CANON s YEOMAN s TALE: Blockchain Technology, Cryptoassets and Related Legal Issues. ACIC Annual Meeting 10/18/18

Transcription

1 CANON s YEOMAN s TALE: Blockchain Technology, Cryptoassets and Related Legal Issues ACIC Annual Meeting 10/18/18 Presented by: John Casanova, Sidley Austin LLP Glynna Christian, Orrick, Herrington & Sutcliffe LLP Kathleen (Kate) Fuentes, AIG Thomas (Tom) Pearson, Conway Mackenzie, Inc. Quinn Moss, Orrick Herrington & Sutcliffe LLP (Moderator)

2 Canon s Yeoman s Tale 1441 "And therfore," seyde he -- taak heede to my sawe -- "And therefore," said he -- take heed of my words "Lat no man bisye hym this art for to seche, "Let no man busy himself to seek this art, 1443 But if that he th'entencioun and speche Unless he the meaning and speech 1444 Of philosophres understonde kan; Of alchemists can understand; 1445 And if he do, he is a lewed man. And if he do, he is an ignorant man For this science and this konnyng," quod he, For this science and this cunning," said he, 1447 "Is of the secree of the secretes, pardee." "Concerns the secret of the secrets, by God." - Canterbury Tales 2

3 Overview 1. Brief Primer on Blockchain Technology 2. Emerging Uses of Blockchain in Finance and Law 3. Risks and Rewards of Crypto Currencies and Other Crypto Assets 3

4 BLOCKCHAIN TECHNOLOGY 4

5 CAST YOUR VOTE: Who are We (#1) Regarding blockchain, has your institution: Vote: A. Started to invest in companies utilizing blockchain B. Started to implement blockchain in your own operations C. Started to think of investing or implementing blockchain D. None of the Above 5

6 CAST YOUR VOTE: Who are We? (#2) * Regarding cryptocurrencies, has your institution started to invest directly in cryptocurrency assets (including derivatives) or companies or strategies where cyptocurrencies are part of the business plan? Vote: A B C D No Yes, in cryptocurrencies assets Yes, in companies or strategies Yes, as both B and C above 6

7 Brief Primer on Blockchain Technology ACIC Panel from 2016: Traditional Solution Potential of Blockchain Cash and financial transaction confirmation Confirmation of transactions Issues Use trusted intermediaries (with costs and risks) Distributed Ledger Decentralized Secure Lower costs Trustless Smart Contracts in private platform (not blockchain), Significant legal and regulatory 7

8 How Blockchain Works BASICS: Distributive Ledger Technology (DLT) Computer software that employs a shared database architecture to maintain multiple, identical copies of an auditable, up-to-date distributed digital record of transactions or data. Smart Contract Alliance 8

9 How Blockchain Works (cont.) BASICS: Distributive Ledger Technology (DLT) cont. Decentralized Immutable Public or Private (or Hybrid) Network 9

10 How Blockchain Works - Distributive Ledger Technology (DLT) (cont.) Decentralized: * No central location for information * Network = thousands or millions of computers/users * Uses the computing power of all computers to transmit (= speed) and store information (= volume) * If any one computer goes down, the network does not * Transparency = everyone in the network has access to information 10

11 How Blockchain Works Distributive Ledger Technology (DLT) (cont.) Immutable Information in a blockchain cannot be altered except when it can * Serves as a digital record of information * Digital identity verification and authorization tool * Transaction authenticity; trusted transaction record 11

12 How Blockchain Works Distributive Ledger Technology (DLT) (cont.) Public or permissionless DLT * Completely open, allowing anyone to join and participate (read, send transactions to and expect to see them if they are valid) little to no privacy for transactions * Anyone can participate in the process for determining what records get added to the DLT and the current state of the DLT * To sync data, each node in the network must solve a complex, resourceintensive cryptographic problem (i.e., proof of work in blockchains) * Difficult to scale because verification requires significant computational cycles * Completely decentralized. There is no central authority overseeing how it works 12

13 How Blockchain Works Distributive Ledger Technology (DLT) (cont.) Private/hybrids or permissioned DLT * Closed and monitored ecosystem / network (privacy) * Restricts who is allowed to participate and in which transactions * Participants must have an invitation (aka permission) to join * Access control may vary: existing participants can decide future; regulatory authority can issue licenses to participate or a consortium can make decisions (scalable, with central authority) * Once an entity has joined the network, it will play a role in maintaining the DLT * Many of the consortiums that build private DLT follow this model 13

14 How Blockchain Technology Works (cont.) 14

15 How Blockchain Technology Works (cont.) 15

16 Benefits Anticipated from Blockchain Technology Reduce costs and complexity Shared trusted transactions without a third party ( immutability ) Reduces errors Resilience Secure Auditable 16

17 Uses of Blockchain in Finance and Law (non-crypto assets) Smart Contracts (digitization of documents and proof of ownership) Health Record Management (decentralization of patient records management) Stock Transfer Ledgers Securities Lending transaction ledgers Enterprise blockchain software for financial institutions (e.g., Quorum, Axoni) Cross Border transactions (international finance deals) 17

18 Uses of Blockchain in Finance and Law (cont.) 18

19 CAST YOUR VOTE: Are Smart Contracts Entering Our Deals? (#3) Have you been involved in investments that utilized smart contracts for settlement or otherwise? Vote A. No, not to my knowledge B. Yes, in Syndicated Loans and/or Bonds C. Yes, in Derivatives/ISDAs 19

20 Blockchain in Smart Contracts Basics - What are Smart Contracts Computer code that, upon the occurrence of a specified condition or conditions, is capable of running automatically according to pre-specified functions. The code can be stored and processed on a distributed ledger and would write any resulting change into the distributed ledger. Smart Contract Alliance (SCA) 20

21 Blockchain in Smart Contracts (cont.) But is it a contract? Acceptance Offer Consideration Capacity Certainty Intent 21

22 Blockchain in Smart Contracts (cont.) SCA models of smart contracts External Code is used to automate performance of some terms. Not part of the contract Internal Code is the entire agreement Code is an integral part of the contract, either written in the contract itself or incorporated by reference 22

23 CAST YOUR VOTE: Is Blockchain being used for Your Health Care Mgmt (#4) Does your institution currently use blockchain in Health Care Management? Vote: A. No, not to my knowledge. B. Yes, thinking about it C. Yes, in the process of implementing D. Yes, fully implemented 23

24 Blockchain in Health Record Management 24

25 Blockchain in Cross-Border Transactions Primary advantages Speed Security Finality Focus on settlement Pre-transaction verification Hold over funds Simultaneous updates to distributed ledger Determinative settlement transaction fails or succeeds Real world applications Correspondent banking SWIFT real time Nostro proof of concept Ripple xcurrent JPMorgan - Interbank Information Network B2B VISA B2B Connect BitPesa - BFX Remittances Santander One Pay FX (using Ripple s xcurrent) Ripple xrapid (using XRP as an intermediate liquidity currency) 25

26 Crypto Assets Overview 26

27 CAST YOUR VOTE How Clear is Regulation of Cryptocurrencies (#5)? Which two of the following statements are true: 1. Bitcoin is currently regulated in the U.S. as a security 2. Bitcoin and/or futures in Bitcoin are regulated in the U.S. as a commodity 3. In general, other cryptocurrencies face tougher regulation than Bitcoin 4. Cryptocurrencies are regulated worldwide in a coordinated manner Vote A. 1 and 2 B. 2 and 3 B. 3 and 4 C. None of the Above 27

28 Regulation of Cryptocurrencies worldwide 28

29 Regulation of Cryptocurrencies Worldwide (cont.) UK Bitcoin, Ether etc. UK Securities tokens, cryptocurrency derivatives US Howey Test, overlapping regulatory bodies Germany bitcoin = unit of account Switzerland guidance for classification of ICOs EU MLD5 Gibraltar DLT Framework Japan regulates exchanges S. Korea legislation pending for exchanges Switzerland exchanges subject to registration Australia exchanges subject to registration UK investor protection EU investor protection US investor protection China crypto exchanges Unregulated asset class Within existing regulation Blockchain / crypto specific regulation or additions Regulatory warnings Outright ban Key jurisdictions may fall broadly across the spectrum Investor protection is a key theme On/ off ramps are a primary target for regulators Individual cryptoassets should be considered on a case-by-case basis Blockchain / crypto specific regulations may be restrictive or permissive depending on regulatory priorities Regulators beginning to implement regulatory sandboxes to better facilitate innovative financial technology Outright bans are not always effective 29

30 Crypto Currencies and Other Crypto Assets Regulation in the U.S. Type Test (in U.S.) Key Regulator (in U.S.) Examples Crypto Currency (a/k/a Virtual or Digital) Commodity (but not spot market absent fraud or manipulation) CFTC Bitcoin, Ether (?) Utility Token Corresponds to unit of entitlement to service or asset (not deemed a security or commodity) Ether Investment Securities Tokens Howey test SEC Tom coins Stable Coins pegged to fiat currency Uncertain: securities? Moneyservicing? SEC, FinCEN tether, TrustToken 30

31 Howey Test - Is the Crypto Asset a Security (U.S.)? Howey Test: Created by the U.S. Supreme Court (in SEC v. Howey) for determining whether certain transactions qualify as investment contracts and are therefore regulated under the Securities Act of 1933 and Securities Exchange Act of 1934, the test is interpreted to include: It is an investment of money [or assets] in a common enterprise with an expectation of profits from the investment where those profits are derived solely from the efforts of the promoters or third parties SEC s DAO Report (7/25/17): Advises those who would use a Decentralized Autonomous Organization ( DAO Entity ), or other distributed ledger or blockchain-enabled means for capital raising, to take appropriate steps to ensure compliance with the U.S. federal securities laws. 31

32 How Many Alchemists are There? 32

33 Other Crypto Assets and Businesses Regulation in the U.S. Type of Asset U.S. Regulation Simple Agreements for Future Tokens (SAFT) Issued as securities, with intent to convert into utility token (regulatory uncertainty) Initial Coin Offerings (ICO) In most cases, as securities (Howey test) with private placement exemptions available Derivatives (e.g.,bitcoin futures) ETFs Mutual Funds Private Funds RELATED BUSINESSES/ ISSUES: Exchanges, Custodians, Broker Dealers (FINRA Statements) Commodity regulated by CFTC ETF shares regulated as securities but also expected to be regulated by CFTC as a commodity pool if futures involved(no Bitcoin ETFs to date) Registered funds not yet permitted to invest substantially in cryptocurrencies and related products Issues relating to disclosure and investment advisers duties 33

34 Regulators Priorities in U.K./EU Investor protection A cryptocurrency is a virtual currency that is not issued or backed by a central bank or government. They have experienced significant price volatility in the past year which, in combination with leverage, places you at risk of suffering significant losses and potentially losing more than you have invested. Cryptocurrency CFDs are an extremely high-risk, speculative investment. You should be aware of the risks involved and fully consider whether investing in cryptocurrency CFDs is appropriate for you. FCA: Consumer warning about the risks of investing in cryptocurrency CFDs AML/CTF More and more regulators are worrying about criminals who are increasingly using cryptocurrencies for illegitimate activities like money laundering, terrorist financing and tax evasion. The problem is significant: even though the full scale of misuse of virtual currencies is unknown, its market value has been reported to exceed EUR 7 billion worldwide. European Parliament Study: Cryptocurrencies and blockchain Adapt existing regulation Policy makers and regulators should not ignore VCs, nor should they attempt to ban them. Both extreme approaches are incorrect. VCs should be treated by regulators as any other financial instrument, proportionally to their market importance, complexity, and associated risks. Given their global, trans-border character, it is recommended to harmonise such regulations across jurisdictions. European Parliament In-depth Analysis: Virtual currencies and central banks monetary policy 34

35 Why invest in Crypto: Investment Opportunities Significant potential upside and associated returns Uncorrelated Assets Limited Supply (Bitcoin, and a few others) New Asset Class Inefficient Market 35

36 But what are the Risks Can They be Addressed? Legal Custody Unknown counterparty, enforceability of agreements? Off-chain dispute resolution Insurance Uncertain regulatory environment and compliance challenge Requirement to be regulated- lack of clear tests/guidance Divergent regulatory approaches Overlapping regulatory jurisdiction SEC, CFTC, FINRA Few Qualified Custodians capable of holding private keys Tax Jurisdiction? Taxed as property, income or some other gain? Which events are taxable? Technical Scalability Interoperability Adoption Vulnerabilities in the code DAO hack Security Loss/theft of private keys Fraud/AML Fake ICOs Market Manipulation (pump or dump) Valuation Liquidity 36

37 Conclusion Final Tips from Our Panel Questions Many thanks for joining us 37

38 Glossary Cryptocurrency (or crypto-token): A scarce digital asset defined by a blockchain protocol and exchanged via that blockchain system. Decentralization: A hard-to-quantify measure of a network s resistance to attack, a function of how broadly control is distributed among different actors. Distributed ledger technology (DLT): A system, most commonly a blockchain, for creating a shared, cryptographically secured database. Initial coin offering (ICO): A blockchain-based fund-raising mechanism in which entrepreneurs mint new crypto-tokens and sell them to investors. Mining: The process by which nodes in Bit-coin, Ethereum, and many other blockchain systems (those that use the consensus protocol known as proof of work) add new blocks to their respective chains and generate new crypto-tokens. 38

39 Glossary (p. 2) Permissioned blockchain: A shared database with a blockchain structure that requires participants to obtain permission before reading or writing to the chain. Contrast this with permissionless blockchains, which anyone can join. Proof of stake: A novel consensus protocol in which, instead of mining, nodes can validate and make changes to the blockchain on the basis of their existing economic stake. Proof of work: The consensus protocol of choice for Bitcoin and many other cryptocurrencies To add a new block, miners must calculate a hash for it that meets certain narrow criteria. Doing so requires an enormous number of random guesses, making it a costly process that deters attempts to commit fraud. Smart contract: A computer program stored in a blockchain that automatically moves digital assets between accounts if conditions encoded in the program are met. It serves as a way to create a mathematically guaranteed promise between two parties. Source: MIT Tech Review April

40 Additional Resources Regulators Speak SEC Statements November 2017 January 2018 September 2018 DAO Report (July 2017) US Congressional Initiatives (3 crypto and blockchain bills introduced by R. Tom Emmer (R.-Minn). (September 2018) NYS AG Office: Virtual Markets Integrity Initiative Report (September 2018) ABA Business Law Section: Securities on Blockchain: Commercial Law and Insolvency Issues Articles - Traders are Talking Up Cryptocurrencies, then Dumping Them (WSJ, Sept. 2018) - The Crowd Machine Crypto Token Theft What we Know so Far (Coindesk, Sept. 2018) -It looks like Coinbase is preparing to add a lot more Cryptocurrencies (Techcrunch, Sept. 2018) - Blockchain Report Examines Benefits (and Failures) of Today s Stablecoins (Bitcoin Magazine 9/28/18) - Winklevoss twins receive NY Approval to launch new crypto coin (American Banker, Sept 2018) -CFTC Does Not Regulate Retail Crypto Markets: Chairman Chris Giancarlo (CNN, July 2018) Alerts A Big Week on the Blockchain: Recent Enforcement and Regulatory Developments (Orrick, September 2018) SEC Disapproves the Listing and Trading of Nine Bitcoin-related ETFs (Orrick, August 2018) EU Fifth AML Directive (Orrick, September 2018) 40

41 UK/EU REGULATORY APPROACH TO CRYPTOCURRENCIES A. FCA 1. FCA Discussion Paper 17/3 (DP17/3) "Distributed ledger technology" (April 2017) 2. FCA Feedback Statement on Discussion Paper 17/3 (FS17/4) "Distributed ledger technology" (December 2017) 3. FCA webpage consumer warning about the risks of Initial Coin Offerings (September 2017) 4. FCA webpage consumer warning about the risks of investing in cryptocurrency CFDs (December 2017) B. Bank of England 5. Staff Working Paper No. 724 "Broadening narrow money: monetary policy with a central bank digital currency" (May 2018). 6. Staff Working Paper No. 725 "Central bank digital currencies design principles and balance sheet implications" (May 2018). C. House of Commons Treasury Committee 7. Treasury Committee Twenty-Second Report of Session : Crypto-assets (September 2018) D. ESMA 8. Joint ESAs warning on virtual currencies (February 2018). E. European Parliament 9. European Parliament Study Cryptocurrencies and blockchain: Legal context and implications for financial crime, money laundering and tax evasion (July 2018) 10. European Parliament In-depth Analysis Virtual currencies and central banks monetary policy: challenges ahead (July 2018) F. Sidley Austin LLP 11. Sidley Austin Update Cryptoassets are here to stay : EU Authorities to Provide Guidance on Cryptocurrencies and ICOs (September 2018) 12. Sidley Austin Update Fintech Without Borders: Regulators Consult on Global Financial Innovation Network (August 2018) 41

42 Bitcoin: A Peer to Peer Electronic Cash System Satoshi Nakamoto satoshin@gmx.com Abstract. A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution. Digital signatures provide part of the solution, but the main benefits are lost if a trusted third party is still required to prevent double-spending. We propose a solution to the double-spending problem using a peer-topeer network. The network timestamps transactions by hashing them into an ongoing chain of hash-based proof-of-work, forming a record that cannot be changed without redoing the proof-ofwork. The longest chain not only serves as proof of the sequence of events witnessed, but proof that it came from the largest pool of CPU power. As long as a majority of CPU power is controlled by nodes that are not cooperating to attack the network, they'll generate the longest chain and outpace attackers. The network itself requires minimal structure. Messages are broadcast on a best effort basis, and nodes can leave and rejoin the network at will, accepting the longest proof-ofwork chain as proof of what happened while they were gone. 42