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Demystify Blockchain Law

Cointime Staff· 12 min read

We have always been triggered by the next airdrop, new tokenomics, flashy defi algorithms, and next protocol updates. As a web3 developer and user, I never feel the need to worry about the traditional dogmatic legal and financial structures, and just focus on inventing new things. However, recent affairs brought attention to the regulatory and legal implication of web3: the collapse of Terra Luna caused a chain reaction of scrutiny in the stablecoin regulation and classification of on-chain assets; CFTC stepped up to file complaints of decentralized organization as in the Ooki DAO case.

So, what do we mean by blockchain law? What is on the table? Why is the well-intended web3 movement interrogated by lawmakers and judges?

I was delighted and grateful to attend the first Blockchain Law for Social Good Conference organized by Professor Michele Benedetto Neitz and Algorand Foundation. From the insightful panels and casual talks to participants, I was enriched with legislative and judiciary perspectives on blockchain law.

In this article, I will guide us to understand the current consensus, key topics in mind, future insights, and how to better interpret the regulator and lawyer perspectives.

Current Consensus

Let me jump to some conclusions. Everyone is looking for more guidance and well-defined blockchain regulations. For example, the ongoing SEC v. Ripple case will be a bedrock of security litigation cases. The complaint alleges that Ripple raised fund through the sale of XRP in an unregistered securities offering. If SEC won, it would set a precedence to file litigation on cryptocurrencies in general. On the other hand, if Ripple won, it might invite more bold and riskier cryptocurrency issuance. Lawyers and entrepreneurs are waiting to avoid a deepening grey area.

It is also a phenomenal time that blockchain regulation receives bipartisan support in Congress and Senate. What does bipartisan support mean? It means that once upon a time Republicans and Democrats stop arguing and want to achieve the same goal. The three key alignments are:

(1) We need clarity in defining digital assets and blockchain activities.

(2) We need better consumer protection.

(3) We don’t want to miss the train.

Clarity is simple to understand. As a developer I want to know what the rules are out there, instead of being hunted down one day for compliance. It can mean that all tokens and on-chain activities are classified into several buckets, and no one is left out in the wild. If anything breaks, there are well defined mitigations so the team or lawyers can efficiently patch the fixes. Clarity sounds like a smart contract to me: the procedures and outcomes are all codified and ambiguities are thrown out.

Consumer protection may sound a bit foreign to developers. It essentially means stop scammers and protect users. I got scammed when I first started; I blanked out as it was impossible to retrieve funds on-chain. The less web3-native users have less cue about how to protect their life savings from buggy protocols and phishing. Moreover, seemingly legitimate protocols such as Terra Luna can also lead to loss of personal savings, which ignites more debate on employing security regulations on tokens to protect people.

Lastly, blockchain applications have huge potentials but currently companies are leaving the US to seek better legal and legislative support. As US is banning more blockchain activities and issuing wishy-washy signals, projects are moving offshore to places like Singapore, UAE, and British Virgin Islands to incorporate and proceed funding. If the US legislative does not move fast enough, the US may likely lose the leading position in future blockchain growth and find it difficult to catch up due to the snowball effect.

Of course, albeit the good wishes, politicians are taking their time to first finish the midterm election and flesh out disagreements on details such as the distinction of bank or private company in certain clauses. It is now a good time to take a leap to understand the regulators and lawyers better.

Regulator vs Lawyer Perspective

As a Mathematics student, I naturally visualize the relationship of companies, regulators, and lawyers as a multi-dimensional parabola.

Okey enough fun; let’s make it more reasonable with a 2D vertical intersection of the parabola.

The surge of number of projects and companies elevates the stress on the regulators to define more rules. Visually, the industry growth is the driving force that pushes up the height and therefore potential energy of the regulators and lawyers. Regulators are synonym of lawmakers and legislators, which means that they need judiciary branch to settle the cases. Lawyers interpret the legislations and therefore ground the laws to figure out actual cases. They are essentially closer to the projects and serve as the middleman between legislatures and companies.

I also highlight issues and events in red as a triangle below the regulator-lawyer parabola. Events such as the Terra Luna collapse triggered a chain reaction that resulted in an increase in industry-wide litigations and legislative concerns. Those events push regulators to higher stakes to fix the system and require large number of lawyers to interpret and handle the cases. So, in essence, lawyers focus on hammering out the legal outcomes of the events, and regulators kick in soon after to fix the overall issue.

That may sound abstract, but if we take a step away to see a bigger picture, those two actors come from very different perspectives. Regulators represent their constituents in their geographic locations. You can call your congressman or senator anytime to express your opinions. They need to go through thousands of inquiries and suggestions each day to boil down their takes on current issues. This implies that they are aggregators of opinions of the community and represent the rights of the constituents. Imagine if you were scammed online and could not find any agencies to help, you might call your local representative and ask for better consumer protection laws.

End of the day, all blockchain users are people and are protected by the laws to have rights. If they are in the US, then US regulators need to ensure the people’s rights and therefore impose additional laws on blockchain. Then it is not too strange to find regulators “firewalling” blockchain applications to US users and entities.

There is a magnitude of difficulties on the legislative side in general. For example, balancing costs and feasibility of new bills is a tough one. Gavin Newsom vetoed a crypto bill this September which intended to impose strong regulation and received near-unanimous support. He casted concerns on the budget to execute the bill and suggested more flexible clauses. A similar licensing bill in New York faced hardship in execution as the office was completely understaffed and kept losing talents to the private sector.

On the other hand, lawyers receive the instructions from legislature and work with the judiciary system to practice law. If I put it into blockchain terms, regulators are the aggregator functions of blocks, and lawyers and judges are the relayers in the system. Lawyers support projects to confront the laws and argue for the projects’ best interests. They may find flaws or new interpretations of the laws to contest the definitions and legality.

However, both the legislative and judiciary branches lack the knowledge of blockchain, given it is young, fast-evolving, and technical at heart. There has been increasing number of advocacy groups to educate the lawmakers and judges about blockchain technologies. In the near future when more confusing and intricate technologies like zero knowledge gain mass adoption, it will be more challenging for the regulators and lawyers to sync up the mechanisms.

Lastly, both legislators and lawyers live as walking encyclopedias. I am always in awe when they continuously output high density information about the legal and legislative cases and clauses.

Key Topics

Litigations

On-chain settlements happen atomically: a swap executes when the transactions succeed and an order complete when an oracle is triggered. However, the matter becomes much more complicated in the real world. Either party can fail to deliver the promise or inflict harm on the other. Here litigations kick in to fix the problems off-chain through the court system.

For example, there is a jump of litigations towards crypto promoters for class action or allegation due to lack of disclosure and compliance or “pump-and-dump” schemes. When the market is going south, everyone is pointing fingers at potential liable parties. The Terra Luna collapse triggered a wave of litigations, as regulators scrutinized the industry and wounded consumers sought support.

Take Coinbase for example: its shares went down 21% when SEC probed into the prospect that the platform was offering unregistered securities. Following the drop, it was hit by another class action lawsuit which alleged that Coinbase knew it should have registered the listed digital assets and its misleading claims pumped the stock prices earlier. Moreover, lawyers argued that it held users’ assets knowing that they could end up as property of a bankruptcy estate. There are more litigations towards Coinbase, and I will not even attempt to summarize.

If we look at the bigger picture, the development of new technologies takes the buffer room to thrive rapidly. Till an unexpected event or a shock takes place, all eyes are on resolving the unsolved questions that have been kept in the buffer. We can see a high volume of class actions in 2018 and 2022, when the bear market hit. We are yet in the shock and witnessing the unprecedented level of scrutiny in blockchain related activities.

IP laws

Intellectual Property law is a beast to fully understand, but recent surge in popularity and market size of NFTs brings caution to the intellectual property. It is not straightforward for an average user and develop to navigate the nuances.

I was fascinated by Bored Ape Yacht Club’s first section in terms and conditions: “you own the underlying Bored Ape, the Art, completely.” When it was first announced, the price of the NFT collection nearly doubled. I almost felt that IP could be priced into artworks in digital assets. Users can do whatever they want, not only with the NFT but also the underlying art? Not quite. Yuga Labs sued Ryder Ripps Bored Ape Yacht Club citing trademark infringement.

The fact is that the terms and conditions are often confusing and self-contradicting. The BAYC license first gives the right for the underlying art but then restricts the rights of personal use and commercial use in the next sections. The internal consistency shown in BAYC’s terms and conditions implies industry wide confusion in crafting IP usage.

Creators of “original works of authorship” always retain rights to their works through copyright. This means that an artwork has essentially two parts: its physical or possessable form, and its underlying copyright. The author can always choose the separate the rights in an artwork to sell a part and keep another. For example, artists tend to use licensing to keep certain rights such as refraining others to spoof their work.

IP law will be a battlefield for on-chain intellectual property usages. There are still ambiguities in defining the legal boundaries, especially as the technological innovation has changed how we consume those works. Luckily, policymakers and lawyers have now realized that NFT is just the wrapper technology and will focus on interpreting the underlying works as the assets.

Regulatory bodies of digital assets

The so-called “Alphabet Soup” is having all eyes on regulating cryptocurrencies. You must’ve seen SEC, CFTC, DOJ, IRS, and OFAC as the popular terms on crypto headlines. There has been no clear instruction about who is regulating what, so that oftentimes they appear together spontaneously to draw lines on crypto cases. Only Congress is in the place to set the guidelines for their jurisdictions.

SEC (Securities and Exchange Commission) oversees security regulations and FINRA (Financial Industry Regulatory Authority) deals specifically with custody of crypto assets. Its current chairman Gary Gensler is particularly interested in cryptocurrencies and specifically wants to target enforcement. This means that all cryptocurrencies aside from bitcoin could be subject to security laws and tokens will be illegal without more scrutiny and filings.

CFTC (Commodity Futures Trading Commission) regulates commodities like corns and metals and recently joins the party to regulate crypto. It is a regulatory agency that does not have precedence, which means that they do not have enforcement power. There is a turf war between CFTC and SEC: in the Coinbase insider trading case, CFTC and Coinbase both opposed SEC regulation, citing SEC was stepping outside its jurisdiction.

SEC and CFTC definitely have the center stage, but let’s also mention the rest. DOJ (Department of Justice) focuses on enforcement of crypto prosecutions and works closely with SEC and CFTC. IRS (Internal Revenue Service) oversees the collection of taxes and has concerns over tax evasion in digital assets. OFAC (Office of Foreign Assets Control) administers the economic and trade sanctions as a part of the Treasury Department. It recently sanctioned Tornado Cash, a crypto private mixer, for the reported money laundries including the hack sponsored by DPRK.

Howey Test: 4 traits to classify digital assets

What are the current rules to classify security? Let me introduce “Howey test”, stemmed from the US Supreme Court case SEC v. W.J. Howey Co (1946). A financial instrument will be considered an “investment contract” and therefore a “security” if:

(1) There is an investment of money.

(2) It is in a common enterprise.

(3) There is an expectation of profit.

(4) It depends on managerial or entrepreneurial efforts of the others.

The first trait is always assumed as digital assets are investment, including airdrops. Common enterprise implies that the price of the token fluctuates, which is assumed in fungible tokens. The next two are less clear cut and leave room for debate. Marketing of tokens frequently involves signaling an expectation of price increase “to the moon”. Liquidity pools and staking also account for passive income. The last trait again signifies others like project teams or validators making the heavy lifting efforts to increase the value.

Current SEC Chairman Gensler emphasizes that proof-of-stake chains are risker since there is a passive income component for all stakers. PoS network can be more centralized which means less point of failures and therefore riskier. More centralized cryptocurrency can also mean higher likelihood to say “yes” on trait 4 as the project teams actively strive for growth. The rules are yet to be refined.

Future Insights

There are other heated topics like KYC (know your customer) and stablecoins that I will leave as a research exercise. In conclusion, the legislative and judiciary bodies have increased their attention on blockchain law and will hopefully set out clearer guidelines and beneficial regulations to support the industry.

Instead of focusing on regulating the technologies, regulators should spend more time on regulating the various use cases of blockchain applications. It means an open space to develop and innovate, while businesses need to be more responsible.

A refined blockchain laws will come out in the next year or two. The US should not be too late to catch the train on leading blockchain innovation in the future. More interest groups are stepping up to bridge the knowledge gap and raise attention for blockchain law. For developers, just keep creating and innovating. Build with good intent and we are gonna make it!

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