Smart Contracts and Cryptocurrencies: The legal Conundrum posed by Blockchain technology

Smart Contracts and Cryptocurrencies: The legal Conundrum posed by  Blockchain technology

Author: Parth Bathla, FIMT, GGSIPU, Delhi.

Abstract

Cryptocurrencies, or virtual currencies, are digital means of exchange that uses a cryptography for security. The word ‘crypto’ comes from the ancient greek word, ‘kryptós’, which means weather hidden or private. Cryptocurrencies challenge the orthodoxy of how a currency works in the ways that worry some and excite others. It could transform the way we do transactions as the so-called distributed ledger technology behind their blockchain can be integrated into all sorts of business processes. The Inter-Ministerial Committee (2019) noted that the technology underlying cryptocurrencies could improve the efficiency and inclusiveness of the financial system. However, several risks have also been associated with cryptocurrencies which have been highlighted through the cryptocurrency bill. The draft Bill therefore, seeks to prohibit mining, holding, selling, trade, issuance, disposal or use of cryptocurrency in the country. A smart contract is a computer program or a transaction protocol which is intended to automatically execute, control or document legally relevant events and actions according to the terms of a contract or an agreement. The objectives of smart contracts are the reduction of need in trusted intermediators, arbitrations and enforcement costs, fraud losses, as well as the reduction of malicious and accidental exceptions.

Introduction

Cryptocurrency is an internet based currency which uses cryptographical functions to conduct financials transactions. Cryptocurrencies leverage blockchain technology to gain decentralizations, transparency, and immutability. The drafts Bill defines cryptocurrency as any information, code, number or token, generated through cryptographic means or otherwise, which has a digital representations of value and has utility in the business activity, or acts as a store of value, or a unit of account. The Financial Action Task Force (an intergovernmental organisation to combat money laundering) defines it as a math-based decentralised, convertible virtual currency which is protected by the cryptography. A convertible virtual currency is one which has an equivalent value in the  real currency and can be exchanged for real currency

Few people know, but cryptocurrencies emerged as one of a side product of another invention. Satoshi Nakamoto, the unknown inventor of Bitcoin, the first and is still the most important cryptocurrency, never intended to invent any currency. In his announcement of Bitcoin in the late 2008, Satoshi said he developed “A Peer-to-Peer Electronic Cash System.“ The single most important parts of Satoshi‘s invention was that he found a way to build a decentralized digitals cash system. In the nineties, there had been many attempts to create digital money, but they all failed. After seeing with all the centralized attempts fail, Satoshi tried to build a digital cash systems without a central entity. This decision became the birth of the  cryptocurrency. To realize digital cash all you need is a payment network with accounts, balances, and transaction. One major problem is every payment network has to be solve is to prevent the so-called double spending: to prevent that one entity spends the same amounts twice. Usually, this is done by a central server who tend to  keep the record about the balances.

A smart contract is a self-executing contract with the terms of the agreement between buyer and seller being directly written into lines of code. The code and the agreements contained therein exist across a distributed, decentralized blockchain network. The code controls the execution, and transactions are trackable and irreversible.

Smart contracts permit trusted transactions and agreements to be carried out among disparate, anonymous parties without the need for a central authority, legal system, or external enforcement mechanism. While blockchain technology has come to be thought of primarily as the foundation for bitcoin​, it has evolved far beyond underpinning the virtual currency.

History

In a decentralized networks like Bitcoin, every single participants needs to do this job. This is done via the Blockchain – a public ledger of all the transactions that ever happened within the network, available to everyone. Therefore, everyone in their network can see everyone’s account balance.

If the peers of the networks disagree about only one single, minor balance, everything is broken. They need an absolute consensuses. Usually, you take, again, a centrals authority to declare the correct state of balances. But how can we achieve consensus without a central authority?

Every transaction is a file of that which consists of the sender’s and recipient’s public keys (wallet addresses) and the amounts of coins transferred. The transactions also needs to be signed off by the sender with their private key. All of this is just the basic cryptography. Eventually, the transaction is broadcasted in their network, but it needs to be confirmed first.

Within cryptocurrency, only miners can confirm the transactions by solving a cryptographic puzzle. They take the  transactions, mark them as a  legitimate and spread them across the network. Afterwards, every nodes of the network adds it to its database. Once the transaction is confirmed it becomes unforgeable and it is  irreversible and a miner receives a reward, plus the transaction fees.

Cryptocurrencies are so called because the consensus-keeping process is ensured with the strong cryptography. This, along with the aforementioned factors, makes the third parties and blind trust as a concept completely redundant.

Smart contracts were first proposed in the early 1990s by computer scientist, lawyer and cryptographer Nick Szabo, who coined the term, using it to refer to “a set of promises, specified in digital form, including protocols within which the parties perform on these promises”. In 1998, the term was utilized to describe objects in rights management service layer of the system The Stanford Infobus, which was a part of Stanford Digital Library Project.

Highlights of the Cryptocurrency Bill And Smart Contracts

 Cryptocurrency emerged as a person-to-person electronics cash system that allows online payments to be sent directly from one party to the another, without any need of a financial institution. Most cryptocurrencies are not even backed by a sovereign guarantee, and therefore are not considered as legal tenders.  For a legal tender, transactions data is usually maintained centrally with financial institutions like banks.  In contrast, cryptocurrency transactions are recorded and shared with all users on their network. Since their values fluctuate in relations to other currencies such as the US Dollar, they are also traded.  As of October 2019, there were more than 3,000 cryptocurrencies across the world, with a daily global trading volume of around USD 50 billion. Over the years, several risks related to cryptocurrencies have emerged such as potential use for the  illicit activities, and a lack of consumer protection.  Countries have adopted different frameworks to regulate the Cryptocurrencies.

Between 2013 and 2017, the Reserve Bank of India (RBI) and the Ministry of Finance issued several advisories against the potential financials, customer protection and security risks pertaining to cryptocurrencies.  In April 2018, RBI prohibited entities regulated by it from dealing n, or providing services for dealing with virtual currencies.  An Inter-Ministerial Committee (IMC), constituted by the Ministry of Finance, studied the issues related with virtual currencies. It highlighted several risks associated with cryptocurrencies such as high volatility in price, vulnerability to money laundering and financial stability risk.  Considering these, it recommended that all cryptocurrencies, except those issued by the government, be banned in India.  It also proposed a draft Bill to ban cryptocurrencies in the country and provide for an official digital currency.

Regulation of Cryptocurrency And Smart Contracts

• Ban on cryptocurrencies: The draft Bill bans the use of the Cryptocurrency as a legal tender or currency.  It also prohibits mining, buying, holding, selling, dealing in, issuance, disposal or any use of cryptocurrency.  

• In particular, the use of cryptocurrency is prohibited for the following: (i) use as a medium of exchange, store of value or unit of account, (ii) use it as a payment system, (iii) providing services such as registering, trading, selling or clearing of cryptocurrency to individuals, (iv) trading it with the other currencies, (v) issuing financial products related to it, (vi) using it as a basis of credits, (vii) issuing it as a means of raising funds, and (viii) issuing it as a means for investment.
   
• Exemptions: The central government may exempt  a certain activities, if necessary in public interest.  The use of the technology or processes underlying cryptocurrency for experiment, research or teaching is permitted.  
   
• Digital Rupee: The central government may, in consultation with the central board of the RBI, approve digital rupee to be a legal tender.  The RBI may also identify a foreign digital currency as a foreign currency. 

Offenses and Penalty

• Under the Bill, mining, holding, selling, issuing, transferring or using a cryptocurrency is punishable offence with a fine or imprisonment of up to 10 years, or both.
   
• Issuing any advertisement, soliciting, assisting or inducing participation in the see of cryptocurrency is punishable with a fine or imprisonment of up to seven years, or both in some cases. Acquiring, storing or the disposing of cryptocurrency with the intent of using it as a non-commercial purposes will be punishable with a fine.
   
• The Bill provides for a transition period of 90 days from the commencement of the Act, during which a person may be  dispose of any cryptocurrency in their possession, as per the rules notify by  the government.

Benefits and risks associated with Cryptocurrency And Smart Contracts

 The Inter-Ministerial Committee (2019) noted that the technology underlying cryptocurrencies could improve the efficiency and inclusiveness of the financial system. These currencies could provide cheaper, faster and more efficient transactions. For example, they can be used for small value cross-border transfers where the cost of sending remittances remains high due to multiple intermediaries.  Cryptocurrencies also provide for a more secure payment mechanism, transparency in transactions, and improved ease of auditing.

However, several risks have also been associated with cryptocurrencies.  First, they pose risks to consumers.  Cryptocurrencies do not have any sovereign guarantee and hence they are not legal tender.  Their speculative nature also makes them highly volatile.  For instance, the value of Bitcoin fells from $20,000 in December 2017 to $ 3,800 in November 2018. 

A user loses access to their cryptocurrency if they tend to lose their private key.  In some cases, these private keys are stored by technical service providers (cryptocurrency exchanges or wallets), which are prone to malware or hacking. 

Second, cryptocurrencies are more vulnerable to criminal activity and money laundering.  They provide greater anonymity than other payment methods since the public keys engaging in a transaction cannot be directly linked to an individual. 

Third, central bank cannot regulate the supplies of cryptocurrencies in the economy.  This could pose a risk to the financial stability of the country if their use becomes widespread. 

Fourth, since the validating of transactions is energy intensive, it may have been adverse consequences for the country’s energy security (the total electricity use of bitcoin mining, in 2018, was equivalent to that of the mid-sized economies such as Switzerland).

These contracts already possess multiple advantages over traditional arrangements. This number is likely to increase in the future as the technology improves.

1. Accuracy

One of the primary requirements of a smart contract is to record all terms and conditions in explicit detail. This is a requirement because an omission could result in transaction errors. As a result, automated contracts avoid the pitfalls of manually filling out heaps of forms.

2. Transparency

The terms and conditions of these contracts are fully visible and accessible to all relevant parties. There is no way to dispute them once the contract is established.

3. Clear Communication

The need for accuracy in detailing the contract results in everything being explicit. There can be no room for miscommunication or misinterpretation.

.4. Speed

These contracts run on software code and live on the internet. As a result, they can execute transactions very quickly. This speed can shave hours off many traditional business processes. There is no need to process documents manually.

5. Security

Automated contracts use the highest level of data encryption currently available, which is the same standard that modern crypto-currencies use. This level of protection makes them amongst the most secure items on the world wide web.

6. Efficiency

A natural byproduct of the speed and accuracy of these contracts is the efficiency with which they operate.

7. Paper Free

Businesses across the globe are becoming increasingly conscious about their impact on the environment. Smart contracts enable the “go-green” movement because they live and breathe in the virtual world.

8. Storage & Backup

These contracts record essential details in each transaction. Therefore, anytime your details are used in a contract, they are permanently stored for future records.

9. Savings

Perhaps one of the most significant advantages of automated contracts is that they eliminate the need for a vast chain of middlemen.

10. Trust

Smart contracts generate absolute confidence in their execution. The transparent, autonomous, and secure nature of the agreement removes any possibility of manipulation, bias, or error.

11. Guaranteed Outcomes (Bonus)

Another attractive feature of these contracts may be the potential to reduce significantly or even eliminate the need for litigation and courts. By using a self-executing contract, parties commit themselves to bind by the rules and determinations of the underlying code

Cryptocurrency and Smart Contracts regulations in other jurisdictions

Considering these benefits and risks, countries are regulating cryptocurrencies in various ways.  In Canada, cryptocurrencies are regulated under the money laundering and terrorist financing laws. Trading of digital currencies on an open exchange is permitted, and revenue generated from cryptocurrencies is subjected to income tax. They can also be used to buy or sell goods and services.  Japan permits the use of cryptocurrencies as a payment system. Cryptocurrency exchanges are registered and regulated by the Financial Services Authority of Japan.  In New York, use of the cryptocurrency as a payment mechanism is permitted subject to the licensing requirements. Every licensee is required to comply with anti-fraud, anti-money laundering, cyber security and information security related regulations.  

Several countries such as China, Thailand, Indonesia and Taiwan ban the use of cryptocurrency.³  Many others, while permitting the use of cryptocurrencies, have issued warnings about their high risk.  For example, the European regulators for securities, banking, and insurance and pension issued a joint statement cautioning that virtual currencies are highly risky and unsuitable as investment, savings or retirement planning products.

Implicarions of  banning of Cryptocurrency and regulations of  Official Digital Currency bill,2019

• Offences and Penalties:The Bill provides for the following offences and penalties:

Table 1: Offences under the Bill

Offence	Punishment
Mining, holding, issuing, selling, or using cryptocurrency	Fine or imprisonment up to 10 years, or both
Issuing advertisement, assisting, soliciting or inducing participation in use	Fine or imprisonment up to seven years, or both
Acquiring, storing or disposing of cryptocurrency with intent to use	Fine

The Bill provides that any subsequent conviction for any offence under the Bill would be punishable with a fine and imprisonment of 5-10 years. Further, attempting to commit an offence will be punishable with 50% of the maximum term of imprisonment for the offence or the applicable fine, or both.  All offences punishable with fine may be compounded.  Offences related to the use of cryptocurrency for issuing related financial products or issuing it as a means for raising fund or investment, would be considered cognisable and non-bailable.  All other offences would be considered as  non-cognisable and bailable.
 

• The Bill provides that the maximum amount of fine levied will be the higher of: (a) three times the loss caused and (b) three times the gain made by the person. If the loss caused or the gain made by the person cannot be determined, the maximum amount of fine for acquiring, storing or disposing of cryptocurrency will be up to one lakh rupees.  For all other offences, the maximum fine will be up to Rs 25 lakh.  The Bill amends the Prevention of Money Laundering Act, 2002 to give effect to the offences.
   
• Regulation of digital rupee and foreign digital currency: The Bill provides that the central government may, in consultation with the central board of RBI, approve a digital form of the currency to be legal tender.  Further, it provides that the RBI may notify a foreign digital currency as a foreign currency in India to be governed by the Foreign Exchange Management Act, 1999.  Foreign digital currency means as  a digital currency recognised as a legal tender in a foreign jurisdiction.
   
• Investigating Authority and punishment:Only officers of the rank of Deputy Superintendent of Police or above may investigate offences under the Bill.  The court will consider few factors while determining the quantum of punishment for the offences.  These include the gains made by the individual and the harm caused to the financial system, among others. 
   
• Immunity and exemptions: The Bill empowers the central government to grant immunity to any person from prosecution under the Act, if such person makes full disclosure of the violation.  Further, the central government may exempt certain activities from the list of prohibited activities under the Act, if it considers it necessary in public interest.
   
• Transition period:The Bill provides for the transition period of 90 days from the commencement of the Act, during which a person may get  dispose of any cryptocurrency in their possession, as per the rules notified by the central government.

Conclusion

The draft Bill takes an extreme position since it proposes to criminalize dealing with an asset in which lakhs of people have invested as a legitimate economic avenue. Jurisdictions like the U.S., E.U. and Japan have found the ways to regulate the crypto-asset activity to mitigate the risks and promote the benefits. This has also been recommended by the G20 and the Financial Action Task Force, the global anti-money-laundering watchdog.

The Bill lends to uncertainty as it does not enumerate ways in which Indian investors can offload their holdings. In view of the criminal penalty, Indian buyers will not be able to buy and the law does not mention anything about cross-border transfers through banking channels. Another point to note is that the definition of cryptocurrency under the draft Bill is open-ended and may need more precise wording. The bill is merely the recommendation of a committee, and not a binding decision. If new regulations are to come into place, they will have to differentiate between currencies, utility tokens and commodity backed tokens all of which have a different purpose. Right now, cryptocurrency does not pose any threat since it is a long way from becoming any kind of financial instrument capable of replacing real currency. Rather than imposing regulations immediately, government and RBI should allow virtual currencies to run for a while as they could help create a more inclusive economy.

One of its key conclusions is that smart contracts are capable, in principle, of forming binding contracts which will be upheld under English law. Effectively the Legal Statement gives the green light to the use of this technology in the UK.

References

• https://www.investopedia.com/terms/c/cryptocurrency.asp
• https://blockgeeks.com/guides/what-is-cryptocurrency/
• https://bitcoin.org/bitcoin.pdf.
• https://www.globallegalinsights.com/practice-areas/blockchain-laws-and-regulations/13-legal-issues-surrounding-the-use-of-smart-contracts
• https://medium.com/@ChainTrade/10-advantages-of-using-smart-contracts-bc29c508691a
• https://www.investopedia.com/terms/s/smart-contracts.asp