FinTech Blockchain Distributed ledger technology and designing the future November 2019 Third Edition Blockchain Distributed ledger technology and designing the future 1 ©2019 Reed Smith LLP The information presented in this document may constitute lawyer advertising and should not be the basis of the selection of legal counsel. Information contained in this publication is believed to be accurate and correct but this document does not constitute legal advice. The facts of any particular circumstance determine the basis for appropriate legal advice, and no reliance should be made on the applicability of the information contained in the document to any particular factual circumstance. No attorney-client relationship is established or recognized through the communication of the information contained in this document. Reed Smith and the authors disclaim all liability for any errors in or omissions from the information contained in this publication, which is provided “as-is” without warranties of any kind either express or implied. 2 Blockchain Distributed ledger technology and designing the future Contents Foreword by the Chamber of Digital Commerce v Chapter 1 The mysterious origins of blockchain 1 Introduction 1 Chapter 2 Blockchain 101 3 How it works 3 Digital currencies and “cryptocurrencies” 5 Advantages of blockchain / DLT 5 Disadvantages of blockchain / DLT 6 Open vs. closed blockchains 7 Proof of work vs. proof of stake 8 Summary 8 Chapter 3 Smart contracts 10 What are they? 10 Smart contract code 10 Advantages of smart contracts on blockchains 11 Disadvantages of smart contracts on the blockchain 11 Smart contracts and derivatives 12 ISDA’s approach 13 Smart contracts, derivatives, and regulation 14 Use cases 15 Smart contracts - going forward 15 Chapter 4 Applications of DLT 16 Tokens 16 Blockchain Distributed ledger technology and designing the future i Chapter 5 U.S. regulatory landscape 18 State regulation - New York 18 Application and licensing process 20 AML, KYC, compliance issues, and examinations 20 Other state virtual currency statutes 21 Federal regulation and guidance 25 Office of the Comptroller of the Currency 28 Securities and Exchange Commission 29 Enforcement 33 Conclusion 36 Chapter 6 European financial regulatory landscape 38 Background 38 Europe – Status of virtual currency 38 MLD5: Virtual currency defined 40 Europe – Regulatory Initiatives 40 Consultation papers: ESMA and European Supervisory Authorities 41 IOSCO 41 FCA consultation papers 42 Europe - Legislation 46 Europe ICO “friendly” jurisdictions 46 Chapter 7 Asian financial regulatory landscape 48 Asian regulatory landscape 48 Chapter 8 Rest of the world financial regulatory landscape 51 Blockchain - The Middle East 51 ii Blockchain Distributed ledger technology and designing the future Chapter 9 Insuring digital currency and digital currency business 55 Insurance and underwriting issues 55 Potential insurance coverage under traditional policies 57 Cyberattacks and ransomware 57 Financial institution bonds and commercial crime policies 57 D&O insurance 58 E&O insurance 59 Kidnap and ransom (K&R) insurance 59 Bitcoin-specific insurance 60 The bottom line 60 Chapter 10 Applications in capital markets 62 Greater efficiencies 62 More security and transparency 63 Consortiums 64 Capital raising: token sales 64 Token sale legal considerations 65 Tokenizations 68 Potential risks 68 Conclusion 69 Chapter 11 Blockchain innovation in energy, commodities, shipping and trade finance 71 How will blockchain be useful? 71 Can it work? 71 Shipping 74 Aviation 77 Trade finance 80 Blockchain Distributed ledger technology and designing the future iii Chapter 12 Privacy and re-identification on the blockchain 84 Anonymity versus privacy 84 Re-indentification risks on the blockchain 85 Pseudonymity as a model 86 Industry-specific privacy concerns 87 Smart contracts 88 Compatibility with regulation 88 Conclusion 89 Chapter 13 Intellectual Property 91 Bitcoin’s open source license 91 Other blockchain application licenses 92 The rise of blockchain patents 92 Chapter 14 Social impact, responsibility and media 95 Lowered transaction fees mean more money for causes 95 Greater transparency 95 Access to financial services 95 Financial empowerment 96 Initial coin offerings 96 Blockchain, media and advertising 97 Social media 98 Improving governance and minimizing corruption 98 Corporate social responsibility 98 Summary 98 Closing note 100 Glossary of terms 102 Key contacts 108 Endnotes 111 iv Blockchain Distributed ledger technology and designing the future Foreword by the Chamber of Digital Commerce Once again our good friends at Reed Smith have assembled a As a member of our Lawyers Committee, Reed Smith is comprehensive compendium of U.S. federal and state, as well particularly well-placed to present its birds’-eye view of these as non-U.S., laws and developments impacting the blockchain developments. As noted in the document, many gray areas and virtual currency ecosystem. Even one year later, the evolving remain within this legal landscape. New digital assets do not regulatory climate remains complex and, at times, uncertain. always fall neatly into existing regulatory guidelines. Working with Even more government agencies have claimed jurisdiction over our membership, The Chamber of Digital Commerce identifies activities using blockchain technology. Recent events and their these gaps, and, where appropriate, advocates for agency or potential scope globally have prompted regulators worldwide, Congressional action to grow the digital asset and blockchain including central banks, to consider these issues with increased industry in a responsible environment. We rely on our membership urgency to inform our views and drive our mission. Reed Smith has been an important member and valued resource in this space, and this Many of the companies in the blockchain space are trying to document is clear evidence of the breadth of their abilities. We solve for a problem – whether it be for digital identity, the efficient support their efforts to bring a comprehensive legal perspective to distribution of loans and payments, or better tracking supply the industry. channels, to name a few. Often, they are technologists who may not be thinking of the intricacies of regulation in the industry. Or, they may be business veterans who are acutely aware of the pitfalls of legal and compliance requirements and need a go-to firm to advise them on the do’s and don’ts currently affecting their intended industry. While innovators are blazing new trails, many areas of law continue to remain unclear and companies must make sensible judgments in achieving compliance. Having a strong understanding of the legal landscape - as well as history of how we got here - is key to building a successful company in the blockchain sector. Reed Smith’s document is an important resource for participants in the blockchain ecosystem, laying out the foundation for regulatory oversight and then diving in to specific use cases and geographies to help guide this industry to success in a regulated environment. We have too often seen sensational headlines drive public perception of this industry. Setting out this information in a cohesive and understandable format is beneficial for everyone. Blockchain Distributed ledger technology and designing the future v ...bitcoin as a digital currency should be distinguished from Bitcoin as a blockchain platform or protocol. vi Blockchain Distributed ledger technology and designing the future Chapter 1 The mysterious origins of blockchain Introduction Finance is the most obvious extension of blockchain tech, given the monetary roots of Bitcoin. Trade finance, security Although the following chapters are mostly devoted to clearance and settlements, cross-border payments, and informing and enlightening the reader about the potential of insurance are all areas that could be overhauled and made cryptocurrencies* and the underlying blockchain technology, the more seamless. Microsoft is collaborating with Bank of origins of these developments are somewhat shrouded in mystery. America on a blockchain to digitize and automate the money Halloween 2008 may have been a particularly frightening one, as flow around trades. HSBC, ING, U.S. Bank, and eight other the world economy was facing its most dangerous crisis since the banks recently completed a prototype application for the Great Depression. Yet it also happened to be the day that bitcoin, same purpose on R3’s Corda ledger. Northern Trust, the the most widely used cryptocurrency to date, was introduced in a asset management firm, is using Hyperledger Fabric for rather simple and unassuming email to several hundred members private-equity deal record keeping. And Ripple built a system of an obscure mailing list comprising cryptography experts and to rival the SWIFT interbank money-transferring service. In enthusiasts. a hotly competitive sector where customers demand faster The sender, known only by the pseudonym “Satoshi Nakamoto,” transactions and lower costs, the rewards of building the best wrote: “I’ve been working on a new electronic cash system blockchain mousetrap could be vast—the penalties for missing that’s fully peer-to-peer, with no trusted third party,” followed by out, proportionately painful. directions to the link http://www.bitcoin.org/bitcoin.pdf – a nine- It is worth noting that bitcoin as a digital currency should be page white paper about a peer-to-peer trustless system of digital distinguished from Bitcoin as a blockchain