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What Lawyers Need to Know About Blockchain

As I am writing this, one bitcoin is traded at about USD$17,600. In 2013, bitcoin traded at about USD$100. I thought it was a scam at the time and did not buy any. Since then I’ve changed my mind and started thinking, writing, and building about and around bitcoin and other blockchain technologies. It helped that I am both a computer programmer and a lawyer and that I had economics training. So if you are a lawyer and you missed the bitcoin rush but interested in catching up in your knowledge, read on.

Bitcoin is one way of using a more general technology known as blockchain. What is blockchain? In a 2016 article, I described it as “an escrow of conclusive transaction evidence.” I have a fresh definition for you today. Blockchain is a timestamped paper trail for mission-critical applications.

Paper trail. It’s a record of past events. They could be sales, blood test results, transfers of property, audit reports, notices, publications and so on. You usually do not need to store the actual record on the blockchain thanks to a technique known as hashing but that’s a separate topic.

Timestamped. Each event record bears a date and a time. This tells us what came before and what came after, what happened earlier and what happened later. You need it to prove precedence of events or publication of documents and to relate blockchain records to physical world’s timeline.

Applications. You don’t always need a paper trail. But it’s indispensable for many human endeavours: adjudicating claims about the past, computing property ownership or money balances, certifying quality based on testing, and proving precedence of publication (relevant to intellectual property) or proving the fact of publication (relevant to legal compliance, fairness, authorship claims and so on).

Mission-critical. Your application expects the paper trail to have the following properties: 1) no one can change it (immutable); 2) no one can forge it (authentic); 3) no one can spam it (transactions cost a fee or require proof-of-work).

Money is an example of a mission-critical application. If you have some money in a bank, and someone can change its amount without your consent, it should not be acceptable. If someone can create money in this bank out of thin air, it should not be acceptable. If someone can send send spam messages with tiny transactions through this bank for free and delay genuine transactions, it should not be acceptable.

Money is of course a paper trail application. The traditional type of money uses accounts: a person has a relationship with an middleman known as “bank.” The bank keeps an “account” for that person. The account refers to a starting balance, a list of transactions, and an ending balance. The bank facilitates that person’s transactions with other people through its relationships with other banks by adding transaction records to accounts, calculating new balances, and exchanging transaction messages with other banks. Most of the time all you care about is your account balance, and there is no account balance without a paper trail.

An alternative type of money, such as bitcoin, does not have accounts. Instead cryptographically signed records of bitcoin fractions or whole bitcoins exist in a database known as blockchain. Ownership of bitcoin means being able to find records on the blockchain with your signature on them and sign them over to someone else. A signature has one owner but one owner can use any number of signatures and sign any number of bitcoin with any signature it controls. (By the way, “wallets” are basically signature-management apps. There is an unfortunate trend to misname things with false analogies in cryptoeconomics.) There are no middlemen checking ids, reconciling paper trails, and settling debits and credits through inter-bank messaging networks. Instead there is bitcoin almost literally with your name on it and bitcoin without your name on it. (I understand that it’s unlikely that there is any bitcoin with YOUR name on it given current bitcoin price and ownership stats. My sympathies. I am in the same boat.)

Let’s go back to the hallmarks of a mission-critical financial network. Conventional banks fail two of the branches of the test. They can take money from your account without your consent (with an on-notice court order in the best case scenario). And they store only fiat money in your accounts. Governments create fiat money out of thin air on a regular basis. And it’s not necessarily unfair because everyone should know these things so everyone should be on notice that the fiat does not promise immutability and authenticity of money.

Crypto money such as bitcoin promise immutability and authenticity of your money. They (and especially all cryptocurrencies other than bitcoin although bitcoin itself is also pretty much in beta) are still in early stages of development. Until they are production quality their implementations will not necessarily work as promised. But at least these are the specs and ostensibly, applications such as bitcoin work towards those specs and have a good track record. Many including bitcoin are also open-source (you or your expert can look under the hood to know what exactly bitcoin does). Because people crave immutability and authenticity of their wealth, those who learn about bitcoin often buy it. The result is found in the first two sentences of this essay.

How blockchain is able to achieve paper trail immunity from all the forces of the world that are constantly trying to alter the paper trail (governments, courts, corporations, criminals) or to spam us (email is also a paper trail) is a hard technical problem. Bitcoin is based on decades of research at the intersection of mathematics, computer science, game theory, economics, and other disciplines. Somehow they did it, and the current version is working despite the odds. The short story is “decentralized,” “proof-of-work,” and “cryptography.” The long story is too long for this essay.

Now, if your application wants to be a real mission-critical application and if it depends on a time-stamped paper trail, you probably should use blockchain. But if you are offering your industry’s version of fiat money or something even less mission-critical, you may very well do with the cloud, your in-house data centre, or even a Windows application.

So this is blockchain. As a lawyer you should know what areas of practice are affected, what sounds like it’s relevant to lawyers but really not (remember the misnaming trend), what some professional and ethical issues are, and how blockchain can affect law and law practice. Continue reading.

The two big areas of law for blockchain today are tax and securities.

The first has to do with two things: capital gains and taxes on transactions including sales and income tax. Blockchain allows anyone to store and sell wealth in digital form. You can sell blockchain assets for fiat such as USD on crypto exchanges. Because so many people see blockchain assets as immutable and authentic, the USD price of bitcoin and other crypto assets have been going up (to put it mildly). In some jurisdictions, if you sell an asset for that jurisdiction’s fiat money, the amount of fiat money you make is a taxable capital gain. (If you think any of this is legal advice, you are, as my friend @DanielGershburg so deftly put it, “crazy town.”) The same goes for selling services and goods in exchange for crypto: could be taxable, could be not, could be taxable at transaction time, could be taxable at conversion time. Who knows. That’s why it’s an area of law. I mean nothing that’s crystal clear is ever an area of law, right?

Securities is even more interesting. Anyone can create their own crypto asset and sell it to the general public. What, you haven’t heard of ICOs? Unfortunately named to sound like IPOs, initial coin offerings are sales of digital tokens that represent either a stake in a common enterprise (similar to equity) or a right to use the company’s service (similar to Canadian Tire money or redeemable points). Securities regulators are struggling to distinguish between the two. In the meantime, extra-jurisdictional ICOs exploded instead of waiting for the law to be clarified. It helps that token sales are often in exchange for other crypto assets such as ethereum or bitcoin bypassing the heavily monitored and regulated banking system altogether. ICO organizers can also operate out of non-cooperating, off-shore, or unregulated jurisdictions taking advantage of the borderless nature of the Internet. Companies and projects (note the distinction) have raised money worth many billions of USD through ICOs. Usually, without resorting to investment bankers, commercial banks, or sometimes even lawyers.

So tax and securities law are two areas to watch in the crypto space today. Tomorrow, add estates, criminal, constitutional, product liability and negligence. Bitcoin owners will age and die. It’s not obvious how estate laws can be enforced in this space. Also, bitcoin and some other crypto assets can have a built-in timer that will release a pre-set amount to another party automatically. Crypto assets replace legal problems and solutions with technology problems and solutions, which are less flexible but potentially cheaper and more certain. Criminal and constitutional refers to a likely clash between the crypto space and governments. The US government tried to ban exports of cryptography before. It can try to ban or censor bitcoin transactions or ICOs. If you wonder why it would do that, let me know. I’ll write an article about it. Finally, product liability and negligence. Because the whole industry is in beta, many products and services will fail. Those claims will be hard to prosecute because many players in crypto are out of the courts’ reach. There is also a whole new body of law waiting to be written about cross-jurisdictional enforcement of orders and in particular seizure and sale of crypto assets. Much of this law will deal with compelling production of private keys directly from parties as there are no intermediaries in possession of responding parties’ assets and eager to cooperate with the legal system.

A word about smart contracts. They are neither contracts nor smart. They are scripts designed to accept and transfer digital assets when pre-programmed conditions are fulfilled. Also, lawyers will not code. Let’s put this notion to rest already. Look at the previous paragraph—they will have enough work as it is.

Lawyer regulators will come up with new professional responsibility and ethics rules in response to the rise of crypto transactions. Can you accept bitcoin in payment for legal services? Can you hold bitcoin in trust? Can you even handle crypto payment infrastructure yourself or should you hire an expert? You think you handle conventional money yourself but in reality experts known as banks and accountants do it for you. How versed should you be in technical aspects of crypto transactions before giving legal advice on ICOs and bitcoin capital gains tax? If you are a securities lawyer who does not know how public key cryptography works, are you qualified to give legal opinions about token sales? I don’t know. The problem is regulators also don’t know and they usually find out by instituting disciplinary proceedings. The law is a blunt instrument.

The end of lawyers has been predicted for a long time. The truth is as long as governments are around, lawyers will have their hands full, even if only to keep governments at bay. Two things will ensure demand for lawyers: regulation and ambiguity. Crypto is expressly trying to minimize both: through eliminating intermediaries that have traditionally been instruments of regulation; through dispersing transactions across jurisdiction lines; through anonymizing transactions; through replacing story-telling (the mainstay of law and lawyers) with algorithms. I don’t see crypto completely eliminating the two. In fact, the real conflict has not even begun yet. But crypto has already removed a myriad of human interactions worth many, many billions out of the conventional legal system. It did it by both moving existing affairs to the decentralized space and spurring a great number of brand new, unprecedented transactions in the Matrix of crypto. Ultimately, it could be irrelevant if decentralized cryptoworld will take over or not. It will simply exist as a parallel universe.

Comments

  1. Excellent piece Pulat. One other area of blockchain I see as ripe for lawyers is commercial litigation. Transaction verification, account ownership, liability for security breaches – I believe we will see this kind of blockchain litigation emerge in the near future.

  2. It’s nice to see some thoughtful words on crypto coming from our profession. I find I mostly still get blank stares when I bring up some of the upcoming challenges/opportunities in the space.

    I agree that lawyers won’t be coding any time soon but I think we can work with programmers and auditors to make sure that the code accurately reflects the parties’ intentions and is enforceable. With educated lawyers and reasonable regulation Canada could be a world leader. I applaud Federal and Provincial regulators that realize this and am disappointed at the ones that don’t.

  3. There is much more than this within the piece that is problematic but one paragraph in particular leapt out as needing correcting:

    “In some jurisdictions, if you sell an asset for that jurisdiction’s fiat money, the amount of fiat money you make is a taxable capital gain. (If you think any of this is legal advice, you are, as my friend @DanielGershburg so deftly put it, “crazy town.”)”

    This is severely underinclusive of the law of taxation of capital gains in most jurisdictions. For Canadian purposes in particular, any disposition of a capital asset can (and usually does) generate a capital gain or capital loss. (Cryptocurrency, of course, might not be held on capital account but on income account, depending on the holder’s circumstances.) Cryptocurrency-to-cryptocurrency transactions will generate capital or income gains or losses just as converting them to other currencies would.

    Next:

    “The same goes for selling services and goods in exchange for crypto: could be taxable, could be not, could be taxable at transaction time, could be taxable at conversion time. Who knows.”

    There is no uncertainty about this in the Canadian context. Earnings of cryptocurrency in exchange for goods or services are income, unless otherwise specifically excluded, just as earnings of dollars, gold bars, or magic beans are.

    I firmly support Pulat’s implicit call for persons making or holding (or indeed HODLing) investments in bitcoin to seek professional tax advice.

  4. Craig, thanks for your feedback. The paragraphs you referred to are not statements of Canadian law or any law. So they cannot be underinclusive of the law of taxation. They are examples of questions that clients have. Sorry if I didn’t make it clear. The purpose of the piece is to tell lawyers what areas of law will see greatest demand for their services. I am curious what else you found problematic in the article.

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