News & Termine

21.09.2016

The legal magnitude of Blockchain

The amount of praise that Blockchain has received within the last few months makes it hard to fathom that its first and still best example — Bitcoin — has been around for almost eight years. Bitcoin is today's ubiquitous virtual currency and a real world “use case” showing how Blockchain technology could be applied in economic practice.

 

Basic questions


In legal terms, units of Bitcoin ("BTC"), other virtual currencies like Ether etc. or even other certain digital assets that are stored on a Blockchain arguably do not necessarily constitute a right or claim, sometimes not even an immaterial right or other kind of intellectual property. They can, however, usually be qualified as a mere object ("Gegenstand") or "digital asset" that can nonetheless have value and over which someone can have factual and legal power, also subjecting them to potential seizure measures of state authorities (see Greier, Möglichkeiten strafprozessualer Sicherung von Bitcoins gemäß §§ 111b ff. StPO, wistra 2016, 249, 252.).

AML Measures


As cryptocurrencies become more popular, the European Commission has adopted a proposal to implement new anti-money laundering ("AML") measures relating to virtual currencies. Certain market participants would then be considered "obligated entities" under the EU’s Fourth Anti-Money Laundering Directive ("4AMLD"), which would have to be implemented by the Member States by June 26, 2017, if not sooner (a directive amendment is pending which would, inter alia, bring the deadline forward to January 1, 2017).  As of now, virtual currency operators were initially not included in the scope of 4AMLD. The additional proposal would subject "all gatekeepers that control access to virtual currencies, in particular exchange platforms and wallet providers" to the 4AMLD’s requirements for obligated entities. These requirements include, among others, implementing preventive AML measures, conducting due diligence on customers and beneficial owners, assessing their associated money laundering and terrorist financing risks, and reporting suspicious transactions involving virtual currencies. According to the proposal, the reason for reducing anonymity surrounding virtual currencies is that this would contribute to increasing the trust of their good-faith users, adding that "anonymity will become more a hindrance than an asset for virtual currencies." Whether this can be squared with one of the main ideals of Blockchain visionaries, enabling "trustless" transactions, remains to be seen.

Lawyers, who love legal definitions, will be excited to learn that the Commission’s proposal for the first time also contains a legal definition of virtual currencies: "'virtual currencies' means a digital representation of value that is neither issued by a central bank or a public authority, nor necessarily attached to a fiat currency, but is accepted by natural or legal persons as a means of payment and can be transferred, stored or traded electronically." As such, this definition will be helpful in determining who is subject to 4AMLD and who is not.

Hence, virtual currency intermediaries who will be classified as obligated entities under the 4AMLD must ensure that they establish a satisfactory compliance program before the Directive comes into effect. This corresponds with the US regulatory scheme, under which certain virtual currency participants are considered "money transmitters" subject to AML rules promulgated by the Financial Crimes Enforcement Network, thus harmonizing EU and US law in that regard. The same cannot be said about law in general:

Conflict of laws and fragmentation


The fragmentation of "the law" in today’s multijurisdictional environment is the common problem of new technologies, which usually, once released, basically function on the identical technical level around the world. The legal situation becomes quickly unclear for purely Internet-based, global services and transactions. Barely a single legal topic exists that is in legal practice wholly subject to globally uniform regulation. Areas such as data and consumer protection, in particular, as well as regulatory standards, primarily in the financial sector, are drafted in extremely different ways according to the region.

As a matter of principle, suppliers initially have to adhere to the law of their own home country. If they then offer their idea across borders, they also have to observe the law of the country where the customers are which they are supplying, to the extent that it contains binding regulations that cannot be waived through a contractual choice of law with the user. This makes a standardized simple unified general worldwide offer of services or transactions practically impossible. The only course remaining for suppliers, therefore, is to initially limit themselves to individual, selected jurisdictions in which they have examined the law and tailored their offer accordingly, and then for them to gradually expand when they experience success, without ever attaining unity of their contractual documentation, but rather adding tomes of legal documentation each time a jurisdiction is added.

Competition between jurisdictions


Against this backdrop, a real location-oriented competition among jurisdictions has now flared up:

Delaware: The Governor of the US state, Jack Markell, announced the Delaware Blockchain Initiative in early June 2016. According to this, the state law of Delaware is to be adapted so that any lack of clarity in connection with Blockchain applications can be removed. Furthermore, companies registered in Delaware are to be given the opportunity to issue their business shares on the basis of Blockchain technology.

Vermont: on June 2, 2016, the Governor signed a bill that added 12 V.S.A. § 1913. The law stipulates that Blockchain is admissible in court. 12 V.S.A. § 1913(b)(1) establishes that a "fact or record verified through a valid application of Blockchain technology is authentic." However, it should be noted that 12 V.S.A. § 1913(b)(4) explicitly states that a "presumption does not extend to the truthfulness, validity, or legal status of the contents of the fact or record." The difference between the legal concepts of authenticity and validity has traditional roots, as suggested by Sections 416, 417 of the German Code of Civil Procedure.

North Carolina: The new Money Transmitters Act introduces a true definition of the legal term "virtual currency." Specifically, it lists the particular activities that require a license. Inter alia, miners of virtual currency and providers of Blockchain software — including Smart Contracts —, multi-signature software, and non-hosted, non-custodial wallets will not require a license. This results in a more business-friendly environment for companies seeking to use technologies such as Blockchain or distributed ledgers.

German law might appear rather traditional or sluggish in that regard. In 2013, the Federal Court of Justice (FCJ) held that when in doubt, declarations of will constituting an electronic contract shall be interpreted by taking into account how a human being would interpret the contract. This approach detaches itself from the actual code running the software. It is that type of detachment that has caused uproar in recent events involving the hacking of "The DAO" (the "Decentralized Autonomous Organization"), see below.

The DAO


"The DAO" was recently in the news as a new major use case for Blockchain technology. It has been created as a platform to gather funds that could be dispersed towards third party projects. Legal experts were arguing whether the DAO was a separate legal entity or legal person (and if so, under which law or laws) and whether investors could be liable as shareholders etc. Users buy into the DAO by acquiring tokens through a proprietary currency (Ether). Voting rights were ruled by the DAO code. But before the fascinating legal questions posed by "The DAO" were resolved, one user found a loophole in the DAO code, arguably abusing it by proposing a project that would eventually earn the arguably rogue user the equivalent of roughly US$ 50 million at the time of this so-called "DAO Hack", about a third of the DAO's net worth. While some members called for a "hard fork" (i.e. a change to the Ethereum Protocol itself) that would essentially reset the system, others argued that this was violating the rules that were written into the code of the Ethereum Blockchain. The debate seems eerily similar to the age-old legal battles between representatives of textualism/originalism and intentionalism. Some even suggested that anyone hard forking the DAO would be liable to the hacker.

Smart Contracts


The DAO is a prominent example of a so called Smart Contract. In essence, Smart Contracts are computer programs that allow a contract to execute itself once certain real life conditions are met. The issue with Smart Contracts is that they are pre-determined as they are based on intrinsic language, i.e. the code used to create them. Much to the contrary, legal logic is extrinsic in that by establishing consequences to ensure compliance, it can function even if its rules are broken. Hence, while some smart contracts are deemed to be simple software, others, given the right complexity and pliability, could arguably rise to the level of a normal commercial (or other) contract among humans and/or legal entities. In the event that complex software or robots (e.g. self driving cars) would be recognized in the future as some kind of "E-Persons" with a separate legal identity that is different from humans and corporations, then it would even be conceivable that such E-Persons interact using Smart Contracts without any human initiative or intervention (but still with human liability?).

Transfer from legal language into code language


Conflicts arise if the Smart Contract — based on its intrinsic logic — executes itself when externally, there is an unforeseen (or at least unintended) event that would require the contract routine to remain idle or to change. Human reason is understanding of the fact that cognition is limited and that contractual intent can be implied and complex. To account for this imperfection, contracts that turn out to be defective can easily be amended, if necessary as mandated under the law. For Smart Contracts, this can be a serious legal issue if they happen to be programmed in way that they are immutable and can technically really not be changed. As a reaction to the DAO Hack, the rough consensus among the Blockchain community seems to be that "there is a need to have a broader contract that explains what happens in the event that things do go wrong." Smart Contracts can manage products or services that need fixing. They cannot, however, fix themselves.

Human thought operates through language. Language is ambiguous and an abstraction of the real world. Language and the world it describes and manipulates are not identical. On the relationship between language and the real world, Alfred Korzybski stated: "The map is not the territory." This semantic tension has been creating a plethora of challenges for legal professionals trying to apply the law to ever-changing real life events. Attempting to transfer language into the realms of computer systems does not eliminate the problems that are inherent to the law as we know it. Due to the transfer from one language into another, loss of information is almost inevitable. It is suggested that legal terms that can only be applied by using human discretion, such as "terminate the lease for cause without notice for a compelling reason", should be documented in plain text as opposed to being implemented digitally.  From a strictly semantic perspective, however, any terms can, depending on the circumstances, turn out to be extremely difficult to apply. It is not the legal term itself that defines the level of complexity, but rather, it is the relation between the legal term and the ever-changing outside world that defines the level of scrutiny required in applying the law.

Perspective


Very aware of the challenges involved with transferring legal prose into executable code, numerous initiatives are undertaking a tremendous amount of research in the race for convincing solutions. During a summit dedicated to Smart Contract templates, Dr Chris Clack of University College London proposed that new languages could evolve that would automatically be transformed into both legal prose and executable code. In the future, a language such as CLACK — Common Language for Augmented Contract Knowledge — might become admissible in court.

Entire cities are now striving to have their electricity grids run on Blockchain. The billing process would be completely decentralized. Big companies such as RWE and Vattenfall are installing Smart Meters to charge electric car batteries on the street. Electric cars, charged over-night, could serve as energy providers for office buildings while parked close by during office hours, thereby flattening day time peaks and night time lows. Constant sharing of available electricity involves a massive data flow between a large number of people and entities — a typical use case for a Blockchain.

Pertaining to the roots of Blockchain, in a July 2016 paper, the Bank of England proposed the issuance of a central bank digital currency (CBDC).  According to the program, each CBDC unit is centrally issued by a singular entity. Comparisons to a full reserve system have been drawn in that the existence of each unit of digital currency would be backed by the central bank. Meanwhile, Deutsche Bank and UBS are planning to introduce the so-called Utility Settlement Coin.  Utility Settlement Coin would eliminate the need for clearing entities, and it would serve as an instrument to execute transactions between banks within fractions of a second.

Blockchain has been put on the map, and it is destined to gain territory. What this would mean from a legal perspective is currently in flux and open to debate. Creating new ways of doing transactions and changing facts in general always have the tendency to lead not to an abolishment of the rule of law but rather to an adaption of the legal system, sometimes slowly in the background, sometimes suddenly.

Dr. Nina Siedler, Tom Braegelmann, and Fabian Hollwitz, DLA Piper UK LLP

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