Posted on Categories blockchain

How may we regulate the blockchain?

Many people assume that the approach for regulating the blockchain should be similar to that for many other new technologies. First, it has to be well understood, before adapting traditional regulations to it. This assumption will not work with the blockchain. A whole new approach is required. It is important to realise this, because otherwise it will lead to a number of misunderstandings.

Why is the regulation of the blockchain so difficult?

Three main challenges mean that blockchain regulation will require a very non-standard approach. First, it is very difficult to attribute what is happening on the blockchain to a particular jurisdiction. No obvious links allow the assignment of a specific proper law to the blockchain. Secondly, blockchain is an area that will see increasing numbers of “autonomous actors” appearing in the form of smart contracts and the algorithms behind them. Therefore, events that take place on the blockchain may be attributed only to a certain extent to traditional legal entities. Thirdly, the dispersed architecture of the blockchain means that there is no traditional sovereign power that can take control of what is happening in that space.

It must be stressed that the above challenges will not appear to the same extent in each implementation of DLT. First of all, it is essential to make a distinction between private and public blockchains. Greatly simplifying, the former are a kind of innovative IT solution, which does not, by itself, cause a particular revolution to law. A private blockchain is simply a decentralised register maintained by a closed group of entities (e.g. banking sector firms operating a decentralised register for their sector’s own needs). This is obviously not a solution that is free of legal challenges (such as personal data issues, or outsourcing regulations), but nevertheless, these are challenges that seem solvable by – let us say – conventional means.

The situation is different with public blockchains. In this case, the above challenges will already be visible. Particularly in the case of more complicated commercial relations, which incorporate elements of smart contracts and artificial intelligence. Even if some of the above challenges are not manifested currently at the appropriate level (e.g. autonomy of actors), these are challenges regarding technology that has become conceptually possible, and it is probably only a matter of time when its first common applications will appear. A contemplation of blockchain regulation should not just consider its current state of development, but should also anticipate solutions that are very likely to emerge in the near future.

Helpful examples

To better understand those challenges, let us consider three examples of relations of varying degrees of complexity that may arise on the public blockchain.

As a starting point, let us take a simple transaction concerning a transfer of ETH 10 by party A to party B. Suppose that these entities are individuals residing in two different states at the time of the transaction. This is a typical peer-to-peer transaction taking place without any intermediaries. Each party has its own address on the Ethereum blockchain and knows the private key assigned to that address. To initiate the transfer, A uses tools that are publicly available and that enable interaction with the Ethereum blockchain (e.g. MyEtherWallet).

In a second example, A and B transfer ETH 10 to a smart contract address that is a gambling game. The transfer of ETH to the smart contract address triggers an algorithm that collects a specified pool of funds and draws at set intervals an address that receives the entire pool. B wins the whole pool. The ETH collected before the draw are transferred automatically to B by the smart contract. The draw and the handing over of the winnings are achieved without resorting to the human factor.

A last example assumes that A, who is an individual, wants to invest ETH 10 and with this objective sends ETH 10 to the address of a smart contract that invests in crypto-assets. Sending ETH 10 to this address triggers the smart contract, which cumulates the collected funds and invests them in specific crypto-assets. The smart contract works relying exclusively on an algorithm; decisions to disburse funds are taken without human involvement. The algorithm sends the collected ETHs to the addresses of other smart contracts, in this case, smart contracts that form a crypto-assets exchange. It instructs the automated exchange to purchase specific tokens in exchange for the delivered ETHs. One of the automated exchange’s clients is entity B which wants to sell specific tokens in exchange for ETH. A transaction is made as a result of which tokens sold by B through the exchange’s smart contract join a portfolio managed by a smart investment contract, which at regular intervals pays the investment premium to A. In exchange for the tokens sold, B receives a certain amount of ETH from the exchange’s smart contract. In this example, a significant part of the transactions takes place thorough autonomous agents and between them.

Proper law

Public blockchains present us with the fundamental challenge of determining the proper law for the events taking place on them. This problem may not be very apparent in the simplest example of a peer-to-peer transaction occurring without any intermediaries. Conceptually, it is relatively easy to reconcile this transaction with a traditional legal system. It is possible to assume that this still constitutes a traditional legal relationship to which we can apply the conflict of laws rules of private international law. The subject matter of this legal relationship and its implementation are innovative, but still acceptable from the perspective of a traditional legal system.

The situation is much more complicated as regards the commercial relations between traditional legal subjects (e.g. individuals) and autonomous agents or those concluded only between autonomous agents. A smart contract is not assigned to any jurisdiction. At present, it cannot be recognised at all by any legal system. Even if one tried to find a link connecting a smart contract with a particular jurisdiction, it might be difficult.

Naturally, it is possible to have smart contracts, whose code explicitly imposes a specific law. However, this is only a matter of the free choice of the smart contract’s developers. Smart contracts can also function freely without having a defined law that is proper for them.

This last issue is of fundamental importance in the context of this discussion. In view of the autonomous nature of smart contracts and transactions that execute autonomously, there is a fundamental question whether there is at all need to identify a traditional law that would apply to blockchain transactions. Many blockchain supporters see no need for this. The blockchain and smart contract-based solutions do actually create viable commercial relations without the need to attribute those relations to traditional legal arrangements. In other words, even if it is impossible to assign a commercial relation that exists on the blockchain (e.g. actions undertaken, in our example, by a smart investment contract) to a particular jurisdiction, it does not mean that this relationship does not exist. It actually exists on the blockchain all of the time and triggers specific effects in that environment. This clearly shows that the blockchain, in fact, establishes an autonomous order that is extraneous to traditional legal order. This is a very important issue, which we will be returning to in the final part of the text.

So why should we give any consideration to making the blockchain subject to traditional legal order? There are several reasons. Their description would provide material for a separate text. So, I will limit myself here to two reasons. First of all, even if blockchain users do not feel the need for governance by a traditional jurisdiction, this need will undoubtedly be increasingly felt by traditional legal systems. This is about very mundane needs, such as the taxation of commerce on the blockchain, and the implementation of specific policies on the blockchain (e.g. preventing potential crimes or frauds). To achieve those objectives, traditional legal order will have to begin to recognise what is happening on the blockchain. In such a case, it will be necessary to determine the law that should apply to the blockchain.

Secondly, it is very likely that over time, the participants in blockchain commerce will also start to feel the need to subject the blockchain to traditional legal order. Despite the expected increase in the number and significance of autonomous actors on the blockchain, its participants will continue to be citizens of specific states who are governed by particular legal systems. The commercial relations that they enter into on the blockchain are not neutral for their rights and obligations under traditional legal order. This is true even in the context of the tax obligations of blockchain participants who are traditional taxpayers. This may also be the case in disputes, when a blockchain participant might rely on a state recognising the effectiveness of a participant’s acquisition of particular assets on the blockchain. All of these situations give rise to the need for blockchain events to be recognised by the traditional legal system and for specific meaning to be ascribed to those events. To achieve this, bridges will have to be found between the order on the blockchain and the traditional legal system, and at least ensure that the traditional system recognises what is happening on the blockchain and finds it legally relevant.

Autonomous actors

The development of DLT technology has led to the possibility of creating smart contracts on the blockchain, i.e. automated relations between blockchain participants. These relations are fixed by code, and may or may not, at the same time, take natural language form. Smart contracts lead to the emergence of autonomous agents in the blockchain space, which act as specific legal relationship nodes. Returning to the examples of the gambling game and the smart investment contract: entities A and B do not enter into any direct relations with each other. Their direct partners are actually smart contracts.

Exactly the same principle applies when we take a loan from a bank where we do not have to enter into any relations with the bank’s savings depositors. An entity exists between the depositors and borrowers that the legal system has vested with legal personality, leading to the creation of its autonomy as an entity. This contrivance, albeit purely an intellectual invention (the company, which, as a legal person, operates the bank, is just a concept, not a tangible subject), greatly facilitates commerce.

A very similar situation may be observed with smart contracts. Here, too, a smart contract is a node that organises more complicated relations, gaining for itself a specific autonomous status. It seems unavoidable that these nodes should be subject to some form of legal governance. Their neglect by law will lead to failure to recognise the actual relations being established on the blockchain. In the future, it is possible that more numerous relations will arise between autonomous agents than today. One smart contract can enter into relations and exchange business with other smart contracts. The traditional legal entities (individuals, legal persons) are generally invisible in such relations.

Lack of sovereign power

Public blockchains are decentralised registries, which are maintained by entities scattered around the globe and which often remain anonymous. The configuration of those entities is dynamic and time-variant. Therefore, events in the public blockchain take place in a space that is beyond state control and outside any particular jurisdiction. The events are unconnected to geographical space.

A traditional court ruling ordering the return of 10 bitcoins from entity B to entity A will remain defunct on the blockchain and will have no significance. At this stage there is no authority or tool (a kind of blockchain bailiff) that would enable a public body to interfere in the blockchain. There is also no entity which, informally speaking, one might call to request that the judgment is enforced. The public blockchain is, therefore, outside all official state authority.

Of course, traditional political systems, in a sense, still retain control of the blockchain. They can use traditional tools to turn off power, block cryptocurrency exchange websites, or introduce penalties into the Penal Code for using computing power to maintain the blockchain. Obviously, such actions may have important practical ramifications for what happens on the blockchain (e.g., cutting off entire communities from the blockchain). Nonetheless, such acts will be limited by territory and will not interfere with the blockchain itself, because of its architecture. The blockchain will continue as long as computing power suppliers continue to exist around the world and are willing to maintain it.

The limited opportunities for state intervention in the blockchain are further evidence of the blockchain’s autonomy and contribute to the extremely heated debate raging over the mutual relations between blockchain and state. For many blockchain proponents, the state’s inability to intervene in the blockchain space is quintessential. This situation is without precedent. We have for the first time the potential to create a fully global and free space for conducting business. This vision undoubtedly stimulates the imagination and is the engine for many projects under development on the blockchain.

On the other hand, the question arises as to whether the unavailability of enforcement on the blockchain of decisions resolved under traditional legal systems may paradoxically constitute a serious obstacle to its further development. The limited possibility of enforcement may result in many users becoming reluctant to do business on the blockchain. Until the blockchain itself establishes effective and fair enforcement systems, for many users only the traditional state will remain the sole guarantor of their rights.

Many criminal activities that have occurred on the blockchain (e.g. thefts of cryptocurrencies) remain without any response. On the one hand, states have no effective tools with which to recover assets stolen on the blockchain, while on the other, the blockchain also has no tools available for effectively penalising the perpetrators of such acts and redressing the harm caused.

Which model of regulation should we choose?

Assuming that public blockchains will continue to grow as dynamically as currently, we will soon be witnessing the progressive alienation of the blockchain with respect to traditional legal systems. It will be harder to ignore the reality of the blockchain. Traditional legal systems will have to respond. In a sense, this is already happening (e.g. in relation to the ICO), but the steps that individual states are taking are very disorganised and fail to show any coherent or far-reaching vision, so far.

The simplest reaction, namely an attempt to subject the blockchain to traditional legal systems, seems to be mistaken. The blockchain is an autonomous order and will, in principle, manage without being subject to any traditional legal order. Simply decreeing that whatever happens on the blockchain is now subject, say, to the laws of a particular state, however tempting, would be a dangerous act, because it could potentially tarnish the reputation of the particular legal system. Any state that attempted to impose its legal order on to the blockchain would not be sovereign with respect to the blockchain, so it would not be able to enforce its laws there. The lack of effective enforcement of the law would undoubtedly undermine its authority.

Public blockchains are not additional areas of ​​reality that the law can easily “colonize”. The difficulties in the traditional approach taken by legal systems were apparent even before the advent of the blockchain and related to the internet. The application to the global internet of a traditional system of law based on geographic jurisdictions has proved to be a desperate attempt to save the old legal order within a reality, which is completely incompatible with it. As a result, there is more and more legal chaos in cyberspace. For example, we are not completely sure whether events in social media should be assessed by the law of the user, the law that governs the operator, or maybe the law of the place where the servers are located which process the social media data. The internet is global, while we perceive what is happening on it through the viewpoint of individual jurisdictions. This divarication does not serve legal entities, as pointedly evidenced by the difficulties and legal challenges faced by victims of cybercrime.

If the traditional approach has not worked well for the internet, then there is a risk that it will not work well with the blockchain. This leads me to the conclusion that the traditional legal system is currently likely to be facing the following choices.

Due to the difficulty of regulating the blockchain using traditional tools and due to the risks associated with the alienation of the blockchain area, the reaction of states and traditional legal systems could be to undertake organised steps for eliminating or at least significantly reducing the risks. States could use the solutions that I have mentioned earlier. They could block access to cryptocurrency exchange websites or prohibit the use of computing power for the requirements of the blockchain, etc. As a result, states will not “switch off” the blockchain, but will be able effectively to discourage their citizens from actively participating in blockchain reality. Alternatively, they could attempt to create their own blockchains under their control, which would be restricted by geography and jurisdiction.

Nonetheless, if we perceive value in public blockchains and are interested in the developing benefits that this new area provides, it would seem essential that there must be a fundamental change to the thinking behind the approach to regulating the blockchain. We cannot attempt to impose a traditional legal order on the blockchain. This will be impossible for the reasons mentioned above. The only possible solution seems to be to accept the legal autonomy of the blockchain and to adopt the logic known more from international law than under domestic law. In this new perspective, the blockchain would constitute an independent legal order with its own rules of operation, which are not necessarily compatible with the principles of traditional law. In adopting the new perspective, the objective ceases to be the introduction of the rules and mechanisms to the blockchain that are known in traditional law systems, but the establishment of rules for the mutual recognition of internal orders and for ensuring the exchange of business between those orders. This could be served, for example, by traditional legal order recognising the legal capacity of smart contracts (once those smart contracts have met certain conditions), and the introduction on to blockchain of mechanisms that would, for example, enable the enforcement of judgments of courts in specific jurisdictions. As a result, public blockchains would still be a space for free exchange, but only some of the blockchain solutions (for example, only some smart contracts or some ways of resolving disputes) would be recognised by particular states. A blockchain user who would wish to rely on a particular state respecting his activities on the blockchain would use only those solutions that are respected by that state.

The proposed approach opens up a completely new and unfamiliar space to traditional political and legal systems. This undoubtedly requires very courageous decisions and non-standard actions. It is obviously very risky. However, if public blockchains continue to maintain their dynamism, those states that are the first to decide to take this unknown trail have a chance to find themselves in the vanguard of a new economic reality.

Krzysztof Wojdyło