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Legal implications of various consensus mechanisms in public blockchains

Each legal analysis requires a prior determination of the underlying facts. The more precise the factual description of the subject to be analysed, the better the likelihood that the legal conclusions reached will be comprehensive and correct. This is one of the reasons why lawyers’ work in the field of new technologies is challenging and fascinating. Within the rapidly changing realities of new technologies, a lawyer’s ability to identify and understand the most legally relevant facts is a critically important skill. Of course, this skill must be supplemented with the knowledge that the facts are subject to dynamic changes.

It is also necessary for lawyers to keep abreast of ongoing developments in new technologies and continuously assess whether technological changes affect previously established legal conclusions. This is also a challenge for lawmakers who, particularly recently, have faced the need to establish laws amidst a veritable avalanche of innovation. Given these circumstances, the principle of “technological neutrality” of law increasingly appears to be the reasonable solution to the problem of laws becoming obsolete upon the arrival of new technologies.

The blockchain world is often the textbook example of a rapidly developing technology which continues to surprise us all. Its history began with Bitcoin – often seen as the enfant terrible of sector. In the first few years of its existence, the opportunities offered by blockchains beyond Bitcoin were mostly overlooked. It could be argued that attempts to impose rigorous regulations of cryptocurrencies at that early stage could have had a significant negative impact on innovations in the field.

In fact, this remains a reasonable fear, as the relationship between cryptocurrencies and the application of blockchain technologies in other (non-financial) areas are not always clearly understood. Since public and permissionless blockchains must possess economic mechanisms which allow them to function as decentralised systems, they are usually based on cryptocurrencies which function as the native units of account. Attempts to regulate cryptocurrencies – based on narrowly perceived facts about blockchains – may have much broader effects on the numerous applications of this technology.

A recent example of this situation can be seen in Poland’s attempt to impose regulations to counteract cryptocurrency-based money laundering activities. Despite the understandable intentions, the new regulation’s broader effects may include a drastic slowdown in the development of any applications of blockchain technology involving the transfer and exchange of tokens in Poland.

This is why we must be certain to not overlook technological changes in the blockchain world which may force us to revise the established ways of thinking about the technology’s legal aspects. One such prominent assumption about cryptocurrencies and blockchains is the method of establishing consensus within these decentralised systems. Anyone that has had any significant involvement with cryptocurrencies is aware of ‘mining’ or, in simpler terms, the process of verifying transactions within the Bitcoin network (and most other public blockchains) as well as the means through which new bitcoins are created (‘mined’) by ‘miners’ who mostly use computers with massive processing power.

The reason why Bitcoin functions in this manner is the result of the chosen method of establishing consensus within a decentralised network, known as Proof-of-Work (PoW). PoW is a practical and effective answer to the difficult question of how to ensure consensus regarding a shared version of reality (such as cryptoasset balances) in an open and distributed system.

It is well established that the mining system has numerous faults. Its current state leads to a type of centralisation of the system in which only entities that have access to expensive equipment and cheap electricity are able to take part in verifying transactions. The staggering amounts of electricity used to operate the Bitcoin system also raise questions about the environmental impact of Bitcoin’s functioning.

However, there are other methods of establishing consensus. The most popular alternative to PoW is Proof-of-Stake (PoS) which allows participation in the validating of transactions through a stake – a type of cryptocurrency deposit which grants entities the power to vote on the content of the next block on the blockchain. PoS has the potential to limit the danger of centralisation, is less harmful to the environment and more secure. In fact, today’s most popular second-generation blockchains (which provide the ability to create smart contracts) allow or intend to allow the use of PoS-type consensus protocols.

I believe that PoS has the potential to alter the way in which the law approaches blockchains. It goes much further toward revealing blockchain’s social character in which the validation of particular transactions is not decided upon by the laws of mathematics, but rather by numerous and distributed, yet specific, entities. The system’s mechanisms should ensure that cheating through manipulating the system is both unprofitable and easily discoverable. Some prominent systems are moving away from the code is law principle and provide entities tasked with verifying transactions with the ability to void them if they are the result of fraudulent activity. Another change is the use of Ricardian contracts which combine traditional legal concepts with code. As we can see, it is possible that lawyers will find numerous points of interest in the blockchain world – which is not often the case today.

We can be certain that these changes represent the beginning of a new set of challenges for lawyers. The number of blockchain experiments regarding the issue of establishing consensus will certainly grow. Lawyers must observe the rapidly changing realities and adapt existing legal instruments to these new circumstances. As I wrote in a 2015 article on blockchain: “Bitcoin [has] opened up a spectrum of possibilities and a legal Pandora’s Box.” It appears that what’s inside that box will keep surprising us on numerous occasions.

Jacek Czarnecki