BLOCKCHAIN RAFAEL ZAHRALDDIN & ERIC SUTTY AUGUST 13, 2019 – SEATTLE, WASHINGTON WHAT IS CRYPTOCURRENCY? • At its most basic level, cryptocurrency is a string of computer-generated code, identified in a public decentralized ledger called a “blockchain.” • This line of code is accessed by an owner’s unique passcode: a secret and private key giving access to the owner’s “virtual wallet” (an account where cryptocurrencies are held). • The interface is functionally similar to traditional banking portals for customers • However, if a user loses his/her private key, the wallet would be forever inaccessible because it is impossible to recover a lost key. • Ownership and use of cryptocurrency is, for the most part, anonymous. 1
CRYPTOCURRENCY (VIRTUAL CURRENCY) VS. DIGITAL TOKEN • Cryptocurrency –digital representation of value that can be traded and functions as a unit of account or stored value. • Token –representation of a unit functionality, service, or rights in or to an asset. • Wallet (or Digital Wallet) –storage mechanism for digital assets. Wallets are cryptographically protected by a digital key that is personal to the owner of the wallet. THE BASICS OF A CRYPTOCURRENCY TRANSACTION • Any blockchain transfer occurs through the blockchain protocol. • A transaction is initiated by the transferor (using his/her private key) to broadcast to other holders of the decentralized ledger that he/she is decreasing their virtual wallet and correspondingly increasing the virtual wallet of the transferee. • The other members of the network verify and confirm the transaction, which is then recorded on the blockchain ledger. 2
CRYPTO-CURRENCY • Cryptocurrency takes many forms with many names such as Bitcoin (the most well known), Ethereum, Komodo and KodakCoin. • There are more than 1,500 of these alternative currencies that operate outside the control of any central bank or sovereign treasury department. • Exchange platforms such as BitConnect and Bitfinex maintain the virtual wallets and facilitate transfers, and the structures of these platforms vary. Special thanks: Rick Rein and John Guzzardo, The Trustee and Bitcoin, Identifying and Recovering International Cryptocurrency Assets, ABI Journal August 2018. CRYPTOCURRENCY? BLOCKCHAIN? WHAT IS IT? • At its most basic level, cryptocurrency is a string of computer-generated code, identified in a public decentralized ledger called a “blockchain.” • This line of code is accessed by an owner’s unique passcode: a secret and private key giving access to the owner’s “virtual wallet” (an account where cryptocurrencies are held). • The interface is functionally similar to traditional banking portals for customers • However, if a user loses his/her private key, the wallet would be forever inaccessible because it is impossible to recover a lost key. • Ownership and use of cryptocurrency is, for the most part, anonymous. 3
BLOCKCHAIN VS. DISTRIBUTED LEDGER TECHNOLOGY (“DLT”) • NOT the same thing • Blockchain is a type of DLT • Other types of DLT include Tempo (Radix) and Directed Acyclic Graph (Tangle) • These DLT platforms argue that they are more scalable than blockchain • Distributed ledgers use independent computers (referred to as nodes) to record, share and synchronize transactions in their respective electronic ledgers (instead of keeping data centralized as in a traditional ledger). • Blockchain organizes data into blocks, which are chained together in an append only mode. HOW BLOCKCHAIN WORKS A wants to The transaction The block is 1 send money or 2 is represented 3 broadcast to every digital asset to online as a party in the B “block” network Those in the network The block is added to The money or 4 5 6 approve the the chain, providing an digital asset transaction is valid indelible and moves from A to transparent record of B transactions 4
DISTRIBUTED LEDGERS A DISTRIBUTED LEDGER HAS NO CENTRAL AUTHORITY AND EVERY NODE IS RESPONSIBLE FOR MAINTAINING THE LEDGER BLOCKCHAIN CURRENT USES Blockchain allows for the confirmation and ownership transfer of basically anything: • virtual currency, • financial services, • corporate and commercial transactions, and • supply chain verification. 5
U.S. FINANCIAL SERVICES REGULATION The SEC has made cryptocurrency an area of concern: • The current SEC position is that Bitcoin and Ether, two of the largest cryptocurrencies are not securities. • When a cryptocurrency becomes sufficiently decentralized the SEC no longer views it as a security. • Smaller initial coin offerings, or ICOs, are almost always securities in the SEC's eyes and subject to the same regulations as normal stocks. The Commodity Futures Trading Commission now permits the trading of cryptocurrency derivatives publicly. • The CFTC has designated bitcoin as a commodity and announced that fraud and manipulation involving bitcoin traded in interstate commerce and the regulation of commodity futures tied directly to bitcoin is under its authority. • The CFTC allowed the CME and CBOE to launch bitcoin futures. CFTC also approved a platform for the trading and clearing of virtual currency derivatives for LedgerX, LLC, a swap execution facility and derivatives clearing organization. EXCHANGE PLATFORMS Example Bitfinex • Bitfinex utilized multi-signature segregated wallets, where both the owner of the account, the exchange platform and a third-party vendor held separate keys — all of which were necessary in order to authorize fund transfers. • These exchanges often reside outside the U.S., making their reach by trustees difficult. • Some exchanges maintain the identity and contact information of their customers, but this is not currently the norm. • However, these exchanges could (and should) have traditional bank account information whenever their customers “cash in” or “cash out” of the cryptocurrencies. 6
VOLATILITY Source: Messari. Prices as of 11:30 a.m. on July 26, 2019 CRIMINAL ORIGINS “It all started with an online marketplace to buy drugs. Well, it had started a couple of years before that, but the darknet outfit known as Silk Road was the first time most people heard about bitcoin and cryptocurrency. After doing more than a billion dollars’ worth of trades in a little more than two years, Silk Road was shut down in 2013 following an FBI investigation. Despite this shady origin story, the technology behind the drug bazaar’s currency — blockchain — is now being touted as the most disruptive technology since the internet.” THE FUTURE OF CRIME IN THE BLOCKCHAIN ECONOMY By James Watkins 7
REGULATION EXCHANGE LICENSING • It is possible to start a cryptocurrency exchange without a license. • Some of the world’s largest crypto exchanges are not regulated. • The most common current regulation is an Electronic Money/Payment Institution License. • These licenses allow wallets to be enabled and therefore support currencies in the exchange but their adequacy with respect to cryptocurrency activities is limited. • Specific regulations adapted to cryptocurrency have yet to be developed or are in their infancy. • Existing regulatory bodies are all watching cryptocurrency activity and some have outright banned all digital currency and others are busy trying to determine whether digital currency falls within existing statutory definitions. • Other jurisdictions have official cryptocurrency licensing and regimes encouraging the expansion of digital currency. 8
FINANCIAL SERVICES: CRYPTOCURRENCY EXCHANGE LICENSES • There is no licensing for cryptocurrency exchanges by the U.S Federal government • New York State, for instance, implemented “BitLicense” regulations, which grant licenses to virtual currency businesses, in 2015. • California has refused to implement regulations FINANCIAL SERVICES: MONEY TRANSMITTER LICENSES AND REGISTRATION REQUIREMENTS • All types of money service businesses must register with FinCEN, the Financial Crimes Enforcement Network, which is part of the U.S. Treasury in order to obtain a money transmitter license, but to operate in 46 of the 50 US states you also need individual state licenses if you will be facilitating payments of residents of those states (California, New York, Texas and Illinois). There is no reciprocal licensing system in the US. The National Conference of Commissioners on Uniform State Laws voted in July 2017 to approve a model act providing for the regulation of digital currency businesses at the state level. • In Europe, there is a Payment Services Directive last updated in 2015 that provides for a unified license system to facilitate payments in the UK/EU so that individual licenses are not required in each country. • Canada has no licensing system (except in Quebec), though there is a registration requirement Federally, with the Financial Transactions and Reports Analysis Centre of Canada (“FINTRAC”) and provincially, in Que ́ bec only, with the Autorite ́ des Marche ́ s Financiers (“AMF”). In Que ́ bec, a business that operates a virtual currency ATM or that provides a platform for trading virtual currencies is required to obtain a license under the Money-Services Businesses Act 9
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