Crypto Tax & Accounting Technical Director, Dion Seymour, discusses the development of web3 technologies and their potential impact on financial services professionals, in Thomson Reuters Regulatory Intelligence.

Dion’s article was published in Thomson Reuters Regulatory Intelligence, 18 September 2023.

This article considers how the development of web3 technologies could affect the financial services profession. It looks at how, and why, web3 differs from web2 — the existing version of the internet — and considers in particular how the internet of tomorrow is likely to be more closely regulated than previous iterations.

What is the internet?

To explain how web3 differs from the internet, it is necessary, briefly, to understand what web1 and web2 are.

Web1 was the beginning of the internet. Before the internet became the internet that we can recognise today, it was mainly an infrastructure that allowed users to send messages, but then Tim Berners-Lee invented the World Wide Web (as it was then known). The internet started to come into being in the early 1990s when developments such as HTML and URLs made it possible for users to browse web pages, although they were “read-only”. This was quite decentralised, with many people hosting their own pages, and was much more community-driven than the internet today.

Then, at the start of the century, the internet started to become more commonplace. Technical developments had enabled the internet to become a much more interactive experience. This became known as the era of web2 (or web 2.0). The importance of interaction on user numbers can still be seen from the impact of social media.

The interactivity was an important driver for web2, with websites such as Facebook, Wikipedia and Twitter (now X), vastly increasing the amount of content available. They also changed the way people could watch, learn and communicate using the internet. Web2 also saw greater centralisation, with business such as Google becoming huge despite providing content for “free” and disturbing the more conventional business models such as by AOL.

This demonstrated that even tech firms could be found to be inflexible and be quickly surpassed.

Web2 also could be characterised by a small number of very large firms that have been able to control the data for a large number of individuals. They have been able to provide “free” services through the monetisation of data. The Cambridge Analytica scandal, however, highlighted how their data may be used way they never intended.

The development from web1 to web2 was gradual and there have been discussions about what the next iteration of the internet would look like, with a vision and the term web3 being coined by the co-founder of Ethereum.

Web3 is much more interactive than web2 and has a vision of greater community participation through decentralisation. As part of the premise the revenues can be given back to the creators and the community (the users) to finance further developments. Some founders of projects have the aim to “exit to the community” rather than sell the project to the highest bidder.

For web3 to achieve this community focus it uses technologies that promote decentralisation such as blockchain (also more accurately known as distributed ledger technology — DLT), crypto-assets including non-fungible tokens (NFTs), decentralised exchanges (DEXs) and decentralised autonomous organisations (DAOs). Some of these terms have entered common lexicon, such as blockchain and NFTs (itself being Collins word of the year 2021). Decentralised technologies also allow for the transfer of value over the internet without the use of third parties, such as banks for other intermediaries.

Other terms, however, may be less well known — such as DAO, which operates like a decentralised company that can raise funds and allows voting to make decisions for the business. That said, it may be more accurate to call DAOs a decentralised entity as it is unclear if a DAO can be a corporate entity. It is the totality of all these technologies that makes web3 different from web2.

It must be noted that decentralised technologies also provide more protection for user data, making a Cambridge Analytica scandal much, much less likely to happen.

Is web3 the same as the metaverse?

The term metaverse is not new. In the 2011 novel by Ernest Cline, “Ready Player One”, people are able to escape their dystopian real world into a virtual reality, a metaverse. The term metaverse came from the 1992 novel, “Snow Crash” by Neal Stephenson, where avatars interacted with each other in a three-dimensional space. While the terms web3 and the metaverse tend to be used interchangeably they are not the same thing, but there are projects that overlap.

Environments such as Fortnite and Minecraft could be argued to be a metaverse, although they do not use technologies such as blockchain. The renaming of Facebook to Meta, with the announcement that they would focus on the metaverse, has not resulted in a significant change in the way most people use the platform. The project appeared that Meta would retain centralised control over their “universe”. This would be metaversal, but not web3.

In contrast, there are examples of metaverse projects that do use the web3 technologies such as Decentraland or Axie Infinity and could be considered to be both metaversal and web3. It is the use of technologies such as blockchain and crypto-assets that makes the world of web2 and web3 diverge.

What does this mean for regulation?

As with the web2 internet, there is no single law regulating activity (in web1, web2 or web3). Regulation of the internet has been a perennial issue since its inception, but more so once it had become more popular. Even today there are difficulties holding people to account; it is arguable that no amount of regulation can make the internet safe for everyone, and the UK government has sought to
bring in legislation such as the Online Safety Bill.

Web3 presents more of a challenge from a regulatory and ethical standpoint. From the ethical point of view the benefit of a centralised party controlling the platform is that if something goes wrong there is someone that can be held accountable, for example, if there is a hack. Where the activity is decentralised, seeking remedy for things such as lost tokens can be considerably harder, and web3 hacks and scams can be in the millions.

From a regulatory perspective, many of the technologies that make up web3 are more regulated than technology used in web1 or web2, as many web3 projects make use of crypto-assets, in some form, that are increasingly subject to some form of regulation. For example, there are global anti money laundering standards, the 5th Money Laundering Directive (5MLD) that applies when cryptoassets are exchanged for fiat (currency such as pounds sterling or dollars).

The UK has recently implemented the “travel rule”, which requires crypto-asset businesses in the UK to “collect, verify and share information about crypto-asset transfers“.

In the EU, the recent Markets in Crypto-Asset Regulation (MiCAR) has created the world’s first bespoke regime that expands the scope of regulation further than money laundering. Most notably,  MiCAR brings with it the requirement for businesses that provide services to EU citizens a requirement to have a presence in the EU. This is quite unlike the position for businesses that provide services via web2, that can be located anywhere in the world.

The United States does not have a clear framework and there remains significant uncertainty as to whether or not crypto-assets should be considered to be a security and, therefore, in scope of the regulations enforced by the Securities and Exchange Commission (SEC). The SEC recently opened a case against Binance for listing crypto-assets that are used for web3 projects such as Decentraland and Axie Infinity as “securities”. The outcome of the case is unclear, but industry participants have complained that the lack of clear guidance as to what makes a security is not helping the United States be web3 “friendly”.

It should also be borne in mind that, with the arrival of ChatGPT, the race for artificial intelligence (AI) is on. The European Commission has recently defined web4 as “integration between digital and real objects and environments, and enhanced interactions between humans and machines”. This includes the interaction between AI and blockchain. The EC has also created the AI Act, the first
regulation on AI.

What about taxation?

In addition to the regulatory aspects, there are also taxation elements to be considered. As detailed in a previous article, crypto-asset transactions are taxable in the UK, United States and parts of the EU. The situation is more complex for web3, however, and influences all aspects of web3. Often the impacts are overlooked, for example crypto-assets are used to “pay” to improve in-game characters or virtual property and, as such, could be considered to create a tax loss.

An online game, Eve Online, witnessed a battle that caused a total of $378,012 worth of damage. While Eve Online is not a web3 game, the premise is the same in that some games can result in real world losses. This could cause tax administrations a lot of headscratching as to whether or not the state should be party to these losses, and this will only increase if web3 becomes more popular.

Has web3 arrived?

Not yet — but this does not mean that it is not coming, and not everyone is convinced that it is the next iteration of the internet. The development of web1 and web2 was incremental, however, and used new forms of technology as they developed over time. Web3, and web4, has a wider range of regulations to contend with, and this is certainly making development more difficult.

The jury for the case for web3 is still out. It is already clear, however, that the verdict will be that, this time around, the development of the internet will not be as unfettered as it was previously.

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