Cryptocurrencies and Distributed Ledger Technologies (DLT) such as blockchain are well and truly on the agendas of regulators worldwide. They are understandably cautious about the use of DLT considering it removes the need for a central authority, and equally cautious about the use of cryptocurrencies considering the increased risks of money laundering, terrorism financing, fraud and cybercrime.
Many countries have now adopted legislation to seek to address the risks yet many more are reluctant to do so before understanding the status of cryptocurrencies and their uses.
Who’s leading the legislative charge?
Gibraltar is one of many countries leading the legislative charge, with the adoption of the Financial Services (Distributed Ledger Technology Providers) Regulations 2017. As of 1 January 2018, any firm in or from Gibraltar using DLT for storing or transmitting value belonging to others, is required to be authorised by the Gibraltar Financial Services Commission. The regulation sets out nine core principles DLT providers need to adhere to. Gibraltar is also planning on implementing legislation governing ICOs in the near future.
The EU has not yet implemented legislation on DLT but it does appear to be close to implementing a directive which will see to the regulation of those entities which act as gatekeepers between the fiat and cryptocurrencies worlds, namely exchange platforms and wallet providers. In July 2016, the European Commission published a proposed directive amending the Fourth Money Laundering Directive ((EU) 2015/849) (MLD4), now known as the Fifth Money Laundering Directive (MLD5).
MLD5 will introduce a definition of ‘virtual currency’ and will require these institutions to implement financial crime preventive measures, including customer due diligence, and report suspicious transactions. The European Commission takes the view that the proposed measures will address the money laundering and terrorist financing risks and will have no negative effects on the benefits and technological advances presented by blockchain technology underlying virtual currencies.
Although not yet in force, the European Parliament and the Council of the EU reached political agreement on MLD5 on 15 December 2017 and voted in favour of its adoption after the plenary session, which took place in April 2018.
The next stage is for MLD5 to be published in the Official Journal of the EU. When this takes place MLD5 will enter into force 20 days subsequently. Member states will then have 18 months to transpose MLD5 into national legislation.
Many companies, both legal and non-legal are investing in a specific application of blockchain technology: smart contracts. Smart contracts are self-executing ‘contracts’ coded on to blockchain framework. With smart contracts, information is fed into the blockchain network, which can then trigger the execution of specific clauses if certain conditions have been met. Smart contracts can either be external, where logic elements of a traditional legal contract are coded but where the code does not legally bind the parties, or internal, where contractual clauses are translated to code and can legally bind the parties.
Whether smart contracts legally bind parties will depend on the applicable law, the coding used and the terms of the contract. Lawyers must therefore ensure that the contractual terms are certain and comprehensive. Without this, courts may refuse to adjudicate over a dispute due to the fact that a legally binding contract had not been formed.
An example of smart contracts in practice can be seen in insurance claims, where automatic payments can be made to customers in the event of an insured event. Smart contracts have also been used by financial institutions, such as the Australian Stock Exchange. ASX is replacing its current clearing house and introducing DLT in order to reduce costs, simplify the clearance and settlement processes and save time. Smart contracts have been used by other businesses in areas ranging from identity management to cross-border payments to derivatives. As a white paper published by the International Swaps and Derivatives Association (ISDA) and Linklaters noted: ‘derivatives are fertile territory for the application of smart contracts and DLT because their main payments and deliveries are heavily dependent on conditional logic’ (Smart Contracts and Distributed Ledger – A Legal Perspective, August 2017: bit.ly/2M034Zi). Barristers may therefore find that they are instructed to advise on smart contracts and on smart contract disputes.
When Bitcoin was first envisioned, its purpose was to enable parties to transact electronically without having to rely on the participation of any government, central bank or financial institutions to settle the transactions. In doing so, the hope was to enable fast, direct settlements at a lower cost than well-established payment methods. DLT was the perfect candidate to facilitate cryptocurrency transactions considering one of its inherent characteristics is the ability to function without the involvement of a central authority. This characteristic, however, may raise legal issues including difficulty ascertaining the correct defendant, and difficulty enforcing a court judgment or arbitration award. Advice from barristers may consequently be sought with regards to drafting and inserting dispute resolution terms or mechanisms into smart contracts and with regards to which party should be sued.
Initial coin offerings
Further opportunities may arise in advising companies pursuing a novel market practice known as an Initial Coin Offering (ICO). An ICO occurs when a company trades future digital tokens to ‘contributors’ in exchange for existing liquid cryptocurrencies such as Bitcoin or Ether. The proceeds of the digital tokens are most commonly used for technical development and operating costs in advance of launching the new service, the details of which are set out in the company’s ‘white paper’ (which is the equivalent of a prospect for an IPO). There are various categories of token, each representing different benefits available to the contributor in return for their contribution. Tokens from certain ICOs are in such demand that they are exchanged on the secondary market. Many companies are seeking clarification on the status of their tokens, including whether or not tokens meet the definition of a security and if not, how they should be classified. Companies are also seeking assistance drafting the white papers and advice on their legal status.
Risks and protection: the criminal perspective
A key characteristic of cryptocurrencies is pseudonymity. When creating accounts with exchange platforms and wallet providers, users enter an email address and are provided with randomly generated keys, which are analogous to bank account numbers (hence pseudonymity rather than anonymity). This characteristic can be seen as a risk as users can choose exchange platforms and wallet providers which do not conduct customer due-diligence. Whilst some legitimate users see cryptocurrencies as a tool for protecting their personal data and exercising their right to informational self-determination, others see pseudonymity as a way of laundering money and financing terrorism without detection by law enforcement authorities. Furthermore, without conducting customer due-diligence, it is not possible to ascertain whether the customer is a politically exposed person or an associate, or subject to sanctions.
As such, opportunities will inevitably arise if and when individuals and business are investigated and prosecuted for using cryptocurrencies to commit offences such as money laundering, terrorist financing, tax evasion, theft and fraud. Prosecutions may arise for the commission of offences contrary to the Proceeds of Crime Act 2002, Terrorism Act 2002 and the Money Laundering, Terrorist Financing and Transfer of Funds Regulations 2017. Further, criminal practitioners seeking to move into this space should be cognisant of the technology considering clients within the sector may seek advice on how to ensure they have adequate protections in place to address the above risks.
Contributor Anthony Eskander is a barrister in KPMG’s legal services team and a door tenant at Church Court Chambers
Blockchain is a type of DLT, which in its simplest form is a record of transactions. This record is maintained by participants (known as nodes) in a decentralised network of computers. There is no central server authorising and storing information in relation to transactions; instead the updates on the blockchain (known as blocks) are synchronised simultaneously across all nodes.
Blockchain, which can be public or private, works through a consensus protocol, where over a certain percentage of the nodes are required to agree on the value of a proposed transaction in order for the transaction to proceed and the ledger to be updated. This protocol creates a daisy-chained immutable synchronised ledger of all transactions. The technology potentially allows for near real-time value transfer between participants.
Cryptocurrencies, on the other hand, are digital assets. They resemble cash in that they are bearer instruments: whoever possesses a unit of a cryptocurrency is considered to be its owner, just as a person holding paper cash is assumed to be its owner; however, rather than physical possession, a string of digital records on the blockchain indicates which network user ‘holds’ the particular unit of cryptocurrency.
There are various types of entity which deal in or facilitate the use of cryptocurrencies. Currency exchange platforms, for instance, enable the buying and selling of cryptocurrencies. Virtual wallet providers offer customers a virtual wallet to store cryptocurrencies, which can then be used to buy services and goods.
Whether smart contracts legally bind parties will depend on the applicable law, the coding used and the terms of the contract. Lawyers must therefore ensure that the contractual terms are certain and comprehensive