If there is one Business and IT subject that is hot (and not only in the financial world), it is without doubt Blockchain and Distributed Ledger Technology (DLT). Not unlike at some point in time ‘Cloud’, the term Blockchain is fast becoming a cure-all capable of solving all the problems of banks, industries and governments.
However, most businesses participants and their advisors have yet to fully comprehend their real use case and utility. Next to having the potential to drive simplicity and efficiency by the development of new services types and (business) processes DLT applications will always require deep collaboration between incumbents, innovators and regulators, potentially adding complexity and delaying implementation.
It should be clear that Blockchain is not a magic potion; instead it should be viewed as one of many technologies that will form the foundation of next-generation services infrastructure. In the end, even though not unique, it is forcing us again to rethink, change and innovate.
Blockchain is a logical and technical mechanism for reaching consensus regarding the state of a shared ledger between an unknown number of parties (permissionless) or known number (permissioned) who don’t trust each other without the presence of an ‘enforcer of trust’ (central authority).
Distinction is often made between permissionless and permissioned Blockchains. Permissionless Blockchains allow anyone to participate and are most commonly used in cryptocurrencies. They assume no trust between participants. Permissioned Blockchains restrict access in terms of who can perform various actions on the Blockchain. They assume some levels of trust, and are potentially more useful for many business applications than permissionless Blockchains.
An important topic amongst these applications is Smart Contracts. Smart Contracts are coded instructions (typically event driven) on the ledger that execute the specific terms and conditions that exist in contract between parties. Under typical (current) circumstances these parties will usually be individuals, corporations, governmental agencies or other entities with a clear legal personality. It is however possible to create sophisticated code that is much more automated and self-executing by creating even smarter contracts. As we have already observed in some emerging endeavors, we may see the creation of autonomous parties (Decentralized Autonomous Organization; DAO) including even IoT (Internet of Things) devices executing into Smart Contracts without human intervention.
The law of the land
It is obvious that by its very nature the emergence of Blockchain, DAOs and Smart Contracts raise significant legal questions. It is equally clear that a simple article as this one won’t flag all the items let alone give all the answers. The aim is therefore oriented on identifying the elements I have detected during my research & development activities in the domain.
The still ‘edgy’ technology is certainly on the radar of the different regulators and institutions. It was even on the agenda of the most recent World Economic Forum in Davos.
Whilst I do see some regulators still lying low and holding off communications (but analyzing and investigating according to sources), there is an increased activity from the regulators in general. For example, the Financial Industry Regulatory Authority (FINRA) in the US released in January 2017 their “Report on Distributed Ledger Technology” containing a wealth of information. Similarly, the UK government published already in January 2016 the report ‘Distributed ledger technology: beyond block chain’.
Also on the EU level (EI Parliament, Commission, ECB, etc.) more activity can be observed starting from a number of rulings on virtual currencies but now also moving to the larger implications for the different industries.
To date, there is no law or regulation in place that specifically addresses the use of Distributed Ledger Technologies in essence; it will currently often depend on the underpinning asset triggering different rules and policies to be applied.
Regardless of which scenario or stage the project is in, it is wise to consider a number of topics grouped below.
Accountability/responsibility/liability/taxation: since there is no central controller/authority and the ledger is by definition distributed, how is control and regulation established? It is at this stage unclear how these ledgers, users (individuals, IoT devices, etc.) and end to end systems can be regulated (except the rules that exist within the Blockchain itself) or specific permissioned ledgers. The setup of such systems requires clarity on accountability (and legal liability) at the different stages of transactions. This complex topic comes even more into play when considering Smart Contracts and Distributed Autonomous organizations (without legal personality) where it becomes increasingly impossible to identify the individual person or legal entity accountable. Existing corporate law does not accommodate and regulate these new entities. There is no law (yet!) that gives certain obligations to an autonomous piece of software that on its own decides to execute or amend parameters with potentially vast implications for assets and users. Anonymity and the on some distributed ledgers are set up may complicate compliance and taxation regulation, whilst consumer protection laws will need to be revised (rather urgently).
Transfer of Assets and Ownership / consumer law: once certain assets are transferred it should be made very clear (also from a legal perspective) where the property, ownership and subsequent liabilities reside. This is valid for all types of assets whether these are cryptocurrency or other (tokenized) assets.
Regulating parties: although valid for other technologies too, it is clear that because of the open / cross-border structure of ledger it remains uncertain that one single authority would be able to create and maintain the regulatory, compliance and taxation requirements. These are still being set either per region, per country or per group of countries. It is therefore recommended that a common standard or set of base principles is created to avoid additional complexity.
Contract Law: Since, for example, Smart Contracts (and DAOs) self-execute, it would be hard to void these contracts on existing grounds of duress, mistake or misrepresentation. Self-executing contracts may very well make specific enforcement remedies no longer applicable. Fully automated and self-enforcing smart contracts may deal with commercial scenarios so complex and unpredictable that the code will fail to embed all possible answers to all possible questions (AI anyone?).
Privacy and security: Distributed Ledger Technology relies on the fact that it is almost impossible to decrypt. However, there are other security concerns, for example, that it could be possible to trace or deduce a party’s identity from transactions or through access to a party that has permission to decrypt the data. The security advantages of the decentralized systems (resilience and robustness) only apply completely to permissionless ledgers that subscribe to a global trust theory. For permissioned ledgers, or examples with other centralized functions, there will be a reduced resilience and robustness, but a stronger ability to assure central trust and/or functions.
Competition/anti-trust: If private distributed ledgers are created that are equivalent to certain consortia, it could be considered a violation of the applicable competition laws. Also in Smart Contracts a code base and algorithms can be set up in such a way competition is nullified, however would remain undetectable.
Next to the technological and business implications, it is wise to keep an eye on the legal and regulatory implications from the onset of a project as certain legal and regulatory principles are so fundamental to the regulation of economic activity that courts and governments will not support enforcing otherwise valid contracts if these principles are not complied. There is a need for further investigation as with all technologies or ideas that force us to question the basic economic fabric we operate in.
Many applications of Blockchain are still in their infancy and may take some time before they are advanced enough to take on real-world use rather than experimental trials, giving the regulators and governments some time to step up and agree on some of the core principles of the transformations that are bound to happen. Additionally, I would like to predict (as some other advisors also started doing) that it’s not unreasonable that most of the Blockchain and Distributed Ledger Technology projects and their codebase will eventually transform and become integrated into enterprise software companies with all the related consequences.
‘Report on Distributed Ledger Technology’, FINRA, January 2017
‘Distributed ledger technology: beyond block chain’, UK Government Chief Scientific Adviser, January 2016
‘Blockchain and the Law’, Clyde & Co, June 2016
‘The future of financial infrastructure: An ambitious look at how blockchain can reshape financial services’, World Economic Forum, August 2016