This article was first published in the Hong Kong Lawyer magazine.
Change is inevitable. Businesses are constantly racing to find solutions that make transactions more efficient, more cost-effective, and more secure.
To move ahead, many companies are now jumping on the blockchain bandwagon to build up their businesses.
What Is blockchain?
Without going into detail, a blockchain is a data structure that organizes data into a distributed ledger.
It is digital and programmed to be decentralised, so that it is not controlled or owned by any single entity. Each block in the chain is linked using cryptography. A peer-to-peer network of nodes (i.e. distributed ledger network of participating computers at any one time) independently verifies new transactions under a set of rules which typically are set by the entities creating the blockchain and/or through the majority decision of the nodes (i.e. a consensus protocol). Nodes can join or can leave the system at any time.
The verification process, which consists of a node solving a difficult mathematical problem requiring an abundance of computer power and the exercise of the consensus protocol by the other nodes to validate the work (i.e. proof of work), in essence ensures that the new block follows from an existing block in the chain. In other words, the nodes can check that within the system, the party giving up the title actually has title to give, and the party paying money has money to spend. Once verified, blocks of encrypted new data relating to transactions occurring at a particular time are added in chronological order onto the chain. Each of the nodes has an identical copy of the blockchain, so that all nodes have an identical (shared) ledger ensuring consistency. Usually, the nodes are motivated by a reward for doing the verification work.
As the blocks refer to certain transactions at a particular time, these time-stamp the respective actions and act as proof of a transaction. The data relating to the transaction (i.e. duration, terms, conditions etc.) can all be written into the block as well.
Once written to the blockchain, the data in the block cannot be changed (i.e. it is immutable). Those with access to the blockchain can see the execution of the transactions of each individual block, and therefore, interested parties can easily verify it.
There are two main types of blockchains-- the public blockchain and the (semi/fully) private blockchain.
1. Public blockchain:
This type of blockchain does not require permission from anyone. An interested party can introduce a new node.an be many validating nodes, all of which can be anonymous. The majority of the nodes will dictate the truth and if they validate it, it will form part of the block to the chain. This system offers more transparency compared to the private blockchains.
2. (Semi/fully) private blockchains:
These types of blockchains require permission and there are fewer validation nodes. The nodes here are in a more private network, not open to the public. Instead of each node being able to validate and confirm a block, the validation of some nodes may have more weight (e.g. like a weighted vote) or may even have veto powers in these types of blockchains. This system allows for more control compared to the public blockchains.
Due to its immutability, which may help to deter fraudulent transactions, and its easily accessible character, blockchain technology promises a plethora of applications and game-changing potential.
What Is Its Application?
Most, if not all, businesses have been making use of technology to further their growth. The digital environment allows for faster processing of transactions, but transactions may be even quicker if the transfer of funds could take place immediately upon the satisfaction of a condition (verified almost simultaneously) with no intermediary to go through. This would also minimize the cost of the transaction fees.
The blockchain technology appears to be able to offer this.
When a transaction is uploaded onto a block, copies of it are simultaneously updated, so that the records of all related parties can show the newest information in a contemporaneous manner, without the need for intermediaries (e.g. a bank or escrow agent) to verify the transaction or to transfer ownership of the item being bought and sold.
Private blockchains may afford more control to businesses, where they can set up and choose what type of nodes can validate or veto (rather than let anonymous masses dictate the outcome), to better control the system of verifying transactions, and lessen the risks of security breaches from the outside. To have the transaction and relevant accounts set into a computerized system could also reduce risk of human error and allow for consistency in productivity.
The fact that the blockchain will record all the transactions that have occurred previously in this ledger also consolidates the record keeping process of a business, and facilitates efficient tracing of transactions.
Over the past few years, the Hong Kong Monetary Authority has been actively exploring the distributed ledger technology and has published two whitepapers on it, on 11 November 2016 and 25 October 2017 respectively. In its whitepapers, it discusses further research into potential uses of the blockchain in, inter alia, mortgage loan applications, properly valuations, property ownership verification, trade finance, and tracking status of trade transactions. Though it has invested into further efforts to explore the use of this technology, it has also noted various outstanding issues that should be addressed before implementation of such a system, some of which are set out below.
What Legal Issues Should Businesses Consider?
Since the blockchain is based on the nodes working simultaneously and quickly, if there was non-cooperation amongst the nodes at a particular time or any issues with the consensus protocol, this will affect the blockchain building process. A fork may arise if a consensus cannot be reached. In theory, fraudsters with enough computer power could maliciously create a fork in the blockchain, so that there is another inaccurate version of the transactions commencing from that block. Since the block could reflect a contract or ownership of a certain item, the new “fake” parallel version of the blockchain could give rise to subsequent transactions that are based on a questionable root. For example, if there was a sale of a bitcoin in the “fake” blockchain, the series of transactions and changes in title that may arise from trading that one bitcoin may all be questionable and even voidable.
Some uncertainty for immediate transactions
Furthermore, as it takes time to verify a block, if there are problems with the block as determined by the consensus protocol, these new blocks could lose its link on the chain. For example, if there is a fork leading to two different blocks (i.e. two different transactions) which involve transfer of title of the same object at the same time, the nodes will check the transactions between the two chains to verify which one is correct (by reviewing the proof of work) and then reject one of the chains. This poses a problem for businesses that require certainty for immediate transaction-processing arrangements. However, this problem might be manageable by using a private blockchain with the setting of particular rules, but how to set those rules is another item to consider and not discussed in this article.
Reliant on working internet and power supply
Some more fundamental problems include the environment which we operate in. The whole blockchain system is digital and based on the need to have a working internet network, computers, and power. If there were issues with the network or power supply, this could be detrimental to a business which relies on blockchain in its day to day trade activities or operations. Consistency and reliability therefore are key issues that must be explored, along with the need for contingency planning and whether insurance can cover these situations.
Privacy concerns have also been raised in respect of the blockchain. As the blockchain is immutable and operates on a global scale, once personal data is written into a block, it is difficult to remove that data or ensure that it is kept only as long as necessary, used only for the purpose it is collected, or that it is properly and securely stored so as not to be accidently disclosed. Governance, establishment of working rules, and monitoring, may be essential to abating these problems, although care should be had to the different jurisdictions that the blockchain will operate in, and their respective laws regarding personal data collection, transfer, and retention.
As a blockchain represents transactions and contracts, competition issues should also be considered if the respective blockchain may act as a technology barrier to enable anti-competitive behavior.
Ultimately, with this new technology, many questions have been raised as to how to implement its use and best protect businesses to avoid, inter alia, the legal problems mentioned above. The first step to finding a solution is to understand the issue -- which is why it is important to learn more about the blockchain. With a clear understanding of the benefits and risk can we then strengthen the building blocks of our businesses endeavors.