19 minute read
Demystifying Cryptocurrency
A GUIDE FOR LAWYERS, PART III
By Daniel Wood
Introduction
It’s pretty cool living in the future.
This is the third and final installment of a series of articles intended to provide attorneys, of all knowledge and experience levels, with an approachable introduction to cryptocurrency and blockchain technology. The series is also intended to help you see past the clickbait headlines about the Crypto Winter and $400,000 NFTs of cartoon apes to get an idea of the technological marvels that might just change how we do business.
As a quick recap, the following are some of the key points from the first two parts of the series, to help inform the topics covered in Part 3:
• A crypto coin or token is a string of unique characters that is associated with an address (a wallet) on the blockchain and can be moved from one wallet to another but can never be copied or counterfeited. Coins are generally used as a form of digital money, while tokens provide some utility, such as access to the functionality of a distributed application (dapp—more on those below). Sometimes the terms “coin” and “token” are used interchangeably, but there are technical differences between the two.
• The blockchain is a technological platform that forms a peer-to-peer network of every user of the software and creates a publicly accessible ledger that records every transaction involving the coins (such as Bitcoin) or tokens (such as NFTs) that exist on the network.
• The nature of a peer-to-peer network is that there is no central administrator or authority; the network operates automatically, with each user (called a client) having an equal role in the performance of the network. This distributes across all clients both the computational labor and the recordkeeping required to implement the system and keep it running.
• Transactions are processed automatically by the blockchain protocols, which removes the need for an intermediary.
• Some blockchains, such as the Ethereum network, were created to support new uses for blockchain technology such as dapps (which can also be written as dApp, Dapp, or DApp—there are no rules; we live in chaotic universe).
This article will dig a little further into the concept of decentralization that is a core part of blockchain and crypto technology and introduce the developments that are taking blockchains from cryptocurrency networks to a massively expanded universe of functions and industries.
Trusted Intermediaries
Before we explore decentralization, we should first discuss centralization. The idea that every system we use in everyday life— money and banking, for instance, or a social media platform—is run by someone is taken for granted to such an extreme that the parties involved in facilitating, administering, and controlling the various systems we interact with daily are effectively invisible. They are like the air: until you are deprived of them, you are likely unaware of their presence.
In the context of financial or commercial transactions, these centralized authorities act as trusted intermediaries that provide security and efficiency in an exchange between two parties that may not know or fully trust one another. When a person goes to a clothing store and pays with cash, there is no need for an intermediary: each party contemporaneously receives what he, she, or it bargained for (cash for the store and clothes for the customer). However, when the customer pays by check or credit card, neither the customer nor the store clerk may even realize that he, she, or it needs an intermediary to complete the transaction.
When a customer pays by check, for example, both the customer’s bank and the store’s bank become involved. In its simplest terms, the store’s bank receives the check, endorsed by the store, and contacts the customer’s bank to confirm that the customer’s checking account has sufficient funds to cover the check. After certain other procedures are followed, the customer’s bank deducts the funds from the customer’s account and transfers them to the store’s bank. Upon settlement, the store’s bank credits the store’s account with the funds. All of these steps happen without the input or knowledge of the two parties to the transaction.
Similarly, if the customer pays by credit card, a point-of-sale terminal reads the customer’s credit card information and communicates that information to the bank that issued the credit card. A third party under contract with the store—a payment processor—operates the systems that communicate with the card-issuing bank and the store’s bank. The processor verifies the availability of funds or credit associated with the card and instructs the card-issuing bank to send funds to the store’s bank account.
As has been the case with every major new technology in the past—from automobiles to computers to the internet—it is not necessary to understand the inner workings to be able to use them or to provide clients with guidance about them.
As a different example, consider escrow agents. In certain transactions, the escrow agent steps between the parties to verify and handle both money and documents or goods. In a real estate transaction, for instance, the escrow agent holds both the funds and certain documents necessary to close the transaction. The escrow agent ensures that the buyer pays good funds for the transaction and that the seller provides the goods or necessary documents. Then, upon completion of all contractual conditions, the escrow agent releases the escrowed funds or goods to the other parties.
In all of these examples, trusted intermediaries act as impartial entities, mitigating risks and building trust between transacting parties by verifying and facilitating the exchange of value. Bitcoin brought about the possibility of using blockchain technology to replace the human-based trusted intermediaries with automated, programmatic systems that obviate the need for any human intervention.
Dapps
As explained in Part 1 of this series, the bitcoin protocols create a peer-to-peer network by joining each computer running the client software together. The source code that runs the Bitcoin protocols includes a set of complex rules that allow the network to effectively run autonomously, leveraging the computational contributions of each software client on the network. Peer-to-peer networks are generally decentralized—there is no central administrator controlling access to, and the functions of, the network.
In the case of Bitcoin, the blockchain network mainly functions to allow the creation and transfer of its cryptocurrency between users. It mimics existing monetary systems, like the Federal Reserve banking system and Fedwire, but removes the trusted intermediary—the Federal Reserve—replacing it with a set of protocols that generally function without human control. When a person transfers Bitcoins to another person, there is no need for a financial institution to verify the value being transferred and perform clearing and settlement services the way that banks intermediate electronic transfers of dollars. The Blockchain network takes over that role.
The development of dapps takes this concept and applies it to more complex functionality, such as gaming, financial services, supply chain management, and social media platforms. Dapps usually look and behave like any other app you might have on your devices, but because they run on a blockchain, they typically come with additional security, transparency, and user control. In some cases, the lack of trusted intermediaries can reduce costs, as well. However, despite the potential for truly disintermediated transactions, many dapps are released by forprofit organizations who find ways other than trusted intermediation to generate revenue—which is to say, some critics argue that truly administrator-less dapps are rarer than one might think.
When Ethereum was launched in 2015, its core concept was to build upon the foundation of blockchain technology pioneered by Bitcoin to create an operating environment for decentralized applications. The Ethereum Foundation built its blockchain network with developers in mind, giving them a programming language and tools to dream up and build new decentralized applications. Developers have been releasing dapp projects on Ethereum ever since; but before we delve into some of the more notable types of dapps, it is important to understand smart contracts.
Smart Contracts
As lawyers, the first thing you should know is that smart contracts are not really contracts. In law school, we all learned that a contract is an agreement between parties that creates mutual obligations that are enforceable by law. By contrast, a smart contract is a blockchain-based software program, although it is more similar to contracts, as we know them, than might seem obvious at first.
The idea of smart contracts was first conceived in 1994 by a computer scientist named Nick Szabo. As originally expressed by Szabo, a smart contract is “a computerized transaction protocol that executes the terms of a contract.” Put another way, a smart contract was envisioned as a tool to automate the performance and enforcement of an agreement. Though the idea was put forward in 1994, smart contracts did not become a practical reality until Ethereum launched.
Today, smart contracts are the atoms that make up dapps on programmable blockchains like Ethereum. Written in a specialized type of computer code, smart contracts are a series of rules and functions that follow a basic “if X happens, then perform Y” pattern. More than that, though, smart contracts are also a form of blockchain wallet: they have an address (remember: a unique string of characters that tokens can be associated with) on the blockchain and can receive, hold, and transfer tokens just like a Bitcoin wallet does with Bitcoins. Generally, smart contracts are permissionless (any user on the peerto-peer network can write and deploy one) and cannot be altered once they are deployed on the blockchain. Users can interact with a smart contract in a number of ways, most simply by submitting token transfers to the smart contract address.
Here is a simple example: for a transaction in cryptocurrency, a smart contract can take the place of an escrow agent. A buyer named Bob and seller named Sally may agree on the terms of a sale of one cryptocurrency for another. They write a smart contract and deploy it on the blockchain. Bob sends his cryptocurrency payment to the smart contract address. The smart contract holds the cryptocurrency, which cannot be transferred out of the smart contract unless the specific conditions written into the smart contract are met. When Sally sends her cryptocurrency to Bob, which satisfies the terms of the smart contract, the smart contract then automatically transfers the escrowed cryptocurrency to Sally. If, instead, the conditions are not met, then at a prescribed time, the smart contract transfers the escrowed cryptocurrency back to Bob, and the deal is off. The smart contract in this example uses the blockchain to provide a decentralized and trustless way to secure the transaction without the parties having to rely on a centralized (and potentially expensive) trusted intermediary like an escrow agent.
Smart Contract Limitations and Risks
Smart contracts can, of course, be much more complex. They can even deploy other smart contracts; but they are not without limitations and risks. For one thing, because they exist only on a blockchain, smart contracts cannot, by themselves, gather any information that is not also on the blockchain. For instance, if in our escrow example, the agreement involved Bob buying US dollars from Sally, the smart contract would have no way of determining whether Sally had sent the real-world currency in order to release Bob’s escrowed cryptocurrency payment. To solve this problem of off-chain conditions, developers use oracles.
It is easiest to think of an oracle as an application that is able to communicate with sources outside the blockchain. An oracle can usually send information from the blockchain to external systems, as well as pull and verify information from external systems to the blockchain. In the previous scenario, Bob and Sally could use an oracle that is able to pull data from Bob’s online banking account. When Sally’s payment is deposited into Bob’s bank account, the oracle pulls that information and updates the smart contract. The smart contract, triggered by the oracle’s update, automatically transfers the escrowed cryptocurrency to Sally’s blockchain wallet.
Or imagine another real-world example. Bob owns a vacation home and wants to rent it to Sally for a week in July. He installs a smart lock on the front door of the house and writes a smart contract based on the terms he and Sally agreed to. Sally sends Bob an electronic bank transfer to pay for her vacation week. One oracle pulls the information from Bob’s bank account to verify that the correct payment was made, then updates the smart contract. Because the required condition in the smart contract is met, it executes a function that tells another oracle to send a command that unlocks the smart lock on the front door of the vacation home. After one week, the smart contract instructs the oracle to lock the smart lock again.
But what if something goes wrong?
Because smart contracts are programs written by humans, they are subject to all the same problems as any other piece of software, such as coding errors, vulnerabilities, or exploits. Smart contracts cannot be hacked once they are deployed, but mistakes in the code can lead to unintended consequences. Additionally, the legal status and enforceability of smart contracts is very much in flux. What if Bob’s smart contract contained an error that resulted in its locking Sally out of the vacation house after only one day? If Bob refuses to refund Sally’s money, what are her options? If the parties relied entirely on the smart contract and an oral agreement, the resulting dispute could be difficult for a court to resolve.
Attorneys encountering smart contract situations should understand that thorough code auditing and developer best practices may be important considerations. In some instances, drafting a traditional written contract in conjunction with a smart contract may mitigate these risks and provide more certain remedies or dispute resolutions. Also understand that the selection of oracles for use with a smart contract can be an important part of a deal. Oracles can be developed by the parties to a transaction or, more commonly, by third-parties; they can be decentralized or centralized; and they can use a single data source or multiple data sources. The security and quality of oracles is a crucial element of complex smart contracts.
DeFi
DeFi—short for decentralized finance—is a type of dapp used to deliver certain financial services using a decentralized model. The most common financial services provided through DeFi are trading, lending, and borrowing. As you may have already figured out, by decentralizing the delivery of financial services, DeFi replaces the central authority of a financial institution (like a bank) with the distributed, peer-to-peer blockchain network.
DeFi generally requires complex smart contracts to deliver the services.
As an example, a decentralized exchange (DEX) is a platform that allows users to trade cryptocurrencies with each other, making transfers from one user’s wallet to another’s through the use of smart contracts. The DEX acts as a marketplace or matching service. The example of Bob and Sally trading cryptocurrencies is a simple version of a DEX. In many cases, though, the buyers and sellers using a DEX will never know each other. When users want to trade on this type of DEX, they send their cryptocurrency to a smart contract address. In addition to holding the cryptocurrency in escrow, the smart contract will match the buyer with an appropriate seller and then execute the trade automatically when the applicable conditions are satisfied. Alternatively, smart contracts can be configured to accept and execute trade requests directly from one user’s wallet to another’s, without holding the digital assets in the smart contract wallet.
DeFi can also include democratized lending models. Instead of borrowers applying for loans from banks or consumer lending companies, they can use cryptocurrency and leverage automated crowdfunding. Here is how it works. Users who wish to lend their digital assets can “deposit” cryptocurrency into the DeFi lending protocol (e.g., by sending cryptocurrency to a smart contract). The protocol pools the assets deposited by various lenders. The terms of the smart contract may, for instance, return interest in one form or another to the lenders. Borrowers can borrow assets from the liquidity pool by providing collateral of some kind, also received and held by a smart contract. Often, the interest rates are algorithmically determined, based on the general market supply and demand for the cryptocurrency involved. When the borrower finishes repaying the loan, the smart contract automatically releases the collateral. Lenders who wish to exit the liquidity pool can withdraw their digital assets—provided they have met whatever requirements may have been in place—and receive interest on their deposits. All of the above happens automatically, executed by smart contracts, with no need for a central lender.
Pros and Cons of DeFi
DeFi has potential to provide a number of benefits that might be preferred over traditional, centralized financial service providers. If a DeFi operates on a public blockchain like Ethereum, the underlying code of a smart contract is generally viewable by all parties—by all users on the network, in fact— after it has been deployed on the blockchain. There are software tools available, such as blockchain explorers, which allow any user on the network to find the smart contract’s address and inspect its code. This transparency enhances trust and security, and once data has been written to the blockchain it cannot be altered or erased, which reduces the risk of unauthorized or fraudulent changes. Further, because a blockchain contains a publicly available distributed ledger that records every transaction, every user can see any transaction going back to the launch of the DeFi. This also enhances trust and accountability. Additionally, the distributed architecture of a DeFi service, as with all dapps, makes it less susceptible to single points of failure (such as a network outage or natural disaster) or cyberattacks; and the most commonly cited benefit is lower—in some cases, substantially lower—costs.
There are also some cons, however. As noted above, smart contracts can have coding errors, and the quality and security of the oracles that smart contracts depend upon can vary. Because DeFi platforms are fundamentally dependent on the use of smart contracts and oracles, they inherit the vulnerabilities and risks of these elements. Financially, DeFi platforms can be risky to users simply because of the volatility inherent in many cryptocurrencies. In addition to sudden price fluctuations, rapid market changes can cause liquidity problems; and the legal landscape remains somewhat unsettled for many DeFi platforms, which means regulatory changes or enforcement actions can happen suddenly, affecting the operation of a DeFi platform.
Other Notable Dapps
We will run out of space long before we run out of blockchain topics, but it is good know a little bit about some of the ways that distributed, peer-to-peer blockchain networks are developing:
Gaming. For example, launched in 2017, CryptoKitties is a blockchain-based collectible game where users collect, breed, and trade virtual cats. Each CryptoKitty is an NFT—a unique crypto token—which contains “DNA” and certain attributes that can be inherited by offspring of CryptoKitties, who are bred. Because the CryptoKitties are NFTs, users can buy and sell them on the secondary market, all without the intervention or administration of the developer of the game.
Distributed computing. Golem is a platform that allows users to contribute their computers’ processing power to a global network of shared computing resources in return for rewards. While a user’s computer is idle, the Golem protocol borrows the computer’s processing power, forming a massive network of such computers all working together. Developers can then use this powerful distributed computational power for more ambitious projects than might otherwise be feasible.
Supply chain management. A number of supply chain solutions have been created as dapps. By recording parts or products on a blockchain, participating businesses can track and verify their goods throughout the supply chain. This can reduce fraud and enhance efficiency.
Social media. There are several decentralized social media platforms that remove the for-profit, ad-based model of centralized social media platforms. Some reward users for creating content, while others focus on preserving user privacy and complete freedom of expression. Generally, these platforms provide users with increased control over their data and content.
DAOs. A decentralized autonomous organization (DAO) is an organization that is managed by operation of a peer-to-peer network on a blockchain. Governance is usually conducted through proposals that members vote on through the blockchain. Members gain voting rights by acquiring and using tokens or NFTs that convey voting power and certain other rights within the DAO. More of an organizational model than an application, DAOs can be created for any purpose. One was created for the purpose of purchasing an original copy of the United States Constitution. Others have been created to issue and manage stablecoins, as democratized venture capital enterprises, and to operate DEXs, as just a few examples.
Conclusion
For lawyers who do not practice in technology-heavy areas, it may be tempting to ignore developments in cryptocurrency and blockchain. But these technologies are incredibly flexible, going well beyond digital money or NFTs of cartoon characters, and will be changing whole industries in the decades to come. As has been the case with every major new technology in the past— from automobiles to computers to the internet—it is not necessary to understand the inner workings to be able to use them or to provide clients with guidance about them. Blockchain networks and applications appear to be growing, not shrinking, so arm yourself with knowledge now to prepare for whatever is to come. Cryptocurrencies and blockchain may not be the future that was dreamed about, but even without the flying cars and personal jetpacks, it is pretty cool living in the future.
