Legal Issues Surrounding Cryptocurrency
Public interest in Cryptocurrencies, such as Bitcoin and Ethereum, has recently surged as multiple industries have been exploring how to capitalize off the new technology. As public interests increase, new uses for cryptos develop almost every day. As new uses of cryptocurrencies emerge, so too do its potential legal liabilities. In this article, we take a look at some common legal issues related to cryptocurrencies.
One of blockchain technology and cryptocurrencies’ most striking features is their self-executing “smart contracts.” Smart contracts are a set of promises, usually specified in a digital format, that act as the basis upon which the parties in a transaction fulfill their specific promises. A smart contract automatically pays the other party when they perform their contractual duties. Due to smart contracts’ unique nature and inherent complexity, whether they fit into the legal framework of traditional contract law is difficult to determine.
The United States has no federal contract law that applies to the country as a whole. Accordingly, contract law varies from state to state. Plus, as of October 2020, no federal law or guidance explicitly defines smart contracts’ or their legal validity. The only exception is the Electronic Signatures in Global and National Commerce Act of 2000, which provides limited legal validity to smart contracts. Since smart contracts’ legal validity is unclear, however, they are likely to result in lengthy litigation processes.
The main idea behind blockchain technology that underpins cryptocurrencies is that it involves no way to pinpoint a ledger’s actual location. Accordingly, transactions conducted on blockchain offer greater privacy than transactions conducted on traditional platforms. But this advantage poses a complex jurisdictional challenge. First, since the nodes of a crypto transaction are located in different jurisdictions, they may be subject to conflicting legal frameworks. Second, the “residence country” for cryptocurrency software is difficult to determine due to the ledger’s lack of a physical location. Third, blockchain’s transnational nature makes determining applicable laws and selecting the correct jurisdiction for blockchain disputes exceedingly difficult. For any national regulator, enforcing laws among blockchain users, transactions, or projects is a herculean task because of the technology’s cross-border reach.
Data Theft and Financial Fraud
Data theft and financial fraud are additional pressing legal concerns surrounding cryptocurrencies. The blockchain’s promise of anonymity—and its apparent freedom from regulations—can entice many users who are involved in illegal activities to use cryptocurrencies for their financial transactions.
In 2017, a researcher at Cornell University identified a serious security flaw in the Ethereum blockchain that put $250 million at risk of theft. Similarly, crypto wallet maker Ledger recently compromised 1 million email addresses in a data security breach. Access to the personal information—such as full names, postal addresses, and phone numbers—of Ledger’s 9,500 customers was also stolen. Whether existing data laws can address data theft and financial fraud originating from cryptocurrencies remains unclear.
Privacy concerns are closely related to data theft in the cryptocurrency space. As we’ve seen, one of the main reasons for introducing cryptocurrencies like Bitcoin was to provide anonymity in transactions between users. However, Chainalysis showed this anonymity to be threatened by the continuous improvement in blockchain analytic tools. The blockchain analytics firm claimed that it can trace the vast majority of Zcash and Dash transactions, making “privacy coins” a misnomer.
The United States has no comprehensive federal data protection framework. Instead, sector-specific privacy and data security laws and regulations apply—such as the Gramm-Leach-Bliley Act, the Health Insurance Portability and Accountability Act (HIPAA), and the California Consumer Privacy Act (CCPA). The United States’ existing privacy and data security laws and regulations do not address the privacy concerns that have arisen due to blockchain technology. For example, blockchain technology’s distributed peer-to-peer network architecture is widely considered to contradict the CCPA’s traditional notion of a centralized, controller-based data processing system. In other words, the CCPA’s assumption of centralized controller-based processing is inapplicable to cryptocurrencies because it disregards the decentralized nature of the new technology.
Several commentators suggest that cryptocurrencies provide criminal organizations with a new way to commit fraud, money laundering, and a host of other financial crimes. This criticism stems from cryptocurrency traders’ ability to remain totally anonymous. Indeed, cryptocurrencies have been used for “dark-market sites,” where criminals can buy and sell illegal items with little chance of being identified. In fact, various governmental agencies have labeled drug dealers that exchange drugs for cryptocurrency as the “new generation of criminals.”
In 2019, blockchain analytics firm Chainalysis estimated that criminal entities transacted $2.8 billion in Bitcoin exchanges, up from around $1 billion in 2018. Before criminals can convert their illegally acquired cryptocurrency into cash, they have to convert it into liquid cash. The popular exchanges for this conversion are subject to anti-money-laundering rules that require firms to identify their customers. But Chainalysis researchers suggested that criminals have found a way to circumvent these rules using over-the-counter trading (OTC).
For US federal income tax purposes, cryptocurrencies are property—not currency. This distinction means that US taxpayers cannot use cryptocurrency as a functional currency for Internal Revenue Code purposes. However, US taxpayers are obligated to report transactions involving cryptocurrencies in US dollars on their annual tax returns. This requirement means that US taxpayers should determine their cryptocurrencies’ fair market value (by converting the virtual currency into US dollars) on each transaction date. As a result, properly reporting cryptocurrencies to the IRS is burdensome for individual taxpayers because they must diligently record the price at which their cryptocurrencies were bought and sold.
Moreover, the United States classifies cryptocurrencies as capital assets. Therefore, individual investors are liable to pay capital gains taxes on any profits they realize via cryptocurrencies. This obligation applies whether or not investors purchased their cryptocurrency from the United States or from another country. Nevertheless, whether US investors who purchased their crypto holdings on foreign exchanges are required to fulfill additional reporting requirements in filing their taxes remains unclear.
Cryptocurrencies are becoming rather popular among intellectual property (IP)–intensive sectors, including the pharmaceutical, automotive, luxury, and consumer goods industries, where goods’ traceability is important, and counterfeit or “gray” goods are a concern. The use of cryptocurrencies in IP-intensive industries raises concerns about: (1) IP ownership and authorship, (2) controlling and tracking the distribution of registered or unregistered IPs, and (3) establishing and enforcing IP agreements, licenses, or exclusive distribution networks through smart contracts. For example, considerable uncertainty surrounds who exactly owns blockchain technologies and cryptocurrencies.
Legal and Regulatory Concerns for Investors
Since February 2020, cryptocurrencies such as Bitcoin have been legal in the United States—and in most other developed countries, such as the United Kingdom, Japan, and Canada. However, although the IRS considers Bitcoin and other virtual currencies legal, some concerns still surround their legal validity.
Cryptocurrencies are not backed by any centralized issuing authority and intrinsic goods, such as gold or silver, do not underly cryptocurrencies’ value. Instead, their value totally depends upon the value that other owners and investors ascribe to them. Since they are not backed by any centralized regulatory body, investors may have few legal resources if any complications arise from their crypto transactions or ownership.
The above legal challenges facing cryptocurrencies are likely to become even more pronounced because no intermediary or authority has the exclusive jurisdiction to settle cryptocurrency-related disputes. For example, in a traditional financial transaction, if a party claims that their account credentials were stolen and that money was fraudulently transferred from their account, their financial institution (such as a bank) can serve as an intermediary and resolve the matter. However, if a parallel situation occurs on a blockchain platform, no mechanism has been established to settle such a dispute because cryptocurrency is decentralized and has no financial institutions that act as intermediaries. Accordingly, victims of cryptocurrency theft will likely have no legal avenue to compensate for their losses.