Demystifying Cryptocurrency:

A GUIDE FOR LAWYERS, PART I

By Daniel Wood

Introduction

In this era of accelerating technological progress, the legal landscape evolves constantly, sometimes leading to confusion and challenges but also presenting new opportunities. One of the emerging frontiers driving changes to a broad array of laws is cryptocurrency and blockchain, a digital revolution that has transformed the way we perceive and experience financial services. Cryptocurrency is, quite literally, the first truly new form of money since paper banknotes, and its potential as digitized value is only a small part of the expected impact of this technology on our lives. This dynamic and complex technology is not just for crypto-bros, speculators, and money launderers. Blockchain technology can drive fundamental shifts in multiple sectors. Like the advent of the internet, it will likely reach its fingers into numerous areas of our lives, sometimes without our realizing it. For lawyers who may not have extensive technology expertise, understanding this complex area may seem daunting but is of growing importance.

This three-part series aims to provide an approachable introduction to cryptocurrency and blockchain, breaking down fundamental concepts, legal developments, and practical implications. No prior technological expertise is needed. After all, one does not need to understand mechanical engineering to drive a car. In this first installment, we will walk through the basic concepts of cryptocurrency and the blockchain, with a focus on the use of cryptocurrency as a new form of monetary value. Later in the series we will delve into other evolutions and use cases for this technology as well as some legal and regulatory considerations. The aim of the series is to give attorneys from all practice areas a sufficient grounding to understand how cryptocurrency and blockchain might affect them and their clients, and to better contextualize new developments.

Key Takeaways

• Cryptocurrency is a digital token that relies on cryptographic techniques for security and operability, and can substitute for money.

• A blockchain is the underlying technology of most cryptocurrencies, serving as both a network and a public ledger to record cryptocurrency transactions.

• Blockchain-based cryptocurrency offers decentralization (also sometimes called disintermediation) that enables peer-to-peer transactions without the need for trusted intermediaries like banks or payment networks.

• There are both pros and cons associated with cryptocurrency.

What is Money?

Before we consider how cryptocurrency is revolutionizing money, it may be helpful to pause and contemplate what money actually is. We all use it every day. It’s the lifeblood of modern societies. But many of us would struggle to give a proper definition off the tops of our heads. Going a step further, have you ever thought about why we use money and where it came from?

At its most fundamental level, money is a portable and transferrable representation of labor. Early on in the development of human society, social groups typically used a barter system: a fisherman trades some of his fish to a farmer for some of his vegetables so that both people can benefit from having both fish and vegetables. (This may not be an anthropologically accurate scenario, but just go with it.) A barter transaction revolves around the relative value of the goods involved, and core components of that value are the effort, skills, and time that go into the goods being traded. The parties literally trade the products of their labor. Unfortunately, barter economies are incredibly inefficient and unwieldy. (Just consider how much fun it would be to carry a barrel of fish to a shopping mall to trade for some new shoes, a pair of sunglasses, and an iPhone.) So along came money.

To solve the problems inherent in a barter system, our clever forebears came up with the idea of using smaller, more portable objects that would represent a universally agreed-upon amount of human effort. As an overly simplified and completely made-up example, if it takes an hour of human labor to catch five fish and an hour of human labor to harvest a pound of carrots, then either we can trade five fish for a pound of carrots, or we can agree that a small object (maybe a small circular slice of a precious metal, as just one example) represents one hour of human labor. This idea unlocks the ability to use these small objects as intermediary trade goods—a medium through which we ultimately exchange the goods and services that are the products of our labors. Hence, we often use the term “medium of exchange” to define, in part, money and monetary value.

Generally, anything considered a currency—i.e. money—serves three basic roles in the society that uses it. Specifically, currency is: (1) a medium of exchange for transactions of goods and services; (2) a standardized numerical unit that can measure the value of things (a “unit of account”); and (3) an asset that retains purchasing power so it can be used in the future (a “store of value”). These days, the three roles are typically assigned and enforced by a government. For example, a reason the U.S. dollar functions in all three roles is because federal law requires that it must be accepted for all public debts and payments, and the federal government carefully controls its creation and administration. But at its heart, the dollar, like all currency, is a way to represent human labor.

One of the key points is that any object—seashells, coconuts, tulip bulbs, coins, bits of paper—can be a currency so long as we universally agree that it fills these three roles. When a society makes such an agreement, the otherwise valueless thing becomes valuable as a currency. In the case of a government-issued currency like the U.S. dollar, we agree it has value because the government has mandated that it must be acceptable as a medium of exchange, and therefore naturally becomes both a unit of account and store of value.1 A currency that is money only because of government mandate is often called “fiat currency,” as it is literally currency by government fiat.

But ultimately, if a thing fulfills those three roles, regardless of whether it does so as a matter of law or by virtue of communal agreement, it serves the purposes of a currency. Put another way, it is certainly possible that a digital token that only exists on a peer-to-peer network, absent any involvement by a government, can be money.

The Cryptocurrency revolution

Though not the first attempt at a virtual currency, Bitcoin was the first cryptocurrency released into the world. Virtual currency is a term generally used to refer to any form of electronic currency. Cryptocurrency, on the other hand, is a specific subset of virtual currency built on, and governed by, cryptographic functionality.

The roots of cryptocurrency development go back to the early 1980s. In 1983, a computer scientist at University of California at Santa Barbara, David Chaum, published a paper called “Blind Signatures for Untraceable Payments” that theorized a method of digitizing payments based on cryptographic protocols. In 1989, Chaum implemented his ideas, founding a company called Digicash, which facilitated virtual payments by “eCash.” Although Digicash went bankrupt in 1998, its technology was an important precursor to Bitcoin. In and around 1991, other computer scientists were also playing with the idea of distributing data in “blocks” that are secured cryptographically in a chain. These two developments can be seen as the core components of cryptocurrency.

In 2008, one or more persons operating under the pseudonym

Satoshi Nakamoto, published a white paper on the internet titled “Bitcoin: A Peer-to-Peer Electronic Cash System.”2 The whitepaper set out in detail the ideas underlying Bitcoin. Then in January 2009, Satoshi Nakamoto released the software that implemented the Bitcoin system described in the whitepaper. It was uploaded to a free, opensource repository called Source Forge. This means that anyone is able to download the software, look at the code themselves, and run it. Or, as we’ll see later, a person could take that publicly available software and write their own alternate version. It would be like someone downloading a copy of Hamlet, changing the main character’s name to Simba, making all the characters African animals, and altering a few plot points to suit their own story ideas. That was, of course, a completely random analogy that is not intended to resemble any real-world creative work. The point is that this is a core concept of cryptocurrency: it was originally created as an open source, free, democratized system that people could adopt, adapt, and use freely. And they did. People immediately began downloading the Bitcoin software, creating new Bitcoins, and trading them as part of a network that ran on its own automated rules.

Bitcoin Basics

You can think of Bitcoin—and nearly all subsequent cryptocurrencies based on the Bitcoin software protocols—as having two core components:

(1) a peer-to-peer, internet-based network built on a publicly viewable ledger of every transaction on the network (the “blockchain”) and (2) a digital token that is unique, cannot be copied or counterfeited, and can be sent back and forth between participants (a “bitcoin,” but also sometimes generically referred to as a “coin” or “token”). It may help to think of Bitcoin as somewhat similar to U.S. mail: the two components are the postal service, which is a network of post offices and mail carriers, and the individual pieces of mail, packets that are sorted and transferred by the postal service between and among people who use the postal service. However, the similarities are only skin deep.

The Blockchain. The Bitcoin blockchain is built on a peer-to-peer network (sometimes abbreviated as “P2P”). As an aside, technically the blockchain and the network are separate things, but in practice, many people conflate the two and use the term “blockchain” to also mean the network of computers connected to the blockchain. Generally, a peerto-peer network is decentralized—meaning there is no central authority running or administering the network—and each participant (or “peer”) has equal status and capability with respect to sharing and accessing resources on the network.

This contrasts with traditional client-server networks, which resemble a hub-and-spoke model, where one central site or server is controlled by an administrator, while multiple clients must connect to the hub to access information or other network resources. Think of the client-server network model like a typical office IT system: each employee is granted login credentials from the central IT administrator and logs in with a workstation to the network owned and operated by the employer; files and other computing resources are stored centrally and under the control of the employer’s IT department. With a peer-topeer network, there is no central repository of files—they are distributed across all members of the network—and no one person controlling the network. Any person can download a copy of the software and install it to become a peer on the network.

The blockchain itself is a ledger that records every transaction that takes place on the network. Because Bitcoin is a peer-to-peer network, each person running the Bitcoin software has access to the blockchain. That means, any person can see every single transfer of Bitcoin that has ever happened. The general term for this type of blockchain-based ledger that is shared across all members of the network is “distributed ledger.” Distributed ledgers are an important part of why cryptocurrency technology is revolutionizing industries that have nothing to do with currency or payments.

As the name implies, a distributed ledger records transaction entries, but it can also store additional data linked to each transaction. Such data can be encrypted by the network protocols so that members of the network cannot see the details of the data being stored on the blockchain without the proper cryptographic keys. As a result, the blockchain can act as a secure repository for information that cannot be tampered with and which can be easily transferred among peers on the network. For example, healthcare companies have been experimenting for years with blockchain solutions that enable patients to easily access, add to, and transmit their medical records.

The main takeaways regarding the blockchain are:

• The blockchain is a distributed ledger that records every single transaction that takes place on the network.

• The network is composed of every computer running the Bitcoin software, and each computer performs certain tasks to ensure the system operates automatically based on its protocols.

• As a ledger, the blockchain is accessible to every network participant.

The Token. Conceptually, a Bitcoin is digital token created through a process called “mining” (sometimes, especially with other cryptocurrencies, also called “minting”), where computers on the peer-to-peer network solve complex mathematical problems in order to validate and record transactions on the blockchain. In technical terms, an individual Bitcoin is essentially a unique string of alphanumeric characters. Each Bitcoin is associated with a Bitcoin address. The Bitcoin address is yet another unique string of alphanumeric characters representing the imaginary location of the Bitcoin.

As a parallel, when you buy a car, you must register it with the state where you live and the car becomes associated with an address, namely the street address of your home. If you sell your car, the new owner must re-register the vehicle, at which point it becomes associated in the records of the DMV with a new address. This is, in a way, how the government records and tracks vehicle ownership. At a very high level, Bitcoin operates similarly. Each time a Bitcoin is transferred, the blockchain makes a record that associates the new address with that Bitcoin.

To hold, send, or receive Bitcoins, a person must create a “wallet” on the Bitcoin network. When a user creates a

Bitcoin wallet, a pair of cryptographic keys is generated—a private key and a public key. In actuality, each key is (you guessed it) a unique string of alphanumeric characters. The public key is mathematically derived from the private key, and is itself used to generate a Bitcoin address. In overly simplified terms, the public key is similar to an email address, and the private key is similar to the user’s password needed to access the email account. Anyone can send a Bitcoin to a public key Bitcoin address without the input or permission of the owner of that public key in the same way anyone can send email to your email address. But to send a Bitcoin out of a wallet requires the private key of that wallet, much like sending an email from your email account requires your account password.

To verify the authenticity of a transaction, the recipient uses the sender’s public key to verify the digital signature of the transfer. Interestingly, because all transactions are submitted to a public, peer-to-peer network, the verification process also involves numerous other users on the network. Multiple users confirm whether the signature matches the transaction data and the public key of the sender. Because the public key is generated from a wallet’s private key, the mathematical verification of the public key and the other transaction data (such as the Bitcoin address) prove that the sender has the private key corresponding to that public key, and thus the network automatically confirms that the transaction is valid. The results are then permanently recorded in the blockchain.

This process happens very quickly. Because of the immense distributed computing power involved, blockchain transactions are processed in moments. Also, there is no central authority that controls, oversees, or approves transactions to slow things down. And because the network simply uses the internet to connect its peers, blockchain transfers cross international borders without any friction whatsoever, limited only by the reach of the internet itself.

You don’t have to understand, or even remember, most of the explanation above because there are numerous businesses that understand and handle all the Bitcoin mechanics, presenting customers with simplified and easy-to-understand interfaces that are much like logging into an online banking account to check your balance or initiate an electronic transfer of funds. But it is useful to understand the following basic concepts about Bitcoins:

• On the blockchain, a Bitcoin is just a unique string of characters. Each Bitcoin is associated with an address (another unique string of characters), which is how “ownership” is recorded on the blockchain.

• Because each individual Bitcoin is a unique string of characters generated by the network using an algorithm, Bitcoins cannot be counterfeited.

• The peer-to-peer network collectively performs mathematical calculations to verify the validity of a transaction. It is, therefore, nearly impossible to fake a transaction or fraudulently transfer Bitcoin from a wallet whose private key you do not have.

• Bitcoins can be transferred from one wallet to another anywhere in the world in moments.

Pros and Cons of Cryptocurrency

Cryptocurrency, as a form of money, presents both benefits and risks as compared to other forms of currency and value transfers that existed in our financial system before Bitcoin appeared. Following are a few to keep in mind.

Fast and cheap. The point of an autonomous system like the Bitcoin network is that it removes the need for a trusted intermediary to keep a hand on the wheel. To put it another way, there is no middleman. Clearance and settlement of Bitcoin transfers are automated and inherently secure (because of the self-verifying nature of blockchain transactions), as well as cheap (no intermediary means no one collecting fees). As an experiment, in July 2016 a Canadian bank used a blockchain (not Bitcoin, but similar in concept) to send $1,000 to a German bank in eight seconds. In April 2017 BBVA used that same blockchain to send fifty transfers from Spain to Mexico in “mere seconds” at a cost 81% less than the correspondent bank network. Central banking systems have been racing to catch up to remain competitive (See, e.g., FedNow).

Systemically irreversible. Bitcoin functions like cash. If you hand a ten-dollar bill to a person, there is no way to reverse that transaction. You would have to force the other person to return it to you. By contrast, electronic payment systems like the credit card networks and the automated clearinghouse system used by banks have mechanisms to reverse transfers either before funds have settled or, in some cases, afterward. Transferring a Bitcoin is like physically handing cash to a person. The only way to get the Bitcoin back is to force the person to give it back to you. But because Bitcoin transactions are purely electronic, many people naturally equate them to electronic transfers by banks and, therefore, assume there are similar protections in place. It is important to understand that there are fewer protections relative to cryptocurrency generally, and unless a transaction is performed through a third-party like a licensed cryptocurrency exchange, there is no way to recover spent Bitcoins.

Pseudonymous. You may have heard that Bitcoin is anonymous. In truth, it is actually pseudonymous, and this pseudonymous nature is based on the public key/Bitcoin address functionality of wallets. While the blockchain records every Bitcoin transaction that has ever happened and ever will happen, it only records the Bitcoin addresses associated with each transaction. Without additional information, a Bitcoin address is a meaningless string of alphanumeric characters. There are clever ways to analyze blockchain activity to deduce useful information, but determining who sent or received a particular Bitcoin is extremely difficult. This can be a benefit to those who value the privacy of their financial transactions but can also increase the risks of criminal activity and be a barrier to law enforcement or regulation.

Many cryptocurrency exchanges require customers to provide identifying information when establishing accounts. As such, it may be possible to find out who owns a particular Bitcoin wallet or who conducted a particular transaction, but only if that wallet is managed through a third-party business like an exchange, in which case the user’s identifying information must be retrieved from the company operating the exchange rather than from the blockchain. There is no aspect of the blockchain itself that collects a user’s personal information.

Conclusion

Cryptocurrency is a complex and hyper-technical subject. Attorneys who do not practice in financial services or similar areas that have been directly affected by the advent of blockchain technology may be tempted to ignore this rapidly evolving field. But as with all new technologies, there are terrific business opportunities as well as practical and useful applications that are worth exploring. It is not necessary to have a theoretical mathematics degree to understand how cryptocurrency and blockchain might drive changes in different industries. A basic grasp of the key concepts is useful for attorneys of all practices.

Daniel Wood is Counsel with Pillsbury Winthrop Shaw Pittman, LLP, as part of the Fintech, Payments & Blockchain team, advising on matters related to financial services regulation. Prior to joining Pillsbury, he was an Assistant General Counsel for the Texas Department of Banking, where among other things he primarily drafted the agency’s policy memo on cryptocurrency.

Endnotes

1E.g., 31 U.S.C. §5103; 12 U.S.C. §411 (“The said notes shall be obligations of the United States and shall be receivable by all national and member banks and Federal Reserve banks and for all taxes, customs, and other public dues. They shall be redeemed in lawful money on demand at the Treasury Department of the United States, in the city of Washington, District of Columbia, or at any Federal Reserve bank.”).

2https://bitcoin.org/bitcoin.pdf. As an additional interesting point, the identity of Satoshi Nakamoto has never been conclusively determined. The pseudonym was active in the Bitcoin online community for a while but eventually ceased all activity and handed over active development of the Bitcoin software to Gavin Andresen and the Bitcoin Foundation.