FinTech Blockchain Distributed ledger technology and designing the future | Contents Foreward by the Chamber of Digital Commerce vii The Mysterious Origins of Blockchain 1 Blockchain 101 5 How It Works 5 Digital Currencies or “Cryptocurrencies” 7 Advantages of Blockchain / DLT 7 Disadvantages of Blockchain / DLT 8 Open vs. Closed Blockchains 10 Summary 11 Smart Contracts 13 What They Are 13 Advantages of Smart Contracts on Blockchains 13 Disadvantages of Smart Contracts 14 Smart Contracts and Derivatives 15 U.S. Regulatory Landscape 17 State Regulation 18 Federal Regulation and Guidance 24 Enforcement 30 Conclusion 31 International Regulatory Landscape 33 Europe 34 Asia 38 The Americas 40 Middle East 40 Africa 43 Contents | iii Insuring Digital Currency and Digital Currency Business 45 Insurance and Underwriting Issues 47 Potential Insurance Coverage Under Traditional Policies 47 Cyberattacks and Ransomware 47 Financial Institution Bonds and Commercial Crime Policies 48 D&O Insurance 49 E&O Insurance 50 Kidnap and Ransom (K&R) Insurance 51 The Bottom Line 51 Applications in Capital Markets 53 Greater Effi ciencies 54 More Security and Transparency 55 Tokenizations 60 Potential Risks 60 Blockchain Innovation in the Energy, Commodities, Shipping and Trade Finance Industries 63 Energy Producers and Consumers 64 Energy Trading 65 Shipping 67 Trade Finance 69 Privacy and Re-identifi cation on the Blockchain 73 Privacy 73 Psyeudonymity Concerns 75 Industry-Specifi c Privacy Concerns 76 Smart Contracts 77 iv | Blockchain: Distributed ledger technology and designing the future Intellectual Property 79 Bitcoin’s Open Source License 79 Other Blockchain Application Licenses 80 The Rise of Blockchain Patents 80 Social Impact, Responsibility and Media 83 Lowered Transaction Fees Mean More Money for Causes 83 Greater Transparency 83 Access to Financial Services 84 Financial Empowerment 84 Initial/Independent Coin Offerings (ICOs) 85 Blockchain, Media and Advertising 86 Social Media 87 Improving Governance and Minimizing Corruption 87 Corporate Social Responsibility 87 Summary 87 Closing Note 89 Glossary of Terms 91 Key Contacts 96 Endnotes 98 Contents | v Foreward by the Chamber of Digital Commerce We commend our good friends at Reed Smith for key to building a successful company in the blockchain putting together this comprehensive compendium of sector. U.S. federal and state, as well as non-U.S. country, Reed Smith’s document is an important resource laws and developments impacting the blockchain for participants in the blockchain ecosystem, laying out and virtual currency ecosystem. Navigating the the foundation for regulatory oversight and then diving regulatory requirements is complex given the numerous in to specifi c use cases and geographies to help guide government agencies that have claimed jurisdiction this industry to success in a regulated environment. We over activities using blockchain technology. With the have too often seen sensational headlines drive public increased activity by federal regulators in particular, it is perception of this industry. Setting out this information more important than ever to have law fi rms advise on the in a cohesive and understandable format is benefi cial legal and regulatory landscape both in the United States for everyone. As a member of our Lawyers Committee, and abroad. Reed Smith is particularly well-placed to present its Many of the companies in the blockchain space birds’-eye view of these developments. are trying to solve for a problem – whether it be for As noted in the document, many gray areas remain digital identity, the effi cient distribution of loans and within this legal landscape. As new digital assets, micropayments, or better tracking supply channels, they do not always fall neatly into existing regulatory to name a few. Often, they are technologists who may guidelines. Working with our membership, The Chamber not be thinking of the intricacies of regulation in the of Digital Commerce identifi es these gaps, and, where industry. Or they may be business veterans, who are appropriate, advocates for agency or Congressional acutely aware of the pitfalls of legal and compliance action to grow the digital asset and blockchain requirements, and need a go-to fi rm to advise them on industry in a responsible environment. We rely on our the do’s and don’ts currently affecting their intended membership to inform our views and drive our mission. industry. While innovators are blazing new trails, Reed Smith has been an important member and valued there are many areas of the law that are unclear and resource in this space, and this document is clear companies must make sensible judgments in achieving evidence of the breadth of their abilities. We support compliance. Having a strong understanding of the legal their efforts to bring a comprehensive legal perspective landscape - as well as history of how we got here - is to the industry. Foreward | vii bitcoin as a digital currency should be distinguished from Bitcoin as a blockchain platform or protocol. viii | Blockchain: Distributed ledger technology and designing the future The Mysterious Origins of Blockchain Introduction Although the following chapters are mostly devoted to years after Nakamoto sent his or her initial, enigmatic informing and enlightening the reader about the potential email, the October 31, 2015, cover of The Economist of cryptocurrencies* and the underlying blockchain featured an article on blockchain (the technology technology, the origins of these developments are underlying Bitcoin), dubbing it “the trust machine.” somewhat shrouded in mystery. More recently, Fortune extensively featured the rise of Halloween 2008 may have been a particularly Bitcoin in its August 22, 2017 article:1 frightening one, as the world economy was facing its most dangerous crisis since the Great Depression. Yet, “Finance is the most obvious extension of it also happened to be the day that Bitcoin, the most blockchain tech, given the monetary roots widely used cryptocurrency to date, was introduced of Bitcoin. Trade fi nance, security clearance in a rather simple and unassuming email to several and settlements, cross-border payments, hundred members of an obscure mailing list comprising and insurance are all areas that could be cryptography experts and enthusiasts. overhauled and made more seamless. Microsoft The sender, known only by the pseudonym “Satoshi is collaborating with Bank of America on a Nakamoto”, wrote: “I’ve been working on a new blockchain to digitize and automate the money electronic cash system that’s fully peer-to-peer, with no fl ow around trades. HSBC, ING, U.S. Bank, and trusted third party,” followed by directions to the link eight other banks recently completed a prototype http://www.bitcoin.org/bitcoin.pdf—a nine-page white application for the same purpose on R3’s Corda paper about a peer-to-peer trustless system of digital ledger. Northern Trust, the asset management “currency” that purports to solve the problem of double- fi rm, is using Hyperledger Fabric for private-equity spending. deal record keeping. And Ripple built a system After fi rst becoming operational in January 2009, to rival the SWIFT interbank money-transferring Bitcoin and its progeny have exploded. Exactly seven service. In a hotly competitive sector where * Please refer to the Glossary for a list of defi nitions. The Mysterious Origins of Blockchain | 1 2 | Blockchain: Distributed ledger technology and designing the future The application of the blockchain is anticipated to extend far beyond fi nancial services customers demand faster transactions and lower distributed ledger to track and settle fi nancial assets. costs, the rewards of building the best blockchain The R3 consortium is a group of FinTech companies mousetrap could be vast—the penalties for and large banks that are developing a fi nancial grade missing out, proportionately painful.” open source distributed ledger platform known as Corda. Delaware recently passed legislation that allows It is worth noting that bitcoin as a digital currency should Delaware chartered companies to maintain their stock be distinguished from Bitcoin as a blockchain platform ledgers via DLT.2 Arizona passed a law clarifying that or protocol. The distinction is analogous to that of an so called “smart contracts” made in computer code on individual email versus the SMTP protocol through a blockchain are enforceable.3 Companies as diverse which the email is sent. Blockchain technology, which is as Barclays, Depository Trust & Clearing Corp. and the described below, provides a cryptographically secured Australian Stock Exchange are aggressively developing ledger that can be examined by all authorized parties, the ability to settle major fi nancial transactions in this but cannot be changed. manner.4 Though Nakamoto initially collaborated with The blockchain has also garnered attention from developers on what has been called a revolutionizing government agencies and regulators. For example, innovation, his participation ended in mid-2010, and the U.S. Offi ce of Comptroller of Currency (OCC) has in April 2011, he completely disappeared with the fi nal proposed a framework where FinTech companies words, “I’ve moved onto other things.” could apply for a special-purpose national bank charter, Though we may never discover the originator of and has released a white paper posing an approach Bitcoin, we are left with a rapidly developing open source for overseeing experiments conducted by banking technology that continues to