Blockchain Reaction: Part II

Bitcoin may seem uncontrollable, but so did the internet back in the day. Eventually, legal systems emerge
George Takach, McCarthy Tétrault LLP
George Takach, McCarthy Tétrault LLP
LAST MONTH I GAVE AN OVERVIEW of “digital currencies” (such as bitcoin and ether) and the so-called “blockchain” distributed ledger system, both of which are starting to gain significant traction in a number of industries and applications. This month, I provide a survey of the legal issues implicated by these two new technologies and business models.

REGULATORY VACUUM

So far, no regulator or government in Canada has implemented a specific regulatory scheme to cover digital currencies or blockchain, with one important exception noted below regarding money laundering (but it is more by way of a clarification). This hands-off approach can be contrasted with, for example, the more cautious approach taken by New York State, which has implemented a licensing regime for certain participants in the digital currency space.

It is always interesting to see how different governments react to new technologies and to novel, digitally enhanced business models. For example, some 20 years ago, when public key encryption (PKI) first came into widespread use, the State of Utah passed a whole new statute aimed at regulating the new technology and its business applications. The effort was an enormous bust, largely because the marketplace in online security developed quite a bit differently than contemplated by the legislators in Salt Lake City.

Partly learning from this Utah experience, some years later when legislators in North America crafted a legislative response to assist the adoption and growth of e-commerce, they sculpted a very minimalist e-commerce statute that was (and continues to be) technology-neutral, and that reinforces several general legal principles rather than details a prescriptive set of particular rules. The result is a very helpful, facilitative law that gives players in the e-commerce space clear guidelines, without being heavy-handed or stunting progress.

One can only hope that legislators at both the federal and provincial level learn from the above examples and tread very carefully before they propose any specific regulatory regime for digital currencies or blockchain applications.

THE INTERNET HAS LAWS

While it may be true that no specific licensing regime has been created for digital currencies or blockchain in the country, that shouldn’t be taken to mean that the area is lawless and anything goes. Rather, a number of laws of general application will apply, depending on what specific activities are being undertaken with these technologies and business models.

This reminds me of the early days of the commercial internet, when a number of internet pioneers — having implemented never-before-seen business models — concluded that the legal system should not apply to the internet. It turned out that these pioneers were wrong, and indeed the general legal rules relating to libel, taxation, securities regulation, etc., etc., have all come to be applied to the internet. And so it will be for digital currencies and blockchain.

THE CERTAINTY OF TAXES

A good example of this relates to taxation. The Canadian Revenue Agency has already given guidance to the effect that in a number of circumstances, tax will be applicable depending on how a particular entity or person participates in the world of digital currencies. For example, if you hold bitcoins (or some other digital currency) as a “commodity,” and you sell it for more than you paid for it, or you sell it for less, then the CRA says regular tax rules will apply relative to the gain or loss you suffered.

Similarly, the CRA has indicated that if you operate a bitcoin exchange and earn income from doing so, the regular rules relating to income tax will apply. Of course, questions around venue, domicile, jurisdiction and the like are still very much in dispute. Blockchain activities, by definition, are widely distributed; the so-called “miners” who keep the bitcoin electronic ledger up and running (and who are rewarded in bitcoin) are not all in one tidy jurisdiction. And their work is indelibly interconnected. So there will be some very interesting questions around which tax authority has jurisdiction, whose rules apply to what streams of income, etc.

Again, we’ve seen these sorts of tax questions before with distance-selling through various e‑commerce models over the internet. But my prediction is that the additional complexities associated with the complete de-physicalization and peer-to-peer nature of digital currencies will greatly increase the debates in the tax realm. At least early on, a number of the first-instance scenarios will read like law school exams. Interesting times for internet lawyers — less fun for clients searching for certainty.

SECURITIES REGULATION

As with tax, securities regulators dealing with the implications of digital currencies will also be guided by the lessons learned from internet regulation. Again, in the early days of the internet, a number of stock promoters believed that, for example, provincial securities regulators would not be able to take jurisdiction where the website offering the securities was hosted outside of Canada. Much to their chagrin, but frankly to no one’s surprise, the Canadian regulators did assume jurisdiction, concluding that they could do so because of the real and substantial connection between the promoter’s activities and Canada.

I anticipate a similar response by securities regulators to digital currencies and blockchain. A threshold question will be whether a specific digital currency can be defined as a “security.” Each activity will have to be viewed on its own facts, but if the “digital currency product” is structured as an “investment contract,” regulators in Q
uébec and Ontario have already given guidance that this will attract their jurisdiction. Presumably, other activities might not. In each case, the specific facts will be key.

Equally, if you are considering developing a crowdfunding business using a blockchain, then you have to understand the securities laws that apply. Don’t think that just because you’re using blockchain the “traditional” rules won’t apply to you. Now, they may apply differently, but they still require a vetting of securities rules.

TERRORIST FINANCING

One major concern that government has with digital currencies is that they can be used to transfer value in a way that facilitates money laundering and terrorist financing. This is not a new concern. The money-transfer industry, which facilitates billions of dollars of remittances from countries all over the globe each year, has had to live with extensive anti money laundering (AML) rules for years.

A few years ago, questions began to be raised as to whether certain participants in the digital currency space were caught by the AML regulations. Ottawa is now in the process of amending these rules to make it clear that those entities or persons who facilitate money transfers by digital currencies are indeed subject to the AML regulations. When these rules come into force, it will mean entities involved with digital currencies will have to register with the Financial Transactions and Reports Analysis Centre of Canada (FINTRAC) federally. They will also have to report transfers greater than $10,000 (or their equivalent in the relevant digital currency), etc.

APPLYING PRIVACY RULES

One of the really challenging questions for the digital currency business, and the operators of blockchain business applications, will be how to apply privacy laws to these new technologies and activities. That’s because one of the arguments in favour of blockchain is that it requires less personal information to be collected from participants in the first place.

On the other hand, what makes blockchain tricky from a privacy perspective is that a certain amount of information “etched on the block” (as it were) is indeed transparent for all to see, as this architectural dimension gives the system its trustworthiness. Put another way, the very design of blockchain is both privacy-enhancing and privacy-limiting. It will be very interesting to see whether privacy regulators ultimately call the glass created by the new technology half full or half empty.

CONSUMER PROTECTION

It’s too early to predict whether new technologies and business products of digital currencies and blockchain will precipitate some unique consumer-protection rules. Just as government waited a number of years to observe the internet before implementing a set of e-commerce consumer-protection regulations, my guess is we’ll have to wait a few years before we have enough experience with digital currencies and blockchain before governments figure out what market failures related to them might need some correction.

In the meantime, participants that offer digital-currency-related services, or blockchain-oriented exchanges, should probably err on the side of more, rather than less, disclosure to potential users. For example, it’s clear that the Canada Deposit Insurance Corporation won’t cover losses suffered in digital currencies — and this should be made clear on the website or other marketing materials offering digital currency services or products.

In conclusion, with digital currencies and blockchain, the legal system is once again confronted by new technologies and business models, and therefore a slew of novel questions and challenges arise. The good news is that with some proactive preparation, and reliance on other internet‑related precedents, these intriguing issues can be adequately managed.

George Takach is a senior partner at McCarthy Tétrault LLP and the author of Computer Law.