Blockchain is coming your way
“When I first started doing the work, I didn’t put cryptocurrency in the forefront of my practice, because it wasn’t a mainstream activity and I didn’t want to draw the ire of regulators,” Osei told Lexpert.
Since the beginning of 2018, however, Osei’s website markets him as a “business and blockchain” lawyer, whose practice areas extend to cryptocurrencies. “The growth in my blockchain practice has been exponential since,” he says. “The technology is something that almost every industry has tested and legal work is going everywhere.”
Osei now spends up to 85 per cent of his working life on blockchain-related matters. “My clients range from everyday cryptocurrency traders to multimillionaires, to cryptocurrency miners, to exchanges, to retail clients who have somehow incorporated bitcoin or blockchain into their business.”
It turns out that, notwithstanding the “Wild West” atmosphere that inhabits the still immature world of blockchain, Osei didn’t have much to worry about. Even as he was quietly building his practice, Canada’s major firms, including Bennett Jones LLP, Borden Ladner Gervais LLP (BLG), Fasken Martineau Dumoulin LLP (Fasken) and Gowling WLG were making no bones about the potential they saw in the new technology. “The demand for legal advice in this arena has grown exponentially in the last 12 to 18 months,” says Mike Stephens, a corporate finance and mergers and acquisitions (M&A) lawyer in Fasken’s Vancouver office. “But the growth has been steady since 2013, and moving in leaps and bounds for a few years now.”
Still, the frenzy surrounding the wild swings in the price of bitcoin over the last year and the speculation regarding the future of cryptocurrency in general has overshadowed the potential of the underlying technology, known as blockchain, as a disruptive force in the business world.
“Blockchain, bitcoin and other cryptocurrencies could create very widespread disturbance because they are horizontal technologies that will affect a multitude of vertically-integrated industries,” says Usman Sheikh in Gowling WLG’s Toronto office. “It is only the rare industry that will be immune.”
All the more so because blockchain applies to the world as we know it, operating on things that are already happening, as it were. “The magic is not that there’s a new species of transaction, such as cryptocurrency trades, taking place,” says Dan Logan in Baker McKenzie LLP’s Toronto office. “It’s still a trade, but the distributed ledger that’s at the heart of blockchain technology allows it to happen much more efficiently and transparently.”
That’s why Stephens believes that businesses that ignore blockchain will soon be running behind the train. “Every organization that has a visionary CEO is seriously looking at how to bring blockchain into their business model,” he says. “Everyone, from parking lot companies to fish canneries, wants to talk to their lawyers about it.”
Certainly, general counsel (GC) and their legal departments are hearing a lot more from their clients about blockchain. If they’re not, they should probably be asking why, and perhaps leading the charge. “The question is whether a particular industry and its counsel want to pivot their business to take advantage of or be ahead of the disruption or whether they will wait to follow others,” Sheikh says.
Some observers compare blockchain to Napster, the music-sharing technology. Both are virtual and peer-to-peer, in the sense that they do not require a centralized server to function securely. In effect, the technology casts aside middlemen or conduits like financial institutions and replaces them with self-directed computer networks whose core is a transparent but unchangeable distributed ledger open to all members of the network. “Blockchain, like the Internet, will change transactions the way that the Internet has changed communications,” says Christian Jacques in Fasken’s Montreal office.
Individual blockchain transactions are unique and identifiable. They cannot be copied and can only be transferred once. Transfers occur when a holder signs a transaction with a private digital key and records it on the shared ledger. The transactions can be seen, but not altered, by anyone on the network. [See Tip Sheet]
“Blockchain is a technology that revolutionizes the transmission of information, creating a fundamentally different way of recording and verifying transactions where multiple computers widely dispersed across the planet execute an algorithm initiated by one of them but confirmed by them all through an answer that is held in the blockchain,” says Ross McGowan in BLG’s Vancouver office. “It’s very difficult to interfere in the process because someone trying to do that would have to get to all of the computers involved.”
Because blockchain focuses on eliminating the middleman, it can create a vast decentralizing effect to which business may find it difficult to adjust. “Blockchain has none of the hierarchies that we have become accustomed to in government and business,” says Toronto-based Conrad Druzeta, co-head of Bennett Jones’ blockchain and fintech group. “It requires a shift of thinking that replaces a central authority with a code of blockchain that will itself set the rules of the game.”
From a legal perspective, the “smart contract” aspect of blockchain technology may be of the most direct interest to in-house counsel and other lawyers. Here’s how Don and Alex Tapscott, co-authors of Blockchain Revolution: How the Technology Behind Bitcoin Is Changing Money, Business, and the World, describe the technology:
“Smart contracts are a form of a program that gives certain conditions and outcomes to money. If there is a transaction between two people, this program can be used to help verify the product or service and whether or not it was fulfilled. Once it has been verified, it can then be transferred to the person’s account.”
According to a report by Mark Walport, the United Kingdom (UK) government’s chief scientific adviser, distributed ledger technology can reduce the cost of paper-intensive processes, including contracts. Smart contracts, Walport stated, can provide “cryptographic certainty that the agreement has been honoured in the ledgers, databases or accounts of all parties.”
No surprise, then, is the Tapscotts’ observation that expertise in smart contracts “could be a big opportunity for law firms that want to lead innovation in contract law.” The opportunity could be just as fruitful for law departments. Timothy Hill, technology policy adviser at the Law Society of England and Wales told media that Walport’ s report makes it clear that blockchains “are a powerful innovation that could have a profound impact on both the law and the provision of legal services.”
Indeed, the applications seem endless.
“[Smart contracts] could be used to declare wills, transfer property or create self-executing contracts,” Hill said. “They also raise profound questions about the future balance between technical code and legal code – something Walport suggests that lawyers and technologists will need to work together to get right.”
Blockchain’s most telling inroads so far have been in the financial services industry, which to a large degree functions as a centralized intermediary. According to Rob Dawkins, McGowan’s partner at BLG in Vancouver, the emergence of cryptocurrency “promises to give a bank account to anyone with a mobile phone, no ID required.”
In other words, the services of banks and other intermediaries will not necessarily be required to keep track of money and ensure that it has been transferred to legitimate parties. In the blockchain, total strangers can keep an accurate ledger of records without resort to trusted third-parties or middlemen.
Major institutions, however, are confronting the threat to their business.
“Before 2015, few major financial institutions had announced investments in the sector,” the Tapscotts write. “Today, Commonwealth Bank of Australia, Bank of Montreal, Société Générale, State Street, CIBC, RBC, TD Bank, Mitsubishi UFJ Financial Group, BNY Mellon, Wells Fargo, Mizuho Bank, Nordea, ING, UniCredit, Commerzbank, Macquarie, and dozens of others are investing in [blockchain] technology and wading into the leadership discussion.”
According to the Tapscotts, “financial titans” are also playing venture capitalist in this arena. Among those who have made direct investments in start-ups or incubators are Goldman Sachs, NYSE, Visa, Barclays, UBS and Citigroup.
In keeping with the times, the Canadian Securities Exchange earlier this year announced the introduction of a securities clearing and settlement platform using blockchain technology. The platform — an intersection of digital assets with traditional financial products — will allow companies to issue conventional equity and debt through tokenized securities. “While the platform is subject to regulation by securities commissions and not a full public blockchain, it is expected to provide real-time clearing and settlement,” Druzeta says.
But financial services are just the tip of the iceberg. “In the near term, the technology is intuitively applicable to certain aspects of a wide range of industries, particularly their supply chains,” says Stephens, like his Montreal-based partner Christian Jacques spends “pretty much 100 per cent of my day” dealing with legal and business issues arising from the technology.
Blockchain technology has already been applied to medical records, land registry holdings, digital identity and even diamond sales. On another front, market capitalization of cryptocurrencies — of which 1565 different kinds were available on the Internet as of April 2018 — already exceeds US$500 billion.
Looking further ahead, proponents of blockchain say it will threaten many of the go-betweens who stand between buyers and sellers, including this era’s corporate behemoths and innovators: after all, Uber, Amazon, iTunes and Ticketmaster are just a few examples of companies whose prosperity comes from being conduits to consumers. “As time goes on, people will find more and more uses for distributed ledger technology,” Druzeta says. “Everything from housing registries to confirming the authenticity of artwork will be affected in one way or another by this new paradigm.”
According to statista.com, a statistics portal, the market for blockchain technology worldwide is expected to grow from US$210.2 million in 2016 to $2.3 billion in 2021. Bloomberg reports that interest in the technology is so intense that when beverage company Long Island Iced Tea changed its name to Long Blockchain Corp. in 2017, its stock price rose almost 300 percent in one day even though it had yet to actually be involved with blockchain.
Governments worldwide have taken notice. In June 2015, the Canadian Senate’s Committee on Banking, Trade, and Commerce released a report that explained why governments should embrace blockchain technology. Later this year, the federal government will publish regulations that govern virtual currency exchanges.
In the US, the National Conference of Commissioners on Uniform State Laws have released a draft of the Regulation of Virtual Currency Business Act. The US, Australian and Estonian postal services are looking at ways that blockchain technology can improve their financial products like money orders and international money transfers. Jurisdictions as disparate as the State of Vermont and Honduras are looking into the opportunities, and the Linux Foundation, the nonprofit organization that enables mass innovation through its open-source approach, is spearheading a collaborative effort to advance blockchain technology.
Law firms have hopped on the bandwagon enthusiastically. Fasken, for example, is a founding member of the Global Legal Blockchain Consortium, a non-profit organization aimed at setting operating and governance standards for the adoption of the technology in the profession. Meanwhile, Gowling WLG has formed a strategic alliance with Toronto-based Decentral Inc., whose founder, Anthony Diiorio, co-founded Ethereum, an open-source, public, blockchain-based distributed computing platform and operating system that generates the popular cryptocurrency known as ether. The alliance is intended to “optimize the many commercial and legal applications of blockchain technology” and to “fuse their expertise on a number of significant initiatives — from engineering practical smart contract technology and drafting foundational legal precedents documents, to helping regulators establish frameworks that encourage the responsible growth of Canada’s thriving blockchain sector.”
The implications for legal departments, then, arise from a myriad of legal, regulatory and business perspectives.“In-house counsel better understand what the issues are because many of their companies will have to adapt,” says Theodore Ling, Dan Logan’s colleague at Baker McKenzie in Toronto. “Once they have identified the issues, they need to do the proper due diligence and analysis on the steps their clients are taking to confront the blockchain challenge, identify the potential risk and move to mitigate.”
Doing so is a formidable endeavour, however, largely because it’s difficult to envision the legal implications of blockchain without understanding its underlying technology — which can be confusing. “The complexity comes from the fact that the technology is not identical in all its myriad applications,” Logan says. “So in-house lawyers, who are generally not experts in tech-related matters, can be dealing with different kinds of blockchain to address different kinds of transaction, with each giving rise to disparate legal issues.”
Legal implications may vary, also, depending on the type of transaction that is the subject of the distributed ledger. “If the contract embedded in the blockchain is a trade, you could be drawn into the entire body of securities law to understand how it applies,” Logan explains. “And if you’re looking at obtaining information from the distributed ledger, you could be drawn into things like privacy concerns.”
Finally, access to the network that supports the blockchain could also vary, ranging from allowing access from only a few identifiable participants to a completely open system that requires no identifiers other than an IP address. “Blockchain is not one-size-fits-all,” Logan says. “Anyone analyzing a platform will have to familiarize themselves with all these variables.”
Recognizing what appears to be the impending ubiquity of the technology and its intricacy, the University of Ottawa Faculty of Law has opened a new research lab focused on blockchain and will be offering a new course in 2018-19 entitled “Blockchain Law and Society” concentrating on legal technology issues.
The importance of understanding the technology underlying blockchain becomes apparent on examination of the legal issues surrounding the ICO (initial coin offerings) phenomenon, which raised about US$4 billion in 2017.
Initial coin offerings, also known as initial currency offerings, are a species of crowdfunding for startup companies that uses cryptocurrencies as a medium of exchange. An ICO involves the sale of crowdfunded cryptocurrency in the form of “tokens” in exchange for legal tender or other cryptocurrencies such as bitcoin or Ethereum. The value of the “tokens” is said to be in their potential as future functional units of currency when the ICO meets its goals and the underlying project launches.
But ICOs currently operate in a gray zone: it remains unclear whether any particular “token” is a “security” that creates an expectation of profit or a “utility” that carries an expectation of use. The former is subject to securities regulation; the latter is not. But what fits where is as yet unclear, and the uncertainty has contributed significantly to the perception of ICOs as risky endeavours — a perception borne out by Fortune magazine’s report that nearly half of ICOs issued in 2017 had failed by February 2018.
In response, China and South Korea have banned ICOs outright. For its part, the US Securities and Exchange Commission (SEC) has stepped up its regulation of the industry, going so far as to issue a cease-and-desist order against Munchee Inc., a mobile restaurant review app, in late 2017. Other American agencies figuring out how to regulate blockchain and cryptocurrencies are the Commodities Futures Trading Commission, the Financial Industry Regulatory Authority and the Federal Trade Commission.
In the United Kingdom, the Financial Conduct Authority recently warned firms offering services related to crypto-derivatives that it had jurisdiction over them. The European’s Parliament’s most recent anti-money-laundering directive included measures to regulate platforms on which virtual currencies are exchanged for legal tender, a step previously taken by both Australia and South Korea. And at the March meeting of the G20’s central banks, their governors committed to extending existing standards, like know-your-customer directives and procedures for tracking suspicious transactions, to the crypto-world.
Canadian regulators, for their part, have not as yet released specific guidance on when a token will be considered a security. According to Davies Ward Phillips & Vineberg LLP’s 2018 Canadian Capital Markets Report, the determination of whether a token is a security “will not be isolated to whether or not the token has ‘utility’ but will ultimately depend on the relevant facts and circumstances”. The report adds:
There are a number of legitimate purposes for conducting an ICO other than raising capital. For example, some blockchain entities use an ICO to distribute tokens to parties interested in using the platform, effectively creating a user base and kickstarting the network.
Fortunately, Canadian regulators have been willing to provide what amounts to advance rulings about an ICO’s susceptibility to securities laws. The first was obtained by Fasken for Axion Zen, a Vancouver company, when regulators provided a formal determination that the tokens Axion sought to generate for its CryptoKitties game, were not securities.
CryptoKitties — the first game successfully built on the Ethereum network — allows players, using ether tokens as the medium of exchange, to purchase, collect, breed and sell various types of virtual cats — with the blockchain ledger recording and verifying all transactions. The game, so successful that it slowed down the Ethereum network by an estimated 11 per cent, has been hailed as an indication of the growing potential of blockchain technology. “CryptoKitties was the first legal Canadian ICO,” says Mike Stephens.
Indeed, 2017 was a breakout year for the cryptocurrency asset class. “Many traditional and alternative asset managers launched investment funds and offered asset management services relating to these assets,” says Stephen’s partner Christian Jacques.
Here again, and also in the financing field, the rapidly shifting regulatory landscape has been primordial fodder for lawyers — so has the need for crypto-mining facilities. “Canada offers some of the world’s best locations for crypto-mining facilities, whose setup has also involved our real estate and energy groups in various issues,” Jacques says.
Not surprisingly, blockchain also engages intellectual property (IP) issues, and in a variety of ways. At the heart of these issues is the fact that many developers are stacking software solutions on the technology, using blockchain to power their applications. “Ownership of that IP,especially as it moves into the open-source arena, then becomes a question,” Stephens notes. “Clients are also asking about licensing and software agreements, among other things.”
The bottom line for in-house counsel, then, is this: blockchain, either as an independent business or as part of your business, is likely coming your way. Do you know enough to ask the right questions when it does, or preferably, before it gets there?
Author: Julius Melnitzer