Distributed ledgers are one of the key underlying technological innovations behind blockchain and the rise of cryptocurrencies. Distributed ledgers arguably present one of the most significant technological shifts for business operations since the dawn of the Internet. But the technology that is driving that shift has not yet coalesced into a standardized form and lacks legal and regulatory clarity.
In this overview, we examine the basics with respect to distributed ledgers and discuss why having the right expertise on your team may matter more to businesses now than it has in a generation.
What are distributed ledgers?
The technology may be complex, but when it comes to the basic mechanics, the name “distributed ledger” really does say it all.
Ledgers are a well-understood concept in business; you buy something and your bank statement records the amount you paid and the name of the recipient. At the same time, the recipient’s bank records that they received a credit from you. The bank, in other words, maintains a centralized ledger of the transactions and the account.
Unlike a centralized ledger system, a distributed ledger system does not reside with the bank or any other financial intermediary. There is no ‘master copy.’ It resides, instead, with everyone who is a part of the system. Each participant (anyone exchanging a value or information on the platform), maintains an identical copy of the ledger. When an update occurs, everyone’s (i.e., each “node’s”) copy of the ledger updates, cementing agreement on the changes. The transactions are visible and can be verified by any node. Because of the manner in which the system operates (i.e., without an intermediary), the participants can engage in direct transactions with one another in real-time.
This technology has been dubbed disruptive. The technological advances indeed mark a paradigm shift that could, where applied, eliminate the need for financial middlemen altogether — fundamentally altering the relationship between transacting parties and, in a sense, “democratizing” the financial system.
Of course, the technology also brings new concerns. The ability to see every transaction within the system—even if one is not involved in the particular transaction—highlights the need to protect the identity of participants. Imagine if you knew that any other customer of your company’s bank could look at your corporate accounts, including your cash on hand and spending habits. A number of other key concerns include user anonymity; encryption; safeguarding the system from hacking, theft, and fraud; and Know Your Customer (KYC) requirements. These represent serious considerations for businesses contemplating the move to distributed ledger technologies. Distributed ledgers need not be public. In fact, many companies now operate internal distributed ledger systems exclusively for use by employees on their private internal networks.
Despite these concerns, many companies are incorporating distributed ledgers into their future strategies. This is not merely a hedge against external disruption, as many have concerns that early-adopting competitors already in their space discover efficiencies that significantly reduce their operating costs, freeing up capital for market price decreases and/or enhanced research and development.
Blockchain and beyond.
Blockchain is the best-known example of a distributed ledger system in practice. Originally constructed to launch the digital currency ‘Bitcoin,’ blockchain ushered in the current era of growth in the decentralized virtual currency market. Similar to many currencies that have followed, Bitcoin has no tangible backing to its currency and no central authority.
But not all cryptocurrencies are blockchain-based. The Chinese government’s push for a Central Bank Digital Currency (CBDC) does not use blockchain; instead, it seeks to launch a digital form of the government’s fiat currency, with the government serving as the clear central authority tracking and controlling the ledger. In August 2020 it was already rumored to be in test rollout; as of late October 2020, the currency has been confirmed to be in test mode and has already spawned digital counterfeits.
Cryptocurrency is arguably the most prominent type of distributed ledger technology in the public eye, but practical examples are in place across many industry verticals. IBM is operating a blockchain-based partnership to help companies manage their supply chains; participants include Nokia, JetBlue, Lenovo, and AB InBev. The nation of Estonia launched a blockchain-based ID card system for its citizens, with nearly full adoption across its citizenry. The decentralized finance industry is actively seeking to disrupt major banking disciplines including payments, lending, and investing—all at the possible expense of entrenched intermediaries.
Distributed ledger applications may vary by industry, but familiar patterns are emerging in the space overall. Startups, often backed by increasingly available private equity funding, are seeking to create innovations and business lines that established players cannot target without undercutting their own proven business models. The entrenched companies have their own advantages in turn; access to cash, employees, brand recognition, and other resources unavailable to startups, including the legal and regulatory expertise to weather potential future challenges.
The shifting legal and regulatory environment and why it matters.
Legislation and regulation often find it difficult to keep pace with emerging technologies. Many rules and guidelines are issued as reactions to developments in the field. Others may come in the form of established methods of regulatory guidance, such as ‘no action’ letters in finance. It is notable that virtual currencies have experienced a high degree of anticipatory regulatory challenges.
China and Russia have banned Bitcoin’s use in banking and financial transactions. Egypt, Bolivia, and many other countries have banned the currency entirely. In the United States, regulators are taking positions industry by industry, and state by state. And virtually all countries hold distributed ledger systems to be within the scope of their fraud, anti-money laundering, and terrorist financing laws; this creates a complex legal environment unfamiliar to entrepreneurs seeking to create startups in the distributed ledger space.
The value of expertise.
As a technology, distributed ledgers are raising serious questions about future business operating structures, laws, and risks. Businesses of all sizes are taking positions on variations to ledger structures that could be rewarded with mass adoption or obviated by regulatory action. This ambiguity can result in long and serious processes of litigation and unexpected changes to public brand perception.
Cryptocurrency securities fraud cases receive the majority of media attention, but cases are being litigated in industries as diverse as consumer privacy law; taxes and accounting practices; and intellectual property. Few business models are designed to seamlessly absorb and respond to changes of this magnitude. Freeman Law remains ready to provide our clients with the counsel, insight, knowledge and experience they need to help navigate this changing environment.