Blockchain & Cryptocurrency Wadih Pazos Justin Wales Senior - - PowerPoint PPT Presentation

Blockchain & Cryptocurrency

Wadih Pazos

Senior VP, WhiteOwl/PaperSave & Principal, MBAF

Justin Wales

Chair of Blockchain & Digital Currency Practice, Carlton Fields

Introduction Justin Wales

• First became involved in Bitcoin in late 2010.
• Became a First Amendment attorney upon graduating from law school in

2012.

• As the industry grew, practice became more transactional and regulatory.
• Founded and became Chair of Carlton Fields’ Blockchain and Virtual Currency

Practice in 2017.

• Represent:

– Exchanges, Wallets, Token issuers, Traders – Advises institutional clients (logistics, healthcare, insurance, telecommunications, etc.)

• n adoption of new technologies.

Introduction Wadih Pazos

• Software Architect specializing in Business Process Automation
• Envisioned PaperSave, a leading Document Management & Workflow

product providing solutions in Accounts Payable Automation, Donation and Donor Management, Contract Management, Collaboration and more.

• Have followed blockchains, bitcoin, and cryptocurrencies since 2011
• I believe that this innovation has made and will continue to make an

impact on information technology and the many industries that rely upon it

What is a Blockchain?

What is a Blockchain?

• A vast, global ledger or database running on millions of devices
• Accessible to anyone, but insulated from hacking or alteration by its

redundancy on myriad devices

• Provides an accounting and repository of currency, titles, deeds,

identities

• Votes can be verified, moved, stored, and managed securely and

privately

What is a Blockchain?

• Trust is assured through mass collaboration and clever coding, rather

than through intermediaries susceptible to intrusion and corruption, e.g., governments and banks

• All parties have a copy of the ledger in a blockchain and can confirm the

status and authenticity of the transaction in real time

• Distributed ledgers and consensus algorithms prevent the tampering of

data making the ledgers immutable

Continuation

How is data stored and transmitted on the Blockchain?

• Participants in a blockchain can generate unlimited unique addresses

(accounts)

• When you record the transfer of an asset from one of your addresses to

another address, it is broadcast to the blockchain as a pending transaction

• The transaction is confirmed through consensus algorithms that end in

the permanent recording of a block in the blockchain

Visualizing the Blockchain

The ledger is a chain of blocks! Each block is created with a pointer to the previous block creating a blockchain.

VISUALIZING THE

The ledger is copied and distributed amongst nodes.

Visualizing the Blockchain

The nodes reach consensus on a new block after the miners verify the validity of a new set of transactions and include those transactions in a new block.

Why Should We Care?

• A blockchain allows for

trustworthy transactions among multiple parties.

• Or, more importantly, it allows

transactions without trust of a third-party intermediary.

What Can Blockchains Do?

• Be applied to any multi-step transaction that requires traceability and

visibility.

• Build supply-chain networks to govern all phases of trade transactions.
• Take the friction out of settling securities transactions.
• Reduce financial services industry compliance costs by providing hack-

resistant means to self-verify and authenticate transactions.

• Address the piracy, control, and monetization issues that plague the

music industry in the digital age.

• Record real estate deeds securely, executing and recording financial

transactions over the internet.

Why is it important?

• Healthcare – manage patient medical

data

• Estate Planning – manage ownership
• f assets and wills
• Finance – effectuate stock trading
• Voting – reduce and possibly eliminate

voter fraud

What Can Blockchains Do?

• Hacking a blockchain is

computationally (and therefore economically) prohibitive

• By current estimates, to hack the

bitcoin blockchain, you would have to purchase over $1.5B of computer hardware

• Cost to run it perpetually would be

$2.8M per day

• Redundancy is created because the

transaction ledger is stored across a distributed network of computers

• There is no central point vulnerable to

failure

Public vs. Private Blockchains

Main Differences

• Who can participate in the blockchain
• Governance – who manages the nodes
• Monetary incentives for network operation
• Visibility, immutability, security, privacy

Blockchain property or function Public Private Decentralized and operates over a peer to peer network Facilitates the transfer of data between network participants (addresses) All information is appended to the ledger and synchronized across nodes through consensus Difficult to modify or tamper with the data on the blockchain due to consensus requirement Fault tolerant - All nodes on the blockchain hold copies of the ledger Participation is open to the public Authentication/authorization is required for participation Monetary incentives for network operation/consensus Ledger is completely open, transparent, and immutable Managed permissions for viewing data and or blockchain history Immutability is governed by the network operator

Smart Contracts

Smart Contracts

• Smart contracts are a type of address on a blockchain containing code
• Contract code can execute when assets transfer into the address to

automate the enforcement of terms in a real world contract

• The smart contract code can perform any action based on conditions

including forwarding an asset to other addresses, storing an asset in the contract address (escrow) and more

• Do not replace legal contracts, but automate their execution

Smart Contract Example

• Car company uses a blockchain to accept digital payment
• Customer sends their monthly payment into a smart contract address

that automates terms in their lease agreement

• The code within the smart contract can also be triggered if payment has

not been received into the contract address by the monthly due date

• The smart contract can safely deactivate the car remotely due to non-

compliance with the terms of the lease

• Sending in a payment + appropriate late fees into the contract address

triggers the smart contract to reactivate the car

Car Leases in the Future?

Blockchain Applications

Decentralized Applications (dApps)

• Decentralized applications (dApps) run on blockchain.
• Enabled through decentralized consensus and trust protocols.
• Authority and trust are transferred from central authorities to the

blockchain.

• Data is managed and maintained by the blockchain and not by a central

authority.

• Fees and rewards for supporting consensus are used to monetize the
• peration of blockchain.

New Intermediaries

Cryptocurrency

• Crypto transfers are done without an intermediary and is recorded on

the respective crypto’s blockchain

• Each address owner holds record of all of the crypto transferred to his /

her address (account) and controls the ability to transfer their crypto to

• ther addresses
• Node operators are compensated for consensus and data storage with

rewards and transfer fees

• Immutable and irrefutable transaction history that is publicly available

Public dApps Disrupting Centralized Banking

Challenges

Is Blockchain Ready?

Significant Challenges

• Underdeveloped ecosystem

infrastructure

• Lack of mature applications
• Scarcity in developers
• Immature middleware and tools
• Scalability
• Legacy systems
• Tradeoffs with databases
• Privacy
• Security
• Lack of standards
• Moving assets to the blockchain
• Quality of project ideas
• Critical mass of users
• Quality of startups
• Venture capital
• Not enough qualified individuals
• Costs issues
• Few best practices
• Unclear regulations
• Government interferences
• Compliance requirements
• Hype
• Taxation and reporting

Cryptocurrency & Regulations

Regulating New Technologies

• Regulators are trying their best but are in a difficult position.

– On the one hand, they are being asked to adapt quickly to new technologies that they may not understand in order to protect the public – On the other hand, overregulation or uninformed regulation can either prevent innovation or create ineffectual laws

• Early challenges in regulating crypto:

– Bitcoin/Crypto/Smart Contracts are often lumped into one category, so proposed regulations often lack the nuance necessary to create practical regulations – So no one really knows how to describe these things

Source of U.S. Legal Concerns

• Federal Laws & Regulations

– Securities & Exchange Commission – Commodities Futures Trading Commission – Internal Revenue Service – Financial Crimes Enforcement Network

• State Laws & Regulations

– State money transmission regulations – State frameworks – i.e., New York’s Bitlicense

Battle Royale

• FinCEN – View at least some crypto as a currency
• IRS – Views at least some crypto as property
• SEC – Views at least some crypto as a security
• CFTC – Views at least some crypto as a commodity
• States – Views at least some crypto as a currency, property, security, or

commodity

FinCEN

• Financial Crimes Enforcement Network – Department of the Treasury.

– Collects information on financial transactions to combat money laundering and terrorism. – Requires money servicer businesses to register and comply with applicable KYC/AML regulations. – March 2018 FinCEN published a letter that indicates tokens released through ICOs could be deemed “money” under applicable regulations requiring issuers to comply with FinCEN’s registration requirements:

• “"...a developer that sells convertible virtual currency, including in the form of ICO coins or

tokens, in exchange for another type of value that substitutes for currency is a money transmitter and must comply with AML/CFT requirements that apply to this type of [money services business]. An exchange that sells ICO coins or tokens, or exchanges them for other virtual currency, fiat currency, or other value that substitutes for currency, would typically also be a money transmitter.“”

• FinCEN actually issued the first federal enforcement against a virtual currency exchanger in

2015:

– Assessed 700k in fines against Ripple for violating the Bank Secrecy Act by acting as a money service business and selling XRP without first registering with FinCEN and implementing AML program to prevent use by terrorism.

IRS

• 2014 IRS first issued guidance classifying virtual currencies, “such as

bitcoin” as property

• Has made no distinction between types of cryptocurrencies
• Subjects all cryptocurrencies to capital gains treatment

– Pro: Recognizes that many purchase crypto as an investment – Con: Limits potential use of bitcoin and other virtual currencies from being adopted as a currency because each purchase (including of other cryptocurrencies) is a taxable event. (i.e. TAX NIGHTMARE)

• At same time, virtual currencies are taxed as income if paid as a wage.

Has not provided definitive guidance on treatment of “forks”, “air drops”

• r virtual currencies that are “mined” by the holder

CFTC

• Commodity Futures Trade Commission views “virtual currencies” as commodities regulated by

CFTC.

– E.D. NY in CFTC v. McDonnel (2018) agreed with CFTC’s position on the basis that “Virtual currencies are ‘goods’ exchanged in a market for a uniform quality and value…They fall well within the common definition of ‘commodity’.” – (1) A commodity, as defined in the Commodity Exchange Act, includes the agricultural commodities enumerated in Section 1a(9) of the Commodity Exchange Act, 7 USC 1a(9), and all other goods and articles, except onions as provided in Public Law 85-839 (7 USC 13-1), a 1958 law that banned futures trading in onions, and all services, rights, and interests in which contracts for future delivery are presently

• r in the future dealt in; (2) A physical commodity such as an agricultural product or a natural resource as
• pposed to a financial instrument such as a currency or interest rate. See 7 USC 1a(9)
• Commodity Exchange Act intends to regulate sale of futures or derivatives of commodities, but

grants authority to exercise jurisdiction on fraud

– By ruling virtual currencies are commodities, CFTC can exercise its jurisdiction over fraud that does not directly involve the sale of futures or derivative contracts – Problem is many virtual currencies are more reasonably classified, and are intended to be currencies or financial instruments

SEC

• The Securities and Exchange Commission regulates securities.
• Underlying purpose is to prevent investor fraud
• Section 2(a)(36) of the 1940 Act defines security as:

– Any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”,

• r any certificate of interest or participation in, temporary or interim certificate for, receipt

for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing

Investment Contract

• SEC’s definition of securities is purposefully broad.
• An investment contract is an investment of:

– Money – In a common enterprise – With a reasonable expectation of profits – To be derived solely from the entrepreneurial or managerial efforts of others. SEC

• v. Edwards, 540 U.S. 389, 393 (2004); SEC v. W.J. Howey Co., 328 U.S.293, 301 (1946)
• As explained by SEC in US v. __ (E.D. NY 2018), the Howey test is designed to be

“flexible” and “capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” Howey, 328 U.S. at 299

“Utility Tokens?”

• Throughout 2017 token offerings or ICOs became a fundraising
• mechanism. Over $4 Billion raised through token sales. Lots of fraud,

poorly managed or designed projects. Some very good projects.

– Many of the tokens purported to be “utility tokens” rather than “securities” – SEC has not weighed in on what constitutes a “utility token.” In fact, they have not recognized the existence of “utility tokens.” They only recognize security vs. not security.

• Considerations on whether something is or is not a security:

– How it is advertised/promoted – Whether there is actually any utility upon purchase of token – Intent of investor

States

• A smorgasbord of different types of regulations including:

– Defining Money Transmission to explicitly include or exclude virtual currencies.

• Money Transmission is a challenge for virtual currency businesses as each state takes a radically

different approach

– Recognizing legality of smart contracts – Including virtual currency into definition of money laundering – Including/excluding certain types of virtual currencies from state securities regulations

• Different Approaches:

– NY: Created the “Bit License” to broadly regulate virtual currency businesses. Drove business away from NY and there are attempts to amended to lessen burdensome compliance requirements – Wyoming: Created definition of “utility token” that exempts certain types of tokens from state’s definition of security and exempted virtual currencies from state’s MT requirement.

Wadih Pazos

Senior VP, WhiteOwl/PaperSave & Principal, MBAF

Justin Wales

Chair of Blockchain & Digital Currency Practice, Carlton Fields