USA: An Introduction to Blockchain & Cryptocurrencies

Advising clients that use blockchain and cryptocurrencies in their business is at once perhaps the most fascinating and also the most challenging area of the law today. Just five years ago, it would have been almost impossible to find a single major law firm devoting significant resources to the space. Today, it would be just as difficult to find any of the country’s top law firms without a dedicated blockchain practice group. Blockchain technology has the potential to impact almost every aspect of the legal practice, from dispute resolution to contracts, from the law of business organizations to securities law and from intellectual property to privacy, and yet we frequently find lawyers and law firms treating blockchain and cryptocurrency as its own separate specialization. At the same time, there is little agreement within the legal community as to what the term even means - ask ten legal experts on the subject to define “blockchain” and you may well get 11 different answers.

To add to all of this, the blockchain sector in 2020 is in a state of significant transition. After several years of seeming unending hype and promise, many of the first generation of blockchain companies and platforms started to retrench, pivot their focus, sell out or simply wind down – not completely surprising where new technologies are concerned. Nonetheless, over the past year important new trends and use-cases for the technology, such as decentralized finance, staking as a service, and decentralized autonomous organizations, emerged. Steady progress was also made in other areas, including the use of blockchain technology in the issuance and management of securities, as well as in healthcare, trade finance, sports and e-sports, and other sectors.

The Basics 

Rather than starting with yet another baffling definition of the term “blockchain” we suggest that you think of blockchain not as a single identifiable and definable technology, but rather as a group of interconnected technological developments, including advances in cryptography, data science, game theory and economics, that can be combined in different ways to achieve different objectives. The amorphous nature of this technology helps to explain why a single definition of the term “blockchain” is so elusive and also why the applications of the technology appear, at least in theory, limitless.

Nevertheless, we can still recognize that the central theme uniting the various developments grouped within the concept of blockchain is that of allowing multiple parties confidently to reach agreement around a set of facts – or state – of a ledger that can keep track of nearly anything imaginable, without the need to rely on any single party or parties to confirm the accuracy of that ledger.

The first and best-known example of a practical application of blockchain technology is Bitcoin, the original cryptocurrency network, which sprung to life in 2009 in the midst of the financial crisis. The global ecosystem that has since evolved around this network is complex, and includes miners, coders, developers, centralized and decentralized exchanges, custodians and a myriad of other “virtual asset service providers” (a term coined by the Financial Action Task Force). However, it is critical to understand that all ownership of a “bitcoin” unit actually means is that the owner has knowledge of a hexadecimal number (known as a “private key”) that allows that person to send a message to a network of computers that will result in a change in a ledger commonly maintained across that network, to decrease the number of bitcoin associated with the owner (at the owner’s “public address” on the network) and increase a corresponding number of bitcoin associated with the public address of the recipient.

That’s it. However, what makes bitcoins valuable to many is also one of the most fascinating aspects of blockchain technology – the ability to use the technology to create digital scarcity in an open and (at least theoretically) decentralized peer-to-peer environment which is not subject to government or other interference or censorship. Due to an ingenious interplay of cryptography, economics and game theory, the computer protocol used to manage the Bitcoin network verifiably limits the total number of bitcoins maintained by the ledger at any given time and makes it extremely difficult for any single actor or governmental entity to alter that ledger to their own interest.

New bitcoins are mined on the network approximately every 10 minutes to incentivize network participants to provide the computing power needed to maintain and protect the validity of the ledger (including against the so-called “double spend” problem, in which a digital asset can be used or “spent” more than once). This occurs through a coordination process among all of the computers running the Bitcoin protocol software (“full nodes”). This process, called “proof of work,” involves causing these nodes to attempt to find a complex random number through brute force trial and error, thereby expending significant real-world resources (equipment, electricity and operations). Because the protocol software is free and widely available, anyone with access to the requisite hardware and the Internet can participate in the Bitcoin network and earn bitcoins through directly or indirectly mining.

It is largely because of this combination of scarcity and censorship resistance that legions around the world have been willing to part with fiat currency and other things of value in the real economy for the knowledge of private keys that relate to public addresses associated with a number of bitcoin on the network’s ledger. Nevertheless, it is also notable that the use of bitcoin for its ostensible primary purpose – as a currency substitute – has taken some time to be accepted, and its most effective use in this capacity is still being discovered.

The Cryptocurrency Bubble 

As important a development as Bitcoin was in and of itself, within five years of its launch even more fundamental developments in blockchain technology occurred, most notably with the arrival of the Ethereum network. Ethereum allows users to run computer programs (known as smart contracts) that execute identically across all computers running a version of the protocol (known as full nodes), thus creating a virtual world computer – the Ethereum Virtual Machine, or EVM.

To ensure that sufficient real-world computing resources are available to the network and that the programs that run on the EVM do not over-consume these resources, the Ethereum network not only rewards the miners that secure the network with its own native token (known as “ether”), it also provides a use for these tokens once they were minted. Ether tokens are needed to pay for the computing resources consumed by smart contracts running on the EVM. That is, ether tokens must be sent to the operators of Ethereum full nodes in amounts corresponding to the complexity of the underlying smart contract code.

As a result of this design, there is an economic reason to own ether tokens, even for those who may not be interested in running smart contracts on the Ethereum network (or in using the tokens as a medium of exchange to acquire other items of value). Like bitcoin, ether tokens are limited in supply. Therefore, as more people seek to run smart contracts on the Ethereum platform, more ether tokens will be needed, and demand for ether can be expected to go up. But because the supply of ether tokens is fixed at any time, it follows that the price of ether tokens would need to go up to meet the demand. As a result, someone could invest in the anticipated future success of the Ethereum platform, not through owning equity in a company, but rather through ownership of the tokens needed to interact with the platform.

This logic – that the value of a decentralized network could be captured through its scarce digital tokens – quickly extended from ether tokens to the tokens sold for other blockchain-based open or “non-permissioned” platforms. This soon included platforms that had not yet even been developed at the time that their “pre-mined” tokens were sold to the public. In 2017, a rush to speculate in all manner of digital assets that might power future decentralized platforms took hold and with that rush came the inevitable wave of dreamers, charlatans and outright fraudsters, eager to raise money through “initial coin offerings” or ICOs – a term loosely borrowed from the initial public offerings of stock that made many early tech investors extremely wealthy. Since these new tokens often used smart contract code running on the Ethereum network, a self-reinforcing cycle appeared to be created, with the rapid growth in ICOs leading to increases in the price of the ether needed to run the code used by these ICO tokens.

The inevitable break in this cycle came in 2019 as promised token projects either disappointed or failed to materialize at all. Aggressive enforcement in the U.S. by both the Securities and Exchange Commission (SEC) and state securities regulators against many who had bilked the public through fraudulent schemes both drove the collapse of this market and created an enormous chill on further development of open blockchain projects as no clear path to launching even the most credible of projects had emerged.

Notwithstanding these significant setbacks, 2019 also saw great progress in the area of open blockchain networks, as concerns about data privacy, the harmful aspects of “BigTech” and the impact of “surveillance capitalism” have captured the attention of the public, policymakers and even technology investors. The promise of open blockchain is “Web 3.0” – a decentralized version of the Internet built using blockchain technology where users maintain personal control over their identity, data and assets, sharing only that information which is strictly needed with service providers and interacting as much as possible on a peer-to-peer basis.

Enterprise Blockchain 

While the cryptocurrency boom was taking place, similar if not greater growth was experienced in what became known as the enterprise blockchain sector (sometimes also referred to as “distributed ledger technology”, in part to distinguish it from its more controversial cousins in the “open” or cryptocurrency-based blockchain community). Proponents of enterprise blockchain sought to eliminate the need for a blockchain protocol to involve a native token by requiring that all parties using the network be permissioned onto the network and agree among themselves to the rules that would govern the relevant ledger (including, critically, the responsibility for the costs of running and maintaining the network).

Rather than embrace the more idealistic philosophy of a censorship resistant decentralized network, enterprise blockchain instead takes a practical approach that uses decentralization to eliminate intermediaries across a range of industries, thereby saving costs and improving operational efficiency of existing businesses. Where open blockchain protocols seek to supplant traditional businesses like data storage, cloud computing, global mapping and many others with peer-to-peer marketplaces, the expectation has been that enterprise blockchains will allow certain existing businesses to continue and grow, while others that serve as middlemen would become unnecessary and wither away. A variety of approaches to enterprise blockchain have emerged, including the Hyperledger Project, started as an umbrella of open-source blockchain protocols by the Linux Foundation, Corda, developed by R3 LLC, Assembly, developed by Symbiont.io, and Quorum, a “fork” of the Ethereum codebase supported by J.P. Morgan and Microsoft.

Although filled with promise, enterprise blockchain solutions have struggled to overcome a version of the “tragedy of the commons” problem: i.e., how to incentivize, allocate and then recoup the investment needed to get a network established. Given the potential for tremendous savings at the enterprise level from even modest improvements in efficiency, work in the area continues across almost all industry sectors as well as in a variety of governmental settings, and a variety of important production uses are expected to launch 2020. The question will be how quickly this adoption will occur, and how many of the consortia developing, hosting and using these solutions will deliver the promised efficiencies.

Regulation and Blockchain 

From the earliest days of Bitcoin, blockchain technology has bumped up against a wide variety of regulatory challenges. Simply put, the legal system in the U.S. was not designed for anything like blockchain, particularly when manifested in a fully open and decentralized network. At the same time, many users and proponents of blockchain technology seem to overlook the critical difference between a network based on a decentralized protocol that will operate as long as the software is available and computers connected to the Internet run that software, and the actions of individuals or business that use that network - the latter being very much subject to the laws and regulations applicable to their activity.

Perhaps the most critical intersection of blockchain technology and regulation is around the area of payments and value transfer. Bitcoin was expressly developed as a “peer-to-peer system of electronic cash”, a role previously only fulfilled as a practical matter by fiat currency. “Money transmission” (the broad term for activity of banks and other businesses that facilitate the movement of value between parties) is one of the most highly regulated activities in the United States, with multiple levels of reporting and oversight, depending on the type of payment or entity involved. Although barter and other peer-to-peer methods of value transmission have always existed, before the advent of cryptocurrencies, there was no practical way for unregulated persons and entities to send value in large amounts to others quickly, cheaply and with limited oversight. Unsurprisingly, many of the earliest uses of bitcoin were as payments for illicit activities, giving more than a patina of lawlessness to the entire blockchain space.

Recently, the U.S. Treasury Department’s Financial Crimes Enforcement Network (FinCEN) reiterated guidance dating back to 2013 that any use of “virtual currencies” in the business of money transmission will be considered a regulated activity and subject to all requirements applicable to movements of fiat currency, including the so-called “travel rule,” which requires money transmitters to track and retain data identifying the sender, recipient and purpose of these value movements in whatever form they take, thus posing significant challenges both to businesses transacting with cryptocurrencies, and the counsel advising them.

The other area of regulation that has grabbed headlines in the blockchain space over the last several years is securities law. Once entrepreneurs and others discovered that blockchain tokens created in minutes with just a few lines of smart contract code could be sold for potentially millions of dollars based on loose suggestions of how a new blockchain network or protocol might work, the landscape was primed for what was quickly recognized as rampant securities fraud – the raising of money from others through the sale of digital assets where the primary if not sole reason for the purchase was the expectation of profit through the promoter’s efforts of building and then growing a decentralized blockchain network.

The SEC first commented on the sale of digital blockchain-based tokens in the summer of 2017 with a Report issued under Section 21(a) of the Securities Exchange Act of 1934 relating to a blockchain platform developed outside of the United States, known as “The DAO”. The DAO Report was swiftly followed by a series of enforcement actions, both by the SEC as well as a number of state securities regulators. These actions began to lay out a theory of how the securities laws would apply to blockchain-based activity in a variety of settings – not just to token issuances and sales in the form of ICOs, but also to exchanges, promoters and third-party dealers.

Yet questions on how to apply securities laws in these contexts continued to swirl and the SEC, through both its Commissioners and staff, began an outreach program of speeches, publications and other activities intended to better inform the public as to their views on how to apply securities law to these activities. Further clarification came in April 2019 in the form of a Framework for “Investment Contract” Analysis of Digital Assets, in which approximately 60 different factors were identified to help the public apply securities law to transactions involving blockchain tokens. This was followed in the summer of 2019 by a joint staff statement from the SEC and the Financial Industry Regulatory Authority (FINRA) on broker-dealer custody of digital assets (although this statement did not apply to bitcoin which, at this time, is far and away the most popular digital asset held for investment). Moreover, as we enter 2020, in addition to a number of important ongoing federal and state enforcement actions (in particular, those involving token sales by Kik Interactive Inc. and Telegram Messenger Inc.), there are also several high-profile civil suits whose resolution may also help shape the direction of the law and give greater clarity to blockchain users.

In addition to money transmission and federal and state securities laws, many other areas of regulation must be considered when undertaking blockchain projects, depending on their structure. Platforms intended to be used by consumers will need to grapple with both federal and state-level consumer protection laws. Platforms that allow the borrowing and lending of digital assets will need to consider the extent to which banking and other financial regulatory laws apply. Blockchain platforms that store personally identifiable information of individuals will need to consider both U.S. and international data protection laws (particularly relevant when the data relates to healthcare information). Enterprise consortia deploying blockchain-based solutions will need to grapple with antitrust laws. And, of course, tax law will apply to almost all economic activity and is made more complicated in the U.S. through the fact that the Internal Revenue Service considers bitcoin and other digital assets to be “property” for which each purchase or sale transaction must be tracked for gain or loss.

At the same time, the regulatory landscape in the U.S. relevant to blockchain projects continues to develop. In many areas, regulators revisited existing regulations, providing interpretations as to how to apply existing rules to digital assets, smart contracts and other elements of blockchain technology. The year 2019 also saw numerous legislative proposals emerge in Congress, including most prominently, the “Token Taxonomy Act of 2019” and the “Managed Stablecoins Are Securities Act of 2019”. While none of these initiatives became law and are not expected to pass prior to the upcoming November election, many observers believe that the next Congress will see a variety of legislative initiatives that could fundamentally reshape the blockchain landscape in the U.S. In the meanwhile, states like Wyoming and Colorado have seized the moment and filled the gap by passing blockchain-friendly state laws.

The Path Forward 

Although many challenges to the growth and development to blockchain technology in the U.S. exist, 2019 also brought with it a number of exciting new developments. “Decentralized finance” platforms use blockchain and smart contracts, built predominantly using the Ethereum network, to create automated peer-to-peer transactions where non-interest-bearing digital assets may be loaned to others to create a return for the asset owner. While questions abound as to how these platforms will scale and how they will behave in an economic downturn, there is ample evidence of significant organic demand for these products among digital asset holders.

In the area of business organizations, new and existing platforms and open codebases, like Aragon and Moloch, are facilitating the formation of “decentralized autonomous organizations” (DAOs). DAOs have allowed tech-savvy groups of individuals to form globally dispersed for-profit communities that use smart contract code to automate many aspects of governance, raising fascinating questions about what it means to be a “company”. Although DAOs are still in the earliest stages of development, many expect broader use of these platforms in a variety of settings in 2020.

Finally, the expected move from “proof of work” to “proof of stake” as the coordination mechanism among nodes on the Ethereum network, combined with the use of proof of stake by other popular blockchain platforms like Tezos, EOS and Cosmos, has opened up opportunities for new businesses to help holders of the native tokens for these protocols to “stake” their tokens (effectively, protect the validity of the network ledger by validating transactions at risk of losing the staked tokens if the validation is done incorrectly or not on a timely basis). These “staking-as-a-service” companies demonstrate the rapidly evolving business models in the blockchain sector.

Looking at all of the above, the only thing about blockchain in 2020 that can be said with any certainty is that much more change is yet to come.