What the Digital Currency Backlash Means for Legal Blockchain

The backlash against blockchain-based digital currencies is now in full swing and understandably may make some worry if advances in legal blockchain and smart contracts will be affected.

What’s Happened?

This week The People’s Bank of China, which has a powerful regualtory voice, stated that Initial Coin Offerings (ICO), whereby a new digital currency that operates on a blockchain is launched to gather funds for a company, are now illegal.

China has been a centre of digital currency activity, with many ICOs specifically seeking to attract investment from investors there. Some of the leading digital currency exchanges and largest Bitcoin mining operations are also in China. In short, this annoucement has major implications to that side of the industry.

It is also not in isolation. This week also, the Hong Kong Securities and Futures Commission echoed the earlier views of the US’s SEC by saying that blockchain-based currencies were securities and as such an ICO likely needed to be regulated just as a corporate undergoing an IPO would need to be. I.e. the Wild West days are over.

One of the attractions of ICOs was that they were very cheap to do. Conducting an IPO, with all the legal oversight and accounting input needed under securities law, is a totally different story.

Moreover, China has indicated it wants any companies that undertook ICOs there to return the funds to investors and also appeared to suggest it would close down any exchanges that dealt in digital currencies. Which is about as terminal as one can be in terms of killing a market.

In the space of a few weeks we have now seen the US, China and Hong Kong wade in. Which country will be next? It’s not clear. But the impact has been felt. After the China announcement the world’s more than 1,100 digital currencies, with a total market cap over $156,681,369,000. (Yep…that’s $156 Billion US dollars’ worth of digital currency in circulation), saw a sea of red on the currency exchanges. Some currencies lost more than 50% of their value. But, prices have bounced back since then and the charts are once again showing a healthy glow of green. 

But, even if digital currencies have bounced back, tech companies planning ICOs have already stopped allowing US investors to participate for fear of getting hammered by the SEC. Now, China and Hong Kong have been added to the list of ‘countries to avoid’ and investors from these countries may simply be banned from participating for fear that the tech company will get dragged to court if it sells to them.

Does This Matter?

As to whether this matters to the development of smart contracts and legal blockchain technology the answer is: yes and no.

For legal tech companies hoping to raise funds quickly via an on-chain ICO the main problems are:

  • Will we be able to raise the capital we want after the global backlash?
  • What if UK and European regulators also classify ICOs as the issuance of new securities and make the fundraising very complex and expensive, or even illegal?
  • And, perhaps most of all, what if we do an ICO, the rules change in 12 months and we have to return the capital, some of which we may have spent?

So far there has been only one legal tech company, smart contract system, Agrello to complete an ICO, which did so just before the Chinese ban came into place. Though, it’s believed at least some of the investors were Chinese. Whether Agrello will have to pay back some of its investors is not clear yet.

UK-based legal tech company Elexirr, formerly LawBot, is also planning a £5m ICO later this year to fund their growth and to launch their own coin that will be used to buy their services. This coin would by US and Chinese rules now be considered a security. Artificial Lawyer reached out to the team, which replied they were ‘discussing’ the issues with their advisors. We wait with interest to hear the outcome, though the statement that it intends to do the ICO remains on the website.

Will other legal tech companies look to do an ICO now? Or has this killed the enthusiasm? At present it’s probably fair to say no US legal tech companies will be attempting it any time soon. But will it kill off UK and European legal tech company ICOs?

The reality is there is probably enough interest still from non-affected jurisdictions to fund a small to medium level legal tech ICO. The question is do legal tech start-ups want to risk dealing with future regulatory issues down the road? We’ll see. But the idea that this is ‘no strings attached’ financing has certainly disappeared.

The Wider Smart Contract and Legal Blockchain Impact

Does this impact the companies and consortia of law firms exploring the use of smart contracts placed on a blockchain, of which there are now several? The short answer is: no.

A smart contract is not necessarily a security. It might deal in securities, i.e. the contract is designed to award shares to an employee at a certain time, but contracts are not in themselves a currency. In which case they are probably not affected by the backlash.

Moreover, even if a contract was using a digital currency to connect to ‘fiat’ currency, e.g. a smart contract that uses ETH on an Ethereum blockchain to pay a salary into an employee’s digital currency wallet, which was then converted into US dollars, it would also not be affected by the rules, at least if outside of China (see below).

Nor does the backlash against ICOs impact the use of blockchain in general. If legal tech companies, law firms and corporates want to work together to find ways to place contracts and other information on a blockchain, that will not be subject to securities law.

But, the truth is that China’s statements on the exchange of digital currencies does create a grey area, or it appears that way to Artificial Lawyer.

The Bank of China says, (following the translation by CoinDesk ) that an exchange cannot: ‘Provide a price bidding or middleman service for the exchange of tokens for cryptocurrency.’

Now, while a blockchain application that utilises a digital currency as a medium of payment, (which is then converted later into dollars, or pounds sterling), is not a formal currency exchange, it is involved indirectly in converting digital currencies. Would this put it in trouble with China’s regulators in terms of being involved in the ‘exchange of tokens’?

I.e. would a smart contract that implicitly required the exchange of a financial token or digital currency, contravene the new rules on exchanges in China? It’s unclear.

And the reality is that many quite innocuous blockchain applications use digital currencies, simply because it makes sense to do so if you’re operating ‘on-chain’. Their intention is not to get involved with currency trading, but if your coin is then being converted into other currencies as part of the process of your application functioning, are you involved in currency trading? I.e. has your on-chain app indirectly become an exchange?

Hopefully China will clarify in more detail what is allowed and what is not. Banning any new ICOs is fairly clear. Banning the ‘exchange of tokens’ seems to open up a can of worms, given that the world is filled with billions of tokens, i.e. Bitcoins, ETH, and hundreds of other digital currencies already and they are being exchanged for both fiat and other digital currencies.

The Short Term

In the short term, even though the Wild West days are clearly soon to be over for digital currencies and will soon become a more regulated environment, this could be seen as a good thing for legal blockchain and smart contract tech development.

Lawyers and corporates want to work in a reliable and trusting environment. Slightly dubious ICOs taking place outside of the legal sector backed by ‘hot’ Chinese money trying to escape tax and banking oversight, didn’t help this. So, the ban may well boost the credibility of less controversial uses of blockchain, e.g. storing information and contracts.

Blockchain consortia and project groups will no doubt continue to grow and develop smart contract applications, such as the Accord ProjectOpenLaw and others. These consortia are not doing ICOs nor are planning to.

Also, once any misgivings over the position on exchanging tokens through a smart contract are cleared up, there is no reason why a global consortium of law firms cannot continue to grow and develop in China also.

To conclude, while the news from China may be terminal for ICOs there, we should not conflate it with an end to the move to develop legal blockchain technology and the use of smart contracts. Fundamentally this backlash is about the unregulated issuance of securities, not the placing of self-executing contractual clauses on a blockchain.

Legal blockchain and smart contracts have a bright future and we’ve only just begun to explore what this technology can do.

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