Blockchain Technology Part 1: “Blockchain Assets” as Collateral

Torys Quarterly: Sharpen Your Focus

Bitcoin was conceived in a 2008 white paper entitled Bitcoin: A Peer-to-Peer Electronic Cash System, authored by one or more persons using the pseudonym Satoshi Nakamoto. But it wasn’t until the launch of Ethereum in 2013 that excitement and appreciation for the true potential around the technology underlying Bitcoin, the blockchain, went mainstream.

Chief among Bitcoin’s many accomplishments was an ingenious solution to a problem that arises when one tries to “digitize” an asset. A physical banknote cannot be spent twice: once you hand it over to the payee you no longer possess it and as a result you can’t spend it again. The vast majority of money in circulation in a modern economy is digital in that it only exists on a bank’s ledgers, but it can’t be spent twice because of the settlement and clearing process run by third party intermediaries such as banks and credit card processing companies. However, before blockchain was invented, a true digital asset that does not require a third party intermediary was not possible because it could be copied easily in the same way that you copy a picture every time you send it to another person over text.

In this series on the blockchain, we examine certain legal challenges to the use of the blockchain for recording asset ownership, including securities laws and privacy laws. We begin our series by examining the challenges a lender would face in trying to take security over a blockchain asset.

What is a blockchain?

A blockchain is a decentralized network of computers otherwise known as nodes which collectively process, maintain and distribute a digital record of activity. Blockchains operate on a computer protocol that uses ingenious cryptography that replaces the function third party intermediaries would otherwise play in verifying transactions.

Given the potential of the blockchain technology to revolutionize how parties transact with one another, a lot of brainpower is spent by entrepreneurs around the world to figure out what other problems it can solve and what assets it can hold. For example, a Chinese company called Onchain Blockchain Services has launched the first open-source blockchain protocol in China. This blockchain (called NEO) touts the ambitious goal of digitizing and recording all forms of asset ownership in China. In Sweden, the government is considering using the blockchain to replace the land registry.1 Bext360 is a startup with the ambition of using blockchain to pay farmers fairly for their coffee beans.2 IOTA relies on a directed acyclic graph, as opposed to traditional blockchain structure, to allow for feeless transactions, unlimited scalability; it is also positioned to be the infrastructure for data transfer for the “Internet of Things.” Symbiont is working with the State of Delaware to transfer Delaware incorporated companies to a blockchain register.3 Companies like Augur and Gnosis are using the Ethereum blockchain to create a predictive markets platform which allow users to bet on the outcome of any future event (i.e., a sporting match, an election or the price of oil.) The list of use cases is seemingly endless and is a driving force behind the exponential growth in the value of blockchain assets over the past few years.

How does a blockchain work?

The challenge with explaining how blockchain technology actually works lies in the way it replaces intermediaries and allows users to transact on a peer-to-peer basis with trust. One way to think about blockchain is to imagine just that, a “chain of blocks.”

The following describes how a blockchain using a proof-of-work consensus algorithm works. When a transaction is submitted to the network (e.g. John sends one Bitcoin to Todd), it sits in a pool with all other pending transactions on the network waiting to be verified by a node (for the purposes of this process, a “miner”). Miners scan the network periodically for pending transactions, then combine one or more transactions into a “block.” The miner races to solve a type of cryptographic puzzle called a hash function to validate such block of transactions. This cryptographic process proves, among other things, that the purported owner of the account sending value does in fact “control” such account (i.e., by verifying that the account number of the sender and the "digital signature" of such transaction, which is derived from a private key linked to the account number as well as certain text from the transaction). This process also verifies that the account sending token of value actually holds the thing it purports to transfer, thus addressing the “double-spend problem” alluded to earlier. To prevent against double-spending, the solution to each cryptographic puzzle (remember, a transaction does not occur until the puzzle is solved) requires some data output (i.e., the hash) from the last block of transactions verified on the chain. So each block links to the previous block in a linear fashion (hence the terminology, “blockchain”).4 This process also renders it unfeasible for anyone to alter a historic transaction without de facto altering the data in every transaction that has since followed; a key underpinning to the security of blockchain technology.

With data breach being a subject of increasingly prevalent concern, there is an inherent value proposition in the enhanced security of a decentralized blockchain network.

Once a node successfully solves the puzzle for a given block, it broadcasts the results to all other nodes on the network which independently verify the solution using simple math. If a consensus is reached by the majority of nodes, the block is placed next in the chain and permanently recorded on the network and time-stamped. The successful miner is rewarded an amount of digital currency to compensate the miner for its costs of verifying the transaction (electricity and hardware). This particular process is referred to as mining or proof-of-work but note that contemporary blockchains are moving towards more efficient processes for validating blocks.5

Why is blockchain technology valuable?

It’s secure. Unlike In a departure from classic conventional computer networks in which a central database exists to which all other nodes in the network connect, a blockchain is a decentralized and distributed network with no central database. Each node in a blockchain hosts its own copy of the master record of all activity occurring on the network thereby eliminating the risk inherent in a classic network containing a single point of failure. And given that data breach is a subject of increasingly prevalent concern to financial institutions, large corporations (and us business lawyers), there is an inherent value proposition in the enhanced security of a decentralized network.

It cuts out the middle man. A corollary to decentralization is disintermediation. Theoretically, a blockchain can allow users to transact with one another on a peer-to-peer basis without the need of trust or intermediaries. The cost savings that this technology may realize through the redundancy of escrow agents and other financial intermediaries is significant.

Legal Issues and Blockchain Assets

There is a lack of consensus on a definition for what blockchain assets are. Fundamentally, blockchain assets exist as a state of information stored within a database.6 And while information is not generally considered to be a form of property in Canadian law (with the exception of intellectual property), blockchain assets are bits of information that only the owner (i.e. the person with the private key) can exercise exclusive control over, akin to private property. Jurisdictions around the world take differing approaches to classifying these assets. In the Philippines, blockchain assets are remittances; in Japan, legal tender; in the United Sates, property or commodities.7 But even if we agreed to classify these assets as a form of intangible property, there would still be a number of legal issues that would need to be addressed before blockchain assets can be fully adopted in current market practices.

For instance, consider the need for financial lenders to be able to perfect security interests over the blockchain assets of borrowers. The Personal Property and Security Act (PPSA) establishes a comprehensive statutory framework to govern the creation, perfection, priority and enforcement of security interests in all types of personal property.8 “Personal property” is best defined as property that is not land.9 “Security interest” is defined in the PPSA as an interest in personal property that secures payment or performance of an obligation without regard to the form of the transaction or the location of title to the collateral.10 There are evident gaps in the rules with respect to blockchain assets, exemplified by the fact that neither the PPSA nor the Securities Transfer Act (STA) contemplate the perfection of security interests over securities that are digitally represented. Currently, there are established rules for certificated and uncertificated securities, but blockchain assets do not seem to fall into these existing legislative frameworks. Absent specific rules governing the perfection of security interests over blockchain assets, it is unlikely that lenders would accept such assets as collateral without having certainty that lenders could legally enforce their rights against such collateral. Before the legislature catches up, the blockchain community might have a technical solution that would significantly disrupt the methods by which financial lenders take collateral over a borrower’s assets. Through the use of “smart contracts” on platforms such as Ethereum, parties could program an autonomous trust agent designed specifically to receive a transfer of digital assets from a borrower as collateral, and either release the assets back to the borrower upon satisfaction and repayment of a loan, or transfer the assets to the lender or some other third party upon an event of default. The smart contract would read and execute the terms and conditions of the underlying loan agreement between the parties. Both the borrower and the lender would have confidence in this process because the underlying code would be transparent, unbiased and incorruptible. It would also have virtually no cost to the parties aside from the nominal electricity costs of operating the nodes.

At the current state of the technology, it is questionable whether the more complex terms and conditions of modern loan agreements are machine-readable. While smart contracts can rely on third-party data provided by ‘oracles’ (trusted sources) to monitor the bank accounts of a borrower to determine whether certain financial covenants are met, smart contracts are unlikely to determine whether a borrower has made reasonable best efforts to cure an event of default, or whether a lender acted in bad faith. Many legal standards are inherently subjective, and until the advent of more advanced forms of AI, these standards are likely to require human intellect to be accurately interpreted.

The more overarching concern relates to the fact that transactions on a blockchain are immutable, and therefore final. In the event that a nefarious lender or borrower (or other third party) managed to exploit a bug in the code of a smart contract or blockchain protocol and misappropriate the collateral funds, there is limited recourse that the parties may take to recover the funds. Such a scenario is not outside the realm of possibility; in 2013 an unknown hacker exploited a bug in the Ethereum platform to steal $150 million worth of Ether from a fundraiser for a project called the DAO (decentralized autonomous organization). In the case of the DAO hack, the majority of the Ethereum community decided that implications of the hack were significant enough to justify “forking” the blockchain (effectively an agreement between every node on the network to "undo" the record of the hack from the history of transactions). At the time this decision as contentious and resulted in the split between Ethereum and Ethereum Classic, the latter being the minority of nodes that principally did not agree to update their record. As blockchains continue to scale, updating every node’s record of transaction history in order to undo an illegal or otherwise contested transaction becomes increasingly unrealistic and impractical. New blockchain projects such as Tezos attempt to address this issue by incorporating voting rights into the project’s native token, so that token holders can theoretically address any issue (such as whether to undo a transaction or otherwise change the protocol) through an on-chain governance structure. But until the security of smart contracting is proven quantity, lenders may be hesitant to incorporate these new technologies into their business processes.

Conclusion

Our goal is not to dismiss blockchain technology’s capacity to disrupt, but to simply complicate the issues. In order for blockchain technology to truly replace the status quo, among its many other obstacles, it has to be able to fit into the rules and practices of the modern economy. The gaps in the existing blockchain technology will undoubtedly require an evolution in legal thinking if the technology can’t adapt to the law.

Disclosure: Some of the authors of this article have invested in blockchain startups, including initial coin offerings.

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1 https://qz.com/947064/sweden-is-turning-a-blockchain-powered-land-registry-into-a-reality/

2 https://techcrunch.com/2017/04/11/bext360-is-using-robots-and-the-blockchain-to-pay-coffee-farmers-fairly/

3 https://bitcoinmagazine.com/articles/delaware-blockchain-initiative-to-streamline-record-keeping-for-private-companies-1462812187/

4 The Virtual is Real: An Argument for Characterizing Bitcoins as Private Property

5 https://www.ethnews.com/legal-experts-call-for-european-regulation-of-cryptoassets-as-a-new-asset-class

6 Book Essentials of Personal Property Security Law – page 4

7 Canadian Personal Property Security Law, p. 18

8 PPSA Ontario security interest definition

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