Cryptocurrency – How to survive legal risks and confusing regulations
Piotr Powązka, independent Contract Management and GDPR Data Protection Consultant with Coauthor: René Franz Henschel, Professor, Aarhus University, Business and Social Sciences, Department of Law, Aarhus, Denmark
What if your contracting party says to you, “We accept your offer, but we will pay in Bitcoin or other cryptocurrency of our choice equaling the pricing currency. The buyer would like Bitcoin or Litecoin to be the contract currency and ask you to convert your pricing into Bitcoin.” 1
Before you can answer, you need to figure out what is coming with this new technology and how you will handle regulations affecting your transactions involving the use of cryptocurrency – let alone the certainty of risks you might not be able to anticipate yet.
Here are some major challenges you will likely encounter right away even as technologies and regulations are likely going to change. It’s smart to find out now…
Is it legal?
Can you use cryptocurrencies in a contract? Will you remain legal with regulators or might you face confusion and debate? Problems surrounding legal issues that could stand in the way of moving forward include:
- Many regulators across the globe are struggling with adopting proper legislation describing the rules for how to handle cryptocurrencies.
- Different regulators within the same country have different views.
- Debate prevails over whether a cryptocurrency is a commodity or an asset.
Not everyone sees Bitcoin the same way. In the US, the Commodity Futures Trading Commission (CFTC) views the Bitcoin as a commodity while the Internal Revenue Service (IRS) considers the Bitcoin property. Similar disparities exist with state and federal responses to the cryptocurrency related to Initial Coin Offering (ICO) 2 and smart contracts.
Disparities among regulators could threaten consumer protection. Britain’s Financial Conduct Authority (FCA) perceives Bitcoin as a “commodity”, and therefore does plan to regulate it. FCA also has hinted that it will step in to oversee Bitcoin-related derivatives. This can result in a lack of consumer protection which has been behind recent FCA warnings on the risks inherent in cryptocurrencies 2.
Two types of tokens with different functions deepen the challenges. Tokens are quite difficult to define, because they serve many functions such as cryptocurrencies, assets, company shares, or methods of payment. Therefore, they must have separate specific regulations, because they represent a new class of digital 3.
Tokens are identified as security and utility. Security tokens represent equity or share in a company and they are included within the Securities and Exchange Commission disclosure in the US, whereas utility tokens represent access to company’s product or service and they do not fall into a disclosure category. The SEC chair has stated that Bitcoin is not a security, because it does not grant “share” of a company/project 4. Based on this perspective, paying with currency such as Bitcoin means that you are “paying” with a commodity, asset, or a collectible. It forms a barter transaction (goods in exchange for this collectible/asset/commodity/bitcoin) and not a sale as long as the seller accepts it and it is not forbidden by law.
Tax liabilities may be huge or lenient which makes calculating tax more complex. Some regulators, like the one in Poland, want to tax every single transaction (buy and sell) with levy regardless of whether a profit is made; this does not include the regular income tax 5. Such would cost more than the capital invested in buying cryptocurrency not to mention paying for the goods or services.
Banks linked to traditional invoicing are unprepared. Another problem involves companies’ internal processes being linked to traditional invoicing. Usually, the invoice price is deposited into the company’s bank account in the currency cited on the invoice or the price is reconverted. However, neither the company’s bank nor your accounting department may be ready for such a transaction and your country (local) tax authority might not be ready either, considering lack of integrity among various legislations and authorities’ viewpoints. Making and receiving a payment in cryptocurrency is a different world than we all know today.
Be aware of differences country-to-country. Countries like Japan legalized cryptocurrencies as legal tender in 2017. Belarus also followed, and a few other countries are planning to do so. The EU has observed the technology first 6,7,8.
If a country grants legal status to Bitcoin as a currency, particularly legal tender, it means:
- paying with Bitcoin as a currency is like paying with Euro or USD (US dollar) and is accepted in many transactions; or
- paying with Bitcoin as legal tender means a merchant (person or organization involved in wholesale or international trade) cannot refuse to receive Bitcoin, because it is legal tender and as such, is considered the same as domestic currency (or Euro within EU)
Because of this, be sure to vet (validate) legal and tax aspects before making any commercial decisions involving cryptocurrencies. It is not unusual for the regulation to lag behind the technology.
Remember also that blockchain technology and cryptocurrencies are different commodities affecting what your country is willing to support. Some countries may support blockchain use but not cryptocurrencies, because they fear money launderers and terrorism financing which obviously must be addressed. If you decide to use cryptocurrencies in your contract, the above challenges are just beginning. More will surface over time.
Can your contracting framework tackle this?
How can a company buy and pay with a cryptocurrency? Assuming you have resolved the issues, your company will pay with cryptocurrency via portals instead of banks. Specifically, this means if you want to exchange your fiat money (inconvertible paper money made legal tender by a government decree) for any cryptocurrency, you will use portals like Bittrex, BitBay, Coinbase, Kucoin, Poloniex and others 9. Some portals offer a very wide selection of cryptocurrencies while others limit them to just a few. All of them will allow you to buy Bitcoin however.
How will it work? You will need to sign up for an account with your portal which is normally defined as individual rather than corporate; therefore, in a corporate environment, you need to be a proxy or have another type of authority to set up an account. To buy a cryptocurrency, you need to top up (fund) your account first either by wire transfer (standard or SEPA) or by using a debit/credit card; therefore, some banks block the use of a credit card and may terminate an agreement if you use a credit card to purchase any cryptocurrency.
Your account offers so called wallets to store company’s digital currency. However, from the funds security standpoint, you should have a more secure private wallet which can be a type of hardware, software or paper wallet 10. You need to be aware of hackers. So, keeping the money on any exchange for a longer period of time is risky, because bank guarantees do not exist in case coins are somehow stolen. The safest wallets are considered to be hardware or paper wallets. All wallets have public and private addresses and public and private keys 11.
How do Bitcoin transactions work? A Bitcoin address is just a shorthand notation for a public key. In contrast, a private key (address) is a secret, alphanumeric password/number which you use to spend or send your Bitcoins to another Bitcoin address. A private key (or address) is like a password to your email or online banking and must be secured and most importantly backed up somewhere. If you lose it, nobody will be able to recover it, nor you will be able to call a hotline to help you.
A public address is like a bank account number which can be known to the other party, thus if you make a mistake and send the transaction to the wrong address, the funds are usually gone and cannot be retrieved. They may end up in an electron heaven and nobody will ever have access to it. A public key/address is also an alphanumeric combination derived from private keys only by using cryptographic math functions. Then, when someone makes a transaction to a public address, that person essentially states, “I give the right to spend this currency to the person who owns the private key (address) corresponding to this public address”. The person who has received this transaction will in turn be able to spend the transaction (currency) by signing the transaction using his private key. With this signature one can prove his or her ownership of the key, without disclosing it. Others can verify the signature using the public key.
As an example, let’s say your invoice is in EUR. You need to buy a Bitcoin, and you can do that using so called USD Tether, a cryptocurrency linked to USD 12 (The tether converts cash into digital currency and tethers the value to equal the price of national currencies). You exchange three currencies and you pay a fee for that.
Also remember that blockchain transactions are still developing and before the Lightning Network 13 is fully up and running, fees for a Bitcoin transaction can be expensive.
For example, the chart below shows the Bitcoin and Etherum average transaction fees skyrocketed between Dec 2017 and Feb 2018. This trend was driven by demand. But companies can still use other coins like Litecoin, Ethereum, etc. Thus, the above may still apply, although Ethereum has been far less expensive and faster during the same time period.
Therefore, from a commercial perspective consider who will access the exchange and wallets while you act as your own bank. In other words, as long as you are responsible for handling your transactions and securing your wallets and funds — you act as your own bank. Your funds are not protected in a virtual world. If you lose funds or they are stolen by a hacker, you won’t phone your bank to block a transaction/card. Even if you use online wallets you literally rely on the other party’s honesty. If the other party is hacked, there is no guarantee you get the cryptocurrency back. By contrast, if your bank gets hacked, you normally can expect your funds to be protected — held in your account.
And for that reason, you need to determine:
- Will your bank support the company in buying cryptocurrency through cryptocurrency exchanges?
- Did you check cybersecurity policy, and can you stay compliant on what should be changed?
- Did you assess currency exchange rate in your business case and related fees and who will pay that?
- How do you show such a transaction in your accounting books and tax statement?
- Did you consider manual work related to your ERP systems which are not ready for monitoring customer’s balances in cryptocurrency?
We need to get smarter, know the risks!
Smart contracts automate a lot of mundane tasks including payments. However, using cryptocurrencies in complex transactions is not so easy. Still, it is worth learning about it and watching closely companies like Amazon, eBay or Starbucks, because published opinion has been released about involvement of these companies in enabling payments for consumers 14.
Know the risks of using cryptocurrency. Regulatory risk, as mentioned above, should be your first consideration in any decision relating to cryptocurrency, because the last thing you want is unnecessary regulatory risk to sidetrack you from focusing on collaboration with your customers and suppliers. It would be good to watch closely the market for now. Hopefully, after more people understand the purpose of blockchain and cryptocurrencies, they might become less confused about the regulations.
Cybersecurity is obviously a risk. In using wallets for cryptocurrency, companies will need to ensure and align their processes to protect their funds. Because the market is at an early stage of development, keeping cryptocurrency funds online is very risky as clearly shown by incidents of Coincheck or Mt. Gox hacking 15. Even when using hardware or paper wallets you need to educate yourself to know what you are doing. Again, bank consultants cannot help you when you send the money to the wrong address (account)!
Regulatory risks have played a part in influencing organizations’ lack of readiness for adopting cryptocurrencies as a payment option. Also, few companies will invest in aligning internal systems and processes to the technology that is so new.
Companies and people need more education in the use of cryptocurrency before they should start adopting it. Just think about the Internet when computers in our offices started to connect with the worldwide web using dial in modems… We did not even know at the beginning what the search engine is and how to use it. Similarly, we need to learn blockchain and cryptocurrencies.
At the moment there are so many cryptocurrencies on the market, it is difficult to choose the right one for a corporate environment and establish relevant processes to support the adoption.
It’s coming – be very cautious but optimistic. Cryptocurrencies can serve as the new payment method streamlining the process together with smart contracts. So, in collaborating with a partner, it’s critical to work closely in understanding all risks. Today, we still need to address many regulatory and organizational challenges now while technology is developing. We need to build a trusted framework to widely adopt new technology and align or create new processes embedding this technology.
- Bitcoin is a type of digital currency (or cryptocurrency) involving encryption techniques that regulate the generation of currency units and verify the transfer of funds. Bitcoin operates independently of a bank. Litecoin is an alternative cryptocurrency based on the Bitcoin model.
- Bitcoin Has A Regulation Problem, By Rakesh Sharma, January 23, 2018 Is Bitcoin Legal? Coindesk website See also article defining Initial Coin Offering
- Security Tokens Vs Utility Tokens
- SEC Statement on Cryptocurrencies and Initial Coin Offerings
- Cryptocurrencies – Crypto Traders Oppose Poland’s Tax Decision, Konrad Krasuski, Bloomberg online April 9, 2018
- Cryptocurrency Regulation in 2018: Where the World Stands Right Now, Andrew Nelson, Bitcoin Magazine, Feb 1, 2018
- Is Bitcoin Legal? Coindesk website
- Blockchain Regulation: Is Europe Getting It Right?
- Exchange Reviews – Copyright©2018 – BitPremiere
- Best Bitcoin Wallets 2018: Hardware vs Software vs Paper – Oliver Dale, Blockonomi Jan 3, 2018
- Bitcoin Public and Private Keys, by Prypto in online dummies, A Wiley Brand (Ad: Related book: Bitcoin for Dummies, available at dummies storeÆ online)
- Cryptocurrencies – Bittrex Gets Bank Agreement to Help You Buy Bitcoin with Dollars, Bloomberg online, Lily Katz, May 31, 2018
- What is the Lightning Network? (Blockchain Event San Francisco – 2-Day Blockchain Conference June 26-27, San Jose, CA – 21 March 2018
- Are Corporate Cryptocurrencies Coming? Amazon, eBay and Starbucks, Blockonomi, Carlos Terenzion, April 4, 2018
- Mt. Gox, Coincheck, Binance and More: How Exchanges Are Learning to Deal With Cyberattacks
This post was originally published in Contracting Excellence Magazine here.