Candian Legal Analysis: Intro
From a legislator’s perspective, the rapid growth of digital assets over the last few years has shaken up the financial regulatory landscape and triggered a call to action in many jurisdictions. As with any new technology, Bitcoin brought forth challenges in determining how to reconcile cryptocurrency within a legal paradigm contemplated for a preceding system. The purpose of this article is to provide clarity on the regulatory landscape surrounding cryptocurrency by examining the application of existing principles of law to novel technology.
By 2017, the widespread use of Bitcoin prompted many policymakers to formally respond to growing concerns of theft, fraud, and market manipulation. Since cryptocurrency makes transactions essentially borderless, a much more globalized economy is beginning to develop despite the absence of an equally unified framework support such international activity. Accordingly, efforts to regulate digital assets have been fragmented between countries. Conflicting approaches across jurisdictions limits the regulatory power of nation states and undermines the enforcement of existing compliance measures. The result is a climate of considerable uncertainty in the governance of cryptocurrency.
Driven in part by the struggles faced by authorities to adequately maintain authority over cryptocurrency markets, and to a lack of foresight, misconceptions surrounding the application of the law exposed financial stakeholders to significant risks.
Early advocates of blockchain presumed that its distinctive qualities of disintermediation make it insusceptible to regulation and argued that cryptocurrency had been created as a solution to the stringent public oversight of financial markets. Under this assumption, many token issuers prior to mid-2017 largely ignored securities law registration requirements meant to protect investors and foster fair markets. Hacks, exit scams and phishing attacks related to token sales have led to over $400 million worth of funds stolen or lost over the last few years. However, when viewed against the historical backdrop of the Internet, it becomes clear that novel technologies do not supersede government intervention or the law. Most financial regulation is enacted in the aftermath of a significant change in the market, and initial legal ambiguity is not indicative of future regulatory architecture.
Objectives of Legal Regulation
Reliable legal remedies are necessary for the protection of individual rights and integral to a functional accountability regime. Especially within the financial sector, where individuals are extremely vulnerable to risk, regulation minimizes consumer exposure to harm and is paramount to maintain market integrity. Law is not an absolute, but rather; meant to evolve alongside developments in society. Indeed, advances in technology sometimes require legislative revision as regulatory models contemplated for a certain set of circumstances can become incompatible with new economic and technological conditions.
How Bitcoin Challenged Financial Legislative Regimes
When such instances of major disruption to an industry occurs, the immediacy with which new risks need to be accounted for often creates a climate of uncertainty as legislators struggle to devise optimal solutions in the face of incomplete information. Bitcoin is no exception, and while most jurisdictions around the world have now issued policy guidance or amendments to existing legislation, its emergence in 2009 was met with significant regulatory ambiguity. By using blockchain technology to automatically verify transactions, Bitcoin became the first cryptocurrency to circumvent the issue of trust, enabling individuals to send and receive money on a peer-to-peer basis without the use of a third party authority to manage the transaction. Though revolutionary, this decentralization makes it increasingly difficult to apply existing principles of law and significantly threatens the ability to enforce compliance with certain standards. Governments have previously relied on regulated financial incumbents such as banks or payment processors to address concerns such as fraud, money laundering, and terrorist financing. No longer imperative to the process, these intermediaries are largely bypassed in token transactions, allowing value to transfer unimpeded. While the ability to freely create, disseminate, and trade assets without such oversight appears advantageous in terms of efficiency, the lack of supervisory control introduces unprecedented manipulation risks that generally outweigh any such gains. Not surprisingly, given that Bitcoin flew under the radar of regulators until 2017, much of the initial interest in Bitcoin use centered around the very concept of bypassing governing authorities.
History Tends to Repeat Itself: The Development of the Internet Regulatory Framework
Before 2017, many developers and early advocates of blockchain had presumed that its distinctive qualities of disintermediation make it insusceptible to regulation and argued that cryptocurrency had been created as a solution to the problem of public oversight of the financial markets. However, by reviewing the historical trajectory of Internet governance, it becomes evident that not only is the regulation of distributed ledger technology viable but it is also immensely important.
In the early 1990’s, when the Internet was just in its infancy, the idea of a space that was able to surpass the physical boundaries of the state became the origin of cyber-libertarianism; the belief that cyberspace both is and should be free from government intervention. Grounded in the fundamental position that the international nature of cyberspace produced a space “too widespread to be easily dominated by any single government,” proponents of this view challenged the traditional concepts of nation-states, proclaiming that governments lacked the legitimacy to have authority over the governance of cyberspace. John Perry Barlow, one of the main scholars behind the cyber-libertarianism movement argued in his Declaration of Independence of Cyberspace, that cyberspace was sovereign in its own right and that the legal concepts of property, expression, identity, movement, and context did not apply to the Internet. Instead of traditional governance structures, the cyber-libertarian view based itself on self-governance to manage conflicts. Indeed, it was believed that the decentralized nature of cyberspace would develop a regulatory system based on the consent of the majority of individuals within cyberspace rather than the rule of law.
Yet in the latter years of the 1990’s, the idealistic visions of an unregulable cyberspace was met with the harsh reality that the rise of global networking does not eradicate reliance on humans or intermediaries. Put into legal theory by influential law scholar Lawrence Lessig in 1998, the architecture of cyberspace contains conditions upon which one enters and gains access is determined by software protocols. Though the ability for coded algorithms to regulate online interactions is by its very nature, a form of governance mechanism, the “code is law” philosophy is fundamentally flawed. The source code that underlies the functions of cyberspace is designed by humans, and thus, the protocols that are in place are inherently regulable by such individuals. As a result, rather than cyberspace being a place of freedom from government intervention, Lessig argued that the technical rules underpinning its infrastructure Internet would cause it to be the “most fully, and extensively, regulated space that we have ever known.
Lessig’s predictions were not wrong. Today, nearly 30 years since its inception, the physical structures of the Internet and the data systems online are maintained through a multi-layered model consisting of private and public stakeholders around the world. Governments increasingly rely on software to directly enforce rules and state surveillance is the present regulatory framework surrounding the Internet is fraught with multiple control mechanisms. Electronic markets certainly reduced or eliminated the roles of some traditional intermediaries, but new roles surfaced for electronic intermediaries that evidently outweighed any trend towards disintermediation.
Comparable to the Internet, blockchain-based systems brought forth a tremendous amount of changes in how the law is understood and applied. In particular, the unprecedented level of autonomy to freely transact using cryptocurrencies led to the same misconception that Bitcoin and other digital assets are inherently un-regulable or unregulated because governmental legislation had not yet adapted to the changes associated with the technology. However, the experience of the past thirty years suggests that government institutions are not easily disintermediated. When there was a strong interest to control online activities, nation States did not simply defer their authority, but developed new ways to regulate.
So Is Crypto Actually Unregulated?
A similar trajectory has begun to follow with regulations concerning blockchain transactions. Even when transactions are entirely peer-to-peer, cryptographically secured and pseudo-anonymous, cryptocurrency users can be identified and remain subject to legal obligations. The fact that regulators have not provided clear guidance on the application of existing laws to these new instruments does not imply that these instruments are unregulated. When specific regulations have not yet been formed, new technologies continue to remain subject to regulation by prevailing laws and precedents.
This principle is demonstrated in the United States government termination of Silk Road. Established in 2011, Silk Road was a marketplace for illicit drugs and other illegal commodities where users could transact securely and anonymously via Bitcoin. During its three years of operation, the site operated relatively uninhibited by legal enforcement, and processed sales worth roughly $1.2 billion. Yet, the existence and functionality of the site did not make the activities conducted through it legal, and in 2013, FBI shut it down and arrested its creator, Ross Ulbright. Convicted of money laundering, computer hacking, conspiracy to traffic fraudulent identity documents, and conspiracy to traffic narcotics by means of the Internet, Ulbright is currently serving a life sentence without the possibility of parole. Since 2013, authorities all over the world have targeted and intercepted drugs and criminal products imported via Silk Road and over 130 other arrests have been made in connection with the site. Accordingly, it is quite evident that while the anonymity inherent in the blockchain may make it more difficult to implement laws, they remain in force.
Computers Are Not Replacing Human Lawmakers (Yet)
With the technology rapidly evolving and pushing the economy increasingly towards disintermediation, large-scale operation of this technology only necessitates a reconsideration of the way in which the role of the law operates, rather than a departure from all regulation. As the Internet previously established, computer code is still subject to human limitations which consequently presents the opportunity for vulnerability to the overall architecture.
The rise and fall of the Decentralized Autonomous Organization (DAO) illustrates the shortcomings of purely algorithmic systems with respect to a lack of government interference. Funded by a crowdfunded token sale in 2016, the DAO represented a new form of corporate organization. The DAO existed as a set of contracts on the Ethereum blockchain that created a decentralized investor-directed enterprise. Instead of delegating corporate decisions to an upper management team, investors decided which companies to fund by using their digital tokens to exercise voting rights. The removal of power from upper management was intended to prevent the misdirection of funds and form a more democratic financial entity. Unfortunately, programming flaws in the system caused a number of security weaknesses and approximately a month after its inception, a loophole enabled a hacker to drain the equivalent of $70 million from the fund. Code was meant to eliminate the need to trust humans, but as it turns out, this is near impossible to achieve. Even if an algorithm is mathematically correct, blockchains are structures conceived and implemented by humans and thus, remain vulnerable to selfish behaviour, attacks and manipulation. Governmental action is therefore necessary to create a regulatory environment that mitigates against uncertainty. Increased reliance on software code is inevitable, and the law must accommodate to these changes operate alongside in order to protect individual rights and safeguard against criminal activity.
Canada’s Regulatory Response
Canada in particular has been one of the leading legal systems working to address issues around blockchain technology and has adopted or modified legislation on the subject matter. On June 19, 2014, the Canadian Parliament became the first government in the world to pass a national law on digital currencies. Since then, the Canadian government has remained fairly proactive in its approach towards cryptocurrency, taking a cautious but supportive stance. Beginning August 2017, multiple policy guidelines have been issued by Canadian Securities Administrators (CSA) and other provincial regulators such as the Ontario Securities Commission on the applicability of securities laws to cryptocurrency. In addition to clarifying the law for businesses engaging with digital assets, regulatory bodies have encouraged experimentation with fintech through initiatives to help companies get limited short-term regulatory exemptions to securities law requirements such as the CSA Launchpad and the OSC Regulatory Sandbox. Please click here for more information on recent updates to compliance regulations.
As the blockchain continues to evolve and disrupt traditional capital raising models, policymakers have an essential role in developing the necessary conditions to create a suitable framework for cryptocurrency to operate safely. With a large quantity of blockchain startups centered in Canada, it is important for Canadian lawmakers to reconcile legislation that is permissive enough to promote opportunities for innovation but strict enough to protect investor and public interest.
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