Blockchain Technology – Regulating the Future

Blockchain Technology – Regulating the Future

The invention of a revolutionary encoding or cryptographic technology known as ‘blockchain’ is already central to a significant proportion of business-to business (B2B) and business-to-consumer (B2C) commerce, legal products and processes. From online purchasing to medical data and prescription management, data sharing of cross-jurisdictional criminal records, to possibly even management of entire countries’ registers and notarisations, this technology has huge potential. But with this potential to develop in as yet undefined ways and into various unregulated areas, one may argue that there is also the risk that ethical boundaries defining our basic rights to ownership, privacy and access to justice may be crossed.

What is blockchain technology?

Blockchain is a chronological database of transactions recorded by a network of computers. Through a decentralised public ledger and a cryptographic mechanism, blockchain facilitates transactions that are sufficiently secure between two parties. Every new transaction carries an unforgettable record of the entire history of the chain and all previous transactions. Put simply, it is a ledger to which anyone can add a transaction but no one user can remove any information.

Blockchain is seen as the second generation of the internet, the technology which will see us shift from the ‘internet of information’ to the ‘internet for value’

In a blockchain, each set of transactions is encrypted and organised into smaller datasets called blocks. Every block contains data about the relevant transaction, references to the preceding purchases, that form the block in the chain and an answer to a complex mathematical puzzle, which is used to validate the data associated with that particular block. To ensure that only authentic transactions are recorded as a block, the network – that is all the other devices that hold the same version of the block – must confirm that any new transactions are valid, and therefore do not invalidate any former transactions. The new block is added to the end of the existing series of blocks only after the network of computers and/or devices reach consensus (that is, 51 per cent) as to the validity of the transaction, thereby can proceed in forming a blockchain. Once a block has been successfully added to a blockchain, it can no longer be deleted and becomes a permanent and immutable record of the transactions contained within it. This can be accessed and verified by everyone on the network.

Many view blockchain as a disruptive technology, while others argue that blockchain will become the foundation for the way that all digital contracts, transactions and records will be executed and stored in the future. Indeed many believe that blockchain will not only revolutionise our lives by securely enabling assets to pass ‘peer-to-peer’ instead of through an intermediary but also that we will be able to transfer assets (and value) over the internet as easily as we now transfer information. Blockchain is seen as the second generation of the internet, the technology which will see us shift from the ‘internet of information’ to the ‘internet for value’.

Blockchain has already been used to make cryptographic tokens. These are a kind of electronic key that may be used in place of, or in addition to, a password, and can represent property or ownership, censorship-resistant communications and file sharing systems, decentralised domain name management systems (DNS) and fraud-resistant digital voting platforms.

Whilst we are still in the early stages of the technology, it is becoming more and more evident that it is highly likely that this technology will radically alter the way transactions are managed in every sector, from financial services to immovable property, from music to healthcare.  Accordingly, this will create significant challenges for regulators and lawmakers.

Blockchain, smart contracts and the exclusion of intermediaries

Blockchain paves the way for what are known as ‘smart contracts’.  These are computer protocols or codes attached to the blockchain, which ensure that certain terms of a contract automatically self-execute. Smart contracts may, among other things, be used for:

  • capital markets trading;
  • real property and intellectual property transfers (including for digital rights management);
  • energy grid management;
  • insurance claims processing; and
  • logistics and supply chain management.

Originators of blockchain envision other innovative uses, such as systems for the music business that packages both artists’ rights management and their royalty payments together. When tracks are released through blockchain technology, the artists who actually make the music would be able to directly control everything to do with the track including holding onto the rights and intellectual property, without the need of middlemen. The system is also designed such that payments made for the track can be automatically distributed among the different musicians, producers involved in it at the exact moment at which the song is downloaded or streamed, in order that everyone is instantly rewarded according to their contribution.

Blockchain is designed to essentially do away with intermediaries and ‘middlemen’ which are prevalent in most industries. If we want to transfer an asset to someone, be it music, money, title deeds or the use of our property we use a trusted intermediary to make that happen.  We use banks, governments, credit card companies, platforms such as Airbnb, which acts an intermediary between the prospective guest and prospective host. Intermediaries are costly since they all take a percentage of the value of the asset, slow down transactions, can often prevent access completely because they require certain data which some people don’t have or as we see in the case of financial services, require a specific infrastructure in which to operate (for example the need for bank accounts to transfer funds).

Given that contract law is embedded into most commercial enterprise, there are very few areas that will escape its application

The company Slock.it (https://slock.it/) would appear to have identified this ‘intermediary problem’ and is currently developing an application similar to Airbnb, but which allows the host’s property’s door (virtual) to be unlocked at the point at which the guest pays the deposit and proves his/her identity.  These facts are checked at the door via a smartphone and, if everything is in order, the door is unlocked.  These steps are self-executing based on the underlying code.

Blockchain and its versatility

Blockchain is likely to change the way lawyers approach contract drafting, administration and enforcement. Given that contract law is embedded into most commercial enterprise, there are very few areas that will escape its application. The following are a few examples of the areas within which blockchain is or may be used:

Bitcoin

One of the foremost applications of blockchain technology has been in digital currencies such as Bitcoin. Bitcoin is a virtual currency that relies on a decentralised blockchain. Based on a peer-to-peer creation and validation system, Bitcoin has a circulation worth over US$1.5bn. While it attracts headlines, Bitcoin and other virtual currencies present a number of risks that drive the need to regulate them closely. They are volatile: virtual currencies are not pegged to a real currency; depend entirely on technology; pose a potential threat to global money supplies, and due to their anonymity, they risk being used as a cover for criminal activity.

Banks

Blockchain has already found a place among the financial technology (‘fintech’) sector’s general pattern of disruptive innovation. Advocates of blockchain claim that it will reduce costs, improve service delivery and streamline digital processes. Banking group Santander’s fintech investment fund calculates that use of the technology could slash settlement, regulatory and cross border payment costs by US$20bn each year. Such savings could be possible due to blockchain’s decentralised distributed ledger technology. It has the potential to remove the need for any intermediaries, thus allowing parties to transfer their assets much quicker and at reduced cost. Perhaps unsurprisingly, this poses a significant threat to any financial institutions that are slow to adapt or ignore this technology completely. Some banks and financial institutions are already investing heavily in developing and testing blockchain technology, so as to incorporate it into their e-commerce and crypto-currency strategies. In January 2016 the Australian Stock Exchange (ASX), for example, announced the development of a distributed ledger solution to replace its current platform for clearing and settling trades. Similarly, the Bank of America recently revealed that it was filing a number of US patents, in relation to protecting its own blockchain-related inventions. In August 2016, it was reported that four of the world’s biggest banks – UBS, Deutsche, Santander and BNY Mellon – had teamed up to develop a new form of digital cash they believe would become an industry standard to clear and settle financial trades using blockchain technology. It is understood that they are aiming for a limited and low-risk commercial launch by early 2018.

Smart contracts

The process of drafting contracts will likely change dramatically when smart contracts become common place. Smart contracts will be self-executing, meaning that once conditions A and B take place and are verified by the blockchain, the cryptocurrency will be automatically unlocked, becoming immediately controlled by the other party. These transactions are virtually irreversible for all their demonstrable verifiability and this will be compounded when we consider the pseudo anonymous nature of the participants in these types of transactions. Initially, there may be workarounds, in the form of built-in arbitration mechanisms. These may at least permit the transaction to be reviewed under traditional legal systems. Such mechanisms, however, will need to be engineered into the code of individual smart contracts at their drafting stage. Similarly, there will be a need to incorporate mechanisms to address issues such as intellectual property, confidentiality, governing law and choice of law.

Smart contracts will be self-executing, meaning that once conditions A and B take place and are verified by the blockchain, the cryptocurrency will be automatically unlocked, becoming immediately controlled by the other party

The entire coding process will be very different to drafting extensive and lengthy contracts using traditional templates.  Instead smart contracts are likely to be drafted with a handful of lines of codes. Accordingly, code ‘libraries’ will be established, which will develop uniformity and overall user and client confidence in the use of smart contracts. To demonstrate the financial benefits for both lawyer and client, one may take into consideration, for example, the management of an estate by an elderly father, who wishes to divide his estate equally to his children upon his death. A lawyer might code a trust in accordance with the father’s intentions and upload it onto the blockchain. The contents of this blockchain would be algorithmically encrypted into an alphanumeric string to uniquely identify the trust. A program coded onto the trust would scan an online death registry, which, upon the father’s death, would immediately trigger a search of financial registries for each of the children, thereafter dividing the equity of the estate to each child accordingly. The estate would be disbursed, almost immediately, in accordance with the father’s wishes with no need for the estate to be revisited by a lawyer or Notary or to pass through any probate office.

Insurance

A recent Deloitte (UK) paper on the use of blockchain suggests it may have use beyond simply facilitating payments. In the context of insurance, it can be used to review claim history, thereby preventing multiple claims arising from the same incident. Additionally, using the internet of things (IoT) to incorporate insured items into the blockchain, it could provide an automatic transfer of cash from an insurer for repairs when the item is broken. Decentralisation could see huge reductions in fraudulent claims, which already cost the sector £1.32bn across all insurance products. It could also help to identify instances of fraud, through the establishment of a public, tamper-proof database to track ownership and transfer of assets – including property and valuables. In creating a digital history of assets, insurers and insurance companies alike could see significant savings in the streamlining of payments of premiums and claims. For example, the company Everledger uses blockchain technology to provide a permanent ledger for the certification and transaction history of individual diamonds. The users of Everledger are able to know who owns which diamond, and where it is at any given point in time. It can trace the movement of diamonds across platforms such as eBay or Amazon, working together with insurers when diamonds are reported as stolen locally, and with organisations such as Interpol and Europol when diamonds have crossed borders or entered onto the black market.

Blockchain – is there a downside?

Blockchain presents unique problems for regulators, because it distorts the current model where a trusted (and regulated) third party is used for transactions to take place and it is those third party institutions that regulators rely on to supervise the parties to the transaction.

While they appear to recognise the positive impact that developments could have for consumer welfare and economic development, there are many calls for regulation to deal with the risks this new technology could bring

In the financial services industry regulators across the world have been grappling with the technology and its potential impact.  The general approach appears to be to regulate the specific uses to which blockchain can be put rather than regulating the technology itself.  So far, only two regulators have implemented specific regulations relating to virtual/cryptocurrencies: the New York State Department of Financial Services and Japan’s Financial Services Agency.  In the United Kingdom, the Financial Conduct Authority (FCA) has set up what they term a ‘sandbox’ which is a system whereby businesses develop new (unregulated) products and services and test them in the real marketplace but in a supervised space, and the FCA checks in on what they are doing as they go along.  In the last row of sandbox applications, 77 businesses applied and 31 were greenlighted to test their products. Similarly, the Malta Gaming Authority (MGA) recently commissioned a sandbox test on the potential introduction of virtual currencies in Malta and the general impact of cryptocurrency on the Maltese economy. The Malta Financial Services Authority (MFSA) has also launched a consultation process regarding the proposed regulation of Virtual Currency Investment Funds. Both regulatory initiatives are ostensibly rooted in the confirmed legislative commitment to develop a broad national strategy that will see Malta embracing blockchain innovation.

Data protection

Data protection is a specific area of law that will need careful examination since Blockchain will see huge amounts of personal data being processed in any number of areas, such as health information, electronic identification and financial details. Because blockchains are decentralised, there is no single identifiable entity responsible for processing that data, so who is responsible for making sure personal data on a blockchain is properly treated?  Moreover blockchains are public and transparent, so the data may be accessible by absolutely everyone.  If there has been a data breach, blockchain’s irreversibility suddenly becomes problematic because you cannot rectify it.  This would also appear to violate current European data protection laws, which include the right to erasure.

Enforceability

Smart contracts appear to pose interesting questions of enforceability.  They are not contracts in the real sense of the word (they are codes), but they carry out the function of a legal contract. So what happens when a transaction goes wrong? How does one establish offer and acceptance and the other elements of contract law? Because there is no central authority when things go awry, to whom will parties look to sort out a dispute? It could be that there will still be a need for a written agreement that overlays the smart contract to cater for specific arbitration mechanisms, governing law and jurisdiction clauses in order to provide greater certainty about what laws would apply.

Lack of regulation

Because the technology is so new, regulators at EU-level are taking a cautious approach to blockchain. While they appear to recognise the positive impact that developments could have for consumer welfare and economic development, there are many calls for regulation to deal with the risks this new technology could bring. There are particular concerns that blockchain technology may be used for money laundering, terrorist financing and fraud. This, in turn, can result in governance gaps, systemic risk, regulator resources and legal uncertainty. At the beginning of March 2016, in less than 24 hours, the UK’s Financial Conduct Authority (FCA), the European Parliament and the Financial Stability Board (FSB), published three documents, demonstrating the extent of their interest in (i) using; and (ii) beginning to regulate, cryptocurrencies and the blockchain. The problem for regulators is that decentralised applications and blockchain-based organisations are difficult to control and regulate. Digital currencies, if they gain widespread adoption, may be impossible to shut down precisely because they are not centralised and not controlled by governments or subject to the authority of any regulators. The pseudo-anonymous nature of the blockchain technology combined with encryption could potentially hamper law enforcement’s ability to uncover and clamp down on illegal activity, such as tax avoidance or communications between terrorist cells.

The MFSA has launched a consultation process regarding the proposed regulation of Virtual Currency Investment Funds. Both regulatory initiatives are ostensibly rooted in the confirmed legislative commitment to develop a broad national strategy that will see Malta embracing blockchain innovation

In an effort to address the early financial issues associated with the widespread use of virtual currencies, the Her Majesty’s Revenue & Customs in the UK (HMRC) set out its views on the tax treatment of Bitcoin and other cryptocurrencies. It confirms that transactions involving cryptocurrencies will be subject to the usual corporation tax, income tax and capital gains tax rules – unless or until HMRC announces any changes – reflecting the potential uncertainty as to how cryptocurrencies will be taxed in the future. Following suit, the European Court of Justice on 26 October 2015 ruled that the exchange of traditional currency for Bitcoin virtual currency and vice versa constituted a valued-added-tax (VAT)-exempt supply of services. Both the European Court of Justice and HMRC have stated categorically that bitcoins do not comprise tangible property and are not legal tender. If bitcoins are not legal tender, this means that existing tax rules cannot be directly applied (as these rules generally assume payment with legal tender).

Blockchain and significant developments across the globe

NASDAQ

In May 2015, NASDAQ announced that it would employ blockchain technology to enhance the equity management capabilities offered by its private market platform as part of an enterprise-wide initiative. NASDAQ stated that it would initially: introduce a coloured coin innovation whereby the value of real world assets can be represented and managed in a blockchain, leverage the Open Assets Protocol in order to enable the issuance and transfer of assets and launch a blockchain-enabled digital ledger technology, which would provide extensive integrity, audit ability, governance and transfer of ownership capabilities. NASDAQ was one of the first multinational financial services companies to explore ways to leverage the blockchain in a non-currency manner. In its first application it hopes to provide a fully-electronic, distributed ledger-style solution for accurate record-keeping, to complement ExactEquity™ – the ‘Nasdaq Private Market’s’ cloud-based equity management solution. This enables private companies to manage their capitalisation tables and stock plans more efficiently.

Delaware

On 2 May 2016, almost a year after the NASDAQ announcement, Delaware Governor Jack Markell announced his support for the creation of a new method of representation of corporate share ownership. Already being the home for many start-up and venture capital-backed businesses (as well as 66 per cent of Fortune 500 companies), the state of Delaware would have the capability – as well as traditional certificated and uncertificated shares – to issue shares using the same technology that underlies the virtual currency Bitcoin. As an integral part of the ‘Delaware Blockchain Initiative’ this would involve the creation of a new type of share registration for Delaware corporations: distributed ledger shares. Expanding on the benefits of the technology, the state of Delaware has included voting and other governance processes in its considered application of blockchain technology. It claims that the adoption of blockchain will be rapid and suggests that entities incorporated in Delaware should consider developing a blockchain strategy through Pillsbury, the state’s Legal Ambassador to the industry.

Honduras and Estonia

Honduras has committed to replacing its existing real-estate records with blockchain technology.

Estonia has taken the technology to the core of its government and financial institutions, using it in the provision, distribution, storage and management of a Public Key Infrastructure or ID cards. These cards allow citizens to order prescriptions, vote, bank online, review their children’s school records, apply for state benefits, file their tax return, submit planning applications, upload their wills, apply to serve in the armed forces and around 3000 other functions. Entrepreneurs are also able to use the ID card to file their annual reports, issue shareholder documents and apply for licences. Government officials even use the ID card to encrypt documents for secure communication, review and approve permits, contracts and applications, and submit information requests to law enforcement.

Australia

The Australian Government appears poised to approve a bill which would arguably bring cryptocurrency regulation one step closer. The bill, which essentially aims to strengthen anti-money laundering laws, will effectively empower the financial intelligence regulator, AUSTRAC, to police digital currency exchanges (where cryptocurrencies are traded for fiat currency, funds or other cryptocurrencies or virtual currencies).

Such virtual currency exchanges would be required to be duly registered under the new regime, a requirement which would appear to point to eventual full regulation.

Gibraltar

The Gibraltar Financial Services Commission has confirmed that it will introduce regulations to regulate blockchain businesses with effect from January 2018.

It is understood that the scope of the regulations will broadly cover the usage, by way of business, of blockchain for the transmission or storage of value belonging to others and is expected to include ICOs, custodians and exchanges.

Malta

In April 2017 the Maltese Cabinet approved the first draft of a national strategy to promote blockchain technology in order for it to be implemented in, inter alia, the Lands Registry and the national health registries.

In September 2017 after 20 months of research and development, the first locally built distributed ledger application targeted at property transfer management, LP 01, was launched through the start-up company, ‘Ledger Projects’.

Malta’s Ministry for Education and Employment (MEDE) is currently working with Learning Machine Group (LMG) to put University degrees and earned credentials on the Bitcoin blockchain using the Blockcerts open standard whilst The Malta Stock Exchange has formed an internal ‘Blockchain Committee’ to guide the development of a strategic roadmap for testing the technology.

Perhaps the most significant regulatory steps demonstrating a willingness to embrace and harness blockchain technology are the above-mentioned initiatives which are currently being driven by the MGA and the MFSA respectively.

Local initiatives so far appear to point to a soft rollout of blockchain and cryptocurrency, within a ‘controlled framework’, geared towards ensuring that the technology can be introduced without putting the country’s economy at risk.

For information about new updates about blockchain technology in Malta you can join the ‘Blockchain Malta’ group by visiting: https://www.linkedin.com/groups/8603237.

What next?

The one certainty thus far would appear to be that virtual currencies present great opportunity coupled with significant risk. The key therefore ostensibly lies in innovative yet prudent regulation

Crypto advocates and sceptics alike cannot but acknowledge that there are distinct benefits to using blockchain, the most important of which is that it offers the functionality of carrying value, thereby allowing instant transfers of funds, which can be applied to almost every area of our lives and industry in which we may be involved.

Accordingly, the one certainty thus far would appear to be that virtual currencies present great opportunity coupled with significant risk. The key therefore ostensibly lies in innovative yet prudent regulation. To this end, tailor-made, fit for purpose laws and regulations would need to be carefully developed to cater for the various uncertainties that have been created by this phenomenon whilst embracing what could quite quickly become tomorrow’s technology.

 

This article has been prepared on the basis of information compiled from the following two sources:

Blockchain technology: Is it building a brighter future?’ A report issued in December 2016 by the IBA Legal Policy & Research Unit (Authors: Jane Ellis, Anurag Bana, Christian Decle)

Everywhere in Chains’: IBA Global Insight – Aug/Sep 2017 edition (Author: Polly Botsford)

Contact Be. Legal Advocates to find out more about the blockchain revolution and the corresponding regulatory initiatives in Malta

About Dr Doran Magri Demajo

Dr Doran Magri Demajo is a Partner at Be Legal and is primarily responsible for corporate law, employment law, financial services and Maritime law.
View all posts by Dr Doran Magri Demajo

Other Posts

Contact Us!
Your message was successfully sent!



10 + 10 =

Menu