We’ve previously written about the push for greater regulation of digital currency and a growing number of lawsuits targeting cryptocurrency companies and their celebrity endorsers. Notwithstanding cryptocurrencies’ increasing social, financial, and business prominence, many interested parties are still left wondering: what is cryptocurrency, really? What is blockchain technology? And what are the early legal issues that market participants need to be aware of as more and more money pours into this budding Wild West? We aim to broadly address these questions in this article.
- What is cryptocurrency?
- A cryptocurrency is a digital medium of exchange that can be sent directly, instantly, and securely. Cryptocurrencies are secured by cryptography, which is a system of digital signatures and complex algorithms used to protect against counterfeiting. Cryptocurrencies utilize blockchain technology to allow for secure, online, peer-to-peer transfers of digital assets without the need for a third-party intermediary like a traditional banking institution to facilitate and verify the transaction. Generally, cryptocurrencies are not issued or overseen by any central authority.
- What is blockchain technology?
- A blockchain is a distributed database that records information electronically. As the name suggests, a blockchain is, literally, a chain of “blocks.” A block is a set of information in a database. Blockchain technology plays a critical role in maintaining decentralized, transparent, immutable records in cryptocurrency systems.
- Cryptocurrency blockchains display blocks of transaction information on a publicly available electronic ledger (using a system of identifiers that preserves the parties’ anonymity). Once on the public ledger, users authenticate transactions through “mining.” Mining (or proof-of-work) is the process through which users leverage their computational capacity to solve complex math problems, thereby verifying transactions and facilitating the release of additional cryptocurrency supply into circulation. Each authenticated block of records reinforces each previously authenticated block (thus creating a chain of blocks, or a blockchain), which in turn allows information to be digitally transmitted and recorded, but not altered. Put differently, each verified transaction on the blockchain necessarily requires a re-verification of each previous transaction and thus continuously ensures the chain’s accuracy. This immutability has also allowed blockchain technology to support the creation of non-fungible tokens (NFTs).
- What are examples of popular cryptocurrencies?
- Bitcoin is a cryptocurrency that uses blockchain technology to allow for secure peer-to-peer transfers of its version of digital cash. Bitcoin came into existence in 2009 and is widely believed to be the first application of blockchain technology. Miners earn bitcoins for solving problems and thus authenticating blocks of transactions and releasing additional bitcoins into circulation. By design, there are a fixed number of bitcoins that will ever exist.
- Ethereum is a shared network enabled by blockchain technology and which includes its own cryptocurrency, ether. While ether as a cryptocurrency is generally similar to bitcoin, the Ethereum network makes broader use of blockchains than Bitcoin does. Ethereum’s broader capabilities include supporting the development of additional decentralized applications (like those used for NFTs and self-executing, or “smart,” contracts) and other cryptocurrencies beyond ether. Like Bitcoin, Ethereum relies on user mining. While the supply of ether is theoretically unlimited, there are inflationary mechanisms in place to control for this.
- What are a few of the legal issues proving to be relevant to cryptocurrencies?
- Are cryptocurrencies properly characterized as securities such that they are subject to scrutiny under federal securities law and oversight from the Securities and Exchange Commission (SEC)?
- While this largely remains an open question given the novelty of this specific issue, both courts and the SEC have indicated that this question should be evaluated based on the “Howey test,” a four-pronged inquiry derived from the U.S. Supreme Court’s decision in SEC v. W.J. Howey Co., 328 U.S. 293 (1946). The Howey test, used to determine whether particular transactions constitute investment contracts, i.e., securities under the Securities Act of 1933, mandates that an investment contract is found where a person: 1) invests their money; 2) in a common enterprise; 3) with the expectation of profits; 4) derived solely from the efforts of others. Given cryptocurrencies’ uniqueness, it will be important for interested parties to monitor the evolving state of the law on this question, the answer to which could subject cryptocurrency companies and investors to vastly different reporting and compliance requirements.
- Fraudulent representations
- Investors are bringing suits against cryptocurrency companies (and their stakeholders) based on various types of alleged fraud. Because securities are subject to more robust standards, this issue intersects with the question of how cryptocurrencies are properly classified.
- See here for in-depth analysis of this issue.
- General regulatory issues
- Various regulatory entities, including the Federal Reserve, the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), and the Securities and Exchange Commission (SEC) have signaled their plans to provide market participants additional clarity on a host of cryptocurrency-related issues in 2022, which will surely be worth monitoring.
- See here for in-depth analysis of this issue.
Cryptocurrency proponents argue that these new mediums allow for faster, safer, more transparent transactions, and that cryptocurrencies provide safety from perceived manipulation of government-backed currencies. On the flip side, detractors point to cryptocurrencies’ extreme price volatility, lack of any meaningful institutional or government backing, and high levels of energy consumption as demerits. Pros and cons aside, there is no question that cryptocurrencies pose novel legal questions that regulators and courts will weigh in on in the months and years to come.