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Bits and Blocks

Bits and Blocks

By Caroline Jones


Snapshot Blockchain technology has the potential to disrupt many industries. The landscape is constantly shifting as diverse stakeholders explore its potential uses. Know the difference between public blockchains, private blockchains and smart contracts. The technology may replace some functions traditionally performed by lawyers, but presents opportunities for new types of work. For the past year or so, you may have noticed the term blockchain being bandied about, usually in the same sentence as “trust” and “third parties”. At one point you might have suspected that The Blockchain was a wellness retreat for the brokenhearted. You would not have been the only one. While I don’t have a background in computer science (I’m a litigation lawyer), I became interested in blockchain technology because, according to its evangelists, it’s going to change the world.1 While the blockchain landscape is in a state of flux, its potential to impact a vast range of client industries is certain. In terms of legal services, the technology has the ability to replace some of lawyers’ traditional functions but it will also generate new work. What is a blockchain? Imagine that you are going overseas and I agree to buy your washing machine. I log in to my online bank account and send $400 to your bank account. This involves my bank checking that I have $400 in my account, confirming your account is valid, and then crediting your account. In the world of the digital currency bitcoin, I can pay you without the bank’s involvement because trust between us is established in a novel way. The infrastructure that allows bitcoin transactions to happen is known as blockchain technology. It is this technology that is generating excitement: while Bitcoin (a word used to denote both the digital currency and the particular blockchain upon which you transact that currency) is the most well-known example, there are many other examples of the technology in action and the number continues to grow.2 A blockchain is one type of distributed ledger. A distributed ledger is a digital, decentralised record of transactions. There is not one definitive ledger held by a central third party (ie, a bank, clearing house or government agency). All computers connected to a blockchain automatically hold a copy of it. Let’s assume that you and I both have “bitcoin wallets” (computer software that allows us to hold bitcoins). If I want to pay you 0.1 bitcoin for your washing machine, this can happen in 10 minutes without the involvement of a central third party.3 How? The ledger for bitcoin transactions is updated and verified by people called “miners”. The concept of mining is intriguing and very technical. In simple terms, miners use special computer software to verify attempted transactions on a blockchain. Anyone with the relevant software can be a miner and these days there are companies running thousands of computers dedicated to mining. When I log in to my bitcoin wallet to pay you 0.1 bitcoin, this intention will be broadcast to the network of miners. My pending transaction presents itself to the miners, along with a bundle of other pending transactions (a “block”), as a complex number puzzle. Thousands of miners put their computer software to work in solving that puzzle. Part of the puzzle-solving requires the miners to confirm that I am in fact the owner of the 0.1 bitcoin I am trying to send. Due to the magic of “public key cryptography” the miners can confirm that I am the owner without receiving any information that identifies me. The first miner to solve the puzzle broadcasts the solution to the network of miners. The other miners view the completed puzzle and can quickly agree that it has been solved. The block of transactions has been verified and it is added to the history of the ledger (the existing “chain”). The first miner to solve the puzzle presented by a pending block of transactions receives digital currency as a reward – this is what incentivises the miners to do their work. Bitcoin miners are currently issued 12.5 new bitcoins4 and any transaction fees offered by users5 when they successfully verify a block. When the block containing the transaction for the washing machine is added to the chain, you will receive 0.1 bitcoin in your bitcoin wallet. Private or public blockchain? Blockchains can be public or private, and the distinction has implications for lawyers. They also have different pros and cons. A public blockchain, such as Bitcoin or Ethereum, is open-source, which means it can be accessed by anyone. It offers unparalleled security for transacting due to its miner verification system and the fact the ledger cannot be tampered with. Public blockchains also offer to speed up and reduce the cost of transacting. Ironically, however, these very selling-points can lose their sparkle as the popularity of certain blockchains grows. As more people use a public blockchain, the number puzzles become more difficult for miners to solve and the verification process becomes slower. Miners demand more compensation for their work, causing transaction costs to rise. The debate around the scalability of the world's most successful blockchain, Bitcoin, came to a head on 1 August 2017. The Bitcoin community disagreed about the best way to improve transaction speeds and block capacity, and ultimately the most dramatic outcome – a "hard fork" – took place. This is when a blockchain splits permanently, and users vote with their fingertips as to which protocol they prefer. Tech websites live blogged the moment a group of powerful miners caused a new blockchain, Bitcoin Cash, to emerge. The viability of this alternative blockchain is being closely watched, as are the political machinations behind this novel "civil war". Another concern with public blockchains is their lack of privacy – every user has a copy of the ledger. Although transactions are encrypted, some are concerned that a prying cyber-genius may be able to decode their private business affairs.6 On the other side of the (bit)coin, some are concerned that it is too private. They are critical of the anonymity afforded by blockchains, which has been conducive to criminal activity. Online black market places Silk Road and Alpha Bay traded illegal drugs for bitcoin before law enforcement shut them down in 2013 and July 2017. In other criminal activity, a cyber ransom was launched in May on thousands of computers across the globe when the “WannaCry” hackers released a virus and demanded a ransom of US$300 in bitcoin to remove it. A private blockchain, on the other hand, can only be used by a group of authorised participants. For instance, private blockchain technology is being cautiously embraced by banks to make cross-border payments to one another in real-time without the need for clearing houses, and to share customer histories without the need for credit agencies. The participants create the rules of engagement and are allowed to change them. Unlike the dramatic new world view offered by public blockchains, private ones raise the question – why bother? The defining feature of blockchains is supposed to be the way it distributes trust to many parties, whereas private blockchains are only quasi-decentralised. Smart contracts Smart contracts go one step further. They are software built into some blockchains which self-execute transactions. If you are a party to a smart contract and a specified event takes place, a pre-written code is triggered to run on all computers in the network. This has the effect of executing all or part of an agreement without human intervention. As examples, smart contracts could be used to: calculate equity trade amounts and transfer funds automatically transfer royalty payments to a musician honour insurance claim pay-outs based on the type of claim and policy. At this stage, only agreements with straightforward terms and outcomes are capable of being encoded as smart contracts. For instance, if a contract includes a term that John will receive $100 from Betty if he uses his “best endeavours” to pass Year 10 Maths, this is not capable of being encoded as a smart contract because the subjective nature of the term leaves open the potential for disagreement between the parties. However, if the contract says that John will receive $100 from Betty if he passes Year 10 Maths, this theoretically could form the basis of a smart contract because the trigger for payment is precisely defined. It is important to note that smart contracts are only as good as the code underpinning them. A stunning cautionary tale is the attack last year on the Decentralised Autonomous Organisation (DAO). The DAO is a collective investment scheme enshrined in code, which sat on the public blockchain Ethereum. The DAO is not run by an executive, rather investors vote on management and investment decisions. The equivalent of US$150 million was invested in the DAO. Not long after its launch, an unknown attacker took advantage of a weakness in the DAO smart contract to siphon off digital currency worth US$50 million. The difficulty of having a leaderless, unregulated organisation quickly became clear. No one had explicit authority to fix the situation and any attempt to retrieve the stolen currency would undermine the idea that “code is law”. Eventually, with the support of DAO investors and Ethereum miners, all funds, including those drained by the attacker, were moved onto a more secure smart contract so that the investors could withdraw.7 Lawyers and blockchains Like the internet, blockchain technology may sound like science fiction today but it could soon become a fixture in our lives. There are two main reasons why lawyers should care about it. Clients care about it Blockchain technology has the capacity to affect a wide range of client industries. Financial institutions are facing significant disruption because of the role they currently play as a trusted intermediary. As a result, they are working to understand the technology’s impact on their core business, while also looking at how they can develop the technology to their advantage. For example, most banks are experimenting with the technology (as noted above) and the Australian Securities Exchange has invested in technology partner Digital Asset Holdings LLC in the hope of creating a private blockchain that will suitably upgrade its existing system for clearing and settling trades (CHESS). It is poised to make a decision on whether it will adopt the technology later this year.8 Global insurers are piloting a blockchain called B3i, aimed at exchanging data between reinsurance and insurance companies. The technology is being used to monitor ownership and quality in supply chains for valuables such as diamonds (Everledger) and food (Provenance and AgriDigital – the latter blockchain also triggers automatic payment to suppliers of goods on their delivery).9 Telstra has pointed to the link with mobile banking and Australia Post wants to store our digital identities on a blockchain to transform its services. AGL is testing blockchain as a means of trading surplus energy, and others are excited about its potential to replace land registries.10 In 2017, blockchain technology has attracted criticism for being over-hyped11 – and perhaps many of its predicted applications will not eventuate – but it is difficult to ignore the innovation it has already inspired. Opportunities for lawyers Blockchain technology may render some functions traditionally performed by lawyers redundant but this will be true for any industry that has an agency component. The view that lawyers will be replaced by blockchains is premised on a misunderstanding that most lawyers only perform process-driven tasks, such as settlement agency or escrow services.12 In some ways, the technology might liberate lawyers from some of the less interesting tasks and provide an opportunity to think more laterally about where their value lies. Public blockchains Public blockchains are completely unregulated – computer code is law. While this doesn’t sound immediately promising for lawyers, there may be scope for lawyers to influence what the code says. If a blockchain is being developed for use in an area that is already subject to government or industry regulation (eg, the financial services industry), in order for clients to avoid legal problems the blockchain should be designed to operate in a way that is consistent with those existing regulations.13 Lawyers could ensure this occurs by partnering with engineers to develop the underlying technology. Private blockchains Private blockchains may attract a lot of advisory and drafting work in setting up new schemes. Participants in private blockchains are likely to seek formal contracts and confidentiality agreements that govern their relationships with one another. If a central third party is engaged to verify transactions, a service contract may also be required. In addition to providing these conventional services, as with public blockchains, lawyers could provide input regarding the blockchain’s overall design. Smart contracts The DAO incident has highlighted problems with relying on computer software to be the arbiter of commercial disputes. Lawyers are ideally placed to advise clients on the types of transactions capable of being encoded as smart contracts and help design them. They can advise on the limitations of smart contracts and when it is appropriate to provide for an element of human decision-making. Without laying out a roadmap for success, blockchain experts Don and Alex Tapscott suggest that “expertise in smart contracts could be a big opportunity for law firms that want to lead innovation in contract law”.14 Conclusion Blockchain technology is poised to shake things up with its new ecosystem of internet-enabled services. Lawyers don’t need to become computer experts but should stay up-to-date with developments and turn their minds to the efficiencies and risks the technology could bring to their clients. Far from replacing lawyers, there may be a significant role to play in designing blockchains and smart contracts. From a policy perspective, lawyers may also want to monitor how the technology evolves to address questions of privacy, fairness and accountability. Caroline Jones is a lawyer at Arnold Bloch Leibler and a member of Victorian Women Lawyers Executive Committee. 1Don Tapscott and Alex Tapscott, Blockchain Revolution: How the Technology behind Bitcoin is Changing Money, Business, and the World (New York: Portfolio/Penguin, 2016). 2At the time of writing, 935 early stage bitcoin and blockchain companies have been identified by (reviewed August 2017). 3At the time of writing (August 2017), one bitcoin is equivalent to approximately A$4000. The value of bitcoin is notoriously volatile and has reached historical highs in 2017. 4Earning a bitcoin reward through mining is the only way for new bitcoins to enter that economy. The system has been designed so that only 21 million bitcoin can be mined in total. Once that point is reached, the only “reward” for miners will be the transaction fees offered by users transacting in bitcoin. See Evan Faggart, “What Happens to Bitcoin Miners When all Coins are Mined?”, 15 August 2015, 5Transaction fees are chosen by people transacting in bitcoin. It is akin to offering a tip to miners to encourage them to verify your pending transaction ahead of others in the queue. See Bitcoin Australia Team, “How to Decide What Size Bitcoin Transaction Fee to Attach”, 17 January 2017, 6Vitalik Buterin (co-founder of Ethereum), “Privacy on the Blockchain”, 15 January 2016, 7Rob Price, “Digital currency Ethereum is cratering because of a $50 million hack”, 18 June 2016, 9James Eyres, “Wheat farmers trial blockchain to sell grain and find it is fast and reliable”, 21 December 2016, 10Danika Wright, “How the blockchain will transform housing markets”, 13 April 2017, 11Tony Boyd, “Blockchain is over-hyped but still part of the solution”, 10 May 2017, 12James Eyres and Misa Han, “Lawyers prepare for ‘driverless M&A’ as smart contract era dawns”, 19 June 2016, and James Eyres, “Blockchain and how it will change everything”, 6 February 2016, 13The Australian Securities and Investments Commission released a framework in March 2017 on the use of the technology, including an entire section encouraging businesses to consider “How does the DLT [distributed ledger technology under consideration] work under the law?" 14Note 1 above, p103.

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