Blockchain and Cryptocurrencies
A blockchain, quite simply, is an ever-growing ledger of records, called blocks, which are linked and secured using computer cryptography. This process allows for decentralized networks of computers to be linked for the common purpose of sharing the same sequence of information. Supporters of blockchain technology assert that it can eliminate various risks associated with existing methods for settlement and record keeping of transactions. For instance, in terms of financial transactions, blockchains have the potential to (1) eliminate the need for intermediaries; (2) provide up-to-date and accurate audit trails; and, (3) with proper know-your-customer protocols, easily identify parties to transactions.
Essentially, cryptocurrencies are digital currencies, operating independently of a central bank, which use blockchain encryption techniques to regulate the generation of units and to verify the transfer of funds. Each cryptocurrency operates on its own blockchain. The unique characteristics offered by different cryptocurrencies (e.g., increased privacy, faster transaction times) are based on the unique properties of how each blockchain operates. There are hundreds of cryptocurrencies and related blockchain technology applications available in the crypto market today. These can be divided into three main categories: (1) transactional cryptocurrencies, which serve as a way to store and exchange value (e.g., Bitcoin, Litecoin); (2) cryptocurrency platforms, which create the infrastructure to build new blockchain applications such as smart contracts (e.g., Ethereum, Factom); and (3) cryptocurrency applications (coins and tokens), which are created on top of cryptocurrency platforms and represent fungible and tradable assets (e.g., commodities, loyalty points). Most coins are created from Bitcoin’s open-sourced, original protocol and have differentiated attributes. Tokens are created and distributed to the public through crowdfunding initiatives such as initial coin offerings (ICOs).
Regulations and Laws
Governmental perspectives toward cryptocurrencies are evolving and vary across countries.
In the United States, the laws are generally friendly to cryptocurrencies, but their status depends on the state and type of operation. For instance, depending on the jurisdiction, they can be considered as money, securities, an investment tool, or property. In 2014, the IRS determined that cryptocurrencies would be considered property for federal tax purposes. Around the same time, the Financial Crimes Enforcement Network (FinCEN) declared that a license is required for the exchange of cryptocurrencies for fiat money as in other operations with fiat money. In 2017, the U.S. Commodity Futures Trading Commission (CFTC) allowed Bitcoin futures to be traded. And the U.S. Securities and Exchange Commission (SEC) in 2017 equated the collection of money through an ICO to an initial public offering (IPO); in other words, companies that release tokens and the exchanges that trade them must register the transactions.
In the European Union, cryptocurrency regulation has not been unified. The European Central Bank has issued a recommendation that banks not conduct cryptocurrency operations until these become directly regulated.
In Japan, cryptocurrencies have recently been authorized as a form of payment by individuals and companies, and incomes from cryptocurrency operations are treated as business income.
Litigation and Enforcement
A substantial number of cryptocurrency-related lawsuits and enforcement actions have been launched in the past year. The types of claims brought forth in these lawsuits span a broad range of laws, including federal securities, blue sky, anticompetitive, false advertising, and breach of contract. For example, the SEC sent subpoenas to numerous entities that have floated ICOs, seeking information about the assets and organizations behind the offerings. And the CFTC filed charges against three cryptocurrency firms, alleging practices ranging from defrauding customers to setting up Ponzi schemes. Fraud is not the only trouble spot. Some online cryptocurrency exchanges are finding themselves vulnerable to cybercriminals. Coincheck was sued after hackers drained $530 million from the exchange’s accounts. And a class-action lawsuit was filed against Kraken after hackers launched a denial of service attack and crashed the online exchange.
Figures 1 and 2 describe the current trend in litigation/enforcement by year and category.
Figure 1: Crypto Matters by Year
Figure 2: Crypto Matters by Category
Given the developing state of the cryptocurrency industry and related regulatory framework, it seems that plaintiff attorneys are still refining their litigation strategy. Looking ahead, some of the current realities impacting the cryptocurrency market, such as high-price volatility and the increasing number of ICOs, are likely to fuel a rise in the number of regulatory actions and lawsuits involving cryptocurrencies and blockchain technology for the foreseeable future.
Potential Roles for Experts
Although blockchain-related regulatory enforcement and lawsuits remain in their infancy, it is expected that traditional expert capabilities in examining questions related to liability, loss causation, and damages (such as expertise in forensic accounting and financial market operations) will be supplemented by specialized capabilities in legal/computer technology and data science. Key issues to be addressed by cryptocurrency experts will likely include (1) explaining blockchain transaction technology and how cryptocurrencies are set up and operated, (2) following the money (accessing and mining raw data on blockchain ledgers), and (3) extracting and managing cryptocurrency data from live and imaged computers.
Blockchain technology and cryptocurrencies represent an exciting, emerging industry that is bound to give rise to a considerable number of regulatory actions and broad-ranging legal claims. Developing a sound understanding of their underlying technologies, processes, and markets will be essential for attorneys and litigation support experts interested in gaining a foothold in this field.
Joao dos Santos and Stefano Vranca are managing directors at Navigant Consulting, Inc., based in Los Angeles, California.