17 minute read
Demystifying Cryptocurrency
A GUIDE FOR LAWYERS, PART II
By Daniel Wood
Introduction
This is the second installment of a three-part series that aims to provide an approachable introduction to cryptocurrency and blockchain technology for attorneys who may have had limited exposure to these concepts, but who want a basic grounding to understand how this complex and evolving technology might affect them and their clients.
The technology behind cryptocurrency and blockchain is likely to continue reaching into new sectors, changing the way people and businesses conduct transactions.
In Part One, we covered some basic concepts about both cryptocurrency and blockchain, including the history of Bitcoin. For purposes of understanding the topics in this article, the key takeaways from Part One are:
• Bitcoin was the first implementation of cryptocurrency and blockchain technology.
• A cryptocurrency is a digital token or coin that relies on cryptographic techniques for its security and functionality.
• A blockchain is the underlying technological structure on which most cryptocurrencies are based, serving as a peer-to-peer network and a public ledger that records every transaction involving any coins or tokens on the network.
• Every computer program (often called a client) connecting to the blockchain becomes part of the peer-to-peer network.
• Each token or coin is a unique string of characters that cannot be duplicated or counterfeited and is associated with a unique address (i.e. a wallet) that represents possession of the token. The blockchain records the transactions such that each peer on the network can see the address associated with a particular token.
• The peer-to-peer network collectively performs mathematical calculations to verify the validity of each and every transaction. It is therefore nearly impossible to fake a transaction.
• Transactions are essentially processed automatically by the blockchain protocols, removing the need for a trusted intermediary (such as a bank or payment processor) to perform transfers.
In this article, we will build on these concepts to explain some of the advancements that have developed in the years since Bitcoin was introduced.
Altcoins
In January 2009, the software that created Bitcoin was released under the pseudonym Satoshi Nakamoto. Satoshi Nakamoto uploaded the software to a free, open-source repository, making the code itself available to everyone. This means that anyone who wishes to do so can download a copy and view the code that comprises the Bitcoin software. Naturally, this eventually led to developers creating new cryptocurrencies using the Bitcoin code as a blueprint.
As early as September 2010, users on an online Bitcoin forum began discussing a hypothetical new coin based on the Bitcoin source code. In April 2011, this new cryptocurrency was launched as Namecoin. Among several innovations brought by Namecoin, it gave us the concept of alternative coins—or altcoins. Literally, altcoins are alternative cryptocurrencies to Bitcoin. Several more altcoins followed closely after Namecoin, but it was not until 2013 that most altcoins began listing on cryptocurrency exchange sites, which caused the most popular ones to gain steam. Today, according to CoinMarketCap.com, there are more than 23,000 cryptocurrencies.
Generally, most viable altcoins are attempts to add new functionality or improve upon some aspect of Bitcoin. For example, one of the main purposes behind the creation of Namecoin was the ability to store data within its blockchain— an absolutely crucial and valuable development in the crypto space. However, because the source code for Bitcoin (and now many altcoins as well) is free and easily available, there is virtually no barrier to entry for creating new altcoins. The result is that we have over 23,000 altcoins—and counting!—zipping around the internet. It is safe to say that many altcoins have no practical purpose for most people, and the majority are quite volatile.
One particularly amusing example is Dogecoin. In December 2013, two software engineers decided to turn a popular internet meme (the image of a shiba inu known as “doge”) into an altcoin as a “joke” (to use their own words). They intended to poke fun at the volatility rampant in crypto markets and the fact that altcoins were cropping up like weeds, often making sizeable short-term profits for their developers and a lucky few speculators. Ironically, enough people took the joke seriously that Dogecoin became a viable cryptocurrency. The joke never fizzled out. Currently, Dogecoin is the ninth biggest cryptocurrency in the world, with a market cap (the total value of all a cryptocurrency’s coins in circulation) of approximately $10.5 billion. Who’s laughing now?
Most altcoins are meant to function as cryptocurrencies: they are used as a medium of exchange in transactions and can serve as a store of value and unit of account. As discussed in Part One of this series, these are the core features of money. Some altcoins, though, are meant for more narrow, utilitarian purposes. Just as the two core components of Bitcoin are the crypto coin and the blockchain, altcoins generally seek to advance the functionality of either crypto coins or blockchains (or sometimes both).
For example, one early altcoin was Litecoin, conceived as a “lite” version of Bitcoin. The developers who created it viewed Litecoin as the silver to Bitcoin’s gold. Litecoin’s blockchain cut down significantly on the amount of time it takes the network to verify a transaction. In practical terms, where a Bitcoin transfer can take around ten minutes to be verified by the network, Litecoin transactions usually take less than three minutes. Litecoin is a great example of a cryptocurrency being developed to improve on one specific aspect of existing cryptocurrencies.
Coins Versus Tokens
It may be helpful to take a quick detour to discuss the difference between coins and tokens. Many people use the terms interchangeably, but there are distinctions between the two:
Coins are generally cryptocurrencies designed to operate as money. Usually, a coin operates exclusively on a specific blockchain, the way that Bitcoins operate on the Bitcoin blockchain, and cannot be used in their natural form on other blockchains. Most coins are decentralized (operating on a distributed, peer-to-peer network) and dependent on cryptographic protocols. Bitcoin, Litecoin, and Dogecoin are all examples of coins.
Tokens provide functionality or value other than as a form of money. For example, some tokens allow users to access decentralized applications (DApps), perform certain functions, or use certain services of a blockchain. These are usually called utility tokens. Others may give owners the right to vote on governance issues of a particular blockchain or DApp (governance tokens), or represent an ownership stake in, or income stream from, an enterprise (security tokens). One of the most famous types of token is the non-fungible token or NFT. NFTs are representations of digital items, which may be tied to real-world things. Often, tokens are able to operate on different blockchains. Because tokens are usually created for their utility, rather than as a form of money, they are not necessarily decentralized. Often they are issued and administered by a centralized authority.
Coins and tokens can be thought of as different species of the same genus. They are generally unique strings of characters associated with a unique blockchain address and are transferred from one address to another using similar protocols. Although this may seem confusing, in most circles both coins and tokens fall under the umbrella term of altcoins.
Stablecoins
Stablecoins are a type of altcoin designed to combat one of the most common cryptocurrency problems: volatility. A stablecoin is a cryptocurrency whose value is stabilized through some mechanism, most commonly by pegging the stablecoin to the value of another asset that is (hopefully) relatively stable. While the majority of stablecoins today gain their stability from being backed by other assets, there is another type of stablecoin that maintains value through algorithmic control of the stablecoins circulation supply. This type of stablecoin is referred to as Seignorage stablecoins. Seignorage coins do not have any assets in reserve as collateral. Instead, they rely on an algorithm to mint more coins when the value is high or remove coins from circulation (called “burning”) when the value is low. It is similar to a central bank that prints or destroys currency to artificially maintain a stable value. Seignorage style coins are heavily disfavored today. Instead, most stablecoins currently in wide use are backed by assets held as collateral.
The first stablecoin was called BitUSD. Released in July 2014, BitUSD runs on the BitShares blockchain. BitUSD was designed to remain stable by pegging to another digital asset, namely the BitShares native token, BTS. The developers designed the platform so that more BTS was locked away on the BitShares blockchain as collateral than the US dollar value needed to keep BitUSD at a value of 1 dollar. In other words, if BTS were valued at 50 cents each, the protocol would lock 4 BTS as collateral for each BitUSD, thereby ensuring that even if the value of BTS fluctuated, the stablecoin BitUSD would remain valued at no less than $1.00. This system was imperfect, and BitUSD eventually ended up dropping below $1.00 sometime in 2018. Today, it still fluctuates around 80 cents, but the underlying concept of a stablecoin proved viable.
The basic concept of stablecoins is simple enough, but there is a confusing array of flavors even among asset-backed stablecoins. Most commonly, stablecoins can be backed by fiat currency, digital assets (such as other cryptocurrencies), commodities, or a portfolio combining any of the three. A simple example would be a stablecoin pegged to the US dollar by a reserve of actual US currency held by the administrator of the stablecoin in a ratio of 1:1, meaning for every coin in circulation, the administrator holds one US dollar in reserve. But some stablecoins might use a reserve consisting of multiple global currencies, or a combination of commodities like gold and silver together with fiat currencies.
Critics of many stablecoin issuers have complained about lack of transparency regarding exactly what assets are held in reserve. When investing in, or dealing with, stablecoins, it is important to research the underlying reserve and understand as much as possible about what assets are held, whether there are independent audits of the reserve available to the public, and how an owner of a coin can redeem the coin for assets from the reserve.
Programmable Blockchains
By contrast to the altcoin projects focused on creating new coins, an example of an altcoin designed mainly to evolve the functionality of the blockchain is Ether, which is the native token that runs on the Ethereum blockchain in the way that Bitcoin is the native coin that runs on the Bitcoin blockchain. Ethereum was originally conceived in 2013 and released in 2015. Where Bitcoin was envisioned as a decentralized and democratized replacement for money, Ethereum was mainly developed to leverage blockchain technology to serve as an operating environment for DApps that go beyond just exchanging value.
Ethereum was created by a non-profit organization called the Ethereum Foundation and provides developers with a toolkit and a programming language to build projects that run on a blockchain. Ethereum was built from the ground up rather than using the Bitcoin source code, but its blockchain and network operate in a somewhat similar manner. This allows developers to leverage the peer-to-peer, decentralized nature of a blockchain to build tokens and applications that benefit from such an operating environment.
For example, Ethereum created a technical standard called ERC-20 that allows a developer to create a token that runs on the Ethereum blockchain. As a result, numerous types of tokens can be created within the same Ethereum ecosystem, each with different features or functionality, which can be exchanged for one another on the same blockchain. Ethereum’s ERC-20 token is also the most common token used for smart contracts. A smart contract is essentially a self-executing, programmable set of terms and conditions that operates on a blockchain.
We will delve into smart contracts and DApps in Part Three of this series. For now, the important point to remember is that just as cryptocurrencies advanced and proliferated, so did blockchains, offering functionality well beyond simply providing a rail for transferring digital assets.
Initial Coin Offerings
During the period from 2017 through 2018, initial coin offerings or ICOs seemed to be everywhere. This ICO boom brought public awareness to a new use case for crypto assets. ICOs were structured to resemble an initial public offering of securities (which incidentally ran a lot of companies conducting ICOs into trouble with the SEC) and served a similar purpose: to raise capital. One of the main differences is that an ICO is accessible to any individual with the digital savvy to set up a blockchain wallet and use crypto tokens. Another is that the investor does not necessarily receive a share of ownership in the entity. Instead, the buyer would generally receive a utility token.
In its heyday, the ICO was an effective way for a project to raise funds outside of the usual venture capital channels. Despite the use of the word “coin” in the name, ICOs usually involved utility tokens instead of true coins. In particular, most ICO tokens were created using Ethereum ERC-20 tokens. The enterprise conducting an ICO would offer crypto tokens for sale to the general public and the tokens would entitle buyers to certain rights or privileges. For example, the token might grant access to a particular product or service from the issuing organization, confer a voting right in the governance of the project, or entitle the owner to a share of the profits derived from the project. There was great variety across the types of tokens involved in ICOs.
Some ICOs ran afoul of securities law, and the SEC is still prosecuting some of these cases. Other ICOs were fraught with deceptive claims and fraud. But some ICOs successfully launched projects or enterprises. One key takeaway from the ICO boom is that blockchain technology can be an attractive way to raise capital. It takes very little programming to create a token on a programmable blockchain like Ethereum. The token is then available instantly on a global market that operates 24 hours a day, with little barrier to entry for individuals seeking to get involved. Some entrepreneurs continue to raise capital by selling utility tokens.
NFTs
You may have heard a lot about NFTs from around 2018 through 2021. A lot of news stories focused on ridiculous sums of money that people paid for things like a digital drawing of an ape. Beyond the sensationalized news stories, NFTs can serve a useful purpose, though. It is relevant here because NFTs are a form of crypto token that evolved from Bitcoin.
An NFT is a form of utility token, similar in concept and technical description to a Bitcoin or an altcoin. However, the most important characteristic of an NFT is that each token is differentiated from other tokens on the blockchain—that is, they are not fungible. Each NFT is a unit of data on the blockchain that represents a unique item of digital content. The digital content represented by an NFT must be something that was created in a digital medium (such as a digital image) or be a digital representation of a real-world object. Because non-fungibility is the key characteristic of an NFT, a person can create multiple editions of a digital work as multiple NFTs, but each is unique, much like a numbered copy of a limited edition print.
If you are not already familiar with the idea of fungibility, an object is fungible if it is interchangeable with another of its kind. For example, dollars are generally fungible: although each might have a unique serial number, there is no aspect of any particular dollar bill that differentiates it from another dollar bill. Gold and other commodities are generally fungible, as well. If a person buys an ounce of gold, that ounce is generally interchangeable with any other ounce of gold. An object is non-fungible if it has unique qualities that differentiate it from others of its kind in a meaningful way. For example, paintings by Vincent Van Gogh are nonfungible.
The idea of NFTs was first discussed in a whitepaper in 2012. The whitepaper looked at Bitcoin and posed the idea that certain individual Bitcoins could be differentiated from others—the whitepaper used the term “colored coins”—and thereby gain greater utility than simply as a form of currency.
The code creating an NFT is a smart contract. Most of the NFT smart contracts are very simple, sometimes as little as 1020 lines of code, but there is great potential for complexity as the form and use of NFTs evolves. The smart contract code underlying an NFT can include more than just the digital object itself, such as descriptions, features, or traits of the object, financial terms related to it, or specific rights granted to the owner.
An NFT can represent anything that exists as a digital file or can be represented by a digital file. As such, there are very few restrictions on what type of content can be tokenized into an NFT. Some examples include original artwork, trading cards, sports figures, or potentially even financial instruments like mortgages, deeds, or property titles. And because an NFT exists on a blockchain, each transfer of the NFT is indelibly traced and recorded from the moment it is minted.
You may be asking, “Okay, but, like, what do you actually get when you get an NFT?” The answer is one of the most lawyerly answers possible: it depends. It depends on the NFT and the object it represents. The NFT could simply provide a way to authenticate ownership. For example, if the deed to a parcel of real property were recorded as an NFT instead of on paper in the county clerk’s office, the NFT would prove the chain of ownership of that property. An NFT could also provide certain legal rights. For example, an artist could raise money by minting an NFT representing a percentage of royalties in a work of art. The owner of the NFT would thus have a right to collect royalties from the artist for reproductions of the artwork. NFTs can also be used for all manner of recordkeeping, from personal identification to health records. The uses of NFTs are limited mostly by people’s willingness to adopt NFTs.
Conclusion
What started with Bitcoin has expanded and evolved into numerous other use cases.
This article has barely scratched the surface of how blockchain and crypto tokens are being used today. The key takeaways to remember are:
• After Bitcoin, came other forms of cryptocurrency, generally called altcoins.
• Blockchain protocols can also create tokens that serve utilitarian purposes rather than functioning as a form of digital currency.
• Stablecoins are a major type of cryptocurrency that are designed to maintain stable value, usually by being backed by other assets with less value fluctuations than non-stablecoin cryptocurrencies.
• There are different methods used to create stablecoins, and caution should be used before investing in, or using, a stablecoin without first investigating how the coin’s value is established and what redemption rights an owner has.
• In addition to developments in crypto coins and tokens, the blockchain has also evolved. Ethereum, in particular, has driven developments in the uses of a blockchain for more than a rail for transferring cryptocurrency.
• Tokens have been used in numerous ways, such as to raise capital (ICOs) or to create unique objects stored and tracked on a blockchain (NFTs).
In the final part of this series, we will explore other blockchain functionality and use cases, as well as certain aspects of the legal landscape related to these technologies.
