Cybersecurity 2018 – The Year in Preview: Cryptocurrencies and Blockchain

by Foley Hoag LLP - Privacy & Data Security

Foley Hoag LLP - Privacy & Data Security

Editors’ Note:  This is the last in a nine-part end-of-year series examining important trends in data privacy and cybersecurity during the coming year.  Previous installments include analyses of HIPAA complianceemerging security threatsfederal enforcement trendsstate enforcement trendsbiometricseducationinternational law and cyberwar, and financial institutions and the SEC.

Bitcoin is white-hot.  The cryptocurrency’s price has increased an astounding 2000% in 2017 alone.  The app for Coinbase, the most popular cryptocurrency exchange, held the #1 spot on Apple’s app store, unseating the likes of Facebook and Instragram.  Earlier this month the Chicago Exchange began offering trades in bitcoin futures, the first major exchange to do so (and futures contracts were up some 560% after one day of trading).

The numbers are staggering, but behind them is a technology – the blockchain – that many believe will change not only currency but also banking, commercial contracts, and even medical recordkeeping.  What’s next for the blockchain?  First let’s take a look at what it is.

What is Blockchain Technology? 

A blockchain is, at its core, a system of recordkeeping.  Data is recorded and published online, and any changes to that data are likewise recorded onto the end of the “chain” of records and published.  For bitcoin, the data is “who owns what coins.”  Here’s a simplified example of a bitcoin transaction:

Alex has a bitcoin.  To be more precise, he has the private key to a public bitcoin address that, according to the public ledger, has a balance of one bitcoin.  That private key will let him conduct a transaction with the contents of the public address, such as giving it to his friend Barb.  Barb gives Alex her public address, and Alex uses software or a website (a “wallet”) to initiate the transfer.  This is where the blockchain comes in.

Alex’s transaction is sent out to be verified by the vast network of computers with a copy of the complete blockchain ledger.  Who runs these computers?  Not any central authority, but rather anyone who wants to try to “mine” new bitcoins.  The miners’ computers try to solve an increasingly-complicated math problem in order to create new coins – this is their incentive for hosting the ledger that ensures the system’s integrity.

The network of miners examine Alex’s proposed transaction and verifies it against the ledger.  Consensus among those in this distributed network prevents fraud: once the miners agree that Alex does, in fact, have the coin he wants to send, they will approve the transaction and record it in the ledger.  If Alex tries to send the same coin again, the ledger will show he no longer has it, and the consensus will forbid the transaction.  Conversely, if Barb wants to transfer the coin, the ledger now shows that she (or at least the address number she controls) has that coin.

Privacy and Security on the Chain

There are a couple of features of blockchain transactions that are especially relevant to privacy and data security:

Decentralization.  The decentralized or distributed nature of blockchains removes certain vulnerabilities.  Your personal information is not stored in any central database, meaning there is no tempting target for hackers.  Of course, unless you mine coins (not something the average user will do), you still need an entry point – an exchange to trade your dollars for bitcoin.  And those exchanges are as vulnerable as anyone to being breached.  (Mt. Gox, formerly the largest bitcoin exchange, had 850,000 coins stolen in 2014 – $14 billion at today’s rates.)  The more contact points your blockchain system has with traditional systems, the greater the risk of falling victim to traditional hacks.

Pseudonymity.  Blockchains like bitcoin are said to be pseudo-anonymous, often shortened to “pseudonymous.”  This word encompasses two important points.  First, your transactions have no overt association with you.  There is no account name.  No one makes you give a phone number or mailing address.  No central authority is collecting your personal information.  In fact, you don’t really have an account in the traditional sense at all: you have the private key to a public address, and could have a dozen such keys and addresses.  Second, the entire ledger of transactions is (and must be) available to be examined.  This makes pseudonymity a double-edged sword: you are anonymous until you aren’t.  If someone is able to cross-reference other data to determine what public numbers are yours, your anonymity is not only lost, it is lost publily and perpetually, as your transaction history remains on display to the world through the public ledger.  (And, of course, there are already companies one can hire to attempt to break bitcoin anonymity.)

The Blockchain in 2018

The breakneck rise of cryptocurrency in 2017 was largely unforeseen – predicting the future in this space is a tricky business.  But there are a few easy predictions to make:

Beyond bitcoin.  Blockchain technology is not going anywhere in 2018.  Bitcoin is the most well-known, but already there are numerous other cryptocurrencies on the market, and bitcoin enjoys about a 50% of the market share.  Some, like Litecoin, seek to improve on the bitcoin model by focusing on the speed of processing transactions.   Others, such as Ethereum or Ripple, aim to provide not only currency, but also  a backbone for other services.  Ripple has built a platform for settlement (payment) between financial institutions.  Ethereum offers “smart contracts” – automated, verified conditional transactions.  Some of the hype here is speculation, but some is likely to stick.

Regulation.  The regulation of blockchain and cryptocurrency is not a question of if, but what.  Securities regulators have been first out of the gate, focusing their attention on so-called “Initial Coin Offerings.”  Companies are using these ICOs to raise funds, selling investors the opportunity to “get in on the ground floor” with a new proprietary blockchain coin or token.  Unlike with traditional IPOs, however, ICO investors are not getting stock, and not getting any of the protections of existing securities regulation.  In July the SEC announced that it considered some ICOs to be securities – a warning shot that regulation was on its way.  State securities agencies are in on the game as well, as we’ve covered recently in this space.  Both the Commodities Futures Trading Commission (CTFC) and the Financial Crimes Enforcement Network (FinCEN) have also expressed interest in regulating the space.

Perhaps the most likely area for new regulatory action in 2018 is on the consumer protection front.  The massive growth in public awareness has led more and more individuals to invest in bitcoin and blockchain.  Given the arcane nature of the technology, however, this wave of investors – your grandmas and average Joes – may not know exactly what they are investing in, which makes them especially vulnerable to fraud.  As of this writing, allegations of insider trading are flying after Coinbase saw the price of a new cryptocurrency, “Bitcoin Cash,” climb more than 700% in the hour before Coinbase added it to its exchange for public trading.  Of course, if these aren’t securities, there is no traditional insider trading.  But that doesn’t mean state attorneys general or the Federal Bureau of Consumer Protection won’t be interested in stepping in.

Finally, a few open questions:  Will the federal monetary authorities have anything to say?  Will the fed try to regulate bitcoin, or compete by launching its own blockchain currency?  One thing is for sure, 2018 is likely to be another madcap year for blockchain technology.  Hold onto your (digital) wallets.

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Foley Hoag LLP - Privacy & Data Security

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