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Is it Time to Coherently Regulate Blockchain?

Blockchain is an emerging ledger technology, based on a peer to peer function that owes its existence to Bitcoin, being introduced in the source code of Bitcoin. It is argued that Bitcoin used Blockchain of the first generation, called Blockchain 1.0, which was only designed to support crypto currencies.

The Blockchain of the second generation however distanced itself from Bitcoin and its single focus on cryptocurrency and allowed all kinds of transactions to be coded into a freely programmable Blockchain, such as the Ethereum Blockchain, where one can implement business logics in so-called smart contracts.

Blockchain technology can be better understood through the introduction of some of the fundamental technical concepts.

(a) Node: A Blockchain is maintained by software that runs on a computer called a node or peer. Each node is connected to the Blockchain network and can submit and receive transactions.

(b) Network: Organisations and possibly individuals maintain computer systems called nodes, these nodes run Blockchain software to communicate with each other and form a Blockchain network.

(c) Smart Contracts: Transactions or contracts that are converted into code to be executed on a Blockchain are known as scripts or smart contracts.

(d) Transactions: Users submit transactions to the Blockchain by sending them to nodes on the network who subsequently disseminate them to all other nodes on the network.

(e) Validation: Nodes receive, process and cryptographically validate each valid transaction while discarding invalid transactions.

(f) Block: Nodes collect and group valid transactions together into a bundle known as a Block. Blocks must follow a pre-determined set of rules for them to be valid.

(g) Blockchain: Each new block contains a reference to the most recent valid block and is placed after that block in the database, forming a “chain of blocks”.

(h) Consensus: The process of ensuring that every node agrees on the Blockchain.

Blockchain is perceived both as ground-breaking as well as disruptive and it presents significant challenges, particularly on privacy, security and operational risk elements arising out of its software as well its decentralised model. Privacy and Data Protection particularly in Europe could be problematic for Blockchain deployment as the rights of data subjects, including the right to port data, erase, to stop data processing and the right of rectification need to be catered for, as well as the correct legitimisation of the processing in a decentralised environment. Non-adherence under the upcoming GDPR could be extremely costly.

Every major bank and financial institution is considering the potential of applying this technology in different areas of their business, such as payment, stock trading, or similar transaction-based processes. Government agencies are also observing Blockchain as they can benefit considerably from the near instantaneous and simultaneous access to a distributed database that stores public records.

Within this backdrop, how are countries tackling and responding to the advent of this innovative technology? How can they safely build the capabilities that are necessary to successfully harness the Blockchain potential, without dampening the appetite for this new technology?

In 2015, Estonia announced itself as a leading country in the development of Blockchain-based services, introducing an e-Residency project (electronic residency system), a Public Notary (electronic version of a Notary) and a project on transferring medical records of Estonian citizens into the Blockchain. Furthermore, in January 2017, the Estonian subdivision of Nasdaq successfully completed testing of the e-voting system designed for voting among shareholders of a company and is going to continue developments in the customer service segment.

In 2016, the European Securities and Markets Authority (ESMA) also published a Discussion Paper entitled “The Distributed Ledger Technology Applied to Securities Markets” to study the impact of Blockchain in the securities market. Similarly, the UK Treasury published a report entitled “Distributed Ledger Technology: beyond Blockchain”, in which it presents a set of recommendations to create a regulation which would address amongst others, technology, governance, privacy, security and disruptive potential on the distributed ledger model.

In the USA, the Securities and Exchange Commission and the Treasury Department warned that Blockchain poses ‘risks and uncertainties which market participants and financial regulators will need to monitor’.

States like Vermont went on to regulate Blockchain. Vermont’s Law (H.868 (Act 157)), presumes that documents written to the Blockchain are authentic, if:

(a)   verification can be obtained as to the date and time of recording of information in the Blockchain;

(b)   such information is entered as a regular practice; and

(c)   the information qualifies as a self-authenticating record and regularly maintained business record for purposes of any legal proceeding in a Vermont court.

Other states in the USA are currently exploring the use of Blockchain technology. Illinois as well as Hawaii are proposing Bills to legislate Blockchain. Similarly, Arizona’s bill HB 2417 also states that smart contracts written on a Blockchain are essentially equivalent to all other forms of contracts.

The bill states that: ‘A signature that is secured through Blockchain technology is considered to be in an electronic form and to be an electronic signature.’ Furthermore, ‘a record or contract that is secured through Blockchain technology is considered to be in an electronic form and to be an electronic record’.

Importantly, the measure also includes a clause on smart contracts – self-executing contracts that run on a Blockchain, saying: ‘Smart contracts may exist in commerce. A contract relating to a transaction may not be denied legal effect, validity or enforceability solely because that contract contains a smart contract term’.

Japan is also moving to finalise its legislation aimed at recognising bitcoin as a legal method of payment while also catering for cybersecurity and operational obligations on the potential use of Blockchain.

The European Commission is also actively considering Blockchain and in 2016 it commissioned a report with the title “Blockchain applications & services” which also touches on developing a favourable regulatory framework for Blockchain. Similarly, in a recent draft communication from the European Commission with the title “Consumer Financial Services Action Plan: Better Products, More Choice” which was published in March 2017, the European Union seems intent to create a Blockchain proof-of-concept focused on regulation. A careful reading of this communication implies that this will both affect Blockchain applications and even require them.

In a similar fashion to the elements of the Bills introduced particularly in Vermont and Arizona, the European Commission is working to facilitate the cross-border use of electronic identification and know-your-customer portability based on Eidas.

The European Parliament in June 2016 also pushed for Blockchain form of regulation, and lately in February 2017 it also issued an in-depth analysis with the title “How Blockchain technology could change our lives” which concluded that:

‘At first glance, the decentralised, encrypted and self-executing character of blockchain technological applications does seem to rely upon or assume a self-regulatory approach that would in principle operate in parallel to the traditional legal instruments. However, looking more carefully at the most advanced blockchain applications, a mixture of traditional and novel legal and regulatory questions are raised that must be considered in a contextual manner as some of the above-mentioned applications challenge fundamental tenets of law and diffuse the object of regulatory attention, as such, in a variety of ways….’

Despite the risks and concerns surrounding Blockchain, this new technology will most definitely bring several changes to numerous facets of our life and economy. These changes whilst having risks and a disruptive element, should be aimed at fostering innovation and improving the economic value chain. Preparing for these changes means investing in research and experimentation as well as stimulating and harnessing the Blockchain potential and not dampening investment and innovation. However, regulation is inevitable, and if applied correctly it can infuse the required checks and balances, transparency and certainty for all the active players in the Blockchain ecosystem to benefit. This will ensure that the legal and regulatory dimensions propel and do not hinder innovation in this space. There has never been a better time to rethink and redefine policy and regulations, and for the academics, industry and Governments to work together and influence the evolutionary path of this new technology, while allowing oneself to be influenced in return.

For more information, if you have any questions or if you would like to discuss this topic further, please feel free to contact Dr Ian Gauci on igauci@gtgadvocates.com

Disclaimer: This article is not intended to impart legal advice and readers are asked to seek verification of statements made before acting on them.