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The FinTech Revolution: The Impact of Blockchain Technology on Regulatory Enforcement

White Collar Watch (December 2017 • Vol. 1, Issue 3)

This is the third installment in a series of articles. For more background on this topic, please read our first article in the series, An Introduction to Financial Technology, and our second article, The FinTech Revolution: Enforcement Actions Brought against FinTech Companies and Their Implications.

A bedrock of the FinTech revolution is blockchain technology—a digital, decentralized ledger of all transactions that take place across a peer-to-peer network of computers. The ledger is visible to anyone within the network, and permanently and securely records, in “blocks,” the history of exchanges that takes place between the peers in the network. All the completed and authenticated transaction blocks are connected and “chained” from the beginning of the chain to the most current block—hence the name “blockchain.” Most importantly, there is no need for a central authority to manage the blockchain because the blockchain records all transactions and the records are considered virtually impossible to modify or delete once entered.

This article considers the potential impact of blockchain technology on regulatory enforcement by examining its application in two different contexts: 1) as a verification tool, and 2) as the vehicle for cryptocurrencies. Whereas the former application promotes regulatory compliance and has the potential to dramatically reduce the costs of regulatory enforcement, the nature of cryptocurrencies and their capacity for preserving investors’ anonymity greatly complicate regulators’ ability to protect against unlawful conduct.

Blockchain Technology as a Promoter of Regulatory Compliance

Because blockchain technology offers the ability to preserve historical records and transactions, it has numerous applications in, among other areas: trade reporting, clearing, and confirmation; record keeping; financial and/or records auditing; due diligence; supply chain management; and contracting. For instance, the technology can be used to preserve records about an individual or company, including individuals’ professional or medical records or individuals’/companies’ financial records. Once the information has been preserved on a blockchain, the information can be automatically downloaded each time a computer, or “node,” joins the network on which this information has been stored.

Blockchain technology also offers the ability for parties to enter into “smart contracts,” which employ coding on a blockchain to define contract terms and execute automatically when specific terms or product deliveries are met. Likewise, blockchain technology can facilitate due diligence in connection with mergers, acquisitions, and third-party business arrangements. Thus, it could, for example, permit U.S. companies working with third-party vendors abroad to easily obtain certifications of compliance with provisions of the Foreign Corrupt Practices Act (“FCPA”).

When used as a tool to preserve records, ensure compliance with contract terms, or to facilitate due diligence, blockchain technology has the potential to greatly improve regulatory efficiency by lowering costs and expediting the time that regulators or law enforcement authorities invest in ensuring legal compliance. Thus, regulators could use blockchain technology quickly and accurately to verify companies’ fulfillment of applicable licensing or reporting requirements. Likewise, in cases where smart contract coding has been used to implement corporate compliance programs by automating certain events if compliance objectives are achieved (or violated), regulators/law enforcement authorities may have an improved ability to monitor the programs and assess their strength.

Cryptocurrencies and Initial Coin Offerings

Another principal application of blockchain technology is as the vehicle for cryptocurrencies. In contrast to fiat currencies, cryptocurrencies have no physical form, and all transactions are recorded in the blockchain. As such, they are not backed by any government or central bank. Moreover, the holders of cryptocurrencies—including those who transact in cryptocurrencies—maintain their anonymity through the blockchain network and by securing access to their cryptocurrency “wallet” through a private “key.”

Preservation of cryptocurrency users’ anonymity naturally heightens the risk of fraudulent transactions and greatly complicates the role of regulators seeking to identify perpetrators of unlawful conduct. Indeed, when individuals’ identities are concealed, digital currency exchanges cannot comply with anti-money laundering (“AML”) and know-your-customer (“KYC”) reporting requirements. In the United States, there has been conflicting guidance as to whether offerors of digital currency are subject to the federal Bank Secrecy Act (“BSA”), which sets forth AML and KYC reporting requirements. Nevertheless, the U.S. Treasury’s Financial Crimes Enforcement Network (“FinCEN”) has pursued civil enforcement actions against digital currency exchanges that it alleged failed to comply with the BSA as required.1

The issues facing cryptocurrency exchanges also extend to the sale of digital “tokens” or coins through Initial Coin Offerings (“ICOs”), which likewise take place on blockchain networks. ICOs permit companies to raise funds through the sale of tokens that can be redeemed for goods or services, or that can be resold for profit on a token exchange. While ICO issuers typically have access to investors’ identifying information, they are not always subject to AML regulation. However, if an ICO qualifies as a security under the test set forth in SEC v. W.J. Howey, 328 U.S. 293 (1946), the issuer is subject to SEC (and AML) oversight. Other countries have sought to mitigate the risk of fraudulent transactions in connection with ICOs in different ways. For example, in September, the British Crown dependency of the Isle of Man announced the creation of the first-ever regulatory framework, the Isle of Man Registered Designated Business ICO, to enable companies issuing ICOs to comply with AML oversight.

Piercing cryptocurrency holders’ identities in order to identify perpetrators of unlawful conduct has also proven to be difficult and costly. In November 2016, the Internal Revenue Service (“IRS”) served a “John Doe” summons on Coinbase, a cryptocurrency exchange, seeking information on all users who transferred virtual currency from 2013 to 2015, in an effort to identify potential tax evaders. This effort, however, has led to protracted litigation concerning the scope and reach of the IRS subpoena.

Lastly, the “virtual” nature of cryptocurrencies makes it difficult for law enforcement authorities to consider them “assets” and subject them to forfeiture and seizure. Judicial authorities in the Netherlands have tackled this issue by ruling that cryptocurrencies qualify as assets and permitting prosecutors to access suspects’ computers so that they can identify the key to their cryptocurrency wallets. By contrast, law enforcement authorities in the United Kingdom are considering whether to classify cryptocurrencies as a form of cash so that they can be more easily seized.2 In the United States, the IRS issued a formal ruling in 2014 stating that “virtual currency is treated as property.”3 Likewise, U.S. courts have authorized the forfeiture of virtual currency in connection with criminal proceedings.4 Notwithstanding these rulings, efforts to forfeit or seize virtual currency face significant obstacles due to the difficulty in tracing transactions.

Conclusion

When employed as a mechanism for verification and record keeping, blockchain technology has the potential to significantly reduce both the costs and time associated with regulatory compliance and enforcement. In order to realize this prospect, companies and governments must work in tandem to address regulatory concerns and root out illegal financial transactions.

  1. See, e.g., In the Matter of Ripple Labs Inc. and XRP II, LLC, No. 2015-05; In the Matter of BTC-E a/k/a Canton Business Corporation and Alexander Vinnik, No. 2017-03.
  2. N8 Policing Research Partnership, “Policing Bitcoin: Investigating, Evidencing and Prosecuting Crimes Involving Cryptocurrency,” available at http://n8prp.org.uk/small_grants/.
  3. I.R.S. Notice 2014-21, 2014-16 I.R.B. 938, 2014 WL 1224474 (March 2014).
  4. United States v. Carl Mark Force IV, Case No. 15-0319 (N.D. Cal. Nov. 3, 2015), Dkt. Entry 88; United States v. Sean Roberson, Case No. 14-565 (D.N.J. Feb 9, 2016), Dkt. Entry 39; United States v. Ross William Ulbricht, Case No. 13-06919 (S.D.N.Y.) (the docket for this case is sealed; however the U.S. Attorney’s office’s press release related to the forfeiture can be found at www.justice.gov/usao-sdny/pr/acting-manhattan-us-attorney-announces-forfeiture-48-million-sale-silk-road-bitcoins); United States v. 178.95842915 Bitcoins stored in MultiBit wallet XXXX4XDAd, Case No. 16-07009 (E.D. Wash. Sept. 29, 2017), ECF 46.

© 2017, Blank Rome LLP. All rights reserved. Please contact Blank Rome for permission to reprint. Notice: The purpose of this update is to identify select developments that may be of interest to readers. The information contained herein is abridged and summarized from various sources, the accuracy and completeness of which cannot be assured. This update should not be construed as legal advice or opinion, and is not a substitute for the advice of counsel.