increases efficiency (i.e., less intermediaries, lower fees, faster processing times) and transparency (i.e., information availability), which has immense potential to improve current systems, especially around record keeping and tracking in areas such as supply chains, healthcare, and government. Per PwC’s estimates, by 2030, blockchain technology could boost global gross domestic product by $1.76 trillion (1.4% of global GDP), while adding 40 million jobs.

The U.S. would reap $407 billion of that added value. However, software developers in the blockchain technology sector have been leaving the U.S. for international jurisdictions at an increasing rate (see this Twitter thread by Electric Capital). Research about the number of jobs, revenue, and economic benefit lost due to this phenomenon will be critical in assessing how to create policy that promotes innovation, protects users, and ensures market integrity. 

Remittances. With decreased transaction costs and more efficient transaction processing, blockchain technology may allow for cheaper and faster remittance payments. In particular, blockchain infrastructure solutions (i.e., layer 2s like the Polygon network) significantly reduce the cost of remittances and allow for even greater volume and speed of transactions. If money becomes more liquid globally, then what shifts would occur with local currencies? How will this affect the U.S. Dollar as the global reserve currency? In addition to considering those questions, there should be research on quantifying how much money could be saved in remittance payments if blockchain technology is used. If blockchains are used for remittances, then what does that system look like, and would any individual be able to access it? 

Privacy. As mentioned above, blockchains are open and transparent. Further, zero-knowledge proofs - an area in which Polygon Labs has dedicated significant R&D resources - will allow people and entities to prove a specific piece of information without disclosing that information to a third party. Although this offers benefits, blockchains should not force users to expose their private information. Research efforts could concern the individual right to retain privacy on blockchains. How should individuals retain privacy on transparent blockchains? Should individuals be required to be able to reveal all their information available on blockchains?

Operational Resiliency of Decentralized Finance. DeFi will have the ability to improve the operational resiliency of the financial system (assuming the risks associated with DeFi are addressed appropriately). Notwithstanding certain seismic events from centralized players in the digital asset ecosystem in the last half of 2022, DeFi protocols did not experience volatility that mirrored the shifts in the centralized system. Understanding DeFi protocols from both a technical and operational standpoint will be critical in understanding the benefits of DeFi and the economic incentives and structures within these protocols. By further understanding why and how decentralized, software-based financial systems can withstand market volatility, we may be able to provide more robust underpinnings for our financial system that are not subject to failures or extreme volatility from large players in the system (e.g., the 2008 financial crisis).

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Conclusion 

The U.S. has been and can remain a center for technological innovation, while also ensuring responsible development of blockchain-based technology. The U.S. can be well-positioned to develop an effective R&D strategy for digital assets and related technologies. 

We welcome the opportunity for further discussion and engagement on these issues