This is a written recap of a discussion organized by Dominicans on Wall Street, a non-profit organization, between legal experts, venture capitalists, and government officials. The author has no vested interest in any of the projects mentioned and does not offer investment advice.
Walk into any coffee shop, workspace, or lounge these days and it’s very likely to overhear the word decentralization thrown around a lot. Decentralized ledgers, decentralized apps, the decentralization of this, the decentralization of that. All the chatter about the next big social network or the Uber of such and such industry has been replaced by something fresher, stranger, and perhaps more consequential than building another attention trap or matchmaking algorithm. Blockchains and cryptocurrencies are drawing all the excitement now. They’re also the topic of an increasingly complicated conversation between government and technology.
Amid congressional hearings on Big Tech’s increasing influence in global politics and media, many realize that blockchain could soon challenge our ideas about exchanging value much like current internet applications have challenged our norms of communication. They already allow participants to issue new currencies and assets, perform online transactions in a truly private manner, and take part in all sorts of self-executing agreements known as smart contracts. It is understood that blockchain protocols and decentralized applications could become to finance what Facebook and Twitter are to journalism, what YouTube is to audiovisual content, or what Spotify is to music. They could be many other things as well, and this raises all sorts of questions about centralized versus decentralized systems. Some of these are relevant to government and its role in both regulating and fostering alternatives to what were once monopolized institutions.
A recent example of a constructive debate on the matter took place at a panel organized by Dominicans on Wall Street and hosted by Baker McKenzie. The event, which aimed to be a 101 on blockchain technology, quickly became an enthusiastic discussion on what it means for the Dominican Republic and the government’s approach to it. Statista reports that Latin America is “the world region where most cryptocurrency users are located,” making the discussion an example of questions that are becoming globally relevant. Surely, there was a lot to unpack.
After an introduction by DOWS Founder and President Josefa Sicard-Mirabal, computer scientist and lawyer David Zaslowsky explained what blockchains are and why the hype around them is unlike anything he’s seen since the beginnings of the internet. He also addressed some of the common misconceptions around them, starting with the fact that blockchain’s use cases go far beyond Bitcoin.
Blockchains, when seen as technical innovations, are a great example of lateral thinking. They are essentially peer-to-peer networks, similar to file-sharing systems like BitTorrent, combined with cryptographic techniques. What is special about them is that these networks keep a database of transactions that take place between its participants. These transactions are recorded in blocks that are then transmitted across the network for verification. Once approved via a consensus algorithm, each block is timestamped and contains a reference to the previous block, linking them together in a chain. Hence the name.
Usually, the system uses hash functions that pseudonymize the identity of its participants and verify that every transaction block is recorded securely to avoid the problem of double-spending. In a public blockchain like Bitcoin, every participant, or node, in the network has a copy of the transaction database, ensuring full transparency as well. It’s worth noting that Bitcoin has never been hacked in the ten years since its implementation.
The real breakthrough in this technology is that it solves the Byzantine Generals Problem, a computer science problem where participants of a network must find a way to reach an agreement without trusting a central authority. As Zaslowsky pointed out, “trust is key to any transaction. This makes blockchains appealing because trust is built into them.” Participants don’t need to know anybody in the network in order to transact with them safely because everyone shares the same information.
A development like this opens up questions for financial service providers, government registries, and many other centralized institutions where trusted third-parties play a costly role. It also raises serious concerns when used for transactions and commercial activities that can bypass government controls altogether. The regulatory landscape around blockchain and cryptocurrencies is evolving fast in order to address these issues.
Zaslowsky is the editor of the Baker McKenzie blog on blockchain besides chairing the firm’s litigation department.
Smart Contracts and Blockchain Applications
Next, Sidley Austin counsel Kenny Terrero expanded on one of the most popular and promising applications for blockchain technology: smart contracts.
The idea of smart contracts was first published by cryptocurrency pioneer Nick Szabo in 1996, more than a decade before Bitcoin became the first successful iteration of his own attempt at creating a digital currency. In a nutshell, Szabo proposed that the same contractual logic that was embedded in simple vending machine software could be extended to all kinds of transactions on public networks. These smart contracts would consist of self-executing computer programs designed to enforce a set of predetermined conditions agreed upon by network participants.
Szabo explained that “the basic idea of smart contracts is that many kinds of contractual clauses (such as liens, bonding, delineation of property rights, etc.) can be embedded in the hardware and software we deal with, in such a way as to make breach of contract expensive (if desired, sometimes prohibitively so) for the breacher.”
A different example of how this might work was shared by Zaslowsky in the form of an insurance contract. Once deployed on a blockchain, if conditions such as a certain amount of rainfall are met, the system would automatically pay the insurance to the affected parties. No need for claims or bureaucratic procedures.
Though only theoretical at the time, Szabo’s idea became feasible a decade and a half later with the introduction of Ethereum. This would expand the possibilities of what could be done on blockchain networks further beyond digital payment systems. While Bitcoin allowed for certain scripting capabilities, Ethereum was implemented as a shared, Turing-complete computer. It was the first blockchain for decentralized applications, enabling experimentation with new crypto-assets built on frameworks of smart contracts. The ERC721 standard for the creation of non-fungible digital assets and the ERC20 standard for utility tokens are some examples. Terrero explained that ERC20 tokens in particular “allowed regular coders to create their own coin and let it sit on the Ethereum platform.” These would later fuel the decentralized funding models known as Initial Coin Offerings and start what some called a “Cambrian explosion of crypto-assets.”
As noted by Terrero, ICOs were blockchain’s first popular use case besides Bitcoin’s utility as a payment system. They created a frenzy that peaked in December 2017 when Bloomberg reported that an unprofitable iced tea and lemonade manufacturer’s shares rose 289 percent just by rebranding itself to Long Island Blockchain. A move that resulted in a subsequent investigation for insider trading and securities fraud.
Similar situations made international headlines everywhere. They were, by no means, the first or the last of government interventions in the space. In the United States, the SEC published a Framework for Investment Contract Analysis of Digital Assets. Existing legal guidelines such as the Howey Test, and now the Hinman Test, should be applied to all forms of crypto-assets to ensure compliance with regulations. It was understood that most crypto-assets created during this period were, in fact, securities that had avoided registration requirements. A notable case being the once-popular messaging app Kik’s $100 million digital token sale in 2017, which was deemed as an illegal securities offering by the SEC. Effectively, ICOs have evolved into regulated funding models such as Security Token Offerings or Simple Agreement for Future Tokens. It’s also important to note that neither bitcoins or ether have been classified as securities themselves.
Terrero has written comprehensively on other regulatory challenges presented by smart contracts in light of their decentralizing effect. In a recent article, he makes note of the many complications that could arise in determining who can be held liable in smart contract disputes.
However, the end of the ICO mania was by no means a ceiling to the potential applications of blockchain, cryptocurrencies, and smart contracts. The crypto-assets market cap still soars above $200 billion in aggregate, any given day. Moreover, Terrero drew attention to the fact that most of the important developments in the field are still to come, given the amount of blockchain-related intellectual property being developed. To him, it is clear that “blockchain technology is in its first inning” as companies like IBM and Bank of America are some of the largest patent-filers. Chinese companies such as Alibaba are also leading R&D efforts. FT reported that more than half of the blockchain-related patents filed in 2017 came from China, despite its government’s attitude towards cryptocurrencies.
Venture capitalist Joel Monegro agreed with Terrero that the most promising blockchain applications are still in an incubation phase. He tells the story of going down the blockchain “rabbit hole” after reading the Ethereum white paper. It then became clear to him that its use cases could be much more than alternative payment systems.
A point of view shared by the panelists, as well as researchers, is that approaching blockchain applications merely as digital translations of existing financial instruments misses the point entirely. For Monegro, “it would be like saying that the internet is just email.” The analogy that follows is that blockchain technology is still at an infrastructure phase of development, similar to the internet in the early ’90s. Bitcoin and Ethereum can be seen as the TCP/IP or HTTP protocols that make way for later developments at the scale of Amazon, Google, and Facebook. These applications had an impact no one could have understood or predicted thirty years ago.
Monegro sees that “the internet used protocols and applications to collapse the cost of communication. What crypto is doing is collapsing the cost of creating and exchanging assets. That’s a powerful thing because it allows us to distribute value over the internet. The idea that we can distribute value digitally is a big deal.”
Most of what could be truly significant about blockchain still escapes our imagination. The fundamental technology does not, however. Some projects Monegro has focused on are good examples of where things might go.
Decred: a blockchain network focused on developing a decentralized governance model. Its developers were dissatisfied with the fact that users generally don’t have a say on the technical decisions blockchain networks make. The project could be considered an experiment on blockchain’s potential for social scalability.
Maker: “a software-based, community-owned credit facility” that issues its own decentralized stablecoin. These are crypto-assets designed to keep a pegged value via collateralization in other assets. They could become preferable alternatives to official fiat currencies given that they solve cryptocurrency’s problem of high-volatility yet remain independent from any particular nation-state’s monetary policy.
Zcash: a privacy-focused cryptocurrency that improves upon Bitcoin’s pseudonymity features by making transactions invisible to parties without a viewing key. It uses an advanced cryptography concept known as zero-knowledge proofs to achieve this. While Monegro admits that these could “give nightmares” to cybersecurity agencies, there is an argument to be made about their value in competitive business operations.
Monegro is a founding partner at Placeholder VC and a former analyst at Union Square Ventures. He is well-known for his investment thesis on Fat Protocols, describing where he believes most of the value in blockchain networks will accrue in the coming years.
A common theme among these and most blockchain projects is the decentralization of services that were previously under the exclusive purview of financial institutions and government. Mario Laul, also at Placeholder, has commented that “in a way, cryptonetworks represent an attempt to break the state's monopoly on symbolic violence by creating ‘information management systems’ – bureaucracies, basically – that can legitimately define, handle, exchange, and enforce symbols, meaning, and information in a way that is relatively independent from the state, at least initially.”
Adults in the Room
Understandably, not all of these big ideas fly well with centralized institutions, let alone those concerned with monetary policy. Fabiola Herrera is the Deputy Manager of Systems and Technological Innovation at the Dominican Central Bank. Her views offered a counterpoint to Monegro’s, specifically in regards to cryptocurrencies given that they are the most popular use case for blockchain technology.
Herrera opened by stating that money and government are inseparable, “you cannot have money without government.” Under this paradigm, the issuance of decentralized currencies is a “challenge to the global economic system.” Therein lies the main disagreement between the panelists. Whether a separation of state and money would be technically and politically possible is an open question.
Technically, cryptocurrencies already provide an alternative to fiat currencies in some respects. Bitcoin became a de facto store of value during the financial crisis in Greece and it is even more so in countries like Venezuela where the official financial system has failed its citizens. In terms of replacing fiat currencies as a medium of exchange, however, they still have some ways to go. There is ongoing experimentation with stablecoins to develop efficient payment systems that don’t suffer from the extreme price volatility of other crypto-assets.
Arguably, there might be no need for a medium of exchange use case. Herrera pointed out that the Dominican financial system is changing and moving into digital solutions. The country implemented new developments in RTGS in the form of instant payments in 2008 and made it available to bank clients since 2014. The service handles over $98 billion pesos and $196 million dollars any given day according to official statistics. It also serves as a hub for international payments in Central America.
From a general perspective, she agreed with a recent statement by IMF Chief Christine Lagard that emphasized the role of government as a protector of the public good when it comes to the development of cryptocurrency technology. A notion that falls in line with the “adults in the room” approach described, albeit critically, by Greece’s former finance minister Yanis Varoufakis. For Herrera, “central banks cannot allow the existence of two parallel economic systems.” She defended the need for centralized economic information “not for control, but for the purpose of economic growth as a whole.” However, she did not discard the possibility of a state-sponsored cryptocurrency.
This is where the debate goes beyond technical arguments. Cryptocurrency’s roots stem from cypherpunk and libertarian ideology. Many cryptocurrency developers hold decentralization as a goal or something to optimize for. They would classify Lagard’s views as “Keynesian dogma,” subscribing instead to the Austrian school of economics where the separation of state and money is a central tenet. This goes back to influential figures like Nick Szabo, who has written from this perspective on the history of money and, more recently, on traditions of non-governmental money. In their view, it is government intervention that creates financial crises in the first place. They envision cryptocurrencies and different crypto-assets replacing, or more likely, superseding official fiat currencies in the market.
Nonetheless, the purchase of cryptocurrencies is not illegal in the Dominican Republic, but they are considered unregulated assets and are therefore not recognized as legal tender, excluding them from all state guarantees. An approach similar to that of other Latin American countries like Brazil, Ecuador, and Costa Rica. Countries such as Bolivia have strictly prohibited their use while Mexico, Panama, and Argentina are developing legal frameworks for cryptocurrencies and foster their development with state-sponsored incubators and public education initiatives.
In the United States, crypto-assets can be considered securities, commodities, or capital assets depending on which government institution is concerned, but they always fall under the umbrella of private property and their sale is a taxable event. In New York, a lawsuit seeking to abolish the NYDFS BitLicense requirements has reached the New York Court of Appeals.
Herrera clarified that Dominican regulation leaves enough room for innovation in financial technology, citing projects such as contactless cards for automated payments of public transportation and an upcoming Central Bank API. She added that “if a crypto project offers advantages over these systems, we are open to hearing about it.”
The Dominican Central Bank’s position on cryptocurrencies was published in an official notice responding to a high percentage of reported fraudulent activity and money laundering related to these assets. This leads to the panel’s final topic.
General Claudio Peguero founded the Cybercrime Division of the National Department of Investigation of the Dominican Republic and is the Advisor to the Director-General of the Dominican National Police on Cyber Affairs. His work is part of a government initiative to close the digital gap in the country. He explained that as more people come online the attack platform for bad actors widens.
When it comes to cryptocurrencies, cybersecurity is key. Despite Bitcoin’s notorious role in the Silk Road case, it is by no means the default cryptocurrency for cybercrime. General Peguero corroborated Monegro’s explanation that alternative cryptocurrencies like Zcash, Monero, and many others, are developed to be less or non-traceable. Different from most popular blockchains where all transactions are recorded and shared publicly, these altcoins make it harder for investigators to attribute transactions to specific parties. This is seen as a concern with regard to money laundering prevention. He explained that these cryptocurrencies complicate the controls that prevent laundered money from entering the financial system, making it easy for criminals to participate in the economy. In these cases, “the challenge is following the money.”
General Peguero shared that, according to his department’s findings, the amount of money laundered via cryptocurrencies so far is around $91 million dollars. A fraction of the total amount laundered in fiat in the country, but still “worrisome in relation to the amount of time cryptocurrencies have been around.” This is a case where decentralization and, more specifically, increased privacy can be seen as a problem for government authorities.
There has also been an increase in fraudulent activities enabled by cryptocurrencies. Although Ponzi schemes can hardly be considered an innovation, both Herrera and General Peguero referred to increased reports of predatory behavior facilitated by the technology. “Everyone wants privacy until they’re the victim of a crime. You want your crime solved. If everyone is private it cannot be solved. There have to be ways for the criminal justice system to investigate where it is justified,” said General Peguero, echoing Herrera’s argument on the protection of the public good.
He also shared that his department has worked with the Central Bank in updating and tightening security.
Like many of the hard questions that the internet has brought to global attention, blockchain and cryptocurrencies are not the domain of any one particular country or institution. Likewise, they are not going away and their true impact is impossible to predict. Optimists like Monegro see them as a “once in a generation opportunity” and as tools that can “include more people into the financial system.” Others are more mindful of the responsibilities that established institutions have and approach them cautiously. The catchall of decentralization is often used in discussions about blockchain and cryptocurrencies but it ignores all the different ways technical possibilities can play out in the real world. As Herrera assured, “this is not the first or the last time we will have this conversation.”