Blockchain Technologies and Digital Currencies
Blockchain technology developed years ago as a way to use a shared, digital public ledger. While it is best known for its use in digital or cryptocurrencies like Bitcoin, where it protects and documents financial transactions, enthusiasts, developers and entrepreneurs are actively exploring new uses. Despite its increasing use, blockchain remains an area that can be difficult to understand from both a legal and technology standpoint. Any parties using blockchain technology and/or digital currencies in a transaction should consult an attorney to avoid potential liability and financial losses.
What Is Blockchain?
Blockchain is a type of database where information is stored in groups or blocks. When a new transaction is added to the database, it is transmitted to a decentralized network of computers around the world that confirm the legitimacy of the transaction. Transactions are not approved unless there is consensus among the members of the network so unauthorized changes cannot be made.
The approved transactions are then grouped in information blocks. Once a block is filled in, it is chained onto a previously filled block, forming a chain of data known as the “blockchain.” New information will keep adding blocks to the chain. Each block is timestamped creating a permanent timeline or ledger of transactions.
Blockchain is the technology behind cryptocurrencies. However, the concept can be applied to many types of transactions, including smart contracts, supply chains, healthcare, banking and voting.
What Is a Cryptocurrency?
A cryptocurrency is a digital or virtual currency that is secured by cryptography, unique digital signatures and complex mathematical algorithms which protect the currency from counterfeiting. Many cryptocurrencies rely on blockchain. Transactions generate virtual “tokens” which are represented by ledger entries that are recorded and transmitted via the blockchain.
Some virtual currencies can be purchased for, or exchanged into, U.S. dollars, Euros and other real or virtual currencies.
Types of Cryptocurrencies
The most well-known cryptocurrency is Bitcoin. However, there are many others (sometimes referred to as “alt-coins” or “altcoins”), including Litecoin, Namecoin, Ethereum and EOS. In addition, new ones are created every day.
Initial Coin Offering
A creator of a new cryptocurrency typically first offers it to the public through an initial coin offering (ICO). The offering is usually preceded by a white paper that explains how the cryptocurrency will work, why it is beneficial and why people should invest in it. The investing public will typically determine the value of the currency based on the white paper, interest in the project or speculation on price changes.
What are the Advantages and Disadvantages of Using Cryptocurrency?
There are several advantages to cryptocurrencies over traditional currencies. Cryptocurrency transactions are not subject to the rules of a centralized authority, such as a bank or credit card company. Potentially, this allows parties to transfer funds more easily and eliminates or reduces processing and transaction fees. It also allows citizens of countries with unstable banking institutions and currencies to conduct business within and outside their country. The blockchain technology also offers protection from hackers as the shared public ledger cannot be altered without the consensus of the network of members. However, exchanges of cryptocurrency could be hacked by taking an individual’s “private key.”
Among the disadvantages is the semi-anonymity of cryptocurrency transactions. This allows them to be used for money laundering, tax evasion and other illegal activities. However, there are instances when privacy may be beneficial. Further, some cryptocurrencies, like Bitcoin, can be traced if needed to identify criminals. Cryptocurrency offerings are regulated much like securities offerings and compliance can be intricate and demanding. Many companies have run into legal issues following non-compliant ICO offerings, and token issuers should be careful to ensure legal compliance in ICO offerings. Finally, cryptocurrency values tend to fluctuate widely and are subject to various investor risks including speculation, fraud and manipulations.
What Laws or Regulations Apply to Cryptocurrency?
As cryptocurrency use has increased, the US and global governments have sought to regulate the industry. In the US, various federal and state laws apply to transactions. These include:
Federal Securities Laws
The Securities and Exchange Commission (SEC) regulations apply to the offer and sale of cryptocurrency tokens. Further, ICOs may also be considered securities offerings that must be registered.
In addition, the Commodity Futures Trading Commission (CFTC) considers virtual currencies as commodities subject to agency oversight. However, CFTC’s jurisdiction is limited to virtual currencies used in a derivatives contract, or if there is fraud or manipulation involving a virtual currency traded in interstate commerce.
Both the SEC and CFTC have issued guidance regarding cryptocurrency transactions.
Internal Revenue Service
Under IRS rules, virtual currency transactions are taxable like any other property transaction and must be reported on the taxpayer’s tax returns. This includes selling or exchanging virtual currencies, using them to pay for good or services or holding them as an investment.
The Financial Crimes Enforcement Network, a bureau of the United States Department of Treasury, regulates money laundering and other financial crimes. Unlike the IRS, which typically views virtual and cryptocurrencies as property, FinCEN generally treats these tokens as alternative currencies, subject to the same rules and restrictions governing money laundering and illegal financing. FinCEN’s published advisories provide guidance to individuals and institutions regarding legal use of virtual currencies and red flags in virtual currency transactions.
New York Securities Law
The New York Department of Financial Services regulates the use of virtual currencies in New York. This includes requiring virtual currency licenses and charters for companies looking to offer virtual currencies.
For those seeking to offer or buy cryptocurrencies, it is important to understand the complex laws and regulations that may apply. Cryptocurrencies can be lucrative but also have significant risks particularly as this is an area that is constantly evolving. As a result, it is important to discuss these issues with experienced counsel to mitigate legal and financial risks.
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