Blockchain, Cryptocurrencies, NFTs and Smart Contracts

The Intersection of Fintech and the Law

While the club of elite tech leaders continues growing in its understanding of the use and value of the blockchain, even among the most skilled and seasoned business owners and investors, the learning curve around blockchain technology remains very steep. It's important to understand how its many parts work together, as they all have incredible value in the marketplace today. So among many questions that surround all things fintech (and cryptocurrencies), the question of what exactly is the blockchain is one that is screaming for an answer that everyone can understand.

Blockchain

So what is the blockchain? Blockchain is a shared, immutable ledger for tracking assets, recording transactions and creating a trustworthy environment for market transfers via parties’ chosen medium of exchange. Blockchain comprises a list of transactions that can be viewed and verified with complete transparency. The blockchain technology, when coupled with media for exchange, usually cryptocurrencies, make it possible to transfer value online without the need for any middleman like a bank or card processor.

When you think about this for even a second, you can see the awesome power that lies behind the technology. No intermediary, complete transparency – suddenly transaction velocity becomes extraordinary. There’s just one thing missing – ubiquity. As soon as we reach a point where it is commonplace for people to transact business on the blockchain, we will eliminate the need for traditional banking. But until that day arrives, monetary exchange continues to be delayed and exposed to fraud in the banking system.

But if there are risks from the traditional system of exchange, aren’t there also risks on the blockchain? Yes, since the markets have yet to prefect a way to make or exchange currency without exposure to some risks, they still exist. Put another way, there is always, at least in the present time, some kind of risk-reward trade off.

On the blockchain, risks arise from the very benefits they bring. “Anonymity, immutability, and distributed control make blockchain a disruptive technology. They are also its greatest vulnerabilities.” The Risks and Unintended Consequences of Blockchain. Hmmm. What does this mean? According to Stuart Madnick, Profess of Information Technology at the Sloan School of Management at MIT, over $1,000,000,000 in loses due to fraudulent transactions on the blockchain occurred between 2011 and 2018. At the time, this was disproportionately higher than losses occurring in the traditional banking system. That is changing, but the data to analyze the relative security at this point is a bit sparse and complicated to interpret.

While the trend in data security on blockchain versus traditional exchanges has changed trajectory with the advent of greater security and control in the blockchain, by no means is it gone. The blockchain today offers more safety, even to the banking system itself than historic means of protecting transactions. But a balanced understanding of the distributive nature, immutability and anonymity it provides is vital to balancing the risks and benefits of blockchain usage. The most important things to know about the blockchain, at this moment, are that it is out there, is highly sophisticated, and is enabling transactions of a type and at a volume we have never seen before.

Cryptocurrencies

In order to make the blockchain viable, it needs a viable medium of exchange. Cryptocurrencies have more than filled this void. Today, the market capitalization of Bitcoin exceeds $1 Trillion, Etherium is approaching $500 Billion, and the third most capitalized cryptocurrency, Binance Coin will exceed $100 Million any day. To those who remain in doubt about the future of cryptocurrencies, they are not going anywhere anytime soon. They are safe, albeit volatile investments, that should be expected to appreciate in value over time. As central banks continue to devalue their own currencies, the alternative to them is the cryptocurrency markets, and the banks have shown they are willing to watch their own worth plummet, all to the benefit of cryptocurrencies and their investors.

Investopedia defines cryptocurrency as:

… digital or virtual currency that is secured by cryptography, which makes it nearly impossible to counterfeit or double-spend. Many cryptocurrencies are decentralized networks based on blockchain technology—a distributed ledger enforced by a disparate network of computers. A defining feature of cryptocurrencies is that they are generally not issued by any central authority, rendering them theoretically immune to government interference or manipulation.

As the world’s central banks are increasingly less stable, and as the US dollar declines in its perspective as the world’s currency, cryptocurrencies are gaining in relative value. More slowly, but necessarily, they are also gaining in terms of acceptable use in the marketplace. And this will continue, organically and practically. The organic growth in crypto may be slowing a bit as merchants realize and recognize the challenges with the various tax implications and accounting issues. Practically speaking, however, this is not likely to inhibit or prevent the use of cryptos in less conventional ways, i.e. in marketplaces of exchange of personally owned property and on the various cash apps that already exist.

With respect to the cash apps, think of it this way. The value of a transfer in dollars always has a corresponding value, in say, bitcoin. While this value can change quite rapidly, whatever it is can always be measured at a set point in time. Thus, if you send your niece $100 on Venmo, and the current valuation of bitcoin is $50,000, you have also used .002 bitcoins to make the purchase.

One of the interesting consequences of the rapid increase in value of bitcoin and other cryptocurrencies is that it this will likely ensure the dollar will continue to be used as the baseline to calculate the store of wealth, or account values of electronic accounts. Ease of calculation, i.e. $100 vs. BC.002, familiarity with the dollar, consistency across platforms and the elimination of the regulatory headaches associated with the government’s tight noose around profiting from crypto usage, all mean the dollar has, in a sense, protected its own longevity for the foreseeable future.

In no way, however, does that mean, that cryptos won’t continue to increase in value, nor that they won’t normalize as trading currencies through the wider marketplace over time. Sheer demand for their use will continue to force valuations higher.

NFTs or Non-fungible Tokens

NFT stands for non-fungible token. NFTs are tokens that we can use to represent ownership of unique items. Merriam-Webster defines fungible as interchangeable, freely exchanged or readily traded. Non-fungible then means something that is, in and of itself, not ripe for exchange or challenging to trade.

NFTs, however, permit the tokenization of things like art, collectibles, even real estate in ways that enable their assigned values to be freely traded in. They can only have one official owner at a time (like a financial security) and secured by the Ethereum blockchain. Yep, Ethereum has a bit of a monopoly on the NFT market of today. No one can modify the record of ownership or copy/paste a new NFT into existence. Ethereum Definition of NFTs.

The concept is rather simple on its face, but it can get confusing very quickly if you deviate from core principles on how they work. So to understand them better, let’s look at how NFTs compare to the traditional uses of the internet:

1, Permanently Unique: Where a .pdf, .jpeg or .docx can be copied and reproduced with very little restriction, an NFT is non-duplicative, the one you see is the only one that exists, anywhere. This is different for the internet. Generally, as long as you have a password, you can duplicate anything you find. Not so with NFT’s. Blockchain security protects them from being used in different places. Have you ever been subjected to fraud over a ticket for a game or a concert. NFT technology can prevent this. If a ticket is set up as an NFT, the only ticket that will get you in the game is the one with the unique identifiers on the blockchain corresponding to the seat number you pay for.

2, Record of Ownership: Ethereum’s design of blockchain architecture has essentially created a unique, digital asset registry. So if you create content, place it on the blockchain as an NFT, you own it. You can sell it, gift it or otherwise exchange it, but it will always and only have one owner. In short, you have created the most secure copyright you could ever imagine.

3, Breadth of Exchange Markets for:

a. Trading different types of NFTs – this just means that if you wanted to exchange blog article for digital artwork, now you can! And if you want to fractionalize (that is divide the NFT into unit shares), you can do that too.

b. Newly created content of all kinds – back to the previous example, written material, artwork, music, household goods, food, crops, livestock, acreage, building materials, services, you name it – all of it can be converted to NFTs.

4, Platform for Exchange: The blockchain replaces the need for secondary platforms, i.e. Spotify, YouTube, TikTok, etc.. But the blockchain is not an intermediary platform like any of those, or even like Robinhood or E-trade. It is merely a secure place to store your information. You are the one who receives all the royalties, you do not pay subscriptions and you cannot have your content censored – it’s yours to treat exactly as you wish.

5, Digitization of Material Things: Above, I mentioned artwork, food, acreage, etc. – all of these can be converted, not just into securitized assets, but literally into digital asset representations of the real thing. So it is now possible to own a 2% share of someone else’s house, or dog, or coffee mug. Perhaps you’re beginning to see both the extraordinary benefit and the potential for complexity NFTs create. The world is changing, and NFTs are enabling the change at a faster rate.

If you haven’t already deduced this, the opportunities are endless with NFTs. To give you an extreme example, you could fractionalize units of the lint you pull from your dryer. As long as you create a unique identifier for it, it goes from non-interchangeable to completely interchangeable on creation. This is an amazing step forward in the marketplace. And yes, the markets will have to come to appreciate that some things really won’t sustain as a lasting value – just as there are companies on Wall Street that go bankrupt, so too will some NFTs. They will always be worth exactly what the market for them will bear.

And just as there are Tik Tok videos, or Tweets, today, that in and of themselves seem to be highly valuable, a day will come when they are valued at something close to zero. At the same time, some will sky rocket in value, and yet there will be others that maintain a relatively static value. I’m not going to dive into investment strategies or predictions of what kinds of NFTs will breakout, but I will suggest to you that there will be many surprises to look for.

Smart Contracts

Before looking closely at smart contracts, let’s do a quick review, or better yet, offer some parallels between the concepts we’ve discussed above and their counterparts in this advanced world of fintech.

• The blockchain compares in a sense to a vault, a safe or a safe deposit box. It is a place for securing what you have.
• Cryptocurrencies are the medium of exchange used on the blockchain. They represent the currency of the blockchain environment. Cryptos can be used elsewhere, but non-cryptos are not useful, in general, on the blockchain.
• Cryptos are blockchain-based currencies. The intersection of the blockchain and cryptos is the blockchain becomes much like the federal reserve bank for cryptocurrency, especially Ethereum. Thus, other currencies are not directly interchangeable on its blockchain.
• NFTs are more like the stocks traded on the blockchain. They fractionalize digital assets in the way that stocks fractionalize company assets. You no longer need the SEC. You don’t need a Secretary of State’s office. You merely need the blockchain.

With this paradigm in mind, then, you can see something that might be missing – contracts that define whose rights are what - enter Smart Contracts.

A smart contract is a contract executed on a blockchain, or distributed ledger.

A payment in cryptocurrency would be made to receive a template contract and would then be available to all parties. Parties can update the contract by mutual agreement before it is executed, and changes would be reflected on the distributed ledger.

Then, once the contract has been agreed, the idea of ‘automatic actions’ can be used to enforce the contract (for actions taken online). For example, with an apartment rental a digital key could be released in exchange for the deposit and first month’s rent. The ledger would record that if a payment is made by ‘x’ date, the key will be released on ‘x’ date. If the renter pays the deposit three weeks early and the owner or renter then changes their mind, it is not possible to refund the money and end the contract. The ‘if-then’ clause has been triggered and will happen regardless of other factors, so the key will be delivered regardless of either party’s wishes.” The Lawyer’s Practical Guide to: Smart Contracts – Thread Legal.

From the above, you might presume that Shakespeare’s famous quote regarding “killing all the lawyers” is finally fulfilled without having to shed any blood. As a lawyer myself, I might be quick to reply, don’t get ahead of yourself.

Elimination of Over-lawyering: First, please note people have worked very hard to find ways to work around the use of lawyers for a long time. Let’s be honest, no one likes to pay legal fees. And when it comes to drafting, reviewing or negotiating contracts, it is quite common to think of a lawyer’s work as just work to add “legalese” to make documents more dependent on the lawyers now and in the future. I won’t deny that there are some lawyers, especially in big firms, with clients who have very deep pockets, who work hard to make sure nothing happens without consulting with them first.

Irreversibility Problem : But if you look at the example given by Thread Legal above, you can see one of the major problems with a Smart Contract. I call it, the “Hotel California” problem, except that instead of checking out any time you like but never be able to leave, you can leave any time you like but you can’t get a refund and there is no way to seize upon the chance to get the money back.

Developers are Imperfect too: That isn’t the only catch. In essence, the choice to use a smart contract is a choice to trade in the knowledge and skill of the lawyer, for the knowledge and skill of the developer. This might not be the best choice if there are any unobserved risks in what you’re doing with the contract, and there usually are. If bugs are included in the coding, those bugs flow through to the contract, and they may not be detectable until the contract is in full swing. If you decide you want to mitigate the risk of the smart contract using a lawyer, you are at least creating a partial duplication of labor, i.e. there are now two professionals working on your contract instead of just one.

Blockchain Effectiveness: A third problem with smart contracts is they can only be as good as the blockchains on which they live. This should make them very “secure” in theory, but you may not know whether that’s true or not.

There are lots of ways to approach smart contracts, just as there are many ways to approach NFTs, cryptocurrencies and blockchains. To discuss, explore or consult with our firm, please reach out to us here.