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Blog / Completing a blockchain risk assessment


18 September 2018

Over the past few months, Lexology has played host to a number of webinars on cryptocurrency and blockchain technology. Discussions have ranged from specific insight on the regulatory challenges faced by the authorities in Malta and Switzerland, to far-reaching overviews of initial coin offerings (ICOs) and the legal challenges that they present. In the latest webinar, DLA Piper unpicks the current state of global regulation – highlighting the various approaches that governments are taking in the wake of a new form of financing.

However, beyond the hype, the fintech landscape is no bed of roses. Although blockchain technology offers additional protection for companies, the cryptocurrencies that it protects still represent a precarious value and are at high risk of loss. Following the recent nosedive in the price of Bitcoin, Keystone Law predicts that a “liquidity crash within the cryptocurrency ecosystem” could be on its way, which “would likely have a knock-on effect on the ICO market”. According to Keystone, the fall in major cryptocurrencies paints a bleak picture. With the instability of the market at the forefront of traders’ minds, we outline the key concerns that companies must bear in mind should they decide to enter the fray.

Weighing up the risk

The rapid rise in blockchain has left many people bewildered by what it all means. In Loeb & Loeb LLP’s mini law lesson, the firm provides a brief overview of the growing technology and how it is revolutionising the face of financing. Indeed, blockchain is having a profound effect across a plethora of industries. As White & Case LLP reports, the potential to increase efficiency, transparency and security in real estate transactions is already being utilised.

Key to blockchain’s success is the fact that, as a decentralised database, it does not require involvement from an intermediary (eg, a bank or administrator). The fact that it has no central location means that the data is harder to hack or manipulate, as it is permanently recorded across a distributed network. However, for Clyde & Co LLP this lack of an intermediary creates a double-edged sword. Since cryptocurrencies are not guaranteed by a central bank or government, their value is based solely on popularity. This creates a volatility in price that has sparked fierce debate among insurers, which – due to the infancy of the technology and the absence of clear regulation – have none of the historic data on which they would usually rely to assess the risk involved.

This disruption to the current regime poses significant challenges. Helpfully, Miller Thomson LLP distinguishes three key areas of concern: liability and jurisdictional issues, illegal activities and data privacy.

Liability and jurisdictional issues

The absence of specific legislation makes it difficult to determine a party’s liability in various scenarios. Instead, blockchain-related disputes must be solved under an outdated regulatory framework. The tax implications for cryptocurrency transactions remain particularly unclear. Thorsteinssons LLP reports that in Canada, parties using cryptocurrencies to buy goods and services are undertaking so-called ‘barter’ transactions; therefore, traders accepting cryptocurrency payments remain liable for income on sale and may still be required to collect and remit goods and services tax/harmonised sales tax. Meanwhile, Cliffe Dekker Hofmeyr reports that in South Africa, value added tax (VAT) legislation will be amended altogether. Until this happens, the supply of cryptocurrencies will not be subject to VAT – turning a grey area into an advantage for market traders.

Patent owners are also benefitting from the new technology. The US Patent and Trademark Office has seen a tidal wave of blockchain-related filings and Knobbe Martens notes that, despite openly criticising cryptocurrencies, Bank of America is leading the trend. Moreover, as major investment banks compete in the race to exclusivity, other giants are hot on their tails. MME Legal Tax Compliance highlights a marked increase in filings by Apple, Amazon and Facebook, as key players seek to monopolise blockchain innovation.

However, where filings are prolific, patents trolls will surely follow. As the authorities try to catch up, the cryptocurrency ecosystem remains vulnerable to attack. In fact, Hogan Lovells warns that some trading platforms refer to themselves as “exchanges”, suggesting that they are regulated by the US Securities and Exchange Commission (SEC) when they are not. As a result, the SEC has advised investors to specifically avoid self-directed individual retirement accounts based on cryptocurrencies.

Illegal activities

Other types of scam are also on the rise. According to Squire Patton Boggs, the UK Financial Conduct Authority (FCA) has reported increasing volumes of fraud involving cryptocurrency and cryptocurrency products. Since many of these products do not fall within the FCA’s remit, there is limited protection for investors when things go wrong.

Reports of the illicit use of cryptocurrencies have also been flocking in from across the Atlantic. The US Federal Trade Commission has highlighted a bitcoin-based blackmailing scam, whereby scammers threaten to expose users for alleged affairs and demand bitcoin payment in exchange for their discretion. In addition, Baker Sterchi Cowden & Rice LLP outlines a California case involving the theft of nearly $24 million in cryptocurrency, while Proskauer Rose LLP argues that Mt Gox, which also involved the theft of millions of bitcoins, serves as a warning to investors that such fraud is unlikely to dissipate. Indeed, the North American Securities Administrators Association has reported more than 200 active investigations involving ICO and cryptocurrency investment products.

In response, Borden Ladner Gervais LLP traces various developments in Canada, including a British Columbia case considering whether cryptocurrency is properly the subject of a wrongful detention claim and the recent questioning of brokerage firms about their business practices in relation to clients using cryptocurrencies. Further, Winston & Strawn LLP introduces the Joint Chiefs of Global Tax Enforcement – a coalition comprising Australia, Canada, the Netherlands, the United Kingdom and the United States, which aims to investigate cryptocurrency crimes, including tax fraud and money laundering.

Data privacy

With the authorities finally wading in, a number of concerns over data privacy have risen to the surface. Meyerlustenberger Lachenal notes that the updated EU Anti-money Laundering Directive enables the competent authorities to monitor the activity of providers engaged in the exchange of services between virtual currencies and fiat currencies, as well as custodian wallet providers – in much the same way as previous Swiss legislature. Further, the Bank of Mexico has amended the Rules for the Interbanking Electronic Payment System, requiring participants to establish a clear process for identifying client accounts that engage in cryptocurrency trading.

However, it is unclear where the line between governance and privacy lies. Under the EU General Data Protection Regulation, individuals have the right to erasure and the correction of their data. Yet, blockchain technology stores data permanently and can reveal more about users than conventional databases do – potentially facilitating insider trading or identity theft. Jenner & Block LLP warns that regulators could view any information sharing among competitors facilitated by blockchain as collusion or a means of policing price-fixing agreements. Similarly, Bird & Bird suggests that the exchange of data which reduces strategic uncertainty in the market may lead to a violation of competition law as it decreases the incentive to compete.

With that in mind…

Businesses that are looking to benefit from blockchain do so at their own risk. Provided that they are cautious and keep a close eye on the developing legislation, the advantages of the technology are abundant. Whitney Moore outlines the multiple benefits of using blockchain, particularly in relation to smart contracts, but notes that as the technology remains unregulated in Ireland, its uncertainty cannot be overlooked.

Similarly, Steptoe & Johnson LLP warns that rapid advancement in the sector has left many practitioners questioning the application of FinCEN’s regulations to new business models. As such, Sidley Austin LLP emphasises how important it is for concerned parties to understand the regulatory framework before launching blockchain solutions in the United States.

Meanwhile, business owners in Abu Dhabi should remain mindful of the new framework regulating spot crypto-asset activities, which will introduce the so-called ‘operating a crypto-asset business’, rather than squeezing such activities into the existing structure.

In Canada, progress has been somewhat slower. Osler Hoskin & Harcourt LLP reflects on the government’s decision to delay the release of its final regulations for cryptocurrency and blockchain companies until late next year, which will make it harder for companies to work together in the interim and will hurt those that choose to self-regulate.

Ultimately, a universal transition to blockchain technology will require collaboration across multiple sectors as the authorities establish a framework that not only facilitates business, but also protects users. In the meantime, maintaining a detailed understanding of both the technology and the developing legislation will be key to navigating the risks involved.