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Law Firms and Cryptocurrencies

In the past, we have looked at blockchain, the technology that underlies cryptocurrencies, and at how blockchain is relevant to law firms. In this article, we have a closer look at the relationship between law firms and cryptocurrencies. We explain what they are and explore the challenges regarding law firms and cryptocurrencies. We also look at the legal services law firms can offer.

What are cryptocurrencies?

Wikipedia defines a cryptocurrency as “a digital currency designed to work as a medium of exchange through a computer network that is not reliant on any central authority, such as a government or bank, to uphold or maintain it.”

Cryptocurrencies are decentralized digital currencies. They use blockchain technology to secure transactions and control the creation of new units. Unlike traditional currencies issued by governments, cryptocurrencies operate on a peer-to-peer network. This allows users to transfer ownership of cryptographic units without the need for a trusted third party, such as a bank. Transactions made with cryptocurrencies are recorded on a public ledger called the blockchain, which ensures transparency and security.

The first and most well-known cryptocurrency is Bitcoin, launched in 2009. It paved the way for thousands of alternative cryptocurrencies, known as altcoins, each with unique features and purposes. The most used cryptocurrency is Ethereum. It is popular in the legal and commercial world because it is being used in smart contracts.

Wikipedia lists six conditions to qualify as a cryptocurrency:

  1. The system does not require a central authority; its state is maintained through distributed consensus.
  2. The system keeps an overview of cryptocurrency units and their ownership.
  3. The system defines whether new cryptocurrency units can be created. If new cryptocurrency units can be created, the system defines the circumstances of their origin and how to determine the ownership of these new units.
  4. Ownership of cryptocurrency units can be proved exclusively cryptographically.
  5. The system allows transactions to be performed in which ownership of the cryptographic units is changed. A transaction statement can only be issued by an entity proving the current ownership of these units.
  6. If two different instructions for changing the ownership of the same cryptographic units are simultaneously entered, the system performs at most one of them.

Challenges regarding law firms and cryptocurrencies

Law firms wanting to deal with cryptocurrencies face several challenges. These may apply to the law firms themselves as well as to their clients. Let us have a closer look.

A first challenge is regulatory uncertainty.  The legal and regulatory environment surrounding cryptocurrencies is quite intricate. Law firms can advise on compliance with securities, commodities, tax, anti-money laundering, and banking laws and regulations. The challenge is that the regulations for cryptocurrencies vary widely from one jurisdiction to another. In some countries, cryptocurrencies are embraced and regulated like any other financial asset, while in others, they face severe restrictions or outright bans. (Wikipedia provides an overview of the legality of cryptocurrencies in different countries and territories). On top of that, the legal landscape is also continually evolving. Law firms must therefore stay abreast of these shifting regulatory landscapes to provide accurate advice to their clients.

A second challenge has to do with compliance with anti-money laundering requirements. Cryptocurrencies are often associated with anonymity. This has raised concerns about their potential use in illegal activities such as money laundering and terrorism financing. Law firms must assist clients in navigating anti-money laundering requirements to ensure compliance with local and international laws.

Next, there are taxation Issues. The tax treatment of cryptocurrencies can be complex and varies significantly by jurisdiction. Law firms can help clients understand and comply with tax obligations, whether it involves capital gains tax, income tax, or value-added tax (VAT) on cryptocurrency transactions.

There also are Intellectual Property (IP) rights to consider. The blockchain technology has led to the creation of numerous innovations, many of which may be subject to intellectual property protection. Law firms play a crucial role in helping clients secure and enforce IP rights in the crypto space.

Another challenging area that is of specific interest for lawyers is dispute resolution. As with any financial asset, disputes can arise in the cryptocurrency space. These can be related, e.g., to transactions, smart contracts, or initial coin offerings (ICOs). Law firms must be equipped to handle these disputes, which may involve complex issues of jurisdiction, contract law, and technology.

Finally, there are ethical considerations. Law firms must comply with the ethical requirements of their bar associations. Specific rules may apply as to what is allowed and what isn’t.

Legal services regarding cryptocurrencies

With all the challenges listed above, it should come as no surprise that there are corresponding services lawyers can offer. Let’s have a closer look.

Law firms can provide compliance and regulatory advice to ensure that cryptocurrency-related activities comply with applicable laws. This includes advising on the compliance of tokens and coins with securities laws, exchange licensing, and the creation and management of smart contracts. Firms also assist with the formation of cryptocurrency-focused funds, reviewing fund offering materials, and advising on tax implications.

An obvious service law firms can offer is dispute resolution and litigation. This includes resolving disputes between customers and cryptocurrency exchanges, as well as issues like locked accounts and frozen assets. Law firms also handle litigation and fraud cases, including recovering stolen digital assets and addressing business and investment fraud. When disputes arise in the cryptocurrency space, law firms provide representation in court or through alternative dispute resolution mechanisms such as arbitration or mediation. They can also represent clients in investigations by various government agencies and provide defence in civil disputes.

Law firms can offer advisory services for innovators and investors. This can include advice on intellectual property protection, company formation, and tax planning. As mentioned above, they can also help with compliance with regulatory and licensing obligations and security and privacy reviews. For investors, law firms can develop tax-effective ownership structures and advise on the taxation of trading gains and income from activities like staking and lending.

Another area consists of specialized services for Digital Assets and Web3. Law firms are at the forefront of advising on new digital assets, cryptocurrencies, NFTs, and blockchain-based protocols. They work with venture capital and investment funds, tech companies, exchanges, and decentralized autonomous organizations (DAOs). This includes engaging with regulatory bodies worldwide to advocate for clients in the digital asset and Web3 ecosystem.

Whether it’s an ICO, a cryptocurrency exchange, or a blockchain-based startup, law firms can help structure transactions to ensure they comply with legal requirements.

A service that is quite commonly offered these days is drafting and reviewing contracts. Smart contracts are self-executing contracts with the terms of the agreement directly written into code. They are a cornerstone of blockchain technology. Law firms are instrumental in drafting and reviewing these contracts.

Law firms can also help facilitate technical integration. Law firms are increasingly using blockchain technology to enhance efficiency and verify transactions. The use of smart contracts is growing. Law firms can advise on their implementation and legal bindingness. Distributed ledger technologies (DLTs) offer potential cost and time savings, which makes them attractive for various legal applications.

Beyond compliance and transactions, law firms offer strategic advice to clients on how to navigate the rapidly evolving landscape of digital assets. This includes advising on risk management, investment strategies, and potential regulatory changes.

Law firms and cryptocurrencies: conclusion

Like many new technologies, cryptocurrencies come with a wide range of challenges and opportunities. Law firms that start focusing on cryptocurrencies can gain a competitive edge through specialization, thought leadership, cross-border work, and collaboration with Technology Experts.

 

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Token Economics for Lawyers (2): the value of tokens

This is the second part of a two-part article. In the first part we explained what tokens and token economics are. We also discussed some legal issues and the relevance for lawyers. In this second part, we look at the value of tokens. Tokens are digital assets. Assets have a value. How is that value assessed? What are the factors in determining the value of tokens? And what are the most common value models for digital tokens?

Factors determining the value of tokens

The value of tokens is determined by a variety of factors, including supply and demand, market sentiment, and the underlying technology. Let’s have a look at those.

Supply and Demand: Like any other asset, the value of tokens is determined by the balance of supply and demand. If there is a high demand for a particular token and a limited supply, the price of the token will go up. Conversely, if there is a low demand and a high supply, the price of the token will go down.

Market Sentiment: The value of tokens is also influenced by market sentiment. If investors believe that a particular token has a strong future, they will be more likely to buy it, increasing its value. Conversely, if there are concerns about the future of a token, investors may sell their holdings, causing the value to drop.

Underlying Technology: The underlying technology of a token can also influence its value. If a token is built on a strong, reliable blockchain network, it may be seen as more valuable than a token built on a less secure network. Similarly, if a new technology is more environmentally friendly than its competitors, it will be considered more valuable.

Terminology

The value of a token is largely determined by the token model. The term token model refers to the design and structure of a token, and how these aim to create a self-sustaining ecosystem that incentivizes network participation and rewards valuable contributions. These models typically include elements such as token distribution, inflation rate, governance mechanisms, and utility functions, among others.

There are several different value models of tokens, each with its own unique characteristics and potential benefits. But before we explain those, it is good to first familiarize ourselves with some of the terminology regarding these characteristics.

A hard cap is the maximum amount of funds that a token sale or initial coin offering (ICO) can raise. Once this cap is reached, no more tokens will be sold or created. A soft cap, on the other hand, is a lower funding threshold that must be met for the project to proceed. If the soft cap is not met, the project may be cancelled or delayed, and investors may receive a refund.

The total token supply is the total number of tokens that will ever be created for a given project. This includes both tokens that have already been distributed and tokens that have not yet been released. The circulating supply, on the other hand, is the number of tokens that are currently in circulation and available for trading. This excludes tokens that are locked up or held by the project team, for example.

The market cap, short for market capitalization, is the total value of all tokens in circulation. It is calculated by multiplying the current price of a token by the circulating supply of tokens. Market cap can be used as an indicator of the overall size and success of a project and is often used to compare different projects within the same industry or sector.

Token value models

There are basically four common types of token value models:

Deflationary tokens

Deflationary tokens are designed to decrease in supply over time, either through burning tokens or reducing the rate of token issuance. In other words, there is a hard cap on the number of tokens created. which acts as a deflationary mechanism as demand increases over time, but supply does not. This creates scarcity and can lead to a rise in the value of the token as demand outstrips supply. The goal is to incentivize long-term holding of the token and discourage short-term speculation. However, there is a risk that the decreasing supply may make the token less attractive for use in transactions, reducing its utility. Examples of deflationary tokens are Bitcoin (BTC), Litecoin (LTC), and Bitcoin Cash (BCH).

Inflationary tokens

Inflationary tokens are the opposite of deflationary tokens. They are designed to increase in supply over time, either through regular token issuance or through other mechanisms such as staking rewards. The goal is to encourage spending and discourage hoarding, as the value of the token may decrease over time due to increased supply. This can also incentivize network participation and development, as new tokens are issued to those who contribute to the network. In this model, there is no hard cap on the number of tokens created. Instead, there are various iterations of the tokens being issued. Some token issuers limit token creation to a yearly basis, while others stick to a set schedule. And some adjust the supply, based on demand data. Examples of inflationary tokens are Ethereum (ETH), Polkadot (DOT), and Solana (SOL).

Dual-tokens model

In a dual-tokens model, there are two tokens: one that serves as a utility token for network access or use, and another that serves as a store of value or governance token. This can help separate the utility and speculative aspects of the token, and potentially provide more stable value for both. The utility token can be inflationary or deflationary depending on the specific model, while the store of value/governance token is typically designed to be more stable. Examples of this are VeChain (VET), VeChain Thor Energy (VTHO), NEO, GAS, Ontology Coin (ONT), Ontology Gas (ONG)

Asset-backed tokens

Asset-backed tokens are tokens that are backed by a physical asset or reserve, such as gold or fiat currency. This provides a degree of stability and confidence in the token’s value, as it is tied to a tangible asset. However, the value of the token may be limited by the value of the underlying asset, and there may be challenges in ensuring the proper reserve ratio and maintaining transparency. Examples are Pax Gold (PAXG), which is linked to the price of gold, as well as Tether (USDT) and USD Coin (USDC), which are both linked to the US Dollar.

Additional considerations

It’s worth noting that these different value models are not mutually exclusive, and hybrid models may also be used to achieve specific goals. Ultimately, the choice of value model depends on the specific use case and goals of the token and its associated network. Overall, the deflationary utility token model is the most popular, with the inflationary token model in second place.

The design of token models plays a crucial role in determining the value of tokens within a given ecosystem. A well-designed token model can create a strong network effect and incentivize various stakeholders to participate in the network. This, in turn, can increase the demand for tokens.

For example, a token with a deflationary supply mechanism may see an increase in its value as the supply decreases over time. Similarly, a token with strong governance mechanisms that allow token holders to have a say in the network’s decision-making process may be more attractive to investors and users, increasing the demand for tokens.

On the other hand, poorly designed token models may lead to a lack of adoption, low network activity, and a decrease in the token’s value. For example, a token with excessive inflation or high transaction fees may discourage users from participating in the network, leading to a decrease in demand and a corresponding decrease in the token’s value.

The value of tokens: conclusion

The value of tokens is determined by a variety of factors, including supply and demand, market sentiment, and the underlying technology. Overall, the value of tokens is closely tied to the token model’s ability to incentivize network participation, promote adoption, and balance the supply and demand dynamics within the network. The success of a token model depends on its ability to provide clear value propositions, promote adoption and usage, and maintain a healthy balance between supply and demand dynamics.

 

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Token Economics for Lawyers – part 1

In this article as well as the next, we have a look at token economics. Now, the expression “token economics” can mean different things depending on the context. What these two articles are about is tokens as digital assets. It is not about token economics in the context of behavioural therapy. (Which is what the entry in the Wikipedia entry is about. So, that may be confusing). In this article, we will discuss definitions of tokens and token economics. We will answer the question “what are digital tokens used for?”. We will also talk about some of the legal issues of token economics, and finally look at the relevance of token economics for lawyers. In the follow-up article, we will focus on the values of tokens as digital assets.

Definitions of tokens and token economics

In today’s digital world, tokens have become a buzzword among investors, entrepreneurs, and businesses. From cryptocurrencies to utility tokens, the rise of tokens has created a new economy where the value of tokens is determined by a complex interplay of supply and demand.

So, what are we talking about? Let’s start with tokens and give an example that everybody probably is familiar with. If you go to a casino, you don’t play with real money. Instead, you exchange real money for tokens, and each token has a specific monetary value. While you are playing, you are using tokens. When you leave, you can exchange the tokens again for real money. A token therefore is something that symbolizes or represents something else.

In the context of token economics, tokens are digital assets, and they are typically created and managed through blockchain technology. They are unique assets that can represent a wide range of things, from cryptocurrencies to loyalty points to real-world assets like stocks and commodities. The key feature of tokens is their ability to store value and be traded freely on digital marketplaces. This means that tokens can be bought and sold like any other asset, allowing investors to benefit from price movements and businesses to raise funds through initial coin offerings (ICOs).

The article on the ESPEO Blockchain website defines token economics as “the study of a new type of economy that can be defined as the design of a particular ecosystem in a blockchain environment. There are as many ecosystems as startups and projects in the blockchain industry, where tokenization is a popular process.” In this context, the expression “token economics” is often shortened to tokenomics.

What are digital tokens used for?

Digital tokens can be used in a variety of ways, depending on the type of token. Some common uses include:

  • Currency: Cryptocurrencies like Bitcoin and Ethereum are tokens that are used as a medium of exchange. They can be used to purchase goods and services or traded for other currencies.
  • Utility Tokens: Utility tokens are tokens that are used to access a particular product or service. For example, a company may create a token that can be used to access their platform or to pay for a specific service.
  • Security Tokens: Security tokens represent ownership of an asset, like stocks, bonds, or real estate. They are governed by securities regulations and offer investors the opportunity to earn dividends or other forms of income.
  • Fungible and non-fungible tokens:
    • Fungible tokens are interchangeable with other tokens of the same type, meaning that each token has the same value and can be exchanged for another token without any loss of value. For example, a 5€ bill is a fungible token, because any two 5€ bills have the same value and can be exchanged for one another without any loss of value.
    • Non-fungible tokens, NFTs, on the other hand, are unique and cannot be exchanged for another token without a loss of value. Each token represents a specific asset, such as a piece of artwork or a collectible item and has its own unique value. For example, a unique piece of digital art might be represented as a non-fungible token. (We talked about non-fungible tokens in a previous article).

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Legal issues of token economics

As tokens are assets, there are several legal challenges and issues regarding token economics that one should be aware of.

One of the main challenges is the regulatory uncertainty surrounding tokens. In our article on NFTs, e.g., we mentioned the issues about whether or when NFTs become securities. Depending on their economic characteristics, tokens may be subject to various regulatory regimes, including securities laws, commodities laws, or money transmission laws. This can make it difficult for issuers and investors to navigate the legal landscape and comply with applicable regulations.

Another issue is the potential for fraudulent or abusive practices in token offerings or trading. Due to the lack of regulation and oversight in some token markets, there have been cases of fraud, market manipulation, and other forms of misconduct. Lawyers may need to advise clients on how to comply with anti-fraud laws and regulations, as well as how to mitigate legal risks associated with token-based transactions.

Additionally, there are intellectual property issues related to token economics, particularly with respect to the ownership and licensing of the underlying technology and protocols that support token ecosystems. Lawyers may need to advise clients on patent, copyright, and trademark issues related to token-related technologies, as well as on licensing and commercialization strategies.

Finally, there are data privacy and cybersecurity concerns associated with token transactions, which can be particularly acute in decentralized networks where personal data is stored and transmitted across multiple nodes. Lawyers may need to advise clients on how to comply with data protection.

Relevance for lawyers

So, how are token economics relevant to lawyers?

As mentioned above, token economics can impact the regulatory treatment of tokens. For example, if a token is classified as a security, it may be subject to more stringent regulations than if it is classified as a utility token. Lawyers may need to be familiar with the various factors that determine the classification of a token, such as its economic purpose, distribution, and governance.

Secondly, lawyers may need to understand token economics to advise clients on the legal implications of launching a token-based project or participating in a token sale. This could include drafting legal documents such as token purchase agreements, whitepapers, or terms of service that incorporate the economic features of the token.

Thirdly, token economics can affect the way that tokens are valued and traded in the market. Lawyers may need to understand the mechanics of token supply, demand, and circulation to advise clients on issues such as token pricing, market manipulation, or insider trading. We will discuss those in our next article.

Finally, token economics is a rapidly evolving field that requires interdisciplinary knowledge and collaboration between legal and technical experts. Lawyers who are familiar with token economics may be better positioned to engage with clients in emerging sectors such as decentralized finance (DeFi) or non-fungible tokens (NFTs), where the legal implications of token economics are still being defined.

Conclusion

Tokens are digital assets that are typically created and managed through blockchain technology. They are assets that can represent a wide range of things, from cryptocurrencies to loyalty points to real-world assets like stocks and commodities. They can be used in a variety of ways, including as currency, utility tokens, and security tokens. As the digital world continues to evolve, the importance of tokens in the economy is likely to grow. By understanding token economics and the value of tokens, lawyers can assist their clients in making informed decisions and navigating this new landscape with confidence.

 

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Legal aspects of Non-Fungible Tokens

Non-fungible tokens (NFTs) made world headlines in March 2021 when a digital artwork NFT was auctioned for nearly 70 million USD. NFTs represent a market that is growing fast: in the second quarter of 2021, NFT transactions already were worth 2.4 billion USD. So, what are Non-Fungible Tokens, and what are some of the legal issues when dealing with them?

The Wikipedia defines a non-fungible token as “a unique and non-interchangeable unit of data stored on a digital ledger (blockchain). NFTs can be used to represent easily-reproducible items such as photos, videos, audio, and other types of digital files as unique items (analogous to a certificate of authenticity) and use blockchain technology to establish a verified and public proof of ownership. Copies of the original file are not restricted to the owner of the NFT and can be copied and shared like any file. The lack of interchangeability (fungibility) distinguishes NFTs from blockchain cryptocurrencies, such as Bitcoin.”

So, key items to remember are that an NFT is a digital asset. It is a piece of software code that is entirely unique, yet transferable. That software code usually is a form of smart contract, and it is stored in a blockchain. NFTs typically have to do with digital media.

Let us use an analogy. Imagine a very famous photograph, taken back in the days before digital photography, where photos were still taken on celluloid film. Next, imagine that the original first print of the photograph or the original negative is being auctioned by the original photographer or somebody who acts on their behalf. You get an authentic piece of art, even authenticated by the artist. You can hang it in your house, or you can sell it. But that does not mean you get the copyrights on that piece of art. The original photographer still keeps the rights to reproduce, license, etc.

NFTs are something similar, but specifically created for digital media rather than physical media. The problem with digital media is that they can be infinitely copied and distributed without any loss of quality. NFTs were created as a way to make sure the original artists can benefit from their artwork. When you buy an NFT, you get an authenticated replica of a digital medium that is unique. It is a smart contract that contains certain terms and condition, e.g., to make sure that the original artists, e.g., gets a royalty when the NFT is sold. The smart contract is executed automatically each time there is a transaction that is registered in the blockchain, e.g., when an NFT is sold to a new owner. In other words, an NFT is a non-replicable digital certificate of ownership of a copy of a digital creative work.

It is worth repeating that while the NFT gives you ownership of a copy of a digital artwork, it does not transfer any intellectual property on the original digital artwork to the owner of the NFT, other than the license to own a copy of it. So, why do people by them? Because they are collector’s items that are authenticated and unique, that cannot be modified or amended, yet are transferable. As such, they can also be used as investments.

NFTs are fairly new, and legislation worldwide still has to catch up with the phenomenon. There are several legal issues that have to be considered.

Are NFTs legal? The answer to this question will vary from country to country. But, generally speaking, if there are no laws in place, they should be considered legal. Some countries have already enacted some legislation. Other are likely to follow, which may change what about NFTs is legal and what is not. But there are several caveats, discussed below.

Proof of ownership happens through the Blockchain. The combination of a public key and a private key allows the NFT to be decrypted and provide the necessary information.

Data hosting and storage: the NFT functions as a certificate of ownership of copy of a digital artwork that is stored somewhere, and typically the code of the NFT links to the stored copy. Problems can arise if the storage ends or the link to the storage changes because it is not possible to update a blockchain entry. So, the smart contract code has to explicitly allow transactions to modify the location of the digital artwork.

Smart Contracts: NFTs are smart contracts. The caveat here is that smart contracts usually only work on a specific platform. What about sales on a different platform?

Royalties: since an NFT is a smart contract, it is possible to include code that a fee is automatically paid to the original artist each time the NFT is sold. But, as mentioned above, what about sales on a different platform than the one where the smart contract originated?

Data Protection Laws: Exercising the personal rights to be erased or to modify or correct personal information appear to be incompatible with the immutable nature of the blockchain. In other words, NFTs that contain personal information may violate data protection laws. It may be wise to include non-executable code in the smart contract that clarifies that the people involved have agreed to have their personal information included as it is.

Intellectual Property Laws: as mentioned above, the buyer of an NFT by default does not acquire the intellectual property rights that are associated with the digital artwork. The buyer may not be fully aware of this or its implications. They may, e.g., not be aware that they are not allowed to make copies of the digital artwork or to use it in a publication, which may then constitute a potential intellectual property infringement liability.

Money Laundering: NFTs can be sold for exorbitant amounts of money. Add to that, that they may be sold using cryptocurrencies. There are valid concerns that the transactions of NFTs are being used to circumvent money laundering legislation.

Estate & succession: NFTs are typically linked to specific individuals. What happens to the NFT when the owner of the NFT dies? The immutable nature of the blockchain will not allow to recognize the heirs as new owners.

Unregistered securities: NFTs can be used as investments and there already are NFT marketplaces that allow several traders to take part simultaneously in the acquisition of NFTs. In other words, the new owners all get a share of the NFT. Some argue that in these circumstances, NFTs could be regarded as unregistered securities.

Taxation: the market for NFTs is worldwide. The artist may be in one country, the transaction may happen in another country, while the buyer may reside in yet another one. Transactions of NFTs may therefore be subject to double taxation.

The market of NFTs is expanding faster than anybody predicted. NFTs offer great opportunities, both for the creators of digital artwork, as well as for collectors and investors. But clearly, there still are multiple legal issues that need to be addressed.

 

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