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Blockchain Technology Will Not Disrupt Financial Services Anytime Soon

Twenty venture capitalists gathered in Silicon Valley last week to discuss the impact of blockchain technology, including digital currency, on financial services and venture capital. The 20 VCs represent an equal number of funds, which invest–or are looking for investment opportunities–all over the world, including the third world. They represented a diverse group of perspectives, with some having regulatory experience, some having experience with conventional payment mechanisms and some with innovative mechanisms such as PayPal. Even their disagreements were instructive of the uncertain future of blockchain technology and its various potential applications.

The consensus is that digital currency is entering a nuclear winter. A majority of Initial Coin Offerings made in 2017–perhaps as much as 75%–turned out to be fraudulent and have no value today. Not coincidentally, the vast majority of Initial Coin Offerings originated in Eastern European countries that are home to spam and bot farms…and where there is little, if any, regulatory oversight.

To the extent bitcoins may become a viable, commercial technology for B2B transactions, it is likely to occur in a technology hub in the U.S. or Europe. Those hubs have the talent, the infrastructure and the robust regulatory structures that can be adapted to ICOs and create the trust necessary to make digital currency a positive, viable alternative to government currencies. In fact, the centralization of technology talent in the U.S. is depriving the rest of the world of talent.

The attempts of island states, like Bermuda, Malta, Cyprus, the Isle of Mann, and even Singapore to draft regulations that facilitate the creation of bitcoin issuers on their soil is unlikely to have a significant impact. Nobody who is experienced and seriously intends to build a global digital technology company and change the financial services industry on a global scale will think one can create the necessary large organization on these islands. These islands do not have an ecosystem of sophisticated VCs and do not have a critical mass of talented engineers. The island states are going for broke because they have so little to lose. When and if the technology matures, U.S. companies will step in and crush competitors based in these islands.

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The Magic of Mt. Gox

The Magic of Mt. Gox

November 27, 2017

Authored by: Bryce Suzuki and Justin Sabin

How Bitcoin Is Confounding Insolvency Law

Arthur C. Clarke famously observed: “Any sufficiently advanced technology is indistinguishable from magic.” Our regulatory, legislative, and judicial systems illustrate this principle whenever new technology exceeds the limits of our existing legal framework and collective legal imagination.  Cryptocurrency, such as bitcoin, has proven particularly “magical” in the existing framework of bankruptcy law, which has not yet determined quite what bitcoin is—a currency, an intangible asset, a commodity contract, or something else entirely.

The answer to that question matters, because capturing the value of highly-volatile cryptocurrency often determines winners and losers in bankruptcy cases where cryptocurrency is a significant asset. The recently-publicized revelation that the bankruptcy trustee of failed bitcoin exchange Mt. Gox is holding more than $1.9 billion worth of previously lost or stolen bitcoins highlights the issue.

The Mt. Gox Case:  Timing is Everything

In 2013, Mt. Gox[1] was the world’s largest bitcoin exchange.  By some estimates, it accounted for more than 80% of all bitcoin exchange activity.  By February 2014, Mt. Gox had shut down its website, frozen customer accounts, and ceased trading.  A leaked internal document indicated that hackers had gained access to Mt. Gox’s online wallets and stolen nearly 850,000 bitcoins, each then worth approximately $550.  That same month, Mt. Gox commenced insolvency proceedings in Japan, and thereafter filed a corresponding chapter 15 bankruptcy in the United States.  Mt. Gox eventually “found” approximately 200,000 bitcoins previously believed to be among those lost or stolen.

When it became clear that Mt. Gox could not reorganize and would proceed with liquidation, the Japanese court appointed a trustee over Mt. Gox’s assets.  A former Mt. Gox exchange customer then filed a lawsuit against the trustee seeking the return of the customer’s purchased bitcoins.  The Japanese court, however, ruled that the bitcoins at issue were not capable of ownership under Japanese law and dismissed the lawsuit.  Article 85 of the Civil Code of Japan provides that an object of ownership must be a tangible “thing,” in contrast to intangible rights (like contract or tort claims) or natural forces (like sunlight or electricity).  Bitcoin, the court ruled, does not meet the definition of a “thing” under the statute and, therefore, does not qualify for private ownership.

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Bitcoin after Brexit: Safe Haven or Harbinger of Future Distress?

What a difference a week can make! On June 17, 2016, bitcoin was trading at more than $750. Five days later, as polls showed the Brexit vote leaning heavily to “remain,” bitcoin dropped as low as $585. After the vote to leave the European Union became final, the British Pound, the Euro, the Chinese Yuan, and global stocks dropped precipitously. Bitcoin, on the other hand, spiked to more than $676. Could this mean bitcoin is being perceived as a new safe-haven asset?

A Brief Background on Bitcoin Generally

Bitcoin often is described as a “digital currency.” On a more technical level, bitcoin is a digital asset within a peer-to-peer computer network payment system created in 2008 by an anonymous cryptographer going by the pseudonym Satoshi Nakamoto. Because the computer network uses open-source, peer-to-peer software, no truly central authority administers and oversees transactions, and no government controls or backs the digital “currency.” Instead, users or “nodes” on the network verify transactions by solving complex computer algorithms. The verified transactions are then recorded on a public ledger (called the blockchain) for all to see. Because transactions employ lengthy key codes rather than traditional personally-identifiable information, users can trade bitcoin quasi-anonymously.

Because bitcoin lacks government or centralized control, conceptually it is accessible to anyone with an internet connection and eliminates many of the transaction costs associated with traditional currency trading. For the same reasons, however, it can be highly volatile. At the inception of the network in 2009 and through 2012, a single bitcoin was worth mere pennies. In 2013, amid a financial crisis and the seizure of bank accounts in Cyprus, holders of Cypriot accounts began buying massive amounts of bitcoin, which drove the price of bitcoin to more than $260 for the first time. By November 2013, the value of bitcoin peaked at $1,242. The price of bitcoin declined thereafter amid hacking scandals, the insolvency proceeding of Mt. Gox (bitcoin’s then largest exchange), and negative perceptions created by the high-profile criminal case involving the elicit online marketplace known as Silk Road. Despite its volatility over the last seven years, however, bitcoin has endured and shows no signs of disappearing.

Bitcoin as a Safe Haven?

Bitcoin’s sharp rise after the Brexit vote appears to evidence a new confidence in bitcoin as a safe haven. Investment professionals, however, have been extremely reluctant to give bitcoin such status. One recent research note observed that calling bitcoin a safe haven “obfuscates the fact that bitcoin is a high-risk and volatile investment” and ignores that “bitcoin’s correlation to other traditional safe-haven assets has fluctuated significantly.” Instead, bitcoin can be viewed as “something entirely different that does not fit into the normal buckets that investments are typically bracketed into.”

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CFTC Asserts Jurisdiction over Bitcoin Trading Platform

On September 17, 2015, the CFTC entered into a settlement with Coinflip, Inc. d/b/a Derivabit and Francisco Riordan. As part of the settlement with Coinflip, the CFTC entered an Order which included findings and the imposition of remedial sanctions. The CFTC found that Coinflip operated an “options trading platform that connected buyers and sellers of standardized Bitcoin options and futures contracts.” By doing so, the company had violated the Commodities Exchange Act by operating a facility for trading options or processing swaps without being registered with the CFTC as a Swap Execution Facility or a designated contract market.

Background

Coinflip advertised Derivabit as a “risk management platform . . . that connects buyers and sellers of standardized Bitcoin options and futures contracts.” Coinflip listed put and call options contracts as eligible for trading on the Derivabit platform. These contracts listed Bitcoin as the asset underlying the option and denominated the strike and delivery prices in US Dollars. Customers could place orders by registering as a user and depositing Bitcoin into an account in their name. The option contracts were settled using Bitcoin at a spot rate determined by a third-party Bitcoin currency exchange. Users could post bids or offers for the options contracts. Coinflip confirmed the bids or offers through the website.

Analysis

The case is interesting because for the first time the CFTC publicly stated that Bitcoin and other virtual currencies are “commodities” subject to CFTC enforcement actions:

Section 1a(9) of the Act defines “commodity” to include, among other things, “all services, rights and interests in which contracts for future delivery are presently or in the future dealt in.” . . . The definition of “commodity” is broad. . . . .Bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities.

To regular observers of the CFTC, the Coinflip decision was not surprising. In May 2013, then Commissioner Chilton noted “[i]n essence, we’re talking about a type of shadow currency, and there is more than a colourable argument to be made that derivative products relating to Bitcoin fall squarely in our jurisdiction.”

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“Is it safe?” Banking in 2014

Szell:  Is it safe?
Babe:  I don’t know what you mean. I can’t tell you something’s safe or not, unless I know specifically what you’re talking about.
Szell:  Is it safe?
Babe: Yes, it’s safe, it’s very safe, it’s so safe you wouldn’t believe it.
Szell:  Is it safe?
Babe:  No. It’s not safe, it’s… very dangerous, be careful.

In the 1976 movie Marathon Man, Babe (Dustin Hoffman) is held down while Nazi war criminal Szell (Laurence Olivier) drills Babe’s teeth without anesthetic, trying to learn if it is safe to sell a cache of diamonds stolen from concentration camp victims.  Babe has no idea what Szell was asking about so has no information to disclose, even under torture.

After a decade of painful regulatory examinations without anesthetic, bankers are now asking the same question from the perspective of the tortured.  Is it safe to do business again?  As in Marathon Man, whether it is safe depends in part on what “it” means – what the proposed business is and who the customer is.  It also depends on the bank’s systems and infrastructure to manage the risk.

Given the changing legal and liability landscape, and changing expectations of examiners, bankers are uncertain about the risks of engaging in many types of business.  Some of the areas of uncertainty include providing banking services to third party payment processors, payday lenders, or money services businesses.  Other bankers are wondering about banking services for legal marijuana retailers, or their clients taking courses for forex, or buyers, sellers, or processors of virtual currencies.  Some bankers are even hesitant to return to mortgage lending in light of all of the new regulations and regulatory scrutiny.

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Should Your Bank Do Business with Bitcoin?

If you hear the word “Bitcoin” and roll your eyes, a glimpse into the Bitcoin economy may inspire a new respect. In Spring 2013, the Bitcoin economy topped the $1 billion mark for a time, which is more than the economy of some small countries. This is not a pyramid scheme — this is potentially a whole new way of making payments.

What is Bitcoin?

If you are not a technology guru, Bitcoin can be a difficult concept to wrap your arms around. Bitcoin is a crypto-currency designed to create a new kind of money. Bitcoin uses cryptography, or a combination of mathematical theory and computer science, to control bitcoin transactions rather than centralized authorities. Bitcoin can be traded within the Bitcoin network, or used to purchase items through online bitcoin retailers, small businesses, and even to purchase drinks in bars.

The decentralized nature of the Bitcoin network makes it difficult to regulate and control. There is no single government or organization controlling the Bitcoin network; rather it is an open source project that is governed by consensus of its users. Bitcoin users value the privacy, security and freedom created by the decentralized network, and there is a strong interest in a currency that is not tied to one particular government. Developed in 2012, the Bitcoin Foundation, based in Seattle, works to promote the currency, improve standardization and security, and advance the core principles of “non-political economy, openness and independence.” Regulators are not standing on the sidelines and the regulatory field changes almost daily. Courts are finding Bitcoin is a “currency.” State and federal regulators are determining that virtual currencies are subject to money transmitter requirements. In March, FinCEN issued guidance indicating certain virtual currencies and exchanges need to comply with money services business requirements. In recent weeks, New York and California, among other states, took steps to pull certain Bitcoin companies within the requirements of the state money transmitter licensing laws.

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