The Two Topics in Law and Blockchain

Josh Stark
Jan 14, 2017 at 14:00 UTC
OPINION

Josh Stark is a lawyer and head of operations and legal at Ledger Labs, a blockchain consultancy based in Toronto.

In this CoinDesk Op-Ed, Stark argues that the field of "law and blockchain" encompasses two distinct topics: the application of law to the technology, and separately, the potential for that technology to transform legal systems and services.

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It's rare for any issue in the blockchain industry to escape conversation about legal implications.

This past summer, The DAO hack prompted discussion of the legal responsibilities of blockchain developers, and the differences between code and law. The popularity of token crowd-sales has led many to wonder about the application of securities laws to blockchain technology. Virtually every blockchain use case involves considering the capabilities and limitations of smart contract code and smart legal contracts.

As such, "law and blockchain" as a subject covers many areas of law. It can be applied to many different industries, and it cuts across many different use cases of the technology. Yet, it can be hard to see from a high level what these topics have in common, or how they might be organized in relation to one another.

In my view, the questions that make up the study of "law and blockchain" can be usefully divided into two types:

First, we have questions of application. How does the law apply to blockchain technology? How should it apply?

Included in this category are questions such as whether cryptocurrencies are legal tender, or how to regulate decentralized applications. Here, blockchain technology is a subject of law – something that our laws will have to adapt to, just as they adapted to the Internet, new medical technology, or social media.

Second, there are questions of transformation. How will blockchain technology change the legal system? How will it change the legal services industry? In this category you'll find topics like how smart legal contracts might be used by businesses, or the potential for decentralized applications to offer services to consumers without a legal entity.

In this instance, blockchains are not simply some new technology to which our laws and regulations must adapt. Rather, they are a tool for the law itself – a new technology that could be usefully applied in legal services. They are part of the more general category of "LegalTech", alongside artificial intelligence and Big Data.

Distinguishing between these two categories helps us view each more clearly.

Questions of application

New technologies often raise novel legal questions.

They may not fit into current legal categories, thereby challenging existing definitions. They may give people powerful new capabilities that lead to unforeseen consequences.

For instance, file-sharing services that reshaped the music industry and changed the way we approach intellectual property. These changes often prompt legal responses, as regulators and lawmakers determine how to reconcile the new world with laws that were built for the old one.

Blockchain applications – cryptocurrencies, decentralized apps, and token crowdsales, to name a few – have already raised many legal questions. They offer new capabilities to engage in financial activity in ways that don't fit neatly into existing legal frameworks.

For regulators, this means determining how best to regulate a new sphere of financial activity. For entrepreneurs, it means navigating uncertain legal territory in order to innovate safely.

Characterizing blockchain tokens

Within this set of questions, one stands out.

Many issues in the application of law to blockchain technology are some variation of the same question: How do we legally characterize blockchain tokens?

Blockchains allow us to create discrete, ownable digital "tokens" that serve as a new type of digital asset. This includes bitcoin, ether and zcash, often referred to as "cryptocurrencies" because they function as a digital equivalent of cash.

When the first blockchain token – bitcoin – gained widespread attention, regulators, lawmakers and courts began to consider how to characterize it under law. Is bitcoin a commodity, a currency, a security or something else?

These questions aren’t just theoretically interesting: they have immediate practical importance. If bitcoin is a commodity, then the Commodity Futures Trading Commission (CFTC) has jurisdiction over bitcoin exchanges. Whether or not it is a currency under certain legislation might determine whether bitcoin transactions can be taxed.

Regulatory bodies responsible for preventing financial crimes like FinCEN in the US or FINTRAC in Canada introduced new regulations to bring bitcoin within the scope of its enforcement, although striking the right balance in these regulations is a continuing challenge.

In other cases, blockchains are used to create tokens that aren't designed to be cash at all. For instance, programmable blockchains like ethereum let users create decentralized applications that have their own tokens.

There are decentralized applications with "app tokens" that entitle the holder to report outcomes to a prediction market or receive a share of revenue from a content platform. These blockchain tokens, like cryptocurrencies, are tradeable and may have a market value, but their purpose is more specialized.

Recently, it has become popular for blockchain companies to hold “Initial Coin Offerings” (ICOs) or token crowdsales. In an ICO, a company or group of developers raises funds by selling app tokens in exchange for cryptocurrency (eg bitcoin or ether). The app tokens, in turn, offer some kind of utility or future value to the purchaser. Here, the token is used in a way that is similar to company stock, which could bring these activities within the jurisdiction of securities regulators.

This issue is what motivated a group of blockchain companies to publish a securities law framework for blockchain tokens. While this remains an unsettled area of law in many jurisdictions, entrepreneurs should exercise caution and, always, speak to a lawyer.

Observers looking at blockchain technology typically view these issues – whether cryptocurrencies are money, whether tokens are securities – as discrete questions, because they involve very different areas of law. However, it’s useful to see them as part of a more general issue.

Blockchain tokens won't be limited to currency-like tokens or stock-like tokens.

Blockchains are a flexible medium for the creation of any kind of value-token we can design and find practical use for, and "currency" and "stock" are just the first of many possible applications.

As the technology develops, we should expect that they will be used as analogs to other kinds of value-objects, where they will raise new legal questions wherever they find adoption within regulated areas of economic activity.

Many applications, many legal issues

Blockchain technology raises many other interesting legal questions beyond the characterization of tokens. While a full review is beyond the scope of this article, there are a few other interesting topics worth highlighting.

Public blockchains like ethereum or bitcoin raise interesting questions of liability.

If a blockchain breaks or fails in some way, is anyone liable? With traditional financial infrastructure, there is ultimately some entity who can be held responsible when something goes wrong.

With public blockchains, there is no legal entity in control, but rather a decentralized network of participants, like developers and miners. The question is whether such persons have legal duties to the users of the blockchain they maintain. Angela Walch explores this issue in a piece considering whether core developers of public blockchains like ethereum are fiduciaries.

The issues we’ve discussed so far focus on public blockchains. But there are also interesting legal questions in private blockchain implementations.

Because these "permissioned" blockchains are being designed with existing regulations in mind, they do not challenge legal frameworks as obviously as public networks. Rather, the legal questions more often result from the intrinsic features of blockchain technology.

For instance, blockchains may raise challenges where financial institutions are forced to comply with certain privacy laws.

Some financial organizations are required by law to be able to permanently remove data when required to do so by a court (often called "right to be forgotten" laws). This can be a challenge for existing blockchain technologies because blockchains by their nature do not allow for past data to be deleted, but rather only updated in subsequent blocks, which may not be sufficient to comply with the law.

Questions of transformation

The second category asks: how can blockchain technology be used in conjunction with, or as a replacement for, certain legal services?

The second category is what makes blockchain technology particularly important for lawyers. Blockchain technology isn't just a new subject for law. It is also a legal technology that could transform law and legal services, by offering new methods for achieving legal purposes.

It's important, too, to be clear about how blockchain technology differs from other technology of this type. The category of "legal tech" is mostly made up of tools for lawyers: software to help lawyers draft documents more efficiently, or AI to help analyze case law.

Blockchain technology, in contrast, might also offer tools for clients of lawyers: tools that help them solve problems that, today, are exclusively solved through legal services.

Within these “questions of transformation”, there are two primary topics:

1, Smart legal contracts and smart alternative contracts

The most well-known example of this capability are "smart contracts".

In a previous article, I articulated a distinction between smart contract code – a program or script executed on a blockchain – and smart legal contracts, the use of smart contract code to define and enforce a legal agreement.

In most cases, "smart legal contracts" would be a combination of traditional legal language and smart-contract code. A typical legal contract would handle terms that can’t be easily reduced to code, like clauses relating to liability or human performance. The smart-contract code portions would handle aspects of the contract that could benefit from automation, like a transfer of funds on certain conditions.

This approach to smart-legal contracts is being built today, seen in the efforts by Monax and R3, among others.

In other cases, "smart contract code" might be useful in the absence of a traditional legal relationship. These "smart alternative contracts" would create financial relationships between parties – mediated entirely through code – that might be sufficient for some narrow purposes.

Many lawyers are understandably skeptical of smart legal contracts. However, often the criticism is naive. Most often, "smart legal contracts" are simplistically compared to traditional legal contracts, with the former being dismissed because they don’t match some particular feature of the latter.

Thinking clearly on this issue requires stepping back and taking a broader view of the purpose of contracts in commercial relationships. Businesses don't sign contracts with one another because they need a contract. Businesses sign contracts because contracts are a tool that solves a specific problem: How can I trust the other party?

Contracts solve this problem by reshaping the incentives of each party until they are sufficiently aligned, enabling them to engage in the risky business of trade. With a legal contract, I have confidence that the other party will pay a significant penalty if they breach the agreement, and that I have access to legal remedies if something goes wrong.

Directly comparing "smart contracts" to "legal contracts" is the wrong approach. It’s comparing a new tool to an existing one, rather than assessing both tools against the problem they are designed to solve. The right question to ask is not 'Can a smart contract do exactly what a legal contract does?', but rather, 'How can smart-contract code, in conjunction with or separate from legal contracts, be used to create trust between parties?'

Even then, people look at this technology and conclude it won’t change much.

They recognize that "smart contract" technology is interesting, but simply don’t think that it would add much value to the vast majority of commercial relationships that exist today. Contracts as they are today work for most businesses, and wouldn’t benefit much from automation or other features of smart-contact code.

That might be correct in a limited sense. These technologies might not replace the traditional contracts used in the majority of commercial relationships. But this view doesn’t consider that the type of commercial relationships that make up our economy will change over time.

New markets, with new needs, may develop that take advantage of the unique capabilities of blockchain technology and smart contract-code.

One obvious candidate in this category is enabling machine-to-machine commerce, where contracts articulated using code and which can be "enforced" without relying on legal entities might be ideal. For instance, a self-driving car that can receive payments from passengers and pay for its own gas or electricity.

If the share of commerce involving machines or automated systems grows significantly, then so too will the importance of smart contracts that today seem like a niche product.

Blockchain technology offers us new tools to solve an old problem: how to create sufficient trust between parties in order to make trade possible.

This doesn’t mean we will throw away existing ways of solving this problem, like traditional legal contracts. It just means we have a new tool in our toolkit, with new capabilities and weaknesses. It might help us solve existing problems of this type in new ways, and it offers us the tools to solve new versions of this problem in new areas of commerce.

2. Coordinating complex economic activity without a legal entity

Blockchain technology has made it possible for decentralized software systems to coordinate complex economic activity that, until now, was only practically possible for a centralized legal entity like a corporation.

This is usually framed as a contest between centralized and decentralized systems, as in this piece by Coinbase co-founder Fred Ehrsam. But at the same time, it challenges our assumptions about the role of legal entities as the de-facto center of economic activity.

OpenBazaar, for example, is a decentralized marketplace. From the user's perspective, it is similar to eBay: you browse items for sale from various sellers, pay them (in this case with bitcoin) and they ship the item to you.

But unlike eBay, there is no legal entity at the center of this service: payments are directly between users, there are no fees collected by a middleman, and interactions between buyers and sellers are mediated through a decentralized application built on the bitcoin blockchain.

Many believe that other "peer to peer" marketplaces - like Uber and AirBnB – could similarly be replicated with a decentralized platform.

Before now, complex economic activity of this kind was only practically possible for a legal entity like a corporation. In other words, there is now a new solution to an old problem: how do I create a service that can manage a complex web of commercial relationships between many different participants?

Until recently, the only answer to that question was to create a legal entity to be a nexus for legal contracts. Now there is another option: build a decentralized application.

Looking forward

Separating these two categories is helpful in articulating why blockchains are different from other technologies.

Blockchains offer people new capabilities that require answering new legal questions and adjusting regulatory systems to compensate where necessary. This is a process that legal systems are by now familiar with, having adapted (albeit slowly) to new information technology over the last few decades.

But more than this, blockchains offer new tools with which to structure commercial relationships or organize complex economic activity. This fact makes blockchains not merely an area of niche practice, but a critical piece of the future for our legal systems and legal services industry.

While these two categories are conceptually distinct, they also interact with one another. The transformational properties of blockchain technology raise difficult questions for the application of our laws to the same.

For instance, our legal systems assume the existence of a legal entity at the center of any complex economic activity. Whenever we decide that an area of economic activity needs to be regulated – for instance, to protect consumers or prevent fraud – we usually do so by controlling the legal entities at the center of that activity. For example, by imposing steep fines on corporations who break the law.

But now it is no longer true that there will always be a legal entity at the center of complex economic activity.

How do we regulate a market if it is mostly made up of decentralized, rather than legal, entities? Decentralized applications like OpenBazaar are small today, but they’ve proven the concept. If decentralized systems grow to the point where lawmakers decide they must be controlled through regulation, how will this be accomplished with no entity to fine or sue?

As the technology matures, the questions in both categories will continue to grow. Distinguishing between them is a useful first step in understanding the full scope of the interaction between law and blockchain tech.

Complicated connections image via Shutterstock

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