Blockchain, smart contracts, cryptocurrency and ICOs

BLOCKCHAIN AND SMART CONTRACTS

What is a blockchain?

A blockchain is a form of ‘distributed ledger’ technology which does away with the need for a central ledger record.

“A blockchain is a tamper-evident, shared digital ledger that records transactions in a public or private peer-to-peer network. Distributed to all member nodes in the network, the ledger permanently records, in a sequential chain of cryptographic hash-linked blocks, the history of asset exchanges that take place between the peers in the network. All the confirmed and validated transaction blocks are linked and chained from the beginning of the chain to the most current block, hence the name blockchain. The blockchain thus acts as a single source of truth, and members in a blockchain network can view only those transactions that are relevant to them.”[1]

Blockchain applications

The blockchain was originated in the financial sector as the technology behind Bitcoin, a form of cryptocurrency.

Within the finance sector there are many different potential applications of blockchain. Apart from cryptocurrencies, blockchain can be used for payments more generally and for trading, clearing and settlement of financial transactions. It could also be used for customer identification. Another application which is being developed is in the area of trade finance to enable payments to be made on delivery of goods.

However blockchains are not confined to finance. The potential applications of blockchain go much wider than that.

Blockchain technology is also being developed for other applications including supply chain management, intellectual property, and government records.

Private and public blockchains

There is a fundamental distinction between blockchains that are private and blockchains that are public. As originally designed for Bitcoin, blockchains were public or permission-less. A private or permissioned blockchain is where there are restrictions on who can use it.

“One of the drawbacks of a public blockchain is the substantial amount of computational power that is necessary to maintain a distributed ledger at a large scale. More specifically, to achieve consensus, each node in a network must solve a complex, resource-intensive cryptographic problem called a proof of work to ensure all are in sync. Another disadvantage is the openness of public blockchain, which implies little to no privacy for transactions and only supports a weak notion of security.”[2]

Blockchains developed for business will generally be private or permissioned. Hyperledger Fabric is an example of a permissioned blockchain framework.[3]

The potential of blockchain and the threats to blockchain

Because blockchains are decentralised ledgers with no single controller, their great promise and potential is to reduce the need for controllers, including government. The Economist talks about blockchain as a disruptor to the “trust business”.[4]

But they only exist as long as regulation does not control them. To take an extreme case, a government could ban the use of blockchains. So blockchains will not be replacing government anytime soon.

Smart contracts

A smart contract is basically a contract that is self-executing, self- enforcing and self-regulating.  Another way of thinking of it is a contract which, once it is set up, is on auto-pilot.

Here are some examples of how a smart contract is conceived:

  • A car loan contract which deactivates the vehicle if the customer stops making payments.
  • A travel insurance policy that automatically pays a claim when the customer’s flight is cancelled.

There is already some level of automation in many contracts. For example, when you buy music on iTunes, the order will be executed to make the music available on all of your authorised devices.

Smart contracts take automation to the next level by giving computer systems the power to make automated assessments about compliance and performance.[5]

Smart contracts do not require humans to take action to enforce them, and so in theory there cannot be default under a smart contract. Like distributed ledgers and cryptocurrencies, they do not require the authority of the state to work. When a normal contract is breached, the ultimate recourse of a party is to go to court. With a smart contract, the idea is that this is not necessary. As such, smart contracts are seen by some as a liberating technology in the same way as blockchain and cryptocurrency.

In principle, a smart contract can operate without distributed ledger technology, but distributed ledgers are seen as enablers of smart contracts because the information required for the smart contract to work is not controlled by any one person. That is where Ethereum comes in.

Ethereum “is a decentralized blockchain platform … Like Bitcoin, Ethereum is an open-source project that is not owned or operated by a single individual. This means that anyone, anywhere can download the software and begin interacting with the network. Unlike the Bitcoin network, the primary purpose of Ethereum is not to act as a form of currency, but to allow those interacting with the Ethereum Network to make and operate ‘smart contracts’ without having to trust each other or use a middleman. Smart contracts are applications that run exactly as programmed without any possibility of downtime, censorship, fraud, or third party interference – a smart contract will work exactly the same every time it is used. Ethereum uses a ‘virtual machine’ to achieve all this, which is like a giant, global computer made up of many individual computers running the Ethereum software. The virtual currency unit that allows this system to work is called ether. People interact with the Ethereum network by using ether to pay the network to execute smart contracts. Ethereum aims to take the decentralization, security, and openness afforded by blockchains and extend those to virtually anything that can be computed.”[6]

‘Oracles’ are third party trusted sources of information used in smart contracts when the contract needs to reference external data in order to operate.

Legal issues with blockchain and smart contracts

  • Jurisdiction: A distributed ledger can be distributed all around the world. Which states have jurisdiction over it? Potentially any jurisdiction where nodes reside or users reside. And what is the governing law of a smart contract? This could be agreed when it is set up, but the agreement of the parties would not necessarily prevent the courts of a country seeking to exercise jurisdiction when there is some nexus to the contract.
  • Governance: This is more of an issue for public or permission-less blockchains. For a permissioned blockchain, the governance mechanisms can be agreed as conditions of membership, like the rules of a club or a company constitution.
  • Performance: A smart contract performs by itself, but what if the coding is defective?[7]
  • Liability: Who gets sued and on what legal theory of liability?
  • Enforcement: Smart contracts are supposedly self-enforcing, but they are not immune from contract law vitiating factors such as mistake, duress, misrepresentation, undue influence and illegality, which can all affect validity of a contract. It’s not just the terms of a contract that determine how it is enforced.
  • Data security/privacy: Blockchains and smart contracts are data driven and like any other collections of data, are subject to privacy laws.
  • Regulation: Blockchains and smart contracts are not immune from regulation. As with any voluntary arrangements, they are subject to overriding statutes. You can’t just agree among yourselves to exclude the operation of the law.
  • Authenticity: Blockchains and smart contracts are potentially open to fraud. Even if the coding prevents fraud, there may be fraud connected with their use (such as stealing the identification or login details of a person using these technologies).
  • Intellectual property: There are many IP issues relating to blockchain and smart contracts including ownership of the IP in the code and rights in overlay services that interface with the core elements of the technology.

CRYPTOCURRENCIES

What is a cryptocurrency?

A cryptocurrency is “a digital asset designed to work as a medium of exchange that uses cryptography to secure its transactions, to control the creation of additional units, and to verify the transfer of assets.” [8]  Cryptocurrencies are a subset of digital currencies. A digital currency is a type of currency available only in digital form, not in physical (such as banknotes and coins).

The best example of a cryptocurrency is Bitcoin. But there are plenty of others, such as Litecoin and Ether.

As well as being a medium of exchange, a cryptocurrency may function as a store of value. In the case of Bitcoin, this currently seems to be a more important function than as a medium of exchange. Hence the recent boom in its price, driven by speculation.[9]

The blockchain was originally conceived of as means of enabling Bitcoin, so they have a common genesis. However strictly speaking a cryptocurrency does not necessarily require a blockchain (and a blockchain can be used for many other things than cryptocurrency).

Legal issues with cryptocurrencies

  • Regulation: Cryptocurrencies only exist as long as regulators tolerate them. In some places they are no longer tolerated. China has banned cryptocurrency trading and initial coin offerings.[10]
  • Tax treatment: From 1 July 2017, sales and purchases of digital currency such as Bitcoin are no longer subject to GST, but a digital currency is an asset for capital gains tax (CGT) purposes.[11]
  • Fraud: Cryptocurrencies are a magnet for fraud.[12]
  • AML/CTF: Digital currency exchange businesses will soon become regulated as designated services under the Anti-Money Laundering and Counter-Terrorism Financing Act 2006 (Cth) and will be required to be registered with AUSTRAC.[13]

INITIAL COIN OFFERINGS (ICOs)

What is an ICO?

The US Securities and Exchange Commission (SEC) has described initial coin offerings or ICOs as follows:

“Virtual coins or tokens are created and disseminated using distributed ledger or blockchain technology.  Recently promoters have been selling virtual coins or tokens in ICOs.  Purchasers may use fiat currency (e.g., U.S. dollars) or virtual currencies to buy these virtual coins or tokens.  Promoters may tell purchasers that the capital raised from the sales will be used to fund development of a digital platform, software, or other projects and that the virtual tokens or coins may be used to access the platform, use the software, or otherwise participate in the project.  Some promoters and initial sellers may lead buyers of the virtual coins or tokens to expect a return on their investment or to participate in a share of the returns provided by the project. After they are issued, the virtual coins or tokens may be resold to others in a secondary market on virtual currency exchanges or other platforms.”[14]

Depending on the characteristics of the coins or tokens being offered in an ICO, they may constitute ‘securities’ under securities laws and be regulated as such.[15]

There is a spectrum of different kinds of tokens offered in ICOs. At one end of the spectrum are tokens which seem like shares or other forms of investment contract. They are likely to be caught by securities laws. At the other end are tokens which will really only be useful as currencies in the project being financed (‘utility tokens’). These are less likely to be caught.

ICOs have managed to raise large amounts of funds. In August 2017 it was reported that the “amount of money raised by cryptocurrency and blockchain start-ups via so-called initial coin offerings (ICOs) has surpassed early stage venture capital (VC) funding for internet companies for the past two months.”[16]

ASIC guidance on ICOs

On 28 September 2017, ASIC issued guidance about the potential application of the Corporations Act 2001 (Cth) to raising funds through an ICO.  Some of the key points:

  • If the value of the digital coins acquired in an ICO is affected by the pooling of funds from contributors or use of those funds under the arrangement, then the ICO is likely to fall within the requirements relating to managed investment schemes.
  • If the rights attached to the coin are similar to rights commonly attached to a share, such as if there appears to be ownership of the body, voting rights in decisions of the body or some right to participate in profits of the body, then it is likely that the coins could fall within the definition of a share.
  • If an ICO produced a coin that is priced based on factors such as a financial product or underlying market or asset price moving in a certain direction before a time or event which resulted in a payment being required as part of the rights or obligations attached to the coin, this may be a derivative.
  • If the ICO or underlying coin is found to be a financial product (whether it is a managed investment scheme, share or derivative), then any platform that enables investors to buy (or be issued) or sell these coins may involve the operation of a financial market.[17]

Legal issues with ICOs

  • Securities regulation: The fundamental legal concern is that an ICO may be an offering of securities and therefore subject to all the disclosure and registration requirements of the applicable jurisdiction.
  • Fraud: The other main legal issue with ICOs is that some of them are just scams.

 

 

 

 

[1] Source: https://www.ibm.com/developerworks/cloud/library/cl-blockchain-basics-intro-bluemix-trs/index.html

[2] Source: https://www.ibm.com/blogs/blockchain/2017/05/the-difference-between-public-and-private-blockchain/

[3] https://www.hyperledger.org/

[4] Source: https://www.economist.com/news/world-if/21724906-trust-business-little-noticed-huge-startups-deploying-blockchain-technology-threaten

[5] Harry Surden, “Computable Contracts”, 46 U.C. Davis L. Rev., 629 (2012).

[6] Source: https://support.coinbase.com/customer/en/portal/articles/2497671-what-is-ethereum-

[7] See what happened to the ‘DAO’: https://www.coindesk.com/dao-attacked-code-issue-leads-60-million-ether-theft/

[8] Source: https://en.wikipedia.org/wiki/Cryptocurrency

[9] Some seasoned investors are sceptical:  https://www.cnbc.com/2018/01/10/buffett-says-cyrptocurrencies-will-almost-certainly-end-badly.html

[10] http://www.scmp.com/business/banking-finance/article/2132009/china-stamp-out-cryptocurrency-trading-completely-ban

[11] See https://www.ato.gov.au/General/Gen/Tax-treatment-of-crypto-currencies-in-Australia—specifically-bitcoin/

[12]See http://www.abc.net.au/news/2018-02-19/more-than-1200-people-complain-to-accc-about-bitcoin-scams/9462240 . Data obtained from the Australian Competition & Consumer Commission’s (ACCC) Scamwatch program indicates that it received 1,289 complaints related to crypto fraud in 2017. Losses totalling $1,218,206 were also reported.

[13] See http://dwyerharris.com/aml-ctf-changes-in-2018/

[14] See the SEC’s Report of Investigation into the DAO available at https://www.sec.gov/news/press-release/2017-131

[15] Ibid. The SEC says: “The “touchstone” of an investment contract “is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others””, citing SEC v. W.J. Howey Co., 328 U.S. 293 (1946).

[16] Source: https://www.cnbc.com/2017/08/09/initial-coin-offerings-surpass-early-stage-venture-capital-funding.html

[17] Source: http://asic.gov.au/about-asic/media-centre/find-a-media-release/2017-releases/17-325mr-asic-provides-guidance-for-initial-coin-offerings/

 

 

Click here to subscribe to our email list for news, comment and analysis