A few other perspectives on cryptocurrencies and ICOs

I received a lot of questions regarding my last post.  Over the past month I have read a number of interesting interviews and articles that I think contribute a lot to the discussion.

Some additional perspectives:

Update:

On July 25, the SEC published a new Investor Bulletin focused on ICOs and also published a report (pdf) detailing their position on ICOs, using The DAO as an example (which they noted violated several US securities laws).

Code is not law

This past Sunday I gave a new presentation at the Palo Alto Ethereum meetup — it was largely based on my previous two blog posts.

Note: all of the references and citations can be found within the notes section of the slides.  Also, I first used the term “anarchic chain” back in April 2015 based on a series of conversations with Robert Sams.  See p. 27.

Special thanks to Ian Grigg for his constructive feedback.

Slides:

Video:

Settlement Risks Involving Public Blockchains

[Note: this article first appeared on Tabb Forum]

Over the past several months there has been a crescendo of pronouncements by several cryptocurrency enthusiasts, entrepreneurs and investors claiming that public blockchains, such as Bitcoin and Ethereum, are an acceptable settlement mechanism and layer for financial instruments. Their vision is often coupled with some type of sidechain or watermarked token such as a colored coin.

The problem with these claims and purported technical wizardry is that they ignore the commercial, legal and regulatory requirements and laws surrounding the need for definitive settlement finality.

For instance, the motivation behind the European Commission’s Directive 98/26/EC was:

“[T]o minimize systemic risk by ensuring that any payment deemed final according to the system rules is indeed final and irreversible, even in the event of insolvency proceedings.

“Without definitive finality, the insolvency of one participant could undo transactions deemed settled and open up a host of credit and liquidity issues for the other participants in the payment system. This results in systemic risk and undermines confidence in all the payments processed by the system.

“Thus, by ensuring definitive settlement, the concept of finality fosters trust in the system and reduces systemic risk. This makes it one of the most important concepts in payments and one that is applied to all clearing and settlement systems, including settlement and high-value payment system Target2 and bulk SEPA clearing system STEP2.”

While many cryptocurrency proponents like to pat themselves on the back for thinking that “immutability” is a characteristic unique to public blockchains, this is untrue. Strong one-way cryptographic hashing (usually via SHA 256) provides immutability to any data that is hashed by it: If Bob changes even one bit of a transaction, its hash changes and Alice knows it has been changed.

What about proof-of-work?

Proof-of-work, utilized by many public blockchains, provides a way to vote on the ordering and inclusion of transactions in a block, in a world where you do not know who is doing the voting. If you know who is doing the voting, then you do not need proof-of-work.

Consequently, with proof-of-work-based chains such as Bitcoin, there is no way to model and predict the future level of their security, or “settlement,” as it is directly proportional to the future value of the token, which is unknowable.

Thus, if the market value of a native token (such as a bitcoin or ether) increases or decreases, so too does the amount of work generated by miners who compete to receive the networks seigniorage and expend or contract capital outlays in proportion to the tokens marginal value. This then leaves open the distinct possibility that, under certain economic conditions, Byzantine actors can and will successfully create block reorgs without legal recourse.

In particular, this means miners can remove a transaction from the history such that a payment you thought had been made is suddenly unmade.

In addition, with public blockchains, miners (or rather mining pools) have full discretion on the ordering and reordering of transactions. While mining pools cannot reverse one-way hashes such as a public key (immutable on any blockchain), they can make it so that any transaction, irrespective of its value, can be censored, blocked or reordered.

To be clear, by reordered, we mean that in the event two conflicting transactions are eligible for block inclusion (e.g., a payment to Bob and a double-spend of the same coins to Alice), the payment to Bob could be mined and then, at any point in the future, replaced by the payment to Alice instead.

In Bitcoin and Ethereum (as well as many others), mining pools have full discretion of organizing and reorganizing blocks, including previous blocks. While there is an economic cost to this type of rewriting of history, there are also tradeoffs in creating censorship-resistant systems such as Bitcoin.

One of the tradeoffs is that entire epochs of value can be removed or reorganized without recourse, as public blockchains were purposefully designed around the notion of securing pseudonymous consensus.

Pseudonymous consensus is a key characteristic that cannot be removed without destroying the core utility of a public blockchain: censorship-resistance. So, as long as Bitcoin miners have full discretion over the transaction validation process, there is always a risk of a reorg.

What if you remove censorship-resistance by vetting the miners and creating “trusted mining”?

If you remove censorship-resistance (pseudonymous consensus) but still utilize proof-of-work, you no longer have a public blockchain, but rather a very expensive hash-generating gossip network.

While this type of quasi-anarchic system may be useful to the original cypherpunk userbase, it is not a desirable attribute for regulated financial institutions that have spent decades removing risks from the settlement process.

Ignoring for the moment the legal and regulatory structures surrounding the clearing and settlement of financial instruments, in our modern world all participants recognize that, from a commercial perspective alone, it makes sense to have definitive – not probabilistic – settlement finality. Because of how the mining process works – miners can reorganize history (and have) – a public blockchain by design cannot definitively guarantee settlement finality.

Markets do not like uncertainty, and consequently mitigating and removing systemic risks has been a key driver by all global settlement platforms for very good apolitical reasons.

Public blockchains may be alluring because of how they are often marketed – as a solution to every problem – but they are not a viable solution for organizations seeking to provide certainty in an uncertain world, and they are currently not a reliable option for the clearing and settling of financial instruments.

There are solutions being built to solve this problem that do not rely on public blockchains for settlement. For example, private and consortium blockchains are specifically being designed to provide users definitive legal settlement finality, among other requirements, because this certainty is necessary for adoption by regulators and regulated financial institutions.

For context, over the past 18 months banks have looked at more than 150 proof-of-concepts and pilots and rejected nearly all of them. Not because they are anti-cryptocurrency, but because public blockchains were not purposefully built around the requirements of financial institutions. So why would they integrate a system that does not provide them utility?

Yet if researchers empirically observe that the failure risks associated with various public blockchains is within an accepted risk profile – in certain niche use-cases – it may be the case that some institutions will consider conducting additional proof-of-concepts on them.

The tradeoffs in designing public blockchains and permissioned ledgers are real. For instance, it is self-defeating to build a network that is both censorship-resistant from traditional legal infrastructure and simultaneously compliant with legal settlement requirements. Yet both types of networks will continue to coexist, and the vibrant communities surrounding the two respective spaces will learn from one another.

And if the goal for fintech startups is to create a new commercial rail for securing many different types of financial instruments, then shipping products that actually satiate the needs of market participants is arguably more important than trying to tie everything back into a pseudonymous network that intentionally lacks the characteristics that institutional customers currently need.

A dissection of two Bitfury papers

BitFuryBitfury, the Bitcoin mining company, recently published two papers:

The underlying motivations for writing them was that Bitfury is trying to assure the world that public blockchains can still be used in “proprietary contexts.” While they provide a good frame for the issue, there are several leaps in logic, or direct contradictions to established theory that necessarily weaken their argument.

Below is my discussion of them. Note: as usual, this only represents my opinion and does not necessarily represent the views of the organizations that I advise or work for.

Overall I thought the two papers did not seem to have been reviewed by a wider audience including lawyers: specifically they should have sent them to commercial and securities lawyers to see if any legal issues should be considered. Much of their pitch basically amounts to mining for the sake of mining.

One final note: for additional commentary I also reached out to Dave Hudson who is proprietor of HashingIt and an expert as it relates to Bitcoin mining analysis.  He is unaffiliated with Bitfury.

Notes for Part 1:

On p. 2, Bitfury wrote the following statement:

The key design element of blockchains – embedded security – makes them different from ordinary horizontally scalable distributed databases such as MySQL Cluster, MongoDB and Apache HBase. Blockchain security makes it practically impossible to modify or delete entries from the database; furthermore, this kind of security is enforced not through the central authority (as it is possible with the aforementioned distributed databases), but rather through the blockchain protocol itself.

Is this a problematic summary?

According to Dave Hudson:

As a network protocol engineer of many years I tend to find the concept of a “blockchain protocol” somewhat odd. Here’s a link to definitions of “protocol.”

What do we mean by protocol here? It’s not actually a network protocol because there is no “blockchain protocol”, there are many different ones (each altcoin has its own and there are many more besides). At best the idea of a “blockchain protocol” is more a meta-protocol, in that we say there are some things that must be done in order for our data to have blockchain-like characteristics. It’s those characteristics that provide for non-repudiation.

Also on p. 2, Bitfury uses the term “blockchain-based ledger.”  I like that because, as several developers have pointed out in the past, the two concepts are not the same — distributed ledgers are not necessarily blockchains and vice versa.

On p. 4 and 5 they list several objections for why financial institutions are hesitant to use a public blockchain yet leave a couple noticeable ones off including the lack of a service level agreement / terms of service between end users and miners.  That is to say, in the event of a block reorg or 51% attack, who calls who?

On p. 7, I don’t think that censorship resistance can be generalized as a characteristic for “all blockchains.”

In Dave Hudson’s view:

Moreover, censorship resistance makes absolutely no sense in many instances. Who would be censoring what?

I’m actually not convinced that censorship resistance is actually a “thing” in Bitcoin either. Plenty of well-formed transactions can be censored by virtue of them being dust or having non-standard scripts. If anything the only thing that Bitcoin does is provide a set of conditions in which a transaction is probabilistically going to be mined into blocks in the network.

For those interested, there are a handful of “standard’ transaction types that are usually accepted by most mining pools.

On p. 11, I disagree with this statement:

If a blockchain database is completely opaque for clients (i.e., they have no access to blockchain data), the security aspect of blockchain technology is diminished. While such system is still protected from attacks on the database itself, interaction with clients becomes vulnerable, e.g. to man-in-the middle attacks. As a built-in protocol for transaction authorization is one of core aspects of blockchain technology, its potential subversion in favor of centralized solutions could negatively influence the security aspect of the system. Additionally, as transactions are accessible to a limited set of computers, there exists a risk of human factor intervening into the operation of the blockchain with no way for clients to detect such interference. Thus, the opaque blockchain design essentially undermines the core aspects of blockchain technology:
• decentralization (absence of a single point of failure in the system)
• trustlessness (reliance on algorithmically enforced rules to process transactions with no human interaction required).

I think trustlessness is a red herring that cypherpunks and Bitcoiners have been perpetually distracted by. It may be an end-goal that many would like to strive for but trust-minimization is a more realistic intermediate characteristic for those operating within the physical, real world.

Why? Because existing institutions and legal infrastructure are not going to disappear tomorrow just because a vocal group of cryptocurrency enthusiasts dislikes them.

According to Dave Hudson:

As with so many things-Bitcoin, I think this is an implementation necessity being seen as a innately desirable characteristic. Bitcoin requires “trustlessness” because it’s non-permissioned, yet in truth it totally relies on trust to work. We trust that Sybil attacks aren’t happening and that network service providers are not colluding to support such attacks. We trust that a large body of miners are not colluding to distort the system. We trust that changes to the software (or updates to compilers and operating systems) have not rendered old, non-recently-used keys are still able to support signing of transactions. We trust that Satoshi (and other large holders) will not drop 1M, or worse 10M coins onto exchanges crashing the price to a few cents per coin! There’s no “too big to fail” here!

In truth real-world people actually like to trust things. They want to trust that their national governments will ensure services work and that invaders are kept out. They want to trust that law enforcement, fire and medical services will keep them safe. I’m not sure that I like the idea of a trustless Police force?

What people do like is the ability to verify that the entities that they actually do trust are in fact doing what they should. Blockchain designs allow us to do just this.

That last statement in particular succinctly summarizes some of the motivations for financial institutions looking to use a shared ledger that is not the Bitcoin blockchain.

On p. 12, I disagree with this statement:

While the permissioned nature of blockchains for proprietary applications may be a necessary compromise in the medium term because of compliance and other factors, read access to blockchain data together with the publicly available blockchain protocol would remove most of vulnerabilities associated with opaque blockchain designs and would be more appealing to the clients of the institution(s) operating the blockchain. As evidenced by Bitcoin, simplified payment verification softwarecan be used to provide a direct interface to blockchain data that would be both secure and not resource intensive.

The reason I disagree with this statement is because the term “opaque” is loaded and ill-defined.

For instance, several groups within the Bitcoin ecosystem have spent the last several years trying to delink or obfuscate transaction history via zk-SNARKs, stealth addresses, mixing via Coinjoin and Coinshuffle and other methods. This type of activity is not addressed by Bitfury — will they process Bitcoin transactions that are obfuscated?

Granular permissions — who is allowed to see, read or write to a ledger — is a characteristic some of these same Bitcoin groups are not fans of but is a needed feature for financial institutions. Why? Because financial institutions cannot leak or expose personal identifiable information (PII) or trading patterns to the public.

Securely creating granular permissions is doable and would not necessarily reduce safety or transparency for compliance and regulatory bodies. Operating a non-public ledger is not the same thing as being “opaque.” While hobbyists on social media may not be able to look at nodes run by financial institutions, regulators and compliance teams can still have access to the data.

It also bears mentioning that another potential reason some public blockchains have and/or use a token is as an anti-spam mechanism (e.g., in Ripple and Stellar a minute amount is burnt).1

On p. 13, I disagree with this statement:

The problem is somewhat mitigated if the access to block headers of the chain is public and unrestricted; however, convincing tech-savvy clients and regulators that the network would be impervious to attacks could still be a difficult task, as colluding operators have the ability to effortlessly reorganize the arbitrary parts of the blockchain at any given moment. Thus, the above consensus protocol is secure only if there is no chance of collusion among blockchain operators (e.g., operators represent ideal parties with conflicting interests). Proof of work provides a means to ensure absence of collusion algorithmically, aligning with the overall spirit of blockchain technology.

This is untrue. People run pools, people run farms. Earlier this year Steve Waldman gave a whole presentation aptly named “Soylent Blockchains” because people are involved in them.

As we have seen empirically, pool and farm operators may have conflicting incentives and this could potentially lead to collusion. Bitcoin’s “algorithms” cannot prevent exogenous interactions.

On p. 14 I disagree with this statement:

There is still a fixed number of miners with known identities proved by digital signatures in block headers. Note that miners and transaction processors are not necessarily the same entities; in the case that mining is outsourced to trusted companies, block headers should include digital signatures both from a miner and one or more processing institutions.

Having a “trusted company” run a proof-of-work mining farm is self-defeating with respect to maintaining pseudonymity on an untrusted network (which were the assumptions of Bitcoin circa 2009). If all miners are “trusted” then you are now operating a very expensive trusted network. This also directly conflicts with the D in DMMS (dynamic-membership multi-party signature).

According to Dave Hudson:

If the signing is actually the important thing then we may as well say there’s a KYC requirement to play in the network and we can scale it all the way back to one modest x86 server at each (with the 1M x reduction in power consumption). Of course this would kill mining as a business.

On p. 14 I think the Bitfury proposal is also self-defeating:

The proposed protocol solves the problem with the potentially unlimited number of alternative chains. Maintaining multiple versions of a blockchain with proof of work costs resources: electricity and hashing equipment. The hashing power spent to create a blockchain and the hashing power of every miner can be reliably estimated based on difficulty target and period between created blocks; an auditor could compare these numbers with the amount of hashing equipment available to operators and make corresponding conclusions.

The authors go into detail later on but basically they explain what we can already do today: an outside observer can look at the block headers to see the difficulty and guess how much hashrate and therefore capital is being expended on the hash.

On p. 15 they present their proposal:

Consequently, $10 million yearly expenses on proof of work security (which is quite low compared to potential gains from utilizing blockchain technology, estimated at several billion dollars per year [54]) correspond to the hash rate of approximately 38 PHash / s, or a little less than 10% of the total hash rate of the Bitcoin network.

This is entirely unneeded. Banks do not need to spend $10 million to operate hardware or outsource operation of that hardware to some of its $100 million Georgia-based hydro-powered facilities.

According to Dave Hudson:

Precisely; banks can use a permissioned system that doesn’t need PoW. I think this also misses something else that’s really important: PoW is necessary in the single Bitcoin blockchain because the immutability characteristics are derived from the system itself, but if we change those starting assumptions then there are other approaches that can be taken.

In section 3.1 the authors spend some time discussing merged mining and colored coins but do not discuss the security challenges of operating in a public environment. In fact, they assume that issuing colored coins on a public blockchain is not only secure (it is not) but that it is legal (probably not either).2

On p. 16 they mention “transaction processors” which is a euphemism that Bitfury has been using for over a year now. They dislike being called a mining company preferring the phrase “transaction processors” yet their closed pool does not process any kind of transactions beyond the Bitcoin variety.

On page 17 they wrote:

[M]aintenance of the metachain could be outsourced to a trusted security provider without compromising confidential transaction details.

If taken to the logical extreme and all of the maintenance was “outsourced” to trusted security providers they would have created a very expensive trusted network. Yet in their scenario, financial institutions would have to trust a Republic of Georgia-based company that is not fully transparent.

Also on page 17 they start talking about “blockchain anchors.” This is not a new or novel idea.  As other developers have spoken about the past and Guardtime puts anchors into newspapers like The New York Times (e.g., publishes the actual hashes in a newspaper).  And, again, this could easily be done in other ways too. Why restrict anchoring to one location? This is Bitcoin maximalism at work again.

On p. 20 they wrote:

Bitcoin in particular could be appropriate for use in blockchain innovations as a supporting blockchain in merged mining or anchoring due to the following factors: • relatively small number of mining pools with established identities, which allows them to act as known transaction validators by cooperating with institutions

This is self-defeating for pseudonymous interactions (e.g., Bitcoin circa 2008). Proof-of-work was integrated to fight Sybil attacks. If there are only a few mining pools with established identities then there are no Sybil’s and you effectively have an extremely expensive trusted network.

Notes on Part 2:

On p. 3 they wrote:

If an institution wants to ensure that related Bitcoin transactions are mined by accredited miners, it may send transactions over a secure channel directly to these miners rather than broadcasting them over the network; accepting non-broadcast transactions into blocks is a valid behavior according to the Bitcoin protocol.

An “accredited miner” is a contradiction.

On p. 4 the first paragraph under section 1.3 was well written and seems accurate. But then it falls apart as they did not consult lawyers and financial service experts to find out how the current plumbing in the back-office works — and more importantly, why it works that way.

On p.4 they wrote:

First, the transfer of digital assets is not stored by the means of the Bitcoin protocol; the protocol is unaware of digital assets and can only recognize and verify the move of value measured in bitcoins. Systems integrating digital assets with the Bitcoin blockchain utilize various colored coin protocols to encode asset issuance and transfer (see Section 2.2 for more details). There is nothing preventing such a protocol to be more adapted to registered assets.

Yes there is in fact things preventing Bitcoin from being used to move registered assets, see “Watermarked tokens and pseudonymity on public blockchains.”  And their methods in Section 1.6 are non-starters.

Also on page 4 they wrote:

Second, multisignature schemes allow for the creation of limited trust in the Bitcoin environment, which can be beneficial when dealing with registered assets and in other related use cases. Whereas raw bitcoins are similar to cash, multisignature schemes act not unlike debit cards or debit bank accounts; the user still has a complete control of funds, and a multisignature service provides reputation and risk assessment services for transactions.

This is the same half-baked non-sense that Robert Sams rightly criticized in May. This is a centralized setup. Users are not gaining any advantage for using the Bitcoin network in this manner as one entity still controls access via identity/key.

On p. 5 they wrote:

One of the use cases of the 2-of-3 multisignature scheme is escrow involving a mediator trusted by both parties. A buyer purchasing certain goods locks his cryptocurrency funds with a multisignature lock, which requests two of the three signatures: the buyer’s, the seller’s, and the mediator’s.

This is only useful if it is an on-chain, native asset. Registered assets represent something off-chain, therefore Bitcoin as it exists today cannot control them.

On p. 6 they talk about transactions being final for an entire page without discussing why this is important from a legal perspective (e.g., why courts and institutions need to have finality). This paper ignores how settlement finality takes place in Europe or North America nor are regulatory systems just going to disappear in the coming months.

On page 7 they mention that:

To prevent this, a protocol could be modified to reject reorganizations lasting more than a specified number of blocks (as it is done in Nxt). However, this would make the Bitcoin protocol weakly subjective [21], introducing a social-driven security component into the Bitcoin ecosystem.

There is already a very publicly known, social-driven security component: the Bitcoin dev mailing list. We see this almost daily with the block-size debate. The statement above seems to ignore what actually happens in practice versus theory.

On p. 7 and 8 they write:

The security of the Bitcoin network in the case of economic equilibrium is determined by the rewards received by block miners and is therefore tied to the exchange rate of Bitcoin. Thus, creating high transaction throughput of expensive digital assets on the Bitcoin blockchain with the help of colored coin protocols has certain risks: it increases the potential gain from an attack on the network, while security of the network could remain roughly the same (as there are no specific fees for digital asset transactions; transaction fees for these transactions are still paid in bitcoins). The risk can be mitigated if Bitcoin fees for asset transactions would be consciously set high, either by senders or by a colored coins protocol itself, allowing Bitcoin miners to improve security of the network according to the value transferred both in bitcoins and in digital assets.

There is no way to enforce this increase in fee. How are “Bitcoin fees for asset transactions … consciously set high”? This is a question they never answer, (Rosenfeld 2012) did not answers it, no one does. It is just assumed that people will start paying higher fees to protect off-chain securities via Bitcoin miners.

There is no incentive to pay more and this leads to a hold-up problem described in the colored coin “game” from Ernie Teo.

On p. 8 they wrote:

As there is a relatively small number of Bitcoin mining pools, miners can act as known processors of Bitcoin transactions originating from institutions (e.g., due to compliance reasons). The cooperation with institutions could take the form of encrypted channels for Bitcoin transactions established between institutions and miners.

This is silly. If they are known and trusted, you have a trusted network that lacks a Sybil attacker. There is no need for proof-of-work mining equipment in such a scenario.

On p. 8 they wrote:

In the ideal case though, these transactions would be prioritized solely based on their transaction fees (i.e., in a same way all Bitcoin transactions are prioritized), which at the same time would constitute payments for the validation by a known entity. Thus, this form of transaction processing would align with the core assumption for Bitcoin miningthat miners are rational economic actors and try to maximize their profit.

It cannot be assumed that miners will all behave as “rational economic actors.” They will behave according to their own specific incentives and goals.

On p. 9 they wrote:

Additionally, partnerships between institutions and miners minimize risk in case transactions should not be made public before they are confirmed.

Registered and identifiable miners is the direct anti-thesis of pseudonymous interactions circa Bitcoin 2008. That type of partnership is a win-lose interaction.

On p. 10 they wrote:

One of the interesting financial applications of colored coins is Tether (tether.to), a service using colored coins to represent US dollars for fast money transfer. Several cryptocurrencies such as Nxt and BitShares support custom digital assets natively.

As it exists today, Tether.to is similar in nature to a Ripple gateway such as SnapSwap: both are centralized entities that are subject to multiple regulatory and compliance requirements (note: SnapSwap recently exited its USD gateway business and locked out US-based users from its BTC2Ripple business).

tether msb

According to FinCEN’s MSB Registrant Search Web page, Tether has a registration number (31000058542968) and one MSB.  While they have an AML/CTF program in place, it is unclear in its papers how Bitfury believes the Bitcoin network (which Tether utilizes) can enforce exogenous claims (e.g., claims on USD, euros, etc.).

Furthermore, there has been some recent research looking at how the Federal Reserve and the Bank of England could use distributed ledgers to issue digital currency.3

If a central bank does utilize some kind of distributed ledger for a digital currency they do not need proof-of-work mining or the Bitcoin network to securely operate and issue digital currency.

Ignoring this possible evolution, colored coins are still not a secure method for exogenous value transfers.

On page 10 they wrote:

Colored coins are more transparent for participants and auditors compared to permissioned blockchains

This is untrue and unproven. As Christopher Hitchens would say, what can be asserted without evidence can be dismissed without evidence.

On page 10 they wrote:

As colored coins operate on top of permissionless blockchains, systems using colored coins are inherently resistant to censorship – restrictions on transactions are fully specified by a colored coins protocol instead of being enforced by a certain entity

This is also untrue. This is a bit like trying to have their cake and eat it too.

On page 11 they have a diagram which states:

Figure 2: Using colored coins on top of the Bitcoin blockchain to implement asset transactions. For compliance, financial institutions may use secure communication channels with miners described in Section 2.1 to place asset transactions on the blockchain

Again this is self-defeating. As the saying goes: be careful what you wish for. If Bitfury’s proposal came true, their pool(s) could become payment service providers (PSP) and regulated by FinCEN.

On page 12 and 13 they wrote:

Bitcoin and other public permissionless blockchains could be a part of the interconnected financial environment similarly to how cash is a ubiquitous part of the banking system. More concretely, cryptocurrencies could be used as: • one of the means to buy and sell assets on permissioned blockchains • an instrument that enables relatively fast value transfer among permissioned blockchains • an agreed upon medium for clearing operations among blockchains maintained by various institutions (Fig. 4).

Bitcoins as a permanent store-of-value are effectively a non-starter as they lack any endogenous self-stabilizing mechanism.4

According to Dave Hudson:

The systemic risks here just make this idea farcical. The Internet is somewhat immune to this because there are technology providers all over the world who can independently choose to ignore things in regulatory domains that want to do “bad things”. There is no such safety net in a system that relies on International distributed consensus (the Internet has no such problem, although DNS is a little too centralized right now). Even if it could somehow be guaranteed that things can’t be changed, fixed coin supply means artificial scarcity problems are huge (think Goldfinger trying to irradiate the gold in Fort Knox) – you wouldn’t need a nuclear weapon, just a good piece of malware that could burn coins (if they’re not stolen then there’s no way to trace who stole them). There’s also the 1M coins dropped onto exchanges problem.

The discussion over elastic and inelastic money supplies is a topic for another post.

On page 15 they wrote:

If a blockchain is completely opaque for its end users (e.g., a blockchain-based banking system that still uses legacy communication interfaces such as credit cards), the trustless aspect of blockchains is substantially reduced. End users cannot even be sure that a blockchain system is indeed in use, much less to independently verify the correctness of blockchain data (as there is no access to data and no protocol rules to check against). Human factor remains a vulnerability in private blockchain designs as long as the state of the blockchain is not solely based on its protocol, which is enforced automatically with as little human intervention as possible. Interaction based on legacy user authentication interfaces would be a major source of vulnerabilities in the case of the opaque blockchain design; new interfaces based on public key cryptography could reduce the associated risk of attacks.

While mostly true, there are existing solutions to provide secure verification. It is not as if electronic commerce did not or could not occur before Bitcoin came into existence. Some private entities take operational security seriously too. For instance, Visa’s main processing facility has 42 firewalls and a moat.

On page 15 they wrote:

Proprietary nature of private blockchains makes them less accessible; open sourced and standardized blockchain implementations would form a more attractive environment for developers and innovations. In this sense, blockchains with a public protocol are similar to open Internet standards such as IP, TCP and HTTP, while proprietary blockchain designs could be similar to proprietary Internet protocols that did not gain much traction. A proprietary blockchain protocol could contain security vulnerabilities that remain undiscovered and exploited for a long time, while a standardized open blockchain protocol could be independently studied and audited. This is especially true for protocols of permissionless blockchains, as users have a direct economic incentive to discover vulnerabilities in the system in order to exploit them.

This is just scaremongering. While some of the “blockchain” startups out there do in fact plan to keep the lower layers proprietary, the general view in October 2015 is that whatever bottom layer(s) are created, will probably be open-sourced and an open-standard. Bitcoin doesn’t have a monopoly on being “open” in its developmental process.

On page 15 they wrote:

As the Bitcoin protocol has been extensively studied by cryptographers and scientists in the field, it could arguably form the basis for the standardized blockchain design.

This is untrue, it cannot be the backbone of a protocol as it is not neutral. In order to use the Bitcoin network, users are required to obtain what are effectively illiquid pre-paid gift cards (e.g., bitcoins). Furthermore, an attacker cannot collect “51%” of all TCP/IP packets and take over the “internet” whereas with Bitcoin there is a real “majoritarianism” problem due to how network security works.

A truly neutral protocol is needed and there have been at least two proposals.5

On page 15 they wrote:

The key design element of blockchains is “embedded economy” – a superset of embedded security and transaction validation. Each blockchain forms its own economic ecosystem; a centrally controlled blockchain is therefore a centrally controlled economy, with all that entails.

This is untrue. If we are going to use real-world analogies: Bitcoin’s network is not dynamic but rather disperses static rewards to its labor force (miners). It is, internally, a rigid economy and if it were to be accurately labeled, it is a command economy that relies on altruism and VC subsidies to stay afloat.6

On page 16 they wrote:

It is not clear how the blockchain would function in the case validators would become disinterested in its maintenance, or how it would recover in the case of a successful attack (cf. with permissionless blockchains, which offer the opportunity of self-organization).

The statement above is unusual in that it ignores how payment service providers (PSPs) currently operate.  Online commerce for the most part has and likely will continue to exist despite the needed maintenance and profit-motive of individual PSPs.  There are multiple motivations for continued maintenance of maintenance transfer agreements — this is not a new challenge.

While it is true that there will likely be dead networks in the futures (just like dead ISPs in the past), Bitcoin also suffers from a sustainability problem: it continually relies on altruism to be fixed and maintained and carries with it an enormous collective action burden which we see with the block-size debate.

There are over a hundred dead proof-of-work blockchains already, a number that will likely increase because they are all public goods that rely on external subsidies to exist. See Ray Dillinger’s “necronomicon” for a list of dead alt coins.

If Bitfury’s proposal for having a set of “fixed” miners arises, then it is questionable about how much self-organization could take place in a static environment surrounding a public good.

Conclusion

Despite the broad scope of the two papers from Bitfury neither was able to redress some of the most important defects that public blockchains have for securing off-chain assets:

  • how is legal settlement finality resolved
  • how to incentivize the security of layers (such as colored coins) which distort the mining process
  • how to enforce the security of merged mining which empirically becomes weaker over time

If Bitfury is truly attempting to move beyond merely processing Bitcoin transactions in its Georgian facilities, it needs to address what constraints and concerns financial institutions actually face and not just what the hobbyist community on social media thinks.

  1. See also: Needing a token to operate a distributed ledger is a red herring and A blockchain with emphasis on the “a” []
  2. See also: Can Bitcoin’s internal economy securely grow relative to its outputs? and Will colored coin extensibility throw a wrench into the automated information security costs of Bitcoin? []
  3. This includes: Fedcoin—how banks can survive blockchains by Robin Winkler and Centrally Banked Cryptocurrencies by George Danezis and Sarah Meiklejohn []
  4. See Seigniorage Shares from Robert Sams []
  5. See: A Protocol for Interledger Payments by Stefan Thomas and Evan Schwartz and An architecture for the Internet of Money by Meher Roy []
  6. See also: Chapter 10 in The Anatomy of a Money-like Informational Commodity and Economic Aspects of Bitcoin and Other Decentralized Public-Ledger Currency Platforms by David Evans []

Distributed Oversight: Custodians and Intermediaries

[Note: This past weekend I took part of a working group at Stanford University as part of the “Blockchain Global Impact”  conference — and we discussed some of the legal issues surrounding digital bearer assets.  Below is my written submission provided beforehand; I am not a lawyer but I did consult with several attorneys familiar with the Bitcoin ecosystem who provided feedback, some of which was incorporated.]

The prevailing view in the bitcoin community is that control, by virtue of knowledge of a private key, is synonymous with ownership of the contents of the associated address. In other words, bitcoin is often touted as a form bearer instrument. With the advent of “exchanges” and “hosted wallets,” the ecosystem birthed facilitators (custodians) and intermediaries (depositories) where an individual no longer controls the applicable access credentials.

As Professor Shawn Bayern noted, the nature of the rights one has with respect to directly-held bitcoin differs significantly from the indirect interest in bitcoin in an account held by a third party: “[As] a matter of law, the [user of an exchange or wallet] probably does not ‘own’ any bitcoins, at least not in the sense of having title to personal property corresponding directly to bitcoins. What the [party] has is simply a contract right against the operator of the website—what was classically, at common law, called a chose (i.e., thing) in action.”

What is the nature of this right? Does the user still own the bitcoins held at an exchange or wallet? Or, instead, has title passed to the wallet/exchange? If title remains with the user, the user might be termed a bailor and the exchange/wallet a bailee. On the other hand, if title has passed to the exchange/wallet, the user would likely be a creditor and the exchange/wallet a debtor. Of course, the user agreements are far from clear on this point. As it turns out, the first question you ask to determine whether a transfer of title has occurred is: does the transferor receive the same exact thing or merely equivalent things that was put in? If the former is true, a bailment may be possible (this is often referred to as safekeeping or custody). If the latter is true, the transaction would not be a bailment except in three specific cases discussed later below.

In terms of both funding and development, the two largest VC-backed verticals in the Bitcoin ecosystem are “exchanges” and hosted wallets – both of which often offer “vaults” called “cold storage” and sometimes some type of insurance for customers. The precise legalities of providing other services such as “tipping” is beyond the scope of this brief article. Suffice to say that at this time, there is probably no US-based VC-backed startup that is fully compliant with all deposit taking laws, money transmission laws, insurance laws and so forth.

Yet irrespective of personal views as to whether or not additional regulatory compliance should be expected of these nuvo financial intermediaries and custodians, one aspect that all startups can and would agree on is the need for “best practices” in financial controls. But this then circles back to legal compliance.

For instance, every funded exchange as of this writing pools their clients deposits into a shared hot wallet which is then dispersed into a cold wallet (which sometimes is further broken into “ice cold” or “glacier” wallets). Yet despite this element of security – or at least security theater – deposits can and have been expropriated by knowledgeable insiders including exchange operators themselves.   Commingling customer bitcoin effectively forecloses the possibility of bailment/custody because, once commingled, the user is unlikely to get the “same thing” bank that they put in.

How can the technology being developed in the larger Bitcoin ecosystem be used to mitigate or prevent his from happening? And more importantly, how can entrepreneurs structure their startups to be in compliance with the law?

In its BitLicense proposal to the New York State Department of Financial Service, the Crypto-Economy Working Group outlined several technology solutions including multisig, escrow, proof of reserves, proof of solvency, keyless wallets and continuous real-time auditing. Empirically we have seen the rapid growth in the use of multisig via a technique called pay-to-script-hash (P2SH) – a method which at the start of 2014 represented roughly 0% of all bitcoins yet now at the time of this writing encompasses about 8% of all bitcoins. That is to say, possessors of those direct and indirect interests have moved 8% of the bitcoin money supply into a multisig schema.

BitReserve is a VC-funded startup that has spearheaded the proof-of-reserve initiative, providing near real-time data of the assets in their “reserve” (cold wallet) and the liabilities or obligations to its depositors. Several other companies have attempted to position themselves as “keyless wallet” providers, most notably Blockchain.info. They claim to be a software company that has no access to user funds, keys or information – solely providing a website that generates a “wallet” based on a multi-word mnemonic that users must memorize or store as it is the sole access credential to “direct interests.” This type of segregation not only prevents maleficence from internal administrators but may also prevent Blockchain.info from being legally defined as a depository or custodian in some, if not all, jurisdictions.

But what happens if Bob loses this mnemonic? Then Bob loses control of the property, the bitcoin becomes inaccessible, ownerless (in our eyes) yet still exists as an entry on the blockchain.

Who does it belong to then? Did the network “steal” it? Its last legal owner was Bob, but to the Bitcoin network there is no distinction between ownership and possession. For instance, stealing is a legal term – not a physical phenomenon – thus whether it is rightfully transferred or not is the subject for legal scholars to debate.

Recall that the job of property systems is to associate the who(s) with the what(s). There is no infallible magic bullet. It is merely a question of best evidence. While possession and control is a pretty crude form of evidence but often nobody has better evidence of ownership. Registration is pretty good evidence but it can still be overcome. Think about a piece of artwork that Bob consigns to a gallery or that he registers. Or a title to his house. No matter what the title search says, Bob can never really know somebody won’t come out of the woodwork with better evidence of ownership. The question is really: how much protection does the law provide to an innocent purchaser for a particular type of property in a particular situation? This is still an open question with bitcoin.

What of bailments then? Does this distributed technology change the legal relationship between a bailor and bailee?

The term custody is reserved for bailments. After some consultation it appears you can only have a bailment when you get the same thing back that you put in and with “pooled” bitcoins, a depositor does not receive the same unspent transaction output (UTXO) as they originally deposited. Exceptions include: (1) fungible goods in warehouse; (2) currency in a particular type of bank account (special deposit); and (3) security entitlements (immobilized securities or pieces of a securitized pie). Bitcoin is not a good. Furthermore, hosted wallets are not warehouses. Bitcoin is not currently a legally defined currency and hosted wallets are not banks. A third idea is the trust company/broker dealer. While an entrepreneur may be able to secure a trust company charter, it has yet to be seen in the wild. And it is probably only scalable for a limited subset of uses and actors.

So, if we don’t have a bailment. We have something else. Again, after consulting with experts, we likely have a transfer of title and a corresponding debt owed to the depositor. If that is “checkable” or repayable upon request of depositor, then certain startups may have a problem under 12 USC 378(a)(2).

This seems to be the model that most startups has assumed is legally allowed. In fact, as of this writing, several VC-backed hosted wallets grant a “security interest” only on bitcoins they own. Alice’s hosted wallet startup may claim that “our bitcoins are insured.” Thus, if we were talking bailment, they would not be Alice’s startup’s bitcoin as the title would remain with the bailor (not Alice’s hosted wallet – who would be known as the bailee).

Now that organizations such as the Consumer Financial Protection Bureau (CFPB) have taken an interest in the Bitcoin ecosystem, how then, can Alice explain this to a consumer in a way that is not unfair, deceptive, or abusive? Is there anything in the technology that can help provide transparency and mitigate abuse?

In practice Alice will need to at least explain the effect on title in a manner that is consistent with reality. And she will likely have to be licensed, regulated and supervised to the same degree as others who operate in the same manner. While laws may change, it does not appear that a hosted wallet company falls within a loophole (currently).

In essence, there is a distinction between a facilitator and an intermediary.

And again, an intermediary is an institution that invests primarily in financial assets and that issues liabilities on itself (e.g., deposits). And a facilitator facilitate the financial transactions between intermediaries and their counterparties. They may hold some financial assets but their holdings are incidental to their facilitating roles. Custodians and money transmitters are the latter. Depositories are the former.

The questions for this working group should take these definitions into consideration and brainstorm how the technology being developed can not only help reduce the compliance requirements (if there is any leeway for that) but also fulfill financial controls “best practices” with respect to existing consumer protection laws.

A special focus should also highlight how exchanges operate in practice, that is to say, since they know the trading history, margin positions, when futures contracts will expire and other customer information – there is potential vectors of abuse such as front running and naked short selling by insiders. How can this be prevented, reduced and stopped?

What about the new BitLicense revision?

A new revision (pdf) of the New York BitLicense was released this week.  Yesterday CoinDesk reached out to several people in the industry to see what their view was on the new copy.  I have a small quote in the subsequent article: “BitLicense Revision Leaves Room for Continued Debate

Below are my unabbreviated thoughts (I would like to thank Ryan Straus for being able to discuss in-depth some of these issues the past week as well):

It is still unclear to me whether the BitLicense is establishing a facilitator regime (like money transmission or custody) or an intermediary regime (like deposit taking).   Does the BitLicense permit the acceptance of deposits by licensees?  If not, then the question remains whether organizations like NYDFS and DOJ considers hosted wallet services to constitute deposit taking. If so, BitLicensees would presumably not be able to avail themselves to the securities exemption that is available to banks and other deposit takers. A deposit is a debt owed by the depository to the customer (depositor).  Does holding oneself out as a depository qualify as a securities offering?  If so, would licensees qualify for the bank exemption to the securities laws?

Obviously I’ll let the lawyers hash this out, but so far the interpretations of what “software” is or is not still seems vague especially since it is still not clear if these firms will be classified as a “custodial regime” as custody denotes possession and bitcoins arguably cannot be possessed in any sense (e.g., is Blockstream acting as a custodian for building and providing a service that enables federated pegs; are the servers that participate as the federated nodes liable?).

Does Smart Contracts == Trustless Multiparty Monetary Computation?

My friend, Zaki Manian, who is working on a very interesting project called SKUChain (discussed in chapter 16), thinks we should reframe how we perceive or rather how we should define ‘smart contracts.’

In his view:

Here is my proposal.

We stop calling the idea ” smart contracts” and we start calling the idea “Trustless Multiparty Monetary Computation”. That should also tell the lawyers that we don’t really need them here at the moment….

Programming Language researchers use the term “contracts” as a way of formally reasoning about multi-part or distributed computation. But PL researchers also understand that this is idea has deep formal connections with reasoning about the relationship between people and organizations.

Here is the relevant prior art.
https://en.wikipedia.org/wiki/Secure_multi-party_computation
The SPJ paper from 2000
http://www.lexifi.com/files/resources/MLFiPaper.pdf

Some implementation of the SPJ’s ideas
http://www.itu.dk/people/sestoft/papers/amlp.pdf
https://rucore.libraries.rutgers.edu/rutgers-lib/23837/

This was in response to the panel discussion last weekend and was brought up by Adam Krellenstein from Counterparty.

If anyone is interested in discussing this further, let me know and I’ll put you in touch with Zaki or others.

A panel on smart contracts with industry developers and educators

Earlier today I participated in a virtual panel covering smart contracts called, “Let’s Talk Smart Contracts.”

The panel included: Adam Krellenstein (Counterparty), Oleg Andreev (CoreBitcoin), Pamela Morgan (Empowered Law), Stefan Thomas (Codius, Ripple Labs), Stephan Tual (Ethereum), Tim Swanson (Of Numbers), Yurii Rashkovskii (Trustatom) and it was moderated by Roman Snitko with Straight.

Below are some transcribed notes of my own statements.

Introduction starting at 09:06:

Hey guys, great to be here.  Thanks for the invite, thanks for organizing this.  So I’m here because you guys needed another white guy from Europe or something like that (that’s a joke).  So the definition I have of smart contracts, I have written a couple books in this space, and the definition I use is a smart contract is “a proposed tool to automate human interactions: it is a computer protocol – an algorithm – that can self-execute, self-enforce, self-verify, and self-constrain the performance of a contract.”  I think I got most of that definition from Nick Szabo’s work.  For those of you who are familiar with him, look up some of his past writings.  I think that the primary work he is known for is the paper, “Formalizing and Securing Relationships on Public Networks.”  And he is basically considered the [intellectual] grandfather of this space.  I’m here basically to provide education and maybe some trolling.

From 22:02 -> 24:15

I think I see eye-to-eye with Adam here.  Basically the idea of how we have a system that is open to interpretation, you do have reversibility, you do have nebulousness.   These are things that Nick Szabo actually discussed in an article of his called “Wet code and dry” back in 2008.  If you look back at some of the earlier works of these “cypherpunks” back in the ’90s, they talked about some of these core issues that Oleg talked about in terms of being able to mitigate these trusted parties.  In fact, if you look at the Bitcoin whitepaper alone, the first section has the word “reverse” or “reversibility” around 5 times and the word “trust” or “trusted” appears 11 times in the body of the work.  This was something that whoever created Bitcoin was really interested in trying to mitigate the need for any kind of centralized or third party involved in the process of transactions to reduce the mediation costs and so forth.

But I suppose my biggest criticism in this space, it is not pointed to anyone here in particular, is how we have a lot of “cryptocurrency cosplay.”  Like Mary Sue Bitcoin.  I’m not sure if you guys are familiar with who Mary Sue is: she is this archetype who is this kind of idealized type of super hero in a sense.  So what happens with Bitcoin and smart contracts is that you have this “Golden Age” [of Comics] where you had the limited ideas of what it could do.  Like Superman for example, when he first came out he could only jump over a building and later he was pushed to be able to fly because it looks better in a cartoon.  You have only a limited amount of space [time] and it takes too long to jump across the map.  So that’s kind of what I see with Bitcoin and smart contracts.  We can talk about that a little bit later, just how they have evolved to encompass these attributes that they’re probably not particularly good at.  Not because of lack of trying but just because of the mechanisms of how they work in terms of incentives for running mining equipment and so on.  So, again we can talk about that later but I think Adam and Oleg have already mentioned the things that are pretty important at this point.

40:18 -> 41:43

I’m the token cynic, huh?  So actually before I say anything, I would like to mention to the audience other projects that you might be interested in looking at: BitHalo; NotaryChains is a new project that encompasses some of these ideas of Proof of Existence created by Manuel Araoz, he is the one who did POE.  NotaryChains is a new project I think that sits on top of Mastercoin.  The issue that people should consider is that proof of existence/proof of signature: these are just really hi-tech forms of certification.  Whether or not they’re smart contracts I guess is a matter of debate.

There is another project: Pebble, Hyperledger, Tezos, Tendermint, Nimblecoin.  With Dogethereum their project is called Eris which apparently is the first DAO ever.  A DAO for the audience is a decentralized autonomous organization, it’s a thing apparently. SKUChain is a start-up in Palo Alto, I talk about them in chapter 16.  They have this interesting idea of what they call a PurchaseChain which is a real use-case for kind of updating the process from getting a Letter of Credit to a Bill of Lading and trying to cut out time and mediation costs in that process.  There are a few others in stealth mode.  So I really don’t have a whole lot to add with cynicism at this point, we can go on and come back to me in a little bit.

59:41 -> 1:02:35

The go to deficiency guy, huh?  They’re not really saying anything particularly controversial, these things are fundamentally — at least from an engineering perspective — could be done.  The problem though I think runs into is what Richard Boase discussed in — if listeners are interested — he went to Kenya and he did a podcast a few weeks ago on Let’s Talk Bitcoin #133.  I really recommend people listen to it.  In it he basically talks about all of these real world issues that run into this idealized system that the developers are building.  And as a result, he ended up seeing all of these adoption hurdles, whether it was education or for example tablets: people were taking these tablets with bitcoin, and they could just simply resell it on a market, the tablet itself was worth more than they make in a year basically; significant more money.  He talked about a few issues like P2P giving, lending and charity and how that doesn’t probably work like we think it does.

I guess the biggest issue that is facing this space, if you want issues, is just the cost benefit analysis of running these systems.  There is a cost somewhere to run this stuff on many different servers, there is different ways to come up with consensus for this: for example, Ripple, Stellar, Hyperledger, they’re all using consensus ledgers which require a lot less capital expenditures.  But when you end up building something that requires some kind of mining process itself, that costs money.  So I think fundamentally in the long-run it won’t be so much what it can do but what can it economically do.

So when you hear this mantra of let’s decentralize everything, sure that’s fine and dandy but that’s kind of like Solutionism: a solution looking for a problem.  Let’s decentralize my hair — proof of follicle — there is a certain reductio ad absurdum which you come to with this decentralization.  Do you want to actually make something that people are actually going to use in a way that is cheaper than an existing system or we just going to make it and throw it out there and think they’re going to use it because we designed [wanted] it that way.  So I think education is going to be an issue and there are some people doing that right now: Primavera De Fiillipi, she’s over at Harvard’s Berkman Center — she’s got something called the Common Accord program.  And also Mike Hearn; listeners if you’re interested he’s made about 7 or 8 use-cases using the existing Bitcoin blockchain including assurance contracts — not insurance contracts — assurance contracts.  And he’s got a program called Lighthouse which hopes to build this onto the actual chain itself.  So there are things to keep in mind, I’m sure I’ll get yelled at in a minute here.

1:23:58 -> 1:28:10

Anyone listening to this wanting to get involved with smart contracts: hire a lawyer, that’s my immediate advice.  I will preface by saying I don’t necessarily agree with policies that exist and so on; I don’t personally like the status quo but there is no reason to be a martyr for some crusade led by guys in IRC, in their little caves and stuff like that.  That’s not towards anyone here in this particular chat but you see this a lot with “we’re going to destroy The Fed” or “destroy the state” and the reality is that’s probably not going to happen.  But not because of lack of trying but because that’s not how reality works.

Cases right now are for example: DPR, Shavers with the SEC, Shrem now with the federal government, Karpeles [Mt. Gox] went bankrupt.  What’s ended up happening is in 2009, with Bitcoin for example, you started with a system that obviated the need of having trusted third parties but as users started adopting it you ended up having scams, stolen coins, people losing coins so you ended up having an organic growth of people wanting to have insurance or some way to mediate these transactions or some way to make these things more efficient.  And I think that it will probably happen — since we’re guessing, this is speculative — I think that this will kind of happen with smart contracts too.  That’s not to say smart contracts will fail or anything like that.  I’m just saying that there will probably just be a few niche cases initially especially since we don’t have much today, aside I guess from Bitcoin — if you want to call it a smart contract.

What has ironically happened, is that we have created — in order to get rid of the middlemen it looks like you’ve got to reintroduce middlemen.  I’m not saying it will always be the case.  In empirical counter-factual it looks like that’s where things are heading and again obviously not everyone will agree with me on that and they’ll call me a shill and so on.  But that’s kind of where I see things heading.

I have a whole chapter in a book, chapter 17.  I interviewed 4 or 5 lawyers including Pamela [Morgan] of different reasons why this could take place.  For example, accredited investor — for those who are unfamiliar just look up ‘accredited investor.’  If you’re in the US, in order to buy certain securities that are public, you need to have gone through certain procedure to be considered a ‘sophisticated investor.’  This is one of the reasons why people do crowdsales outside of the US — Ethereum — because you don’t want to have to interact with the current legal system in the US.  The reason I mention that is because you end up opening yourselves to lawsuit because chains — like SWARM — cannot necessarily indemnify users.  That’s legal terminology for being able to protect your users from lawsuits from third parties; they just do not have the money, the revenue to support that kind of legal defense.  Unlicensed practice of law (UPL) is another issue.  If you end up putting up contracts on a network one of the issues could be, at least in the US, are bar associations.  Bar associations want to protect their monopoly so they go after people who practice law without a license.  I’m not saying it will happen but it could happen.

My point with this is, users, anyone listening to this should definitely do your due diligence, do your education.  If you plan to get involved with this space either as an investor or developer or so on, definitely at least talk to a lawyer that has some inkling of of an idea [on this].  The ones I recommend, in addition to Pamela here are: Ryan Straus, he is a Seattle-based attorney with Riddell Williams; Austin Brister and James Duchenne they’re with a program called Satoshi Legal; and then Preston Byrne, who’s out in London and he’s with Norton Rose Fulbright.

1:52:20 -> 1:54:43

Guys look, I understand that sounds cool in theory and it’s great to have everything in the background, but the reason you have to see these “shrink wrapped” EULAs [end user license agreements] and TOSs [terms of service] is because people were hiding stuff inside those agreements.  So if you hide what’s actually taking place in the contract you end up making someone liable for something they might not actually agree to.  So I’m not sure, I think it’s completely debatable at this point.  If we’re trying to be transparent, then you’re going to have to be transparent with the terms of agreement.

I should point out by the way, check out Mintchalk.com, it’s run by guys named James and Aaron in Palo Alto, they’re doing contract building.  ACTUS is a program from the Stevens Institute, they’re trying to come with codified language for contracts.  Mark S. Miller, he’s got a program over at Google, he does something with e-rights.

I mention all of this because, we already have a form of “polycentric law” if you will in terms of internationally with 200 different jurisdictions vying for basically jurisdiction arbitrage.  Ireland and the Netherlands have a tax agreement that Facebook, Google, Pfizer they take advantage of.  It’s this Double Irish With a Dutch Sandwich.  In fact my own corporation is incorporated in Delaware because of the legal arbitrage [opportunities].  Obviously smart contracts might add some sort of new wrinkle to that, but people who are listening to this, don’t expect to be living in some Galt’s Gulch tomorrow or something like that.

For example, when you have something that is stolen, there is something called Coinprism which is a colored coin project.  They can issue dividends on stock.  The cool thing with that is, “hey, you get to decentralize that.”  The double-edged side of that is if that when that get’s stolen: people steal stuff like bitcoins and so forth, what happens to the performance of that dividend?  If the company continues paying that dividend in knowing that the person had been stolen from: if somebody stole from me and I tell the company, “hey, it was stolen” and they continue paying, then I can sue them for continuing to pay a thief.  If they stop paying then it defeats the purpose of decentralization because anonymity is given up, identity has taken place.  Obviously this moves into another area called “nemo dat” it’s another legal term talking about what can be returned to the rightful owner, that’s where the term “bona fide” comes from.  Anyways, I wanted to get that out there.  Be wary of disappearing EULAs, those have a purpose because people were being sued for hiding stuff in there.

2:10:05 -> 2:12:23

So I think everybody and all these projects are well-intentioned and have noble goals but they’re probably over-hyped in the short-run, just like the Segway was.  It eventually leads to some kind of burnout, or over-promise and under-delivering.  I’m not saying this will happen, I’m just saying it could happen.  I actually think the immediate future will be relatively mundane, such as wills and trusts kind of like Pamela was talking about.

One particular program is in Kenya there is something called Wagenitech which is run by Robin Nyaosi and he is wanting to help farmers move, manage and track produce to market to bypass the middleman.  That doesn’t seem like something really “sexy,” that doesn’t seem like the “Singularity” kind of thing that everyone likes to talk about.  But that is needed for maybe that particular area and I think we might see more of that along with PurchaseChain, NotaryChains, some of these things that we already do with a lot of the paperwork.

Again, blockchains and distributed ledgers are pretty good at certain things, but not everything.  It has real limitations that vocal adopters on the subreddit of Bitcoin like to project their own philosophical views onto it and I think that it does it a very big disservice to this technology long-term.  For example, LEGO’s can be used to make a car but you wouldn’t want to go driving around in one.  A laptop could be used as a paper weight but it’s not particularly cost effective to do that.  And so what I think we’ll end up running into a tautology with smart contracts, it’s going to be used by people who need to use them.  Just like bitcoin is.  So what we’re going to have is a divergence between what can happen, this “Superman” version of Bitcoin and smart contracts, versus the actual reality.

So for example, people say it’s [Bitcoin] going to end war.  You had the War of Spanish Succession, there was a Battle of Denain, a quarter million people fought that in 1712 and it was gold-based [financed by specie].  Everyone that says bitcoin is going to destroy fiat, if the state exists as it does today there’s always going to be these institutions and types of aggression.  I do think smart contracts do add collateral and arbitration competition and it does take away the problem of having trust in the system itself, but the edges are the kryptonite.  And always will be.  So we need to focus on education and creating solutions to real actual problems today with the actual technology and not just some hypothetical “Type 2” civilization where we are using [harvesting] the Sun for all of our energy.

How to avoid lawsuits in the era of appcoins and cryptoequity?

What originally began as a small post for this site ballooned into something much more informative and well-rounded.  I spoke with 5 lawyers for a new piece at CoinTelegraph: Mitigating the Legal Risks of Issuing Securities on a Cryptoledger

Quote of the day: Unaware of legal environment

Below is a part of an interview between Juan Llanos, executive vice president of Bitreserve and David Landsman, Executive Director of the National Money Transmitters Association (NMTA):

JL: I understand you have been in touch with Bitcoin industry members.  What have those discussions been like?  How do their approaches and strategies compare to yours or the NMTA’s?

DL: Most Bitcoiners I have spoken to are not aware of their legal environment, or in a state of deep denial. It is not only about the federal and state legalities I mentioned above. They lack of awareness of the direct culpability society attaches to the Bitcoin dealer, if it later turns out that his Bitcoin customer dealt in drugs, terror, human smuggling, copyright infringement, hacking, or any type of criminal activity.  How could you have known, you say?  You are not responsible, you say?  Well, it is your responsibility, they say, to develop a credible ‘Know-Your-Customer’ program, one that is ‘reasonably designed’ to prevent, detect and report illegal money that moves through, or is in any way facilitated by, your company.

There are now at least 3 funded startups in the Bitcoin KYC space: Blockscore, Coin Validation and CoinTrust.

This all ties together with a post by Kristo Käärmann back in March: Government backed bitcoin

Cryptocurrency in the news: #12

A few links over the last couple of days:

Why are exchanges in China still allowed to operate?

I am asked this question frequently and currently I cannot give you a non-speculative answer.

My guesses are thusly:

1) That policy makers, despite knowing Bitcoin/Litecoin has the ability to bypass capital controls would still like to see if there are other potential “legitimate” uses for it.  Remember, this is a developing country that is trying to turn Shanghai into a real international financial center (pdf) through initiatives like the new Free Trade Zone.   So for example, maybe they have been briefed on the ‘smart property’ features of the crypto protocols (e.g.,  secure time-stampingproving ownership of tangible propertydecentralized DNS and new ways to sign contracts).  I doubt this is the case though.

Or:

2) Instead of being relegated to a paltry few options such as owning multiple apartments and/or sometimes sketchy wealth management products (WMPs) perhaps they would like to permit residents to diversify and try out new financial instruments.  And as happenstance cryptocurrencies are seen as a new alternative asset class.  While the PBOC officially stated that private ownership and public participation are okay for now, they do not seem to view cryptos as meeting their criteria as a “legitimate” asset class, withholding their stamp of approval.12

Remember, because of strict capital controls [pdf], PRC nationals cannot transfer more than $50,000 in foreign currency abroad each year, the domestic banking system has a very large captive consumer base from which to essentially extract rents from (e.g., no need to innovate as the market is essentially walled off from outside competition).  Again, these limitations are expected to change over the next decade, though officials and analysts have been saying that since at least 2008 when I first arrived in China.3

Or:

3) Perhaps I am an incorrect in my assessment of the PBOC which has been based on the stern comments from Sheng Songcheng, head official of investigation and statistics at the PBOC (see his recent essay “虚拟货币本质上不是货币” as well as my commentary here).  In contrast, my friend over at Aha Moments wrote this past week:

Of course, to a certain extent this merely reflects the general laissez-faire approach which characterizes the Chinese government’s approach to private wealth, an aspect of Chinese reality which understandably attracts little coverage in countries with more voracious governments. The reality on the ground is in fact almost unimaginable to younger inhabitants of, say, the United States or Western Europe. Not only is there is no capital gains tax in China, but C2C bank transfers are for the most part instantaneous and unlimited. I can send 50000 yuan to my buddy in Xinjiang and he will have it in seconds, all for a token transmission fee. You can also walk into any bank in China with the equivalent of one million euro in cash and deposit it with no questions asked. Simply put, the government’s policy is to leave people and their money alone. While they do endeavor to tax some income at the source, for the most part that’s about as far as they go.

Aha does have a valid point in terms of the C2C transfers, it was always easy for me to transmit this specific type of transaction nearly instantaneously (assuming you are using ebanking or an ATM — face-to-face service is still quite slow and tedious).  So perhaps there is a liberalizing strain within the PBOC policy making that has remained in the background regarding cryptocurrencies.  I don’t buy that though either.4

Or:

4) That policy makers are biding their time to see what, if any, international consensus is built around the regulation and management of exchanges.  There is no global standard yet, Singapore’s government is taking a hands off approach towards cryptocurrency right now whereas Denmark plans to regulate and oversee its use.  In the US, all fiat exchanges have shut down with the exception of Coinbase and that is because its founders had previous business relationships with Silicon Valley Bank (the partner bank).5 And even with this exception, Coinbase technically is not an exchange per se, but rather receives its coins through other sources like Bitstamp.net.

I think this is the most likely, as regulators can put a squeeze on the industry as a whole, forcing artificial consolidation and/or bankruptcies quickly.6 Then the PBOC and other peer organs will only have to worry about a handful or participants instead of 20+.  We already see the verification process being rolled out as customers at large exchanges such as BTCChina and OKCoin require national ID names and numbers in order to register and conduct transactions.  This will likely allow the PBOC and other departments to track capital flows to specific individuals.

A sell signal?

Yesterday the Financial Times published a report detailing the Chinese regulatory environment for cryptocurrencies.  It reconfirmed what I discussed a couple weeks ago, that fiat deposits at several exchanges, notably Huobi, are being transmitted through the CEOs personal account.

What struck me however was how several entrepreneurs went on record with FT, using their own identities to explain how they were bypassing regulations and/or finding loopholes.  Of course the inner libertarian in me cheers for a liberalized, self-organized world but a couple of their viewpoints seemed naive, short-sighted and wishful thinking.  And will likely end bad for them.  In fact, yesterday I was corresponding with Vijay Boyapati (who incidentally is the same person who convinced me of the long-term merits of cryptocurrencies and their protocols) and he asked me about the recent rise in price levels and if had to do with liquidity from China.

Here was my response:

I do think that the added liquidity (or at least the appearance of liquidity, who knows how deep it is on the Chinese exchanges) is helping buoy the price levels.  I don’t think it will last on the Chinese side, especially with articles like that from the FT.  PBOC staff read that newspaper, those comments are just going to make the officials want to close all the loopholes even more — at least that’s my guess.

24 hours later and the price for BTC token has dropped from ~5800 RMB to 4900 RMB and LTC token from 180 RMB to 145 RMB.  Who knows why, perhaps it will jump back up to those heights again tomorrow.  Self-reported volume on OKCoin and Huobi are still roughly the same as they have been the last few days.  Perhaps it is just the typical volatility.7

Yet the longer term issue still remains unresolved for several of these exchanges named in the FT piece: how to legally keep fiat liquidity flowing in both directions.  Are investors at exchanges prepared for the possibility of yet another December panic sale or hedged against a possible lower liquidity environment?  What about the personal liability issues that someone like Li Lin is now potentially facing in the event that a future audit takes place?  Perhaps now is the time to contact a risk management attorney to see if there other upsides (or downsides) to this nebulous guidance.8

  1. Getting an official seal, or chop, is very important for tax purposes in China.  See Chinese Chops Or Seals from About.com and What is a Chinese “Chop” or Seal? from Yahoo! []
  2. For more specifics and commentary about the PBOC notice on December 5th readers are encouraged to view: China’s Statement on Bitcoin is Open to Interpretation from CoinDesk and Despite panic, China’s regulation of Bitcoin leaves room for optimism from Tech In Asia []
  3. HNWI and financially savvy individuals can bypass some of these regulations by sending RMB-denominated funds through Hong Kong.  See This issue was directly discussed in Getting Money Out Of China. That’s Illegal. from ChinaLawBlog and In Reversal, Cash Leaks Out of China from The Wall Street Journal []
  4. This current stance by the PBOC seems to have taken many by surprise.  For example, back in October 2013 Bobby Lee was interviewed on a local station called International Channel Shanghai (video).  At the 12:38 minute mark Bobby says: “I hope personally to see more government regulation on bitcoin to clarify what businesses can and cannot do with bitcoin, to clarify how individuals can and cannot buy and sell bitcoins.”  Again, I have not spoken with him, but I doubt what he had in mind was what the PBOC and other organs announced/enforced last month regarding banning 3rd party payment processors. []
  5. See Regulatory risks, challenges and opportunities of cryptocurrencies in China and elsewhere []
  6. This is all speculative but there may still be time for new market entrants to enter the industry and merge/acquire with competitors. []
  7. One new story that came out today is that Taobao has a new rule (Chinese) that will ban the buying and selling of crypto coins.  Thus it will purportedly impact vouchers such as those being offered by BTCChina. []
  8. I do not know if law firm Harris & Moure has any particular advice on these issues at this time, but Dan Harris publishes a popular site: China Law Blog that discusses many legal issues regarding the mainland. []

Cryptocurrency Cat-and-Mouse games in China

btcc voucherSeveral updates to this ongoing cryptocurrency story in China and elsewhere (each subheading below is a slightly different topic).

Yesterday Bill Bishop linked to a story posted at Sina, “虚拟货币本质上不是货币” written by Sheng Songcheng.  Mr. Sheng is the head official of investigation and statistics at the PBOC (the central bank).

Bishop’s quick comment of the article was that, “No reason the belie[f] there will be any positive news from PRC regulators about bitcoin, or that somehow the recent crackdown was good, as some of the bitcoin bulls have been trying to spin.”

Too long; didn’t read

In addition to Bishop’s nutshell, another tl;dr comment that I would add is this, because Mr. Sheng works for the PBOC, his essay pretty much encapsulates what that important organ of the government thinks. Based on his essay, they do not recognize Bitcoin’s legality (although there is no clear indicator that they see a difference between protocol and token) and according to his own words, without government oversight or backing by any country, the token itself has no value.  Mr. Sheng uses the example of the recent 60% price drop of the bitcoin token on BTCChina last month as proof that without government approval, it has little value (a correlation-causation fallacy).  Furthermore, he thinks that if there is a developing country (such as China) that does begin using it, the deflationary aspect (the fixed ‘money’ / token supply) would actually present an obstacle and hinder the country’s economy to grow.  In fact, he says that Bitcoin and other cryptocurrencies will never become a country’s major currency and as a consequence, will not be a “real” currency.  And that it could only become so in the “utopian view of technocrats and libertarians” (技术至上主义和绝对自由主义者的乌托邦).  Yes, he uses the Chinese word for idyllic libertarian  (绝对自由主义者).

From a technical viewpoint, he states all cryptocurrencies do not have a unique origin, nor are its token generation, exchange and storage methods particularly special.  Any currency that has Bitcoin’s features could replace it such as Litecoin, which the public has become familiar with.  And continuing, he states that Bitcoin does not have any physical attributes found in gold and silver nor exclusivity enforced by the law so it will be really easy to replace.  Therefore it cannot replace the role of general currency which is the medium of trading. Thus his overall attitude (and that of the PBOC) is that the central government does not recognize any specific values of the token; that it is illegal to use (though he does not specifically say who or what timeframe) and it doesn’t justify its own existence.

Again, while we can argue over the epistemological, economic and technical problems with this essay (e.g., why do economies grow, deflation versus inflation [pdf], the economics of Bitcoin [pdf], what utility cryptocurrencies have, how the protocol works, etc.) all of which have been discussed elsewhere, as Bishop noted above, this essay is hardly a positive sign for the crytpocurrency segment in China.  Thus, while speculative, after reading the article the impression readers are left with is that the PBOC will crack down on cryptocurrencies on the mainland for the foreseeable future.

Cat-and-mouse

There have been discussions over the past weeks as to how mainland exchanges could bypass the current hurdles.  One idea was to create yet another type of virtual token that could then be exchanged on exchanges.

Over the past couple of hours on reddit, users have posted a new method that BTCChina is using to get around the current depository predicament the mainland industry is currently in (e.g., all payment processors are barred from providing fiat liquidity to crypto exchanges).  However, the small stop-gap solution is for BTCChina customers internally (this is not the same thing as the online vouchers like BTCe has).  BTCC code is to allow one customer with CNY on the site to sell the CNY to another customer.  The medium is the BTCC code which is in two parts: one is for the customer the other is for the site.

Imaginary Capital Markets has a few more details and screenshots, but let me just emphasize once more that this is not a complete workaround (yet) but just a way for BTCC users to exchange CNY with one another.  My speculation: if the CEO role as sole depositor is still active, perhaps this could be a way for him/her to distribute funds to friends & family who can then exchange the fund to the wider customer base.  If this is the case, perhaps other exchanges will follow suit (assuming that the CEO can still deposit funds into the exchange through their personal account, see the explanation here for more).

[Update: Taobao has a new rule (Chinese) that will ban the buying and selling of crypto coins.  Thus it will purportedly impact vouchers such as those being offered by BTCChina]

Also regarding the CEO bank accounts I discussed the past two weeks, Eric Meng, an American attorney friend of mine currently in China explained to me that the use of personal bank accounts to do business is a huge red flag in general.   It does not mean that anything is being done illegally, but it’s something that investigators watch out for.1

Bots again

Regarding the purported fudged numbers on Chinese exchanges (discussed here), another friend (in Europe) recently wrote to me explaining that someone could easily write a bot and test the liquidity to see whether it is real or not.  It could be that some exchanges on the global stage act as a market maker (similar to the NYSE which employs “specialists” [pdf explanation] who always make sure that there is a reasonable bid and ask available and who take short term positions in order to provide liquidity).

This same friend who has both mined and then built proprietary HFT arb software on BTCe is reasonably sure that BTCe runs their own arbitrage bots with zero fees but sometimes turns them off (or they have certain limits, he is not sure).  Again, arbitrage is not bad per se and basically makes sure that you can execute your orders at a ‘fair price’ all time.  Of course it would be better if the exchanges are more forthcoming about what they do behind the scenes but as long as there are no regulations they can do whatever they want and earn some extra money.  Yet again, no one is forced to use a particular exchange so people can easily vote with their feet or open their own (transparent) exchange.

Notes in the margin

One last comment I received is from Mark DeWeaver (author of Animal Spirits with Chinese Characteristics and GWON’s Foreword) is that,

It occurred to me that the argument about bitcoin having a big “carbon footprint” is really poorly thought out.  Is the footprint really bigger than that of paper currency, which has to be transported from countless businesses to bank’s safe deposit boxes at the end of each day.  And think of all the gas people must burn on trips to ATM’s!

This is in response to my explanation of Charles Stross’ contention that cryptocurrencies are more of a burden on the environment than fiat currencies are (they are not).  Mark’s comments are empirically valid because these up-armored vehicles (typically Ford 550 chassis or similar classes from competitors) are frequently used to move fiat currencies to and from distribution centers to branch banks and ATMs.  For example, The Armored Group currently lists many used armor transportation cars for sale.  And a quick search on Fuelly gives you an idea of how much fuel the average F550 consumes in the city (~9 mpg).  This also ignores the supply chain needed to build the vehicles in the first place which is an entire logistical segment that cryptocurrencies do not need.  Nor does it include the carbon consumption of the driver and guards ferried around in the vehicles (e.g., eating, sleeping, shelter, etc.).  One can only imagine the sheer number of vehicles in developing countries where digital fiat are not nearly as common and thus paper/metal is transported more frequently.

Again, this is not to say that cryptocurrencies are mana from heaven, that they won’t be replaced or will somehow axiomatically usher in a world of milk and honey.  But these specific claims by detractors need to be backed up with real numbers as they are positive claims (e.g., burden of proof).  If you do think that the Bitcoin transaction network (the most computationally powerful, public distributed system currently)2 consumes more carbon than all ~200 fiat currencies right now, you need to prove that.  And from my quick research I detailed in my article, that does not seem to be the case (today).

Also, for other occasional commentary on crypto in China I recommend visiting my friend’s site, Aha Moments (specifically this recent post).  Drop him a note and tell him to update more.

  1. Eric also suggested I link to the following guide that potential investors conducting due diligence pay attention to in the aftermath of Madoff: Six Red Flags and Tips for Investment Risks from CAMICO. []
  2. See Global Bitcoin Computing Power Now 256 Times Faster Than Top 500 Supercomputers, Combined! from Forbes []

Introducing China Law for Expats

A good friend of mine, Eric Meng, recently launched a new site targeting a specific niche: China Law for Expats.

I worked with Eric last year at the American Chamber of Commerce.  He graduated from the University of Virginia law school and is a New York licensed attorney.

And according to him, his goal is to help provide answers to many of the commons hurdles, struggles and questions that confound the expat community in China.  For example, one of his recent posts discusses work visas, describing the process and eligibility requirements for those without work experience.

Consequently, I know from first hand experience (see Chapter 10) how useful it can be to have cogent, legal advice out here.  Thus if you plan to work or even travel out on the mainland for an extended period of time, be sure to visit his site or contact him for more information.

Chapter 10 – Legal services

[Note: below is Chapter 10 from Great Wall of Numbers]

I have been more or less fortunate not to have any problems with government authorities at any level (yet).  However whenever you put a group of laowai (foreigners) into social setting you will eventually hear a story or two – sometimes embellished – about legal problems.  The one personal story that I have involves visa delays.  About two months into my most recent teaching position I received a notice from my HR director that my visa was being delayed by the PSB – Public Security Bureau (equivalent to the Immigration Services).  They wanted me to come in person for a face-to-face interview at a local police station with an officer.  My director said while this was unusual we could prepare for it and analyze what they may inquire about.  At around 2pm on a June weekday I went in and met a number of plain-clothes inspectors.  One handed me a worn book of immigration laws covering the sections I possibly had violated.  After a few questions and three hours of sitting next to their terminals, one of them – Zhang (not his real name) – approached me and after a brief exchange allowed me to leave without any recourse.

Fortunately the paperwork had been merely misplaced and nothing came of it.  But what should foreign firms and expats expect when starting a business?  Always be prepared.

There are several ways in which you can proactively protect both your physical assets and employees.  The first almost goes without saying: hire a legal advisor to analyze and asses any liabilities, risks and loop-holes in your contracts and business model.

For example, Dan Harris is an American attorney at Harris & Moure who frequently travels to China and publishes the popular ChinaLawBlog.  In an email exchange in October 2012, he noted “that the most common challenge for US service-oriented SMEs is getting paid. Chinese companies are reluctant and slow to pay for services. Most service companies do not have much IP [intellectual property] so that is not always a big issue for them. And thus I would have to say contracts is their biggest issue, which gets us back to getting paid.”

Dan and his co-blogger Steve Dickinson, who lives and works in China, have written a number of excellent overviews of contract law in China and about protecting your assets, your employees and even your IP.1

Why is professional advice such as theirs important?

Ten years ago when China’s Railway Ministry elicited bids for building a nation-wide high-speed network (called the CRH, HSR or 高速铁路), several foreign companies from France and Japan submitted bids.  As part of the deal to do business on the mainland, the Ministry required that foreign firms set up joint ventures (JV) with domestic suppliers and provide technology transfers to these firms.23 Japanese firms, unfamiliar with the nebulous legal framework in China, ultimately handed over their ‘best practices’ and engineering techniques to the JV.  Their Chinese partner (CSR, 中国南车集团) then quickly replicated and reverse-engineered the technology using domestically sourced parts and labor.  As a consequence the Japanese companies were edged out of the Chinese market by the very machinery they had originally designed.4

Another example is General Motors which, wanting to gain access to China’s car market (now the world’s largest), transferred and exchanged technology to their JV partner, SAIC.  While GM still operates in China (hitting a record 2.54 million in vehicle sales in 2011), they have found themselves between a rock and hard place with China’s new policy regarding electric cars.5 This policy mandates that foreign firms provide technology transfers to their JV partners in order to have access to the Chinese electric car market.6 Since foreign firms are holding out – not wanting to part with their trade secrets and proprietary information – Chinese firms now have a distinct advantage because the national government is offering nearly a 50% subsidy to consumers for each sale of an electric car in China.78

Let’s discuss this over dinner

As noted in Chapter 1, guanxi, or personal connections, can be a very tricky and hard to fully describe to those who have never lived or worked in China.  For example, compared with thirty years ago, contracts are relatively more ironclad in legal disputes – yet the “rule of law” today is not quite the same as it is in Western countries.  This presents a challenge to any firm wanting to do business in China and thus building guanxi, personal connections with suppliers and even buyers is sometimes just as important as the resources spent in drafting contracts, subpoenas and lawsuits.

While guanxi can work for you – you might land a deal with a mere handshake at a KTV (Chinese businessmen typically dine and sing in contrast to discussing business deals on golf courses in the West) – not having enough guanxi, or not having guanxi with the right people could prevent your company from exporting your goods to consumers outside of China.9

Can you just “grease some palms” and make things happen?  Over cocktails with other laowai it may be common to hear insinuations various businesses that used bribes to improve their guanxi.  I should point out that the Foreign Corrupt Practices Act (FCPA) and UK Bribery Act deals specifically with bribery.  To better understand this law and its enforcement, it is highly advised that you consult a lawyer because the FCPA is actively enforced and the penalties for violating it are quite stiff.  Furthermore, as I mentioned in the first story in Chapter 1, even if you know the right people and make the right connections this does not immediately translate into success.

Legal structures

If you do decide to operate a business in China, what legal structure will you use?  Should you try to start up a Wholly Foreign-Owned Enterprise (WFOE), Variable Interest Entity (VIE) or some other joint-venture structure?10 Stephen Dickinson, the Beijing-based American attorney above, has written a number of primers on what legal structures foreign businesses should and should not create.  Because of Chinese regulations that prevent foreign ownership of companies from being directly involved in “sensitive” areas of the economy (e.g., for national security reasons), one way to skirt such limitations was to set up a VIE.11 Yet due to new regulations issued last year, VIEs are no longer an option and the SEC itself is rumored to be investigating how they operate as well.12 While this was not particularly surprising to lawyers and serial entrepreneurs, it may have come as a surprise to the uninformed and those who failed to carry out thorough due diligence.

Similarly, during the summer of 2011 several shareholders of Yahoo were ‘surprised’ when the Alibaba Group (owner of Alibaba, Tmall and Taobao) transferred the ownership of Alipay.13 Alipay is an online payment method (similar to Paypal) that is currently the domestic marketshare leader, at 47%.14 According to Chinese law, online payment processing companies cannot be owned by foreigners, something that a VIE structure was considered as a means to get around.  What resulted was a high-profile, very vocal series of discussions that headlined the business press for several months between May to July of 2011.  The lesson here is that, as Dan Harris noted, this was not unprecedented.  His law firm “has been involved in probably a dozen similar matters.”15 So once again, talk to a legal advisor before you set up any kind of presence in China, even if it is as “simple” as a minority shareholder position.

What kind of opportunities are there for legal professionals?

I asked a couple of Chinese lawyers this question.  They both quickly noted that experienced practitioners can find a number of opportunities in areas such as FDI and M&A.  For example, in addition to Harris & Moure discussed above, King & Wood Mallesons is an international legal firm with offices in China that specializes in more than a dozen areas of law including, Import/Export Credit Facilities, M&A, FDI and PE deals.16 Their foreign expertise allows them to provide services like FDI that local firms – lacking in international experience – sometimes cannot fully provide.

Yet before getting on an airplane with your fresh JD and Bar certifications consider the following challenges.  In order to practice on the mainland you need to be licensed in China as well. That means you need to take the National Judicial Exam (国家司法考试) which means you not only need to be fluent in Chinese but because of sovereignty issues, at this time the only people legally eligible for sitting for the exam are citizens from the mainland plus Hong Kong, Macau and Taiwan.  For comparison, in the US, each state has its own residency and citizenship requirements.  Some such as California and New York currently allow foreign nationals to take their bar exams and set-up practices.17

A frequently asked question from friends overseas is if there are many licensed lawyers in China?  Yes.  In fact, according to their new 2012 White Paper on judicial reform, the State Council Information Office states that there are nearly 220,000 lawyers and 18,200 law firms in China (this is substantially higher than the 200 lawyers in 1980).1819 These same lawyers acted as counselors for 392,000 clients and handled 2.315 million litigation cases in 2011.

A legal professional I know in New York recently asked me if there is a work-around for this to provide paralegal services instead.  Perhaps, but you probably would not be able to access large portions of information that have restricted access.  For example, currently in China only licensed lawyers can look up internal business records (e.g., shareholder meeting minutes, the shareholders list, the composition of the board, the balance sheet and other related financial reports).  And there are conditions for even licensed lawyers to access this information.  Currently, the authority granted to lawyers must be justified by some “reasonable concerns.” Access is allowed only for the appropriate purposes – for example, if a shareholder wants to exercise his inspection right, his lawyer then could claim the right to see the company records on the shareholder’s behalf.20 Similarly, doing investment research on the mainland as a WFOE (Wholly Foreign Owned Entity) is not currently legal.21

In contrast, in the US just about anyone can look up the full company records of any public company.  In addition, the domestic legal profession on the mainland has run into a number of barriers that some have called a “clawback” relative to reforms implemented in the 1980s and 1990s.22 Thus the nebulous uncertainty and dynamism for legal professionals is something to consider before establishing a permanent physical presence on the mainland.

Explicit and implicit rules

While many expat companies will set up a Hong Kong office to reduce the tax burden and liability on incomes earned on the mainland (e.g., your workers are paid through the Hong Kong subsidiary and are thus taxed at the lower Hong Kong rates), many Chinese companies also have set up Hong Kong subsidiaries to reduce their tax burden.  For example, in the Chinese energy industry, several companies that manufacture hydrocarbon drilling equipment on the mainland will ship and sell (e.g., “export”) their physical products to a Hong Kong controlled subsidiary, and then re-import them.  In some cases they can reduce their taxes by up to 20%.23

According to Chinese law, the maximum amount of funds that any individual can move out is $50,000.  Thus how to repatriate your assets is another key issue.  The Wall Street Journal has published several reports this past year about the labyrinthine difficulties that both Chinese and foreigners face when attempting to move funds outside of China.24 While not explicitly encouraged, the Hong Kong legal system protects certain activities including money transfer agents who essentially move capital across the border.  It is highly recommend that you consult with an attorney or tax expert before attempting to do the “Hong Kong shuffle.”25 Failure to do so could result in being (temporarily) arrested, like Yan Suiling – who was accused of money laundering in China (because the process she used is illegal on the mainland) but was later acquitted (because the process she did it by was legal in Hong Kong).26

Another example of legal issues and lawful avoidance involves real-estate purchases.27 In an effort to “cool down” the property market, over the past several years larger cities like Beijing and Shanghai have implemented a number of regulations that place restrictions and “curbs” on individuals purchasing multiple homes.28 This move into multi-home ownership was done in part because strict capital controls prevent domestic savers from investing overseas.  As a consequence many savers have few places to park their assets.  Depending on the region, one of the areas where they can typically invest more freely is real-estate.  So in addition to suppressed (low) interest rates set by the central bank which have incentivized construction projects and capital consumption, many savers in the past decade have had few investment choices and thus have purchased, invested and speculated in real-estate markets.29 And due to a perceived “bubble” in the real-estate market, several cities subsequently enacted laws that make it increasing prohibitive to buy multiple homes (e.g., by increasing down payments from 20% to 50%).  In an attempt to legally circumvent this, some prospective home buyers will pool their resources together and purchase housing units in a “group buy” method (e.g., like GroupOn).

Takeaway:  While there are numerous opportunities to do business in China there are also a number of challenges, including legal uncertainties.  This includes the legality of contracts, movement of assets, protecting IP and lowering tax liabilities.  In addition there is a cultural practice called guanxi, or personal connections, which can directly impact many (if not all) business transactions on the mainland.  While there may be opportunities for experienced legal professionals to work in niches, before moving to the mainland it is highly recommended that you do your due diligence to find out what specific niches areas are in demand.  In addition, all proprietors are encouraged to speak with and perhaps hire a legal counsel that is proficiently versed in both the mainland legal system as well as the culture.  Failure to do so may result in being unable to protect your assets and possibly even forfeiting them as well as the market access that your firm had hoped to achieve.


Endnotes

  1. For their series on protecting your IP in China, see How To Protect Your IP from China from ChinaLawBlog []
  2. For their discussion on technology transfers and legal statutes in China see How To Handle Chinese Negotiating Tactics. Part Three. from ChinaLawBlog []
  3. For more regarding legal issues surrounding joint ventures on the mainland see, China Joint Ventures. Watching The Sausage Get Made. from ChinaLawBlog []
  4. See Japan Inc shoots itself in foot on bullet train from Financial Times and IPR fears won’t derail bullet train exports from China Daily []
  5. General Motors closest competitor is Volkswagen, who sold 2.81 million cars in 2012 but initiated one of the largest recalls beginning April 2, 2013.  See Volkswagen recalls over 384,000 cars in China: watchdog from Reuters []
  6. General Motors in China: Coping with the Changes in the Automobile Industry from ICMR []
  7. GM and SAIC join forces on electric cars from Financial Times []
  8. See Road Gets Bumpy for GM in China from The Wall Street Journal and GM and SAIC’s Open Marriage from China Bystander []
  9. There are endless amounts of anecdotes retold by colleagues and coworkers over the years.  One notable story involves a friend who wanted to buy natural and artificial hair in China and ship it to the US targeted specifically for African hair salons for use as braiding.  She spent several hundred hours traveling across Shandong, filing the necessary paperwork, building guanxi, buying hair samples and contacting US hair salons.  Yet due to the thin margins, legal fees related to permits, import & export duties on both sides of the Pacific and transportation costs, her business plan would prove to be unprofitable.  Thus collecting all of the necessary requirements and doing due diligence is highly recommended before investing any significant capital into an overseas endeavor. []
  10. For a step-by-step guide on forming an WFOE see China’s Approval Process for Inboud Foreign Direct Investement from the US Chamber of Commerce.  See also Forming A China WFOE. How Long Will That Be Going On? from China Law Blog and Selling In And Into China. Four Good Tips And Mine. from China Law Blog []
  11. VIEs In China. The End Of A Flawed Strategy. From ChinaLawBlog []
  12. Variable interest entities in China from China Accounting Blog []
  13. Yahoo gets short end of stick in Alibaba deal from Reuters []
  14. According to Analysys research and consulting, as of Q2 2012, Alipay leads with 47.3%.  This is up from 46.9% in Q4 2011.  See Alipay Lead China 3rd Party Internet Payment Market 2011Q4 from Analysys []
  15. Yahoo/Alibaba/Alipay/Jack Ma/Carol Bratz: What Really Happened And What It All Means. from ChinaLawBlog []
  16. See Harris & Moure and King & Wood Mallesons []
  17. See Chart 4 on p. 14 in Comprehensive Guide to Bar Admission Requirements 2012 from National Conference of Bar Examiners []
  18. See p.5 in Judicial Reform in China from the State Council Information Office []
  19. China has 220,000 lawyers from China Daily []
  20. There are other requirements as to the eligibility of the shareholder for claiming the inspection right as well.  In addition, the restrictions on this and on accessing full company records will vary city by city. []
  21. On Doing Investment Research In China As A WFOE. Not Legal. from ChinaLawBlog []
  22. China’s Turn Against Law by Carl F. Minzner []
  23. In some ways this is similar to retailers in Western countries that practice “rolling inventory” at the end of the year.  Speak with a legal professional before conducting this type of transaction. []
  24. In Reversal, Cash Leaks Out of China from The Wall Street Journal []
  25. This issue was directly discussed in Getting Money Out Of China. That’s Illegal. from ChinaLawBlog []
  26. The Mechanics of Moving Cash Out of China from The Wall Street Journal []
  27. Another area that may change in the near future is capital gains tax on returns for private equity firms investing in China.  See Tax Experts: China May Crack Down on Capital Gains from The Wall Street Journal []
  28. Property curbs to stay from Global Times []
  29. One of the reasons this rate incentivizes real-estate speculation is that the interested earned at a bank is usually lower than CPI or inflation.  Thus merely placing funds into a savings account will actually net a loss once adjusted for inflation.  Readers may also be interested in the analysis from Michael Pettis, a finance professor at Peking University and Patrick Chovanec, a finance professor at Tsinghua University as well as Animal Spirits with Chinese Characteristics by Mark DeWeaver. []