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Blockchain Technology - Legal Insight

07 October 2016

Even before some realised the sun was setting on the Third Industrial Revolution, others are proclaiming the start of the Fourth Industrial Revolution. What is going to fuel this Fourth Industrial Revolution? According to many, while the First Industrial Revolution was steam-powered, it is argued that the Fourth Industrial Revolution will be driven by blockchain.

Definition

The Blockchain is a technology based on a cryptographically secured database of a continuously growing list of data records that is shared by all parties participating in an established, distributed network of computers. No central server holds control over the database and the database relies on distributed ledger technology (“DLT”). DLT provides the foundation for bitcoin and other cryptrocurrenices.

One way of conceptualising DLT is simplifying it to as basically amounting to a permanent ledger which records transactions. In practice, it is a consensus of replicated, shared, and synchronized digital data geographically spread across multiple sites, countries, and/or institutions which creates a robust environment for real-time and secure data sharing – see more at www.blockchaintechnologies.com/blockchain-definition.

Unlike a traditional ledger, however, a blockchain is stored collectively by all of the participants on its network. Each of these copies is called a node. When a new block of data is to be added to the blockchain, a majority of the nodes within the network, each of which possesses copies of the existing blockchain, must verify the proposed transaction. Each transaction is stored with others in a unit of data called a block, and, as the name blockchain suggests, those blocks securely link to one another, forming a chain of records going back to the beginning of the ledger. Such a structure enables unknown counterparties to transact with each other securely and removes the need for intermediaries to oversee such transactions.

Such a structure enables unknown counterparties to transact with each other securely and makes blockchain a trustless system. That is, blockchain makes it possible for participants that are not necessarily known to each other to transfer a digital asset without the need for intermediaries to oversee and validate such transactions.

The practical applications for blockchain appear endless. However, it remains in its infancy and for the time being exists in an immature ecosystem. These new applications present significant legal disruptions to many important areas of law. In this article we will look in overview at how blockchain may:

  • be approached by regulators;
  • bring smart contracts into commercial use and the associated issues which may arise;
  • present data privacy issues;
  • change the way that the ownership of property is tracked;
  • revolutionise the way in which financial transactions are conducted;
  • create jurisdictional quandaries;
  • need to be regulated to protect consumer; and
  • raise issues for tax regimes in their current form.

Regulation

Lawrence Lessig famously said that “code is law” pointing out that coders by making a choice about the working and structure of IT networks and applications, made defining decisions about the rules which would govern the systems. In this capacity, coders replaced traditional legislators. So far regulators have allowed this to happen to a large extent, taking a light touch approach in relation to the regulation of blockchain.
In terms of supporters, the Bank of England has expressed general support, stating on its website that it will monitor developments in this area. However, at the EU level, there are indications that a more cautious approach may be taken. The European Parliament’s Committee on Economic and Monetary Affairs released a draft report on cryptocurrencies and blockchain. While recognising the positive impact it could have for consumers and economic development, it called for regulation to deal with the risks. In particular, the risks of money laundering, terrorist financing, fraud, governance gaps, systemic risk, regulator resources and legal uncertainty were highlighted.

Europe already has in place a legal framework for the regulation of electronic money, which could be used to cover cryptocurrencies. The Electronic Money Institutions Directive 2009/110/EC contains rules for all sorts of electronic purses that can be used to store value in an electronic format, be it via a computer, a mobile device or online. However, it can be expected that this area will see new legislation introduced over the forthcoming years.

Nevertheless, too much regulation early on may stifle the technology. Although, it is a difficult balance to strike, as in the absence of significant regulation and legislation, businesses and consumers may be reluctant to exchange significant value using such technology.

Smart contracts

Smart contracts are contracts where the terms and conditions are embedded into the contract by code. The code dictates that if X occurs then Y should happen. This is not exactly novel, and is how direct debits work. However, a smart contract goes beyond this and is able to interact with other systems and registers, and verify the performance of contractual obligations and subsequently ensure the performance of corresponding obligations.

Using blockchain as a platform for recording and executing transactions may provide the basis for bringing smart contracts into commercial use. One of the integral features of blockchain is that its records are indelible and irreversible, and therefore, once the self-executing code is properly recorded onto the blockchain it cannot be altered.

This would present a problem if the parties wish to unwind or void the contract. A party under a traditional contract would be entitled to do this if for example an event relating to fraud or force majeure occurred, but this may not be possible with a smart contract.

Identity and data privacy issues

Blockchains can be used to collect, store, process and transmit personal data. Another ostensibly positive facet of blockchain is that all of the data in each block is encrypted under a pseudonym. Although the data is public, whom the data relates to is theoretically private. However, if personally identifiable data from other sources were exposed and correlated to blockchain data, or if blockchain data were aggregated and analysed, transactions could be tracked and compared even though the ledger is pseudonymous.

Personal data that has been pseudonymised can fall within the scope of the General Data Protection Regulation (“GDPR”) depending on how difficult it is to attribute the pseudonym to a particular individual. If the data is considered personal data, then the company collecting that data will be obliged under the GDPR to ensure that it is kept securely and that it is stored for no longer than is reasonably necessary. It is difficult to see how these requirements can be reconciled with a system that relies upon granting full access to all users’ transaction records to all other members of the network and making sure that those records are held permanently and indelibly.

Property

Blockchain has the capacity to track changes in ownership of an asset. This means it has potential to replace property title registries. Titles to property could be stored and verified via a blockchain ledger, and transfers of title could be effected - and verified - without the use of a centralised third party. It could also track ownership and licensing of intellectual property. Ownership of intellectual property could be similarly recorded on a decentralised ledger.

Governments may be reluctant to move official registries onto a decentralised blockchain ledger, but private systems and government departments willing to more rapidly adopt new technology may one day utilise potential blockchain advantages such as higher security, reduced opportunities for fraud and decreased cost to effectuate transfers and associated recordings of transfers.

Financial transfers

Many analysts believe that blockchain can revolutionise the way that financial transactions are carried out, and make them more secure at the same time. As blockchain is not controlled by a central party, but instead involves decentralised control, it is less vulnerable to cyberattack. Also, as blockchain cannot be lost or corrupted by participants, counterparty risk in transactions is significantly reduced. Nevertheless, we are some way away from blockchain realising its potential, as it relies on huge processing power and can only cope with a limited number of transactions per hour.

In addition, escrow can be accomplished via blockchain by using "multi-signature transactions." A multi-signature transaction might consist of three parties: the two parties at either end of the transaction and a third-party escrow. Such an escrowed transaction would involve depositing the funds to a virtual currency address to initiate the transaction. Completing or refunding the transaction would then require two of the three parties to sign the transaction (by entering their private keys): the satisfied buyer and seller, or one dissatisfied party and the escrow party. Multiple signature transactions can also be used in situations where multiple authorisations are desirable, such as for approving expenditures in an organisation.

However, there are also risks associated with using blockchain to carry out financial transactions. The most obvious risk inherent in blockchain technology is the fact that the ledgers it creates are indelible and irreversible. No change to the collective ledger can be made without the agreement of all keepers, which prevents a transaction being corrected or reversed without unanimous agreement.

Litigation and jurisdiction

For a contract to be valid, many jurisdictions require that it must have been entered into by a legal person with the legal capacity to do so. Under English law there also needs to be sufficient certainty over who the contracting parties actually are. As transactions using blockchain can be conducted pseudonymously, it is not clear who the contracting parties are. Therefore, even establishing who to bring a claim against would not be straightforward.

Blockchain also creates jurisdictional quandaries. As the nodes on a blockchain can be located anywhere in the world, a transaction potentially comes under the legislative umbrella of wherever a node exists. The blockchain would therefore need to be compliant with the legal and regulatory regimes in place in each of the jurisdictions where a node is located.

Consumer protection

Blockchain has the potential to benefit consumers in a number of ways; not least, it can reduce cost and delays involved in transactions. However, the sophisticated nature of the technology, and the fact that many consumers may not understand how it works, will likely mean that regulators will feel the need to step in. For the time being, regulators in the UK have taken a backseat position observing the development of the technology, wary of stifling innovation through the premature imposition of regulation. In an effort to avoid regulation, those utilising blockchain have been urged to consider covering the cost of fraudulent transactions, much as banks already do for credit cards.

Tax

Blockchain also poses complex tax questions. Typically, where tax is due under a contract has been where the contract was concluded. However, as blockchain is not pinned down by borders and to an extent exists in the ether, it can appear to transcend traditional tax regimes.
There has also been much debate over whether cryptocurrenices should be classified as a currency or a commodity, which will have an impact on its taxable status. However, this has been resolved in at least once part of the world, as in one of the first major virtual currency court cases impacting the EU as a whole, the ECJ on 22 October 2015, held that bitcoin should be treated as currency for tax purposes.

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