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Regulation of Blockchains and DLT – It’s All in How You Use It

Scott L. Winkelman, Crowell & Moring.

The disruptive potential of blockchain and distributed ledger technology (DLT) has been likened to that of the internet in its early stages of development. A growing number of leaders across industries think these new technologies have the potential to change fundamentally the way our economy operates.  This is true not only for the financial markets, where applications based on blockchain and distributed ledgers are already coming online. Applications for energy, where utilities can track the status of energy grids using distributed databases, are being tested.  Applications for storage of medical records and secure exchange of patient information are in development. Companies are working on applications for tracking items and verification of payments in international supply chain transactions.

Blockchain and DLT, in their most basic form, work as an engine for processing exchanges of information and then securely storing that information once the exchanges are complete. There are two key concepts that define what any blockchain does. First, in any blockchain, a group of “transactions” – whether that transaction is a sale of bitcoin, the creation of a new medical record, or the movement of an item in a supply chain from one stage to the next – are bundled into a digital “block.”  This means that the basic facts of each transaction are written into encrypted computer code, and the encrypted code for several transactions are grouped together. Once this group or “block” is created, it is “wrapped” in more encrypted code.  The wrapper code connects the block to the previous block in the chain, and this connector is based on the contents of the previous block.  So each block is connected to the previous block, and so on. This interconnection among all blocks in the chain makes it difficult to go back and change a transaction after it’s already happened. To alter a previous transaction, you would have to change not only the block containing that transaction, but also every subsequent block.

Jenny E. Cieplak, Crowell & Moring.

Second, blockchains are maintained on “distributed ledgers.” After a block is created, it is broadcast to a large number of computers, referred to as “nodes,” which each maintain a copy of the blockchain. Each node is designed to be constantly checking in with the other nodes to make sure that its copy of the blockchain mirrors the other copies. This makes it even more difficult to go back and change a transaction, as the change would have to be made on all the systems throughout the network – or at least on a majority of them, since the network operates on a “majority rule” basis if there are disagreements among the nodes.  It also gives the network resiliency – if one node stops working for whatever reason, that node will be shut off from the rest of the network.

Like the internet, there is precious little regulation of blockchain and DLT itself. Any provider of a commercial solution using DLT, however, will need to consider the regulatory landscape in which that solution will be used.

 Providers of health records solutions will need to understand how HIPAA (health care privacy rules) and other privacy regulations restrict what data can be accessed and by whom.  Supply chain solution providers must understand whether a DLT solution will be embraced by customs regulators. Providers of financial industry solutions will need to consider the multitude of regulations applicable to that industry – not only regulations regarding how assets are traded but also whether use of DLT will have an impact on regulatory capital and other compliance requirements, and whether DLT can replace or fit within currently mandated reporting and record keeping requirements. Beyond industry-specific requirements, DLT solution providers must consider regulations that span industries.  Laws specific to virtual currency may also apply. For example:
  • What data privacy regulations govern information stored using the solution?
  • If the solution involves a virtual currency, would the provider be subject to anti-money laundering or other money transfer regulations?
  • Do antitrust and competition restrictions bar sharing information among industry participants on the blockchain?
  • If DLT-related assets will be tokenized, are the tokens in question considered “securities” and thus subject to regulations on their sale?
  • If tokenized assets can fluctuate in value, will holders be required to report transactions for tax purposes?
  • How should errors on the blockchain be treated?
  • If the solution uses smart contracts, what enforcement mechanisms are needed?
  • Where might access to dispute resolution systems be necessary?

Solution providers should have and implement a regulatory and legal strategy. They should explore whether current regulations inhibit or facilitate their proposed application – and whether there are opportunities to interact with regulators and to seek their guidance on bringing applications to market.

Some regulators will be approachable and receptive, others less so. The UK’s Financial Conduct Authority has expressed keen interest in the use of DLT in financial applications, with the FCA’s “sandbox” giving fintech provides compliance advice as well as a “safe space” in which businesses can test innovative solutions in a live environment without immediately being fully subject to all applicable regulations. Other regulators have taken a “wait-and-see” approach, with some requesting white papers from industry, others simply waiting to be approached, and still others in defensive crouch. In any case, dialogue with regulators can prove beneficial in addressing potential applications upfront rather than awaiting unwelcome enforcement surprises.

These are exciting times for blockchain. With exciting times comes legal peril, and opportunity. Savvy participants will be peering around the corner for legal trends — and will be forceful and creative movers in creating those trends.

About the Authors

Scott L. Winkelman and Jenny E. Cieplak are members of Crowell & Moring’s Blockchain / Distributed Ledger Technology (DLT) practice where they advise clients on how this breakthrough technology can be applied to their industry in a compliant manner.

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