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Lawyers caught in bitcoin quicksand

Capgemini
2019-08-08

Professional services now demand multidisciplinary teams. Legal finesse or commercial acumen on their own are no longer enough. We’re in an age where industries are converging and lawyers, accountants and financial planners need to have a far broader understanding of technology, economics and global trends.

Lawyers need access to consultants; accountants should be working with technologists, and financial planners should be engaging entrepreneurs and developers to truly understand client’s needs and offer innovative solutions.

One of the biggest grey areas are cryptoassets. When I say cryptoassets I’m referring to any cryptographically secured asset or currency residing on a blockchain (or similar data structure) such as Bitcoin, Ether, Ripple, and many others. Many of my colleagues today are being asked difficult questions about cryptoassets and frankly the level of industry knowledge and understanding isn’t quite there yet.

Let me provide two examples.

Commercial agreements

“ … shall not retain more than $100,000 worth of Bitcoin or other like-assets in any single cold storage wallet on premise at location [X].”

This is a clause I read recently in a commercial agreement between two financial service providers. A lawyer drafted this.

Here’s what bothers me.

  • Value of assets. We all recognize that cryptoassets are notoriously volatile. We’ve already seen Bitcoin swings of up to +35% in less than 24 hours. There’s little indication here of timing when valuing the assets and if at any point in time the value surpasses $100,000 is there liability? To draft a clause like this, at least a macro-level understanding of token economics and theory should be present and additional guardrails put in place for valuation methods and timing.
  • Cold storage wallets. There appears to be a misunderstanding about the role of cold storage wallets and the “housing” of assets. Cryptoassets are not “stored” in wallets. Wallets hold public/private keys to enable users to sign transactions on a blockchain. After all, crypto is still just digital internet money with no physical asset to point to. It seems there is a trend towards attributing traditional custodian-style thinking (i.e. “I’m holding the wallet, therefore I’m holding the assets”) to digital assets which, at a fundamental level, is probably incorrect.

The benefit of cold storage wallets (as opposed to “hot wallets”) comes from signing transactions in an offline environment. Rather than signing transactions in an online environment (which may expose the private key to hackers/malicious software), the transaction is temporarily moved offline, signed, and then transmitted to the network. This makes the transaction more secure and safe because the private key does not come into contact with a live server.

  • Assets on premises. This part also seems rooted in traditional custodian style thinking. Cryptoassets are not “held” on premises. Cryptoassets exist only as records signed on a ledger. It’s a few lines of code marking attributes associated with a transaction (i.e., the amount of Bitcoin signed against a public key). We should start shifting the logic away from custodianship when dealing with crpytoassets.
  • Single cold storage wallet on premises. We need to be careful about these terms and what exactly is meant by “ … any single wallet … ”. A wallet can have multiple private/public key pairs and therefore multiple amounts of funds associated with it already creating ambiguity.

Additionally, even cold wallets provide a secret backup code to retrieve the keys and funds in the event the cold wallet is lost. If private keys are lost, there is no way ever to retrieve the cryptoassets associated with that key pair.

The mere existence of a secret backup code, in whatever form it may take, whether it’s written down on a piece of paper or otherwise, means you may have already displaced the physical existence of keys.

Source

My view is that trying to apply any traditional location-based thinking to cold storage wallets, passwords or cryptoassets is fundamentally flawed and is likely to lead to all sorts of difficulties in the future.

  • Bitcoin or other like-assets. I understand the lack of regulatory guidance has forced many of us to lump Bitcoin and other like-assets together.

For example, Bitcoin could reasonably be defined as a speculative, censorship-resistant, digital asset class with no particular rights or underlying guarantees associated with its value. It’s an alternative piece of financial infrastructure (and a pretty successful one at that).

However, let’s look at another cryptoasset with rights attached to it – DAO coins. DAO coins are listed and traded on secondary exchanges and have the potential to fill the same role as Bitcoin. However, having DAO coins also can provide holders with voting rights inside the DAO to decide which projects get funding.

What if we consider some form of derivative or security such as DGX tokens? DigixGlobal issues DGX tokens with each token representing 1 gram of gold stored in a safe house in Singapore. The value of DGX tokens is linked to the price to price of gold and a custodial arrangement with DigixGlobal. Ultimately, DigixGlobal are responsible for holding the assets along with a complex web of governance structures with DigixDAO and DGD tokens (additional tokens used to vote on changes to the Digix network).

Quite simply, these are not like-assets for the purposes of a commercial arrangement. They are significantly different assets with different rights, revenue streams, functions, and value attached to them.

Interim property orders

“ … [Party A] shall indemnify [party] against any and all losses in relation to the loss or depreciation of any digital assets or currencies associated with the Bitcoin wallet with the following public key 1BSSBwiHeK … ”

The above is a clause I came across in a recent draft interim property order. It’s an agreement that imposes interim obligations on parties involved in a divorce pending a final settlement.

  • “ … shall indemnify … ” The shift in ownership that comes from cryptoassets is the ability to have complete control over your funds. Modern banking defers this trust component to your local bank/branch where you would have a bank account that holds your funds. The bank usually bears liability for any malicious attacks or losses beyond your control. This is a critical part of providing a custodianship service, and banks go to great lengths to provide security and protection as part of their service offering.

If you’re holding your cryptoassets in your own wallet, you’re in complete control. You’re (hopefully) the only one with access to your private keys and the only one capable of signing transactions using your funds. The obvious risk is that if things go wrong, you get hacked or you lose your keys the accountability rests entirely with you. You lose the safety nets banks provide because you’re responsible for securing your assets.

My concern is parties may be inadvertently taking on the roles and responsibilities of a bank when engaging in commercial dealings involving cryptoassets. These responsibilities may extend beyond B2B transactions and could have broader implications on fiscal policy, cash flow, and banking regulations.

  • Loss or depreciation. The issue around loss or depreciation is a complicated one given the volatile nature of cryptoassets and timing will become a hot topic for cryptoasset valuations. Fundamentally, cryptoassets are not depreciating assets. It would be incorrect to call them that. My view is that most cryptoassets operate as speculative vehicles because they’re traded on secondary exchanges and often fill functional roles within an ecosystem. (Take a look at this article on token economics for a more in-depth explanation of what that means https://www.capgemini.com/au-en/2018/08/tokenomics-faults-in-a-fault-tolerant-ecosystem/)

The order book and traditional supply/demand principles dictate the value of an asset. Indemnifying any party against losses relating to a highly volatile asset is risky and can present potentially uncapped liability in the scope of cryptoassets.

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  • Bitcoin wallet and public key. What does this mean? Assets associated with a particular key? At what point in time? What if the user moves assets to a different address? Does this classify as a loss? Does this classify as defrauding the agreement? Courts approach issues like this by examining intention, i.e. whether the movement of assets was to avoid obligations under an arrangement. Even then, courts are constrained by terms in the agreement and can only depart where there is obvious uncertainty or ambiguity.

Engaging a court, particular a family court, to grapple with the intricacies of cryptoassets and wallets at this point in time would likely be a hellish experience. The learning required by all parties involved (i.e. barristers, solicitors, judges, witnesses) to fully grapple with the technology would be huge, even before considering the arrangement itself. Even after some level of knowledge is gained, courts could still make an incorrect decision based on the movement of assets and considering the nascent stage the technology is still in.

My concern is if clauses like this end up in the court system it’s going to be an incredibly cumbersome and expensive exercise to reach a decision. Given the low level of adoption around these assets, we may also start setting some dangerous precedent.

So what?

Ultimately, cryptoassets are not going away. The launch of massive enterprise-scale projects like Facebook’s Libra protocol are likely to bring more cryptoassets into the mainstream. Libra presents a 2.2-billion user base that could mark a monumental shift in how we settle retail transactions and day-to-day spending, JP Morgan’s JPM Coin is already being used to settle backend transactions for the corporate banking sector and Bitcoin has retaken its $10,000 price this year.

To get this right, a multidisciplinary approach is needed. Lawyers and advisors need to work together with consultants and technologists. Professional services should create environments to enable growth, not create more obstacles.

This article is intended solely to provide the author’s opinions and general knowledge on the matter of interest. It is not intended to constitute any form of legal or financial advice and should not be relied upon for those purposes.