The Big Picture: Blockchain and Cryptocurrency

THE

BLOCKCHAIN AND CRYPTOCURRENCY

Even as investors eye global financial markets nervously in the face of headwinds from higher interest rates and surging inflation, the outlook for cryptocurrencies and blockchain assets remains ever more uncertain. How will an asset class which has never before been through a global recession perform if the potential for worldwide contraction becomes a reality? Will this prove to be a transitional phase for this asset class, a ‘crypto winter’ – or even, as some are now suggesting – an ice age?

It’s a critical question for a sector which continues to be buffeted by a series of ‘extinction events’. In 2020 and 2021, crypto investments generated staggering returns for some investors, but during 2022 these events have created cascading losses and contagion throughout the sector. Most recently, the shocking collapse in November of one of the largest cryptocurrency exchanges, FTX, has been described by commentators as the sector’s ‘Lehman moment’, echoing the 2008 investment bank failure that sparked widespread fear the global financial system would collapse. Bitcoin remains down around 75 per cent from its November 2021 high, and many of the lower-ranked cryptoassets have fallen in excess of 90 per cent, with many worth close to zero. Price volatility is not unusual for

this sector and it recovered following similar periods in 2014 and 2018. Will it do so this time? If it does, will blockchain assets recover equally, or will some fall by the wayside?

In 2014 the collapse of the Mt. Gox exchange sent the price of bitcoin plummeting and some doubted its prospects for survival.

In 2018, the rise of alternative cryptoassets such as ethereum seemed under threat. In 2022, similar questions are being raised over newer cryptoasset sectors such as NFTs or blockchain gaming.

To complicate matters further, cryptospecific headwinds exist in terms of regulatory concerns around a range of factors, from environmental concerns and security laws, to the potential for sanction evasion. Yet some may see regulations as providing the legal certainty needed to allow greater participation by institutional investors in cryptoassets.

Despite the possibility of a ‘crypto winter’, where prices plummet and remain low for a protracted period, to date many projects continue to build and develop. In TheBig Picture:BlockchainandCryptocurrency , we take stock of where blockchain assets could still make progress and where questions remain, highlight key trends and cover some of the critical regulatory issues facing this sector.

A transition phase, a ‘crypto winter’ ‒ or an ice age?

Divergence ‒ two themes emerge

The crypto space is vast and involves thousands of projects and assets, but at this point in time two dominant universes have emerged. Each have their own key themes and ideas. One falls under the banner the ‘Future of Money’, encompassing cryptocurrencies and assets that resemble currencies or stores of value. The other, ‘Web 3.0’, is a term used to describe a broad set of applications that use blockchain and cryptoassets in pursuit of other goals that build on internet use cases already in place.

Future of Money

Bitcoin is the original cryptoasset, and still has the largest market cap in the sector. Its value is sometimes seen as a form of private, digital money but it is also compared to a form of ‘digital gold’ in the sense that its pre-programmed scarcity could create a store of value.

There are a number of other types of cryptoassets with monetary properties. Most notable are ‘stable

coins’ that are usually pegged to the USD, or privacy coins that use blockchains which cannot be traced back to users.

Central banks around the world are also exploring the possibility of issuing digital versions of government currencies – using similar technology to blockchain but centralized and subject to government controls or restrictions.

DECENTRALISED FINANCE (DEFI)

Web 3.0

Web 3.0 applications use blockchain and cryptoassets in a wide variety of ways. Among the most prominent types of projects are:

These projects rely heavily on smart contracts and supporting blockchains such as Ethereum, Cardano and Solana.

Allowing for decentralised financial activities such as trading, lending or market making without a centralized entity.

SOCIAL MEDIA TOKENS

Companies such as Reddit are exploring community tokens awarded for participation in their forums and NFTs for use as avatars.

NON-FUNGIBLE TOKENS (NFTs)

These tokens use unique metadata to link each token to a particular item ‒ artworks, gaming assets or other items like a concert ticket.

THE METAVERSE

This is a broad term that encompasses a range of applications including virtual reality, shared worlds, gaming and virtual items.

Central bank digital currencies

STATUS OF CENTRAL BANK DIGITAL CURRENCIES AROUND THE WORLD

In March 2022, U.S. President Joe Biden released an executive order which called for measures to explore a U.S. CBDC by placing urgency on research and development of a potential CBDC, should issuance be deemed in the national interest.1

Source: https://cbdctracker.org

It may be that the future of money will bear a closer resemblance to the past than the early pioneers of cryptocurrency would have envisaged. A majority of governments around the world are now exploring the potential for government-backed digital currencies.

According to the Atlantic Council, more than 100 countries, representing over 95 per cent of global GDP, are looking at CBDCs. Some 50 countries are in an advanced state of exploration, and 10 have fully launched digital currencies.3

There are a range of difficult issues for central banks to grapple with, from technology to a slew of harder choices. Will any CBDC be blockchain-based or will it use some other kind of distributed ledger technology? To what extent will data be accessible, or will privacy have primacy? Can transactions be ‘censored’ –blocked or reversed? Perhaps most critically, how will any digital currency sit alongside conventional or physical currency?

In New Zealand, the RBNZ disclosed last year that it would consult with the public and is testing on the potential for a central bank issued New Zealand dollar and has itself now issued a series of discussion papers on the “Future of Money”.2 This is now par for the course with most central banks either in test or consultation phases.

Breaking systems

Recent setbacks have come at a pivotal time in this development. In 2022, three dramatic events caused severe losses for many investors in the crypto space.

JUNE 2022

A major ecosystem using the Luna blockchain effectively collapsed to zero. The Luna ecosystem relied on a stablecoin known as Terra USD, which relied on an algorithm to maintain the price at a peg of USD$1, rather than being backed by a currency reserve.

Terra USD depegged,  which in turn caused the Luna token itself to collapse to zero over several days, causing a loss totalling in the billions.

MAY ‒ SEPTEMBER 2022

Not long after, a number of custodial platforms that offered passive income crypto products began to halt withdrawals and it soon emerged that they had become insolvent (in some cases due to the Luna collapse). Among these platforms were Celsius and Voyager – with assets under management in the hundreds of millions.

NOVEMBER 2022

The collapse of one of the world’s largest cryptocurrency exchanges, FTX, in November has left the sector facing some stark questions as 2022 draws to a close – not least because FTX was seen as one of the more regulation-friendly crypto entities with the potential to help lead the sector into a new era to sit alongside other financial markets.

The combination of these events has caused major losses in the sector and it is expected that regulators will be looking at ways to avoid similar events in the future.

Regulation of cryptoasset products and services in New Zealand

The FTX collapse, along with other recent high-profile failures, will likely lead to increased scrutiny and more protective regulation of cryptoassets globally. In New Zealand there are no specific regulatory regimes dealing with cryptoassets or services. The extent to which cryptoassets are regulated depends on whether existing laws of general application apply.

The Financial Markets Conduct Act 2013 (the FMCA) regulates the provision of financial products and financial services in New Zealand. The application of the FMCA to a particular cryptoasset in part depends on the threshold question of whether the cryptoasset in question is considered a “financial product” under the FMCA – a determination that requires a case-bycase analysis of the cryptoasset or service being offered. Any such determination is complicated by the absence of detailed regulator guidance or relevant case law in New Zealand.

Which type of financial product is it?

There are four categories of financial products in the FMCA, each of which is defined in the legislation:

1. equity securities

2. debt securities

3. derivatives

4. managed investment products

Each category has potential application to various kinds of cryptoassets or products.

1. EQUITY SECURITIES

The equity security definition in the FMCA is more specific to shares in companies, industrial and provident society and building societies. Accordingly, cryptoassets are generally less likely to fit into this category of financial product. However, given the vast range of cryptoassets (including NFTs), conceivably there could be certain cryptoassets that could constitute equity securities.

2. DEBT SECURITIES

A debt security is defined as a right to be repaid money, or paid interest on money, where that money is deposited, lent to or otherwise owing by any person. Intrinsic value coins, such as Bitcoin or Ether, are unlikely to fall within the definition “debt security” under the FMCA on the basis that they are not convertible into fiat currency. However, a cryptoasset may be a debt security if the holder has the right to redeem the cryptoasset for fiat currency (that is, money). As an example, certain stablecoins (for example, USDC) are likely to satisfy this test.

Cryptoasset

4. MANAGED INVESTMENT PRODUCTS

3. DERIVATIVES

A cryptoasset may be a derivative if the issuer or holder may be required to pay an amount or provide something else in the future, and the amount to be paid or value of the cryptoasset is derived from the value of an underlying asset.

A cryptoasset or service may be considered a “managed investment scheme” (MIS) (and an interest in such MIS, a “managed investment product”) under the FMCA if investors contribute money or cryptoassets in exchange for an interest in a scheme, have a right to receive a financial benefit (that is, capital, earnings, or other financial returns) principally produced by someone else, and do not have day-to-day control over the management of the scheme. As an example, New Jersey-based BlockFi Lending has a lending product called BlockFi Interest Accounts (BIAs), which was the subject of a settlement between the SEC and BlockFi Lending earlier this year. This product may be considered a managed investment scheme. Through its BIA crypto service, BlockFi Lending allowed customers to commit cryptoassets to a pool, which was then used for certain financial activities, such as providing cryptoasset loans to institutional and corporate borrowers. The customer was entitled to a share of the profits, for example, interest on the loans, generated from such activities.

Regulation in New Zealand

In addition to the four categories of financial products, the Financial Markets Authority (the FMA) possess a general “call-in” power to declare that a “security” (which could include a cryptocurrency) that would not otherwise be a financial product is – in fact – a financial product of a particular kind. The FMA has not used this power to date for any cryptoassets or services, nor has it signalled any future intention to do so.

Offers of cryptoassets that are deemed financial products will be subject to the onerous disclosure, governance and reporting obligations under the FMCA. At this stage, no purpose-built regulatory regime applies to offers of financial products

that are forms of cryptoassets, so any person proposing to offer such financial products would likely face practical challenges with satisfying these requirements in respect of many cryptoassets. Entities offering trading of such products will need to consider the application of the licensing regime that applies to the operators of financial product markets under the FMCA. In addition, even if the cryptoasset or service is not considered a financial product, the provider of such cryptoasset or service may still be required to comply with the “fair dealing” rules that prohibit misleading or deceptive conduct in the FMCA.

the ‘call-in’ power

Provided that the Financial Service Providers (Registration and Dispute Resolution) Act 2008 (the FSP Act) applies to them, exchanges issuing their own cryptoassets to facilitate trading, and exchanges allowing for cryptoasset trading, are considered by the FMA to fall within the financial service categories under the FSP Act. The FSP Act applies in various circumstances, including where a cryptoasset or service provider has a place of business in New Zealand or provides the relevant service to any retail clients in New Zealand. Investbybit, trading as Binance New Zealand, has recently registered on the FSPR this year for the provision of certain financial services in New Zealand.

Cryptoasset and service providers may also be subject to the obligations imposed by the Anti-Money Laundering and Countering Financing of Terrorism Act 2009 (the AML/ CFT Act) on “reporting entities”.

A Parliamentary inquiry was established in July 2021 to look into “the current and future nature, impact and risks of cryptocurrencies” following a similar review conducted by the Australian Parliament. There will certainly be future developments in this area, and in particular, there may be scope for a bespoke regime that deals specifically with cryptoassets and services.

Countries making moves

Internationally, many countries and regions are introducing new regulations as the crypto sector develops – or even banning parts of the market entirely. Major moves over the past 18 months include:

The EU came to an agreement on the Markets in Crypto-Assets (MiCA) laws, which will introduce a common regime and EUwide ‘passporting’ approach to registration and licensing. This empowers the European Securities and Markets Authority to draft relevant standards and guidelines, for example, as to the disclosure of information related to adverse environmental and climate-related impact of actors in the cryptoasset market. It also improves consumer protection by requiring some entities, for example, stablecoin issuers, to maintain large and liquid enough reserves to better allow for mass withdrawals.

Russia has issued bans on the use of cryptoassets as a means of payment, though these have recently been relaxed in recognition that sanction laws are creating difficulties for conventional banking payments.

Ukraine is taking donations in crypto directly to fund its defence efforts.

The United Kingdom announced a goal of becoming a major investment hub for the cryptocurrency industry.

The United States continues to explore various regulatory options for the sector – most recently imposing bans on the use of certain crypto ‘mixing’ applications that mask the origin of crypto asset transactions (for instance, Tornado Cash).

China declared a ban on cryptoasset mining in late 2021, with many mining operators moving their equipment to other countries.

A range of countries have made moves to adopt bitcoin as legal tender including El Salvador, which adopted bitcoin as legal tender in 2021.

DEFI ‒ a distinct use case

One of the stand-outs of Web 3.0, decentralised finance (DeFi), has a distinct use case when contrasted with centralised exchanges. DeFi allows participants to trade or participate in markets without giving custody of their crypto assets to a third party. In the short time since the collapse of FTX, there has been a notable uptake in the use of these decentralised platforms.

DeFi poses challenges to the traditional financial system. The blockchain-based system offers financial services with no central authority: the middleman is replaced by a smart contract within a cryptocurrency wallet. A cryptocurrency wallet stores the keys enabling the cryptocurrency owner to access their asset, and smart contracts are effectively programmable operations built into a wallet which let it automate certain products or transactions.

DeFi provides cryptocurrency owners an avenue to make loans to earn yields, borrow money, issue financial products, and provide liquidity. Such services can operate across borders on a blockchain that offers transparency and a defined set of rules. Blockchains like Ethereum allow smart contracts on which DeFi platforms like Compound or Uniswap can be built. That platform or protocol allows holders of particular cryptocurrencies to lend in return for rewards. Coins can be moved around different protocols in search of the highest

yield. This is commonly called yield farming or liquidity mining.

Some DeFi projects have turned out to be exit scams that offered fantastically high returns – then disappeared with investor funds in what is termed a ‘rug pull’. A sudden crash in the price of a cryptocurrency TITAN has

drawn headlines around the world because US billionaire Mark Cuban confirmed he was among the investors caught up when large investors, known as ‘whales’, sold out and the currency lost nearly all its value. The team behind TITAN described it as “the world’s first large-scale crypto bank run”.4

Despite market conditions, DeFi continues to grow and evolve. As at November 2022, the total value of cryptoassets deployed into DeFi protocols is US$43 billion – up from US$15 billion at the start of 2021, but down from the all-time high of US$180 billion in November 2021.

NFTs ‒ from insurance to art

linked to a unique digital token and sold for US$69 million through a single-lot auction hosted by 255-year-old auction house Christies.5 Growth in NFTs is exploding in the art world and the market seems content that they have some intrinsic value, though what is being bought is a digital token linked to an image rather than ownership of a physical asset, or copyright.

There are still questions being asked about the value proposition. With no copyright it is possible that proposition is more akin to owning a rare collectible, where the value is from ownership of a rare item, rather than the value attributable to an asset that can be exploited.

WHO OWNS IT?

insurance contract – or a piece of art. This form of tokenization moved centrestage in 2021 with the sale of a unique piece of digital artwork. More than an image, the artwork Everydays:TheFirst5000Days was

The NFT market has certainly seen a fall in prices and volumes for digital artworks using NFT technology. However, alternative use cases for NFTs are being explored – for example, issuing concert or sports event tickets as NFTs to combat ticket forgeries. Other use cases include video games providing ownership of in-game assets (such as collectible costumes or avatars) via NFTs, or including NFTs with real world asset such as shoes or fine wine so that the authenticity of the asset can be confirmed.

As NFT use cases and utilities grow, legal questions will continue to arise in terms of their legal classification in terms of taxation and even potential security laws.

NFTs raise interesting intellectual property (IP) issues, in particular from a copyright perspective. As is often the case with new technologies, it can be challenging to fit NFTs into the traditional framework of IP laws. For example, many early purchasers of NFTs did not understand they were not purchasing the copyright in the tokenised piece of art; thus making it impossible for them to stop others, including the artist, from further monetising that piece of art. This shows that in contrast to the traditional approach to IP, which is about obtaining control over a work and securing exclusive rights to exploit it, NFTs are not so much about exclusivity or scarcity per se, but more about owning ‘the’ NFT for that particular work, like a unique, limited edition print of a well-known and otherwise widely available artwork.

Another interesting IP issue that has arisen in relation to NFTs is how it has allowed artists to regain some control over the monetisation of their work. For example, the code of the smart contract embedded in the digital token linked to Everydays:TheFirst5000 Daysincluded a right to “resale royalties”: every time Everydays is resold using a smart contract on the blockchain, its creator, Beeple, will receive 10 per cent of the resale price. While resale royalties are applied in many jurisdictions, including in Europe and Australia, they are not included in the New Zealand Copyright Act.

BLOCKCHAIN AND CRYPTOCURRENCY

Tax take, tax challenge

Tax collection agencies around the world are also watching crypto activity closely.

The Federal Court of Canada has ordered major crypto exchange, Coinsquare, to provide client information to the Canada Revenue Agency (CRA). The first-of-itskind ruling orders information including

certain value in transactions. It had previously issued a similar order to Coinbase in 2016.7

In New Zealand, Inland Revenue has taken a keen interest in the compliance of crypto investors, last year requesting firms dealing in cryptoassets pass on customer details. With the range of new options emerging through DeFi, it’s no longer a given that someone who buys cryptocurrency has the intent of selling it for profit – they may be buying a cryptocurrency in order to seek yield. Grappling with the changes that arise along with an ever-broadening array of cryptoasset types is the next challenge facing tax regulators in this space.

customer bank accounts, transactions, cryptocurrency types and trading activity to be provided.6

In April last year, a US court authorised the IRS to serve a ‘John Doe’ summons on a major digital currency exchange, Circle Internet Financial and its affiliates, requiring client details of taxpayers who had reached a

New Zealand has clarified some of its tax legislation – most notably confirming that most cryptoassets are exempt from GST and that the income tax ‘financial arrangement’ rules do not usually apply to cryptoassets. But there remains uncertainty as well as practical compliance issues for investors in this space.

An eye on the environment

Achallenge facing cryptocurrency

stalwart Bitcoin was one of the biggest stories of the year. The dramatic sell-off of cryptocurrencies in May was sparked by a tweet from Tesla CEO Elon Musk, in which he said Tesla had suspended bitcoin vehicle purchases out of concern over the “rapidly increasing use of fossil fuels for bitcoin mining”.8 Not all cryptocurrencies are built around mining (also called proof

of work), there are more environmentallyfriendly options that exist and some energy-intensive cryptocurrencies are rethinking their models. But earlier this year the energy use required by the crypto ‘mining’ process used to produce Bitcoin and similar cryptocurrencies saw the crypto world collide with another of the decade’s most significant macro trends, the push to combat climate change. Notably, the

second largest blockchain Ethereum has transitioned away from its own proof of work model and it now uses proof of stake which will mean that it is less exposed to any regulatory move that targets mining. Part of this change also included a change to the issuance of the Ethereum token with the total supply having become deflationary as more tokens are used for transaction

fees and removed from the system.

The US Government is also exploring possible solutions, with a report issued by the White House proposing various measures including further tracking the environmental impacts of digital assets, developing performance standards and providing local authorities with ‘tools’ to mitigate environmental harms.

Interest remains for institutions and business

Despite the market conditions, many institutions are still seeing opportunities for growth and potential new market products. In some cases, advanced regulations might provide the additional clarity that is needed to bring these to market.

For example, the CME group (which offers one of the world’s largest derivative

marketplaces) has issued an Ethereum futures product while Blackrock has launched a private trust to allow institution investors to invest into cryptoassets like Bitcoin. Other notable offerings in this space include the Greyscale Bitcoin Trust, Galaxy Digital, listed bitcoin mining companies (such as Marathon Digital) and exchange tradeable funds that focus on

the blockchain industry (for example, the Amplify Transformational Data Sharing ETF).

Many such institutions may be looking ahead to the future for a point when global markets enter a recovery phase and demand for cryptoasset exposure grows. An initial point of recovery may need to follow a phase of government regulation to protect

investors from any repeat of the FTX collapse – however, those regulations may encourage more participants if it is seen that there are sufficient protections in place. Many new institutional offerings or exchanges may need to include some form of security such as blockchain data that shows all funds are backed one-for-one and secure.

Endnotes

1 https://www.federalregister.gov/documents/2022/03/14/2022-05471/ensuring-responsible-development-of-digital-assets

2 https://www.rbnz.govt.nz/money-and-cash/future-of-money

3 https://www.atlanticcouncil.org/cbdctracker/

4 https://ironfinance.medium.com/iron-finance-post-mortem-17-june-2021-6a4e9ccf23f5 h

5 https://www.christies.com/about-us/press-archive/details?PressReleaseID=9971&lid=1

6 https://aboutbtax.com/WpL

7 https://www.justice.gov/opa/press-release/file/914226/download

8 https://twitter.com/elonmusk/status/1392602041025843203?s=20

Bell Gully’s practice

Our FinTech experts work closely alongside our technology, intellectual property, data, privacy, and corporate and tax specialists, to provide advice and targeted solutions for your business.

Whether you are a start-up, an established player embracing innovative products and services, involved in the sector or investing, our specialist team has the expertise to ensure that your venture has the best prospect of success. Our team has expertise in the space of technology, client advice on blockchain ventures and various cryptoasset investments. We have liaised with New Zealand government departments, including Inland Revenue, on related

policy and technical issues. We have a history of advising clients on ‘token generating events’, digital asset exchanges and payments including digital wallets and contactless solutions.

We can provide you with advice on:

• Navigating the regulatory and compliance environment and associated risks including – blockchain and other distributed ledger-based applications. Our regulatory experts can advise on the registration, licensing requirements, as well as on the full suite of securities, consumer credit and responsible lending laws, market conduct, anti-money laundering rules, and other prudential regulations for

banks, non-bank deposit takers and insurers.

• Data, privacy, cyber-security and customer trust, which is critical to most blockchain business models. Our team can unlock the value of your data by understanding current and emerging trends in data protection and privacy laws, as the "open data" movement challenges ownership and control of data as a valuable business asset.

• Intellectual property and contracting. We have specialties to advise you on how to best protect your proprietary algorithms and software, and assist in the negotiation of confidentiality and licensing arrangements.

• Capital structure, shareholder arrangements and governance. For maximisation of flexibility and future value, we can ensure your corporate and capital structure is fit-for-purpose and tax-efficient. We can utilise our international connections to provide you with multi-jurisdictional legal, regulatory and tax advice should you need to scale or look to offshore investors.

• Joint ventures and alliances, in a sector where we are increasingly seeing start-ups and incumbents entering into partnerships.

Bell Gully’s team

If you have any questions about this report, please contact one of the team listed below or your usual Bell Gully adviser:

TAX

BANKING AND FINANCE

Campbell Pentney

SPECIAL COUNSEL

DDI +64 9 916 8917 MOB +64 21 836 412 campbell.pentney@bellgully.com

Zac Kedgley-Foot

SENIOR ASSOCIATE

DDI +64 4 915 6820 zac.kedgley-foot@bellgully.com

BANKING AND FINANCE

David Craig

PARTNER

DDI +64 4 915 6839 MOB +64 21 674 851 david.craig@bellgully.com

CORPORATE

Toby Sharpe

PARTNER

DDI +64 9 916 8637 MOB +64 21 330 021 toby.sharpe@bellgully.com

DATA PRIVACY & CYBER SECURITY

Laura Littlewood

PARTNER

DDI +64 9 916 8928 MOB +64 21 828 429 laura.littlewood@bellgully.com

INTELLECTUAL PROPERTY

Sebastien Aymeric

SENIOR ASSOCIATE

DDI +64 9 916 8343 MOB +64 21 106 1369 sebastien.aymeric@bellgully.com

TECHNOLOGY CONTRACTS, FINTECH

Dean Oppenhuis

PARTNER

DDI +64 4 915 6921 MOB +64 21 317 697 dean.oppenhuis@bellgully.com

Acknowledgements

Our thanks to Bell Gully lawyers Lothar Krumpen and Sameer Mandhan for their assistance in preparing this report.

AUCKLAND VERO CENTRE 48 SHORTLAND STREET NEW ZEALAND

WELLINGTON

BELL GULLY BUILDING 40 LADY ELIZABETH LANE NEW ZEALAND

Disclaimer: This publication is necessarily brief and general in nature. You should seek professional advice before taking any further action in relation to the matters dealt with in this publication. The views expressed are our own. No client views are represented in this publication.

All rights reserved © Bell Gully 2022