Cryptocurrencies have exploded in number and popularity over the last few years, and legal practitioners need to start familiarizing themselves with the essentials
Over the past few years, cryptocurrencies have exploded in popularity and in number, driven in large part by the phenomenal price growth of Bitcoin and Ethereum. By the end of summer last year, there were already more than 1000 different cryptocurrencies with a combined market cap of over $131 billion. Today, those numbers are over 1500 and over $300 billion, and interest and investment are still growing.
Cryptocurrency has also been showing up more and more frequently in the legal industry. Some lawyers and law firms actually accept cryptocurrency payments, despite the risk associated with its price volatility. Additionally, several major firms have begun recruiting lawyers with financial technology expertise and begun marketing groups with cryptocurrency and blockchain specialists. Major cryptocurrency companies have also begun hiring prominent in-house counsel to prepare for the regulatory oversight and litigation that is coming.
With such rapid growth and so many implications for the legal industry, practitioners would do well to familiarize themselves with the topic. In this short series, we’ll provide an overview of five essential things for legal practitioners to know about cryptocurrency: what it is, how it works, why people use it, what’s happening legally, and what the discovery implications are. We begin in this first Part with what it is.
Cryptocurrencies are, generally speaking, digital assets intended to be used as a medium of exchange just as traditional money is. They derive their “crypto” prefix from their basis in cryptographic processes and the blockchain, which we will discuss further in the next Part. Unlike traditional money, cryptocurrencies rely on distributed, decentralized recordkeeping and transaction verification systems (akin to how peer-to-peer file sharing works) instead of central state authorities or banks. One recent academic paper defined a cryptocurrency as having 6 essential elements:
Beyond these basics, cryptocurrencies come in a few varieties. Bitcoin is by far the most well-known cryptocurrency and is intended as a medium for exchange like traditional money. Ether, the next most prominent cryptocurrency, is based in a blockchain system called Ethereum that is designed to function as a platform for contracting and other organizational and record-keeping functions. In addition to Ether’s value as a speculative investment, it has value for use executing other tasks on the Ethereum platform. This makes it something commonly referred to as a “utility token.” Still other offerings act like ownership shares in a network making them “security tokens” rather than utility tokens. Forbes articulated the distinction between utility and security tokens well in an article last fall:
. . . “utility tokens” – multidimensional coins which function only partially as a sort of equity in a network, whose value results from a mix of speculation in the asset and the demand for their use in that network. For instance, a token that powers a decentralized storage network, if it’s structured correctly, should grow in value as usage of storage on the network increases. However, unlike company stock, its value wouldn’t derive from any one corporate entity but from all the activity by a variety of actors on this open source network. In contrast to utility tokens, security tokens – coins that, like traditional securities, represent shares in an entity similar to company stock or shares in a limited partnership – don’t have any additional utility beyond representing the value of the fund and the profits would depend on the promoter.
New coins and tokens are being launched frequently, often through initial coin offerings (ICOs) that can be a bit like crowdfunding, a bit like a stock IPO, or a bit like a product or service presale, depending on the type of coin or token and the specific structure of the offering. These distinctions have regulatory implications for whether a particular ICO or other cryptocurrency offering qualifies as a security under Securities and Exchange Commission (SEC) regulations, which we will discuss further in Part 3 of this series.
Upcoming in this Series
In the next Part of this series, we will discuss how cryptocurrency and the blockchain work and why people use them.