Smart contracts aren’t contracts — and other crypto legal puzzlers

Researchers at Queen Mary University, London and Cambridge University have published a paper that suggests that lawmakers will need to address several legal issues that could affect blockchain technologies to ensure the technology can become an integral part of the public and private sector going forward.

Blockchain and the law

The report titled "Blockchain Demystified: A Technical and Legal Introduction to Distributed and Centralised Ledgers," written by Jean Bacon, Johan David Michels, Christopher Millard and Jatinder Singh, introduces readers to distributed and centralized digital ledgers from both a technical and legal standpoint.

It is an excellent read for those new to blockchain technology as it provides easy-to-understand but detailed insight into the workings of blockchain networks and cryptocurrencies. More pertinent, however, is the researchers’ dive into the legal aspects of blockchain networks and how they may or may not comply with different laws.

According to the paper’s authors, for blockchain networks to function in a legally compliant manner, they will need to take several laws into consideration including contract law, data protection law, securities law, property law, intellectual property and, finally, company law,

Smart contracts are not ‘legal’ contracts

A major challenge for widespread commercial and public sector blockchain adoption is that these networks need to comply with the law. This becomes even more apparent when the use of smart contracts is involved as there is currently no framework that provides smart contracts with legal validity.

The term "smart contracts" is cool and catchy, but in reality is very misleading as they are not legal contracts – in most jurisdictions – but are instead automated self-executing code. This was recently recognized by Ethereum founder, Vitalik Buterin, who tweeted that instead of calling them smart contracts he "should have called them something more boring and technical, perhaps something like "persistent scripts"."

"One could argue that a smart contract is not a legally enforceable promise, but an automated mechanical process. […] The creator of a smart contract will ordinarily need to explain his offer to human counter-parties in human intelligible language. This explanation can form the basis of the agreement between the parties and thereby determine the terms of the contract," the paper states.

Blockchain and the GDPR

Significant legal challenges for blockchain adoption are posed by privacy and data protection laws. Blockchain networks can contain sensitive information, such as personal data, that should not be privy to third-parties. However, in public blockchain networks, it is difficult to prevent the public from viewing all data contained on the blockchain.

Looking at the EU’s new General Data Protection Regulation (GDPR), which covers "the processing of personal data that falls within the regime’s territorial scope," it could be argued that public blockchain data – such as wallet addresses on the Bitcoin blockchain – could fall under the new regulation’s scope as this constitutes personal data. This could affect all wallet providers and exchanges that service European customers.

While it remains to be seen how the new privacy laws will be interpreted and enforced in practice, it will be unlikely that large global blockchain networks such as Bitcoin or Ethereum will be affected by the EU’s data protection laws due to their censorship resistant, distributed natures. However, centralized blockchain networks built for specific purposes will need to adhere to these laws.

Fortunately, for businesses and public sector institutions who are exploring permissioned ledgers to improve their operations, the research paper found that centralized blockchains can be compliant with the EU’s new laws provided the party controlling and processing data will adhere to the rules set out in the GDPR.

ICOs and securities law

Since the start of the ICO boom of 2017, it has been debated whether ICO tokens should be considered securities or not. While many startups have used the utility token approach to exempt themselves from securities laws, the reality is that investors purchase these tokens with the expectation that they will earn a return on investment further down the road as opposed to actually using the token to interact with the platform once it is launched.

As pointed out in the paper, "The difficulty [in determining whether an ICO token is a security or not] lies in the fact that ICOs often combine elements of investment and utility tokens. While the tokens can be used to access the service, ICOs may also offer investors the opportunity to profit from a company’s success by selling tokens at a profit on secondary markets."

Regulators across the world have responded to this by declaring that if an ICO can be classified as a security, it will need to register as such. However, no specific ICO laws have yet been drafted. For this new form of fundraising to succeed, new legislation could be helpful.

More legal questions that need to be answered

The paper also cites property law and intellectual property and how it relates to cryptographic assets and blockchain databases as legal challenges that need to be addressed. Moreover, it poses the question if DAOs are illegal since they may constitute companies and, thus, would need to be registered as such.

If no clear legal definitions exist for digital tokens or the use of blockchain databases, it will be harder for the technology to scale as many legal questions will remain unanswered, creating a legal risk for the institutions involved.

"Given the diversity of possible blockchain platform designs, no one-size-fits-all legal analysis is possible. Instead, each application of blockchain technology will need to be considered on its facts," the report suggests in its conclusion.