This article has been written by Jyotiranjan Mallick, pursuing a Diploma in Cyber Law, FinTech Regulations and Technology Contracts from LawSikho.
Table of Contents
Introduction
In 2009, a white paper was published by Satoshi Nakamoto called Bitcoin which would enable a Peer-to-Peer Electronic Cash System built on the mechanism of the Blockchain. Back to 2021, Bitcoin has soared to an all-time valuation of over $51,000. The hype around Cryptocurrency has reached its pinnacle which has continued debate around its legality and impact on finance. However, what poses a promising and bohemian essence behind the crypto assets are the Blockchain technologies. It has the capability of disrupting the current world and ushering in a modern framework through Crypto assets, smart contracts, and Decentralised Automated Organization (DAO).
Blockchain, which is the technology behind Bitcoin, can be defined as an open, distributed ledger that records transactions between parties efficiently and in a verifiable and permanent manner. Bitcoin is just one facet of Blockchain technology, which at its core is a distributed ledger that is shared with multiple parties.
Blockchain is an efficient technology that is often called the Internet of Value. Similar to the facets of all the new technologies that help in increasing the speed of communication, the Blockchain also has the capability of increasing the efficiency in which transactions take place online. What makes the Blockchain highly disruptive can be understood from the simple understanding of the mechanism of Bitcoin or for that matter any other crypto assets.
The white paper published by Satoshi provided a framework of a pure peer-to-peer (P2P) version of a transaction between parties without the need for an intervention of central authorities. The principle of decentralization of monetary power to the people is a reinvigoration of the structure of the current economic and legal regimes. In essence, the mechanism of Blockchain applications makes us recalibrate as to how we handle money and the need for a central authority in the very first place to monitor such transactions. Despite predictions that the future is perilous, there is evidence that blockchain is a remarkable, new technology that will change the way transactions are made, based on its ability to guarantee trust among unknown actors, assure the immutability of records, while also making intermediaries obsolete.
The application of Blockchain can have a great impact in the commercial sector in which the transactions are completed instantaneously with a very high degree of automation. The application of the technology is not only limited to transactions but with the potential of smart contracts, the merits of Blockchain can be used in the management of supply chain in the field of manufacturing, E-commerce, digital health, airlines, and retail. The framework of Blockchain thus can shape the discourse of how commercial transactions and contracts take place.
The application of Blockchain although provides a tamperproof, verifiable, and transparent mechanism to conduct a transaction, however, the inherent characteristics of decentralization have the potential to cause chaos and disruption in the current economic system. Most jurisdictions around the world had tended to ignore the rise of Blockchain. With the increasing popularity the question that all the legal regimes need to answer is if there is any need for regulatory oversight to its applicability, and if yes then how can a balance be created between the Blockchain and the existing system.
What characteristics of the Blockchain make it a breakthrough technology?
The mechanism of Blockchain
The blockchain operates on a mechanism in which there is a safe ledger shared cryptographically between the members. This ledger records the data between the users in a chronological order which in turn creates a record of a transaction that is irreversible and immutable. This is owing to the mechanism in which the new transaction is authenticated using cryptographic digital signatures approved by the decentralized consensus of the network. The same is added to the ledger as a new ‘Block’ in the chain. This encrypted chain is publicly viewable making it completely transparent. The unique approach of the Blockchain is that once a block is created in the ledger, it cannot be tampered with and the same is distributed among the network participants which makes it hard for a single entity/person to have control over it.
Unique characteristics of Blockchain
The mechanism as represented above creates a system in which transaction is done efficiently without the need for intermediaries. The unique characteristics of the Blockchain that catapults it as a breakthrough and disruptive technology can be regarded as follows:
Trust
As represented in its mechanism, a new block can be created in the ledger only when the transaction receives the approval of a majority of the network participants. This consensus is reached only when it is verified that the information circulated is cryptographically secured by the ledger. The updated information is distributed among the network participants making it trustworthy.
Transparency
Blockchain can improve the accuracy of transactions in a global supply chain. The smart contract in using the Blockchain application can be used in price tracing systems along with enhancing the transparency of the product distribution structure. Blockchain allows real-time authentication which in improving the sustainability of the manufacturing process can be quite fruitful. This transparency can be used in improving the governance and participative process in the decision-making.
Immutability
Information once annexed to the previous ledger in the Blockchain cannot be altered, modified, or lost. This makes the record incorruptible and permanent in the system. Similarly, transparency is also maintained as all changes are reflected in the ledger that can be audited by any network participant.
No requirement of “central authority”
The ledger database being publicly available to the network participants is not maintained by any single person, central intermediary, or government. This means the transaction between the two participants in the ledger can be authenticated without the need for a central authority. The consequence would be a ‘decentralization’ of monetary powers which is a breakthrough innovation.
Secure operation
The Cambridge Analytica scandal brought to the notice of the world the plight of data security of the individuals who operate in the traditional internet database. This made the authorities around the world bring a strong data protection regime among which one of the crucial legislation is the GDPR of the European Union. However, despite these regulatory measures, data security is one of the issues which cannot be effectively dealt only with the regulatory assurances. This is where the Blockchain fills the lacunae. Blockchain offers enhanced security due to the mechanism in which the information is transferred cryptographically. This makes it ideal for storing highly sensitive information including personal data.
What are the problems associated with the applicability of Blockchain technology?
Challenge in ascertaining jurisdiction
The most challenging aspect of Blockchain applicability vis a vis legal implication is the lack of a mechanism to ascertain jurisdiction. Permissionless Blockchain like Bitcoin can be operated by anyone with the requisite know-how and hardware. This means that the ledger can be operated from any part of the world without rooting to any specific location. The lack of a central intermediary and national regulation makes the issue further complicated. The repercussions can be specifically daunting in transactions that have to follow Know your Customer (KYC) or Anti-Money Laundering (AML) guidelines. The loophole can also be used by a notorious organization such as hackers to siphon off funds. A recent example of which was Twitter in which major accounts were hacked demanding bitcoin in ransom.
The applicability of Blockchain would make it difficult to track the location where the cause of action has occurred. The repercussion can result in a chaotic scene in which the defaulting party/fraudster may simply get away with the liability of their action. This is specifically important in those cases where Blockchain applicability might be used in Smart contracts. Similar challenges emerge when considering territoriality aspects and court jurisdiction in relation to torts and non-contractual disputes. The solution would be to maintain a cross-jurisdictional harmony, but that might not be fruitful owing to the complicated structure in which every nation governs contracts/liability under the strong foothold of municipal law.
Anonymity in the Blockchain application- One of the prime features of Blockchain is that transactions can be done with partial or complete anonymity. The pseudo-anonymity means a person will be linked to a public Bitcoin address, but no one will get to know the actual name or address. This potential has the dangerous repercussion of creating lawless zones which may be used as a free pass for criminals and fraudsters. The pseudonymity can be potentially used to evade tax obligations and launder money from offshore entities. However, the anonymity in Blockchain transactions isn’t a big implication currently and can be handled effectively through permissioned applicability like Ethereum. The permissioned Blockchain enables the identity of the actor through which accountability can be easily determined. Even a permissionless Blockchain like Bitcoin which can be accessed by any leger operator doesn’t support anonymity. Regulation thus can be crucial in prohibiting complete anonymity so that even in case of partial anonymity, audit and trail of wrongdoing can be unmasked by tracking immutable ledger.
Issues in ascertaining liability
The law in its essence represents obligation and prohibition of certain actions and holds liable any person who fails to comply with such obligations. The primary aim of such a mechanism is to harmonize society to create an order. Liability is an aspect of law through which an injured person is given damages/compensation for the action of a wrongdoer. Ascertaining liability in Blockchain application can be a daunting task as the platform might be used overseas by participants which makes the delineation of jurisdiction difficult.
The Blockchain platform like any other digital platform like Facebook, Twitter is an intermediary in which there can be two broad demarcations of roles. The first being core software developers and the second being the network participants. In ascertaining the liability of major corporations like FB, Twitter we can consider the example of various data protection legislations like GDPR in the EU or Information Technology Act 2000 in India. Section 43 A of the IT Act 2000 imposes an obligation on these intermediaries to follow reasonable practices while handling the personal data of users. In case of default, they may be held liable and imposed with a hefty fine.
The problem with permissionless Blockchain is that there is no central entity that controls the system at large. Moreover, a Blockchain application may be created without revealing the identity of the core developer (e.g., Satoshi Nakamoto of Bitcoin). This situation makes it complicated to ascertain and enforce the liability in case of an issue with the transaction of network participants.
Data Protection
In the wake of a mass data breach of individuals in the Cambridge Analytica scandal, various Nations brought a strong Municipal regime for data protection. The European Union in 2018 enforced the General Data Protection Regime which stipulates the obligations of data controllers/processors to protect the personal data of EU subjects. The limitation of GDPR with respect to Blockchain was that it was drafted before the prominence of Blockchain technology. This scenario has resulted in conflict between municipal data protection regime and Blockchain applicability:
- As already discussed under liability, the lack of a central authority makes it difficult to ascertain who is the data controller or processor. This makes it difficult to impose the obligation of such a data protection regime.
- Applicability of Blockchain may prevent the exercise of various rights given under data protection law such as GDPR. For example, the immutability of altering the transaction in Blockchain makes it difficult to exercise rights such as the Right to be forgotten, the Right to rectify personal data, etc.
Legal implications of smart contracts
The applicability of Blockchain technology is not only limited to crypto-assets but can be applied in other domains in a uniquely interesting way. The popularity of Cryptocurrency showed that the same mechanism of Blockchain can be used to share computer-coded programmes in such a manner that it could automate itself without the control of any single entity. This means programmes can be created tailored to a specific purpose which is self-executing in nature and is combined with other features of Blockchain. The term was coined by Vitalik Butlerin who founded Ethereum which was the first major platform to introduce this concept.
Based on this mechanism the SC can be used to automate simple business processes in contracts which can help to increase efficiency and reduce costs. For example, it can be used to code various contractual agreements such as Software development agreements, Escrow agreements and can be made to run in an automated manner based on pre-decided conditions coded in the Blockchain.
This could potentially help in maintaining transparency and trust since it would be difficult to back out of the process of self-executing nature of SC. Smart contracts can further be improved by the application of Artificial Intelligence(AI) through which these programmes can be made capable of reacting to the specific environment and can make an automated decision on their own. These is also referred to as decentralized autonomous organizations (DAOs). This breakthrough innovation however raises certain complications with the legality of contracts which can only be effectively tackled by effective regulations.
Whether smart contracts can be held as a binding agreement as per law
The smart contracts vis a vis general contract laws raises an issue of the binding nature of smart contracts and whether they can satisfy the formal requirement set by law for a valid contract. Consider for instance the Indian Contract Act 1872, which governs the general contractual terms. Even though it accepts oral agreement as binding but various contracts need to be notarized by proper authorities as per their own specific set of regulations. Moreover, complications may also arise since there may be difficulties in ascertaining the computer code as a language of the contract. This repercussion could also result in difficulty of judicial interpretation. The complication could also persist in the manner in which digital signature is used to authenticate transactions in smart contracts.
Immutability of smart contracts
The smart contracts built upon the principles of Blockchain follow the principle of immutability. This means smart contracts can be used to code “unalterable” agreements which cannot be changed once they come into operation. The plus point is that they will enforce the written code no matter what happens which makes parties bound by their commitment.
However, this rigidity acts as a hindrance to legal applications. The lack of flexibility means the code cannot adapt to any change in conditions, regulations, or business environment. In the perspective of any contract law, for example, Section 62 of the Indian Contract Act, 1872 applicability Blockchain raises an issue as to what would be the recourse if there is a novation/rescission in the contract. This rigidity implies that in case of a need to bring changes in the smart contract, recourse has to be taken to off-chain settlements. This means that the applicability of Smart contracts isn’t immune to a breach of contractual obligations and the same needs to be governed through effective regulations/laws for maintaining the balance.
Other challenges
Since smart contracts run on Blockchain principles, it is also prone to negatives of Blockchain. The lack of a mechanism to identify actors on blockchain networks raises the issue of interaction between users and authorities. This effectively means that the current judicial system for enforcement of liability may no longer be effective. Moreover, a lack of transparency in the issuance of such digital assets makes it complicated and difficult to protect consumers from scams. The Initial Coin Offering(ICO) boom of 2017 is one such example. In the boom, companies issued a large amount of capital worth millions of dollars through tokens.
These tokens were issued without any reporting requirements to securities regulation. Even though the boom resulted in raising huge capital, a large number of ICOs turned out to be a fraud. This entire mechanism of an irreversible transaction and lack of transparency can only be resolved by an efficient regulatory approach. Regulations can mandate these smart contracts to be written in such a manner to make them compliant with regulations. For example, KYC and AML functionality can be coded within smart contracts while transferring assets digitally.
How Blockchain applicability can be shaped by regulatory approaches?
The distributed ledger technology like Blockchain has the capability of transforming the modern world. Similar to the initial phase of the Internet, the Blockchain even though seems daunting but has the capability of transforming regulatory oversight. The need of the hour is to frame such legal policies that could act as a facilitator of Blockchain application. The use of Blockchain could help regulators in monitoring certain activities for legal compliances. For example, it can be used in financial markets, AML compliance, monitoring market manipulation, etc through assessing cryptographic verifiability.
Lawmakers should consider and classify both legal and illegal practices while framing the policies so that enough room can be left for experimentation. Rather than using a strict approach of completely banning other forms of cryptocurrency except as issued by the state (e.g., India) lawmakers should consider limited legal intervention while simultaneously ensuring data reliability and eliminating fraudulent activities through enforcement.
Since Blockchain has the capability of improving regulatory oversight and the strategies should focus on the adoption of industry practices using active surveillance. Issue of territoriality can be resolved by framing a distinct legal policy in which parties can be allowed to select governing jurisdiction for Blockchain applicability. Even though anonymity doesn’t seem to be a potent problem in the Blockchain narrative, however states could use identification tools in collaboration with the private sector for enforcing responsibility in the blockchain space.
Apart from entering into the Blockchain arena, the state can harmonize Blockchain applicability by crafting regulatory policies that should be aligned with such technologies. Incorporating Distributed Ledgers within the ambit of legal definitions would be the first step towards the regulatory approach. A proper definition can be helpful in ascertaining as to what Blockchain and smart contracts are along with help in determining the legal obligations. Similar to this initial phase of Blockchain, the internet was in the same position back in the early ’90s.
The internet even seemed to be a lawless territory but as time progressed law adapted to the technology by crafting legal regimes for its regulation. The Information Technology Act of 2000 is one example which in early hay-days of the internet, properly defined computer systems and offenses related to the same like Tampering with computer source documents, Hacking with a computer system, Cheating using computer resource etc. A similar approach can be taken for Blockchain applicability. France is a good example that framed legal policies to define Distributed Ledgers and allowed its application in the securities market.
One steady approach would be for the regulators to understand the mechanism behind the technology. This means to get first-hand experience the policymakers should focus on the development of an independent institution that is equipped with people that are experienced in this field. Blockchain as already discussed has the capability of helping in regulatory enforcement, one prime example is Smart Contracts that helps in automatic enforcement of copyright which can be crucial in the protection of Intellectual Properties. Regulators should enter the domain of distributed ledgers rather than banning them so that an efficient harmony can be maintained for its application. This can be achieved by working on high-impact cases and closely monitoring activities in the Blockchain space.
Conclusion
Blockchain applicability has the potential of transforming the modern world. The mechanism of a P2P transaction without the control of a central authority and self-regulating behaviour is revolutionary. The underlying mechanism of trust and efficiency improves its ambit which can help in eliminating the cost of manual processes. With the soaring value of Bitcoin and the growing popularity of Cryptocurrency as an acceptable form of payment, entities have started realizing its potential and have started adopting favourable policies. As its use increases, so would be innovation and advancement.
The applicability of DLs could be used in running decentralized and secured networks that can handle transactions. On the other hand, if combined with efficient AI and machine learning technology, it has the capability of securing the handling of voluminous data. Despite all these potentials, its applicability has the tendency of causing severe disruption. Sufficient mechanisms must be deployed to counter its disruptive use like anonymity, irreversibility of transactions, etc. Legal policies can be crafted in such a manner that promotes its application while simultaneously ensuring demarcation of liabilities and obligations of respective stakeholders.
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