The Challenge ^
Critical Success Factors ^
The starting point of the discussion will be the Etherum «The DAO hack» and the questions it raised in relation to the existing legal context. Then I will touch on what can be done to embed blockchain applications in the existing legal context2. Subsequently, I will discuss what is needed de lege ferenda to create regulations to best utilize the potential of blockchains3.
Preliminary Remark: Compliance and Regulatory Efforts as a Myth of Sisyphos? ^
Blockchains and its Applications as Humble Distributed Databases ^
- Many blockchain applications are in effect nothing else than distributed utilizations of excel spreadsheets put on a cloud server, allowing for document versioning and decentralized access4.
- Even many ICOs/ITOs (initial coin or token offerings respectively) are in essence nothing else than well-known customer retention programs, like collecting frequent flier miles or payback points. Remaining discussions about whether or not to add valued-added tax can be settled easily.
- If one takes money or crypto equivalents for a vague idea without any prospect to roughly realize the propagated expectations, he simply is a fraud because he has deceived someone and damaged others with intention.
- If blockchain applications or concepts fail with regard to poor software quality and program errors, there should be compensation for damages due to a lack of quality of supply.
Legal Findings ^
- Accountability – The DAO as a legal entity: The DAO did not have a formal legal anchorage, so the question came up, as to how it could be treated from a legal perspective. In the end, it has to be regarded as a general partnership or a private corporation with all involved stakeholders (investors, creators, operators) being personally liable.
- Code is not law – Relationship of code and law: If the stated assumption that Code is Law would have been correct, there would have been no need to wind back the blockchain and to fork Etherum classic. There would have been no incidence at all because everything happened as predefined by the algorithmic and programming context. Obviously, the assumption that code replaces law is simply wrong. The code in place operates always in a legal context which has to be determined and setup appropriately.
- Error fixation – missing error correction: The DAO «hack» also revealed a major shortcoming of so-called smart contracts with regard to the option of error correction. Error correction in software development is an expression of learning ability and agility, with regard to creatures it is even a condition for survival. Blockchains should rely on open source software, so that software errors can be located by a larger audience. Blockchains also should provide mechanisms to fix located errors quickly, though this is obviously in conceptual contradiction to the consensus mechanism.
- Know Your Customer – Transparency and identity: Blockchains offer ambiguous transparency. On the one hand every account and its actions are publicly available and fully reproducible, on the other hand the identity of the persons or organizations behind an account are not revealed as it was the case for The DAO «hacker», at least not by the system itself. If one stakeholder reveals the relation of his identity to his account, this can also threaten the anonymity of the other participants. A blockchain creator and operator can also determine his level of identity awareness by requiring full identification before getting access (e.g. via a wallet). If a state operates a blockchain, this will result in full knowledge and power of the state to identify each participant and each transaction without exception.
- Rollback and liquidation procedures – Too big to fail: After the financial crisis, discussions on how to avoid banks which are «too big to fail» came up. One idea is to cogently require phaseout procedures covering both legal (phaseout of a legal person) and financial aspects (return deposits). As The DAO case shows, the same principles make sense with regard to blockchains: They should also define rewind and phaseout procedures upfront.
- Staged ICO – Uncontrolled offerings: The DAO ICO was, with regard to the plain concept, offered unlimitedly. It raised $150 millions at once. Though it is unclear whether a staged ICO would have changed the course of action, there are good arguments to establish some kind of staged control of ICOs, e.g. with regard to the relationship of business substance (idea – whitepaper – prototype – organization with positive cash flow), to the business model (to sort out Ponzi-scheme like concepts), to the allowed amounts and with regard to the distribution and contribution for individuals and organizational investors.
State Specific Differences ^
- Switzerland has, also with regard to its finance industry, a very strong FinTech and RegTech community and movement, organized around blockchain technology. Particularly well-known are the small city and «Kanton» of Zug, which managed to establish themselves under the brand «crypto valley»7. As a resident I can even pay my taxes with Bitcoins and a digital citizen ID based on blockchain technology will become effective in early 20188. However, the Bitcoins are converted each day and the acceptance rate seems to be very modest, so far.
- Singapore’s Central Bank’s Chief emphasizes to avoid regulation but to be alert about possibly upcoming risks. He does not see the technology risky in itself, but its misuse. At presence, virtual-currency intermediaries such as exchange operators are already regulated with regard to combating money laundering and financing of terrorism9.
- In Canada adaptive steps are taken to welcome the use of cryptocurrencies and blockchains10. The regulators seem to be cautious and intentionally avoiding premature measures.
- So far only China has explicitly forbidden cryptocurrencies. As already mentioned, it sounds reasonable that the highly centralized and authoritarian state wants to avoid decentralized public management developments and will focus on utilizing blockchain for its own centralistic purposes subsequently.
- Due to the fact that internationally aligned regulation is missing, there is a certain competition between states at stake. Each state that prematurely bans blockchain related applications like cryptocurrencies or ICOs will loose interest, talents and money due to its locational disadvantage.
- States like Austria or Germany still have excellent prospects to harvest low hanging fruit and attract the blockchain industry by demonstrating domain specific understanding and appropriate regulation strategies. This seems to be an easy game, however, even that might be asking too much of the currently not established government in Germany and the new right-wing government in Austria. The same seems to be true for the Brexit-focused government in the United Kingdom, who has to hedge its importance as a location for international banking.
General Options ^
- Legal organization: What kind of organization is planned and makes sense to be utilized? This includes choosing an appropriate legal location.
- IT organization: What kind of transparency and publicity does the target technology provide and ask for? How are operational aspects reflected and taken into account?
- Domain specific regulations: Does the venture take place in a specific regulated area, e.g. banking, insurance, etc.?
- Tax-related issues: Are there probable tax-related issues which can be clarified? If accomplished upfront, this can avoid substantial threats to business models.
- Stages, stakeholder interests and phaseout: What kinds of stakeholders are involved and what is the legal relationship to each group? Is there a mechanism to start the project and to phase it out in case it fails or faces actual, unforeseen issues?
Power Consumption ^
Publicity of Blockchains / Identity Management ^
Transparency and Error Correction ^
Organizational Accountability ^
Regulation of ICOs ^
- Organizational clarity: Who is initiating the ICO? Which legal subjects are entitled to initiate an ICO?
- Legally binding documentation (e.g. white paper) / project state: Content of the ICO? In which state is the project in (e.g. idea, start up, minimum viable product, first customer base, and positive cash flow)?
- Stages as a determination of a certain course of action: Rules about investment cycles with regard to the state the project is in, e.g. rules about participants, investment limits and the spread for each cycle.
Local Regulation vs. International Regulation ^
How to Regulate Blockchain Regulation / a Plea for Human Rights ^
Alloway, Tracy, An Experiment, 2017, http://www.tracy-alloway.com/?p=577.
Bheemaiah, Kariappa, The Blockchain Alternative, Apress, 2017.
Biederbeck, Max, Der DAO-Hack: Ein Blockchain-Krimi aus Sachsen, Wired, 2016, https://www.wired.de/collection/business/wie-aus-dem-hack-des-blockchain-fonds-dao-ein-wirtschaftskrimi-wurde.
Brodu, Etienne, Blockchain, Degeneration of an Ideal, OuiShare Magazine, 2017, http://magazine.ouishare.net/2017/11/blockchain-degeneration-of-an-ideal/.
Chadwick, Sam, Crypto Valley Association Comes Out in Support for Careful ICO Regulation; Announces ICO Code of Conduct, Crypto Valley, 2017, https://cryptovalley.swiss/crypto-valley-association-comes-out-in-support-for-careful-ico-regulation-announces-ico-code-of-conduct/.
Chanyaporn Chanjaroen/Andrea Tan/Haslinda Amin, Singapore Won't Regulate Cryptocurrencies, Central Bank Chief Says, Bloomberg, 2017, https://www.bloomberg.com/news/articles/2017-10-24/singapore-won-t-regulate-cryptocurrencies-remains-alert-to-risk.
Ebenhoch, Peter/Gantner, Felix, Smart Contexts für Smart Contracts – Legal Programming für valide Blockchain-Verträge, in diesem Band, 2018.
Gerard, David, Attack of the 50 Foot Blockchain, CreateSpace, 2017.
Gourdan, Shidan, How Future Regulation Will Shape Canada’s Blockchain Environment, Techvibes, 2017, https://techvibes.com/2017/12/15/how-future-regulation-will-shape-canadas-blockchain-environment.
Henderson, David, Blockchain Regulation in Europe and Potential Hurdles, Nasdaq, 2017, http://www.nasdaq.com/article/blockchain-regulation-in-europe-and-potential-hurdles-cm854360.
Kleinz, Torsten, Initial Coin Offerings: China verbietet Investmentform mit Kryptogeldtokens, Heise Online, 2017, https://www.heise.de/newsticker/meldung/Initial-Coin-Offerings-China-verbietet-Investmentform-mit-Kryptogeldtokens-3821656.html.
Hosp, Julian, War’s das mit deinem Invest in Bitcoin? Regulierung der Blockchain wirft Fragen auf (Podcast), T3N, 2017, https://t3n.de/news/bitcoin-blockchain-regulierung-863540/.
- 1 Kleinz 2017, with reference to: http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3374222/index.html (all websites last visit on 30 January 2018).
- 2 In the article «Smart Contexts for Smart Contracts», presented at the IRIS 2018 conference, I examine with Gantner in detail how so-called «smart contracts» can be legally programmed and embedded in a legally compliant way (Ebenhoch/Gantner 2018).
- 3 Due to space constraints, the question how blockchains can be utilized to provide compliance mechanisms on their own (RegTech for «Regulatory Tech») and for surveillance purposes cannot be discussed here.
- 4 The original phrase, how Tracy Alloway put it: Alloway 2017.
- 5 Biederbeck 2016.
- 6 «Ether» is the currency of the Etherum blockchain.
- 7 «Ehemaliges Schweizer Fischerörtchen Zug als Krypto-Mekka», https://futurezone.at/digital-life/ehemaliges-schweizer-fischeroertchen-zug-als-krypto-mekka/295.150.097, futurezone, 2017. Cf. also https://cryptovalley.swiss/.
- 8 This is also possible because Swiss «Kantons» have their own legislation and are only partially legally bound by Switzerland as state.
- 9 Chanjaroen/Tan/Amin 2017.
- 10 Gourdan 2017.
- 11 I have developed a method to focus on legal key issues when dealing with technical compliance, named it «Lean GRC» (abbreviating «Lean Governance, Risk and Compliance»). Further information can be found on the dedicated website http://www.lean-grc.com.
- 12 https://digiconomist.net/bitcoin-energy-consumption.
- 13 Brodu 2017.
- 14 It is worth noting that there might be conceptual alternatives to these kinds of power hungry consensus mechanisms and that this restriction actually only applies to blockchains which are completely decentralized and public. An internal blockchain can be run with very modest energy consumption.
- 15 This is in particular true when blockchains operate in connected mode: If a smart contract exchanges cryptocoins for the ownership of a house for example, there is not only a simple exchange of a certain amount of cryptocoins from one wallet to the other in the same blockchain (e.g. Bitcoin), but also an exchange of cryptocoins and a change of ownership in the land register/ledger, probably in two blockchains which are connected via interfaces. The blockchain technology itself has no unique mechanism to ensure that the real property exists and that the seller is truly that person or legal subject.
- 16 FINMA-Aufsichtsmitteilung 04/2017, https://www.finma.ch/de/dokumentation/finma-aufsichtsmitteilungen.
- 17 The author has developed a concept of «smart contexts» to support the development and validity of smart contracts. Cf. Ebenhoch/Gantner 2018.
- 18 Henderson 2017.
- 19 Chadwick 2017.
- 20 Expressed by Dr. Julian Hosp, see Hosp 2017.