This guide to distributed ledger tech, and digital currencies is taken from a collection of presentations and comments prepared by our firm, and articles written by our firm.
What is it exactly, this Blockchain or distributed ledger?
Consumer payments and ways of transferring value in Canada and globally have shifted over the last several decades from paper-based media, such as cash and cheques, to card-based media such as credit and debit cards, electronic methods such as pre-authorized payments through ACH, and more recently, digital methods such as digital currencies.
A digital currency is a digital form of a monetary instrument (1) with a bidirectional flow, meaning it allows users to both buy and sell, or use, the digital currency. Bitcoin is the most popular digital currency. Bitcoin operates peer-to-peer and machine-to-machine (M2M). Unlike traditional fiat currencies that are issued by national governments and controlled by central banks, Bitcoin has no central monetary authority and is not backed by any central bank, authority or government. The supply of Bitcoin is not controlled by any central governmental authority, and it is not legal tender in any jurisdiction.
Users can buy digital currencies in person, at an ATM or online with real monetary instruments and can subsequently use them to buy goods and services globally or to transfer value. The purchase and selling price of digital currencies is determined by supply and demand in the digital currency market.
Trust me — “Because its trustless, its trustworthy”
The transactions for goods and services bought or sold using digital currencies are not processed through a centralized authority, or clearing house. A Bitcoin transaction is processed through the Blockchain, which acts similar to a third party clearing house except that the clearing (or reconciliation and verification of transactions) component is entirely M2M on the Blockchain (i.e., direct).
Cryptographic software validates each transaction through a process referred to as mining where participants compete to make records by solving computationally complex cryptographic problems. In the transactional validation process, transactions are time-stamped via a hash algorithm which creates an ongoing chain, and a decentralized digital and permanent record (the ledger) that theoretically cannot be altered or eliminated. A proof-of-work concept records the transactions chronologically and publicly. The shared public distributed ledger is the Blockchain. The Blockchain, by design, prevents anyone from double-spending, and therefore using digital currencies they do not own.
Although it may appear an oxymoron to say so, financial transactions on any distributed ledger tech, including the Blockchain, are in our view, “designed to be trustless and therefore they are trustworthy.” What we mean by that is that they are designed with a lack of trust in respect of all its users, which makes the system trustworthy. Not everyone in the distributed ledger tech space agrees with us on this point.
By contrast, other online currencies or payment systems, such as bank credit cards are indirectly settled – they involve a central administrator or financial institution middleman that sits between the transacting parties. These intermediaries validate and reconcile transactions to avoid double spending by a person. Digital currency transactions on the Blockchain rely on computer software to perform that function, cutting out the institutional go-between in financial transactions.
As a result of the Blockchain, it is now possible to buy currency, shop for goods or services and remit value internationally almost instantaneously, purely M2M without the need for institutional middlemen.
Ethereum & Smart Contracts
Canadians created distributed ledger technology early on. It’s true – Canadian talent, including law firms, were involved in the space early on when no one knew what a Bitcoin was.
For example, Ethereum is a distributed ledger company that was created in Toronto. It moved to Switzerland when Canada announced the world’s first regulation of digital currencies. Its digital currency is called Ether. It is a distributed ledger that is programmable by users. Etherium promotes something called “smart contracts” which are not actually contracts or smart contracts. They are escrow payments that are, in essence, arrangements established purely by computer coding. The theory behind it is that a contracting party will buy Ether through Etherium and pre-pay certain Ether into a wallet and have it programmed to be held in escrow. Upon the fulfillment of the relevant legal condition precedent under the contract between the parties, the payment held in escrow on the distributed ledger is automatically released to a contracting party as a matter of computer coding.
The Ethereum distributed ledger is also often mischaracterized as able to “enforce legal contracts” or the so-called smart contracts; but it does the opposite – these smart contract complete the payment terms of a contract voluntarily by pre-agreement of the parties and performs no enforcement function whatsoever.
Ethereum is very novel and cool tech but it cannot create legal contracts or contracts that are enforceable on the distributed ledger – what it can do is much more simple – its tech can be used for escrow payments in Ether that are auto-released to an Ethereum wallet, irrespective of the existence of a contract between parties.
Potential applications of Ethereum include the possibility of creating invoices that automatically execute a payment when a shipment arrives or the issuance of dividends which are automatically paid to shareholders if corporate profits reach a certain level.
Cool Law Enforcement Uses
Independent of traditional uses of digital currencies, there are a much broader set of potential applications for Blockchain beyond the payments industry which are significant. As noted earlier, a distributed ledger operates as an online ledger where all the validated transactions that are processed through it are recorded, linked, and can be traced.
In some respects, the distributed ledger is like a public searchable database of all of a bank’s transaction records for every financial transaction ever completed by a customer. If a person’s wallet address is known, anyone can view the history of their financial transactions. In our view, as financial crime legal experts, If wallet addresses were eventually not anonymous, the Blockchain and distributed ledger technology would be the world’s most perfect counter-terrorist financing and anti-money laundering tool for law enforcement because its unique features mean that it is a permanent depository of evidence, in the legal sense.
Cool Law Purposes
There are other legal applications of distributed ledgers and the Blockchain. It can be used to store limited characters of data in each financial transaction. This allows for the permanent recording of certain records in circumstances where it may be commercially expedient to do so, such as to record the date of issuance of stock options and other securities-related transactions. It has applications as well in cases where it is legally expedient to record certain legal information or triggering dates, such as notice periods, limitation periods, warranty periods, or the commencement of options to exercise certain legal rights. This potential of the Blockchain is often also mischaracterized in promotional material by startups as the ability to record land titles, deeds, contracts and such on the Blockchain. Technically, all that can be done at this point is to enter limited characters (like a Tweet) with a Bitcoin transaction, evidencing the transaction’s existence on the distributed ledger permanently. Moreover, such application are not legal in the sense that no court of law or judicial or legal body has vetted or approved such use as legally relevant, let alone legally binding upon any third party or government agency.
Distributed ledgers and the Blockchain can revolutionize not only the banking sector, but equally the role of law enforcement, financial transactional reporting, and the practice of law and the administration of justice by virtue of what our firm terms the “permanent bank of evidence.”
Vision for the Future
This is what we believe are the humanistic promises of the tech that, relevant to the practice of law in which we are involved:
- A reduction in terrorist financing if transactions were operated through a distributed ledger system by virtue of the permanent evidence of transactions on the distributed ledger and Blockchain that can be used simultaneously and cooperatively by law enforcement agencies globally;
- Elimination of some forms of fraud because of the impossibility of double spending using distributed ledger and the Blockchain for financial transactions that could save billions in environmental fraud that we’ve been involved in mitigating and investigating arising from the carbon credit trading systems and securities-law related fraud that we have also been involved in from a financial crime perspective in Canada’s capital markets;
- Elimination of bank corruption in developing countries, for example in places like Vietnam, where we have seen citizens that are required to pay bank employees bribes, in addition to bank fees, for the privilege of using the banking system to remove or deposit money into their bank accounts or cash pay cheques;
- An inexpensive remittance system that can service millions of poor and unbanked populations, mostly in Africa and Asia, that allows them to receive value from relatives abroad to keep their families alive, and allows more fortunate Canadians to send value directly to them;
- Empowerment, and sometimes the survival, of marginalized or undocumented sectors of the population who are denied financial services because they live in refugee camps in destitution or live on the street with no government issued ID to set up bank accounts. We have seen this first hand in Jordan and Turkey;
- Financial freedom for women, especially those who are denied banking services because of social, political, economic or geographical circumstances, for example, because they live in repressive societies where women cannot receive banking services or are victims of human trafficking whose ID is confiscated by traffickers;
- Ability to quickly and easily transfer value to hundreds of thousands of volunteers who work with international aid organizations around the world in times of crisis when traditional financial institutions are shut down (or destroyed) such as during a terrorist attack, a tsunami, or an earthquake. This is a serious concern that is ever present in the counter-terrorism field in which we work; and
- To provide financial inclusion to First Nations across Canada who are unbanked because they lack permanent residences (are homeless or live in halfway houses) to set up bank accounts or there are no bank branches within proximity to them. We know this is the case because some of them are the pro bono clients of our firm.
Obviously, the humanitarian case studies, above, are unique to the experiences of the lawyers at our firm but nonetheless present real problems that one day could be mitigated against with distributed ledger tech and digital currencies.