Incorporating blockchain technology within existing financial systems raises several legal considerations that should be addressed to comply with current law and minimize liability and risk. Financial organizations must comply with regulations in financial activities, including but not limited to the Bank Secrecy Act (BSA), anti-money laundering (AML) laws, and Know Your Customer (KYC) rules. For example, if an organization offers a blockchain platform that allows users to trade cryptocurrencies, the organization must implement some sort of AML and KYC process to mitigate money laundering and to verify the user’s identity; organizations such as Bitfinex and Poloniex have been investigated by regulators for questionable practices in their own AML/KYC regulations.
Blockchain-based tokens may be included within laws that relate to securities. Recently, the SEC designated the ICO tokens of both Telegram and EOS as securities, initiating stricter regulations regarding these tokens. Beyond regulations surrounding tokens, the integration of blockchain technology also creates concerns regarding data privacy and security; for example, in the EU it creates a potential conflict with compliance with the General Data Protection Regulation (GDPR), as blockchain-based technology is immutable and the user has a right to be forgotten, often granted by the GDPR. An example of this challenge is Ernst and Young’s blockchain, which they are using around audits, as they must ensure that companies using this blockchain adhere to GDPR compliance; also, in the U.S. a financial institution using blockchain must comply with the Gramm-Leach-Bliley Act (GLBA) to protect the consumers’ financial information.
Smart contracts, which self-execute, raise legal considerations regarding enforceability and liability. The Parities Multi-Sig Wallet Hack, for example, brought attention to the difficulties in assigning legal liability when blockchain contracts fail or are hacked. Regardless of the agreements between parties on the blockchain, it can create jurisdictional issues, seen with Ripple’s cross-border extension bringing into question whether application was following the laws of the state or country originating the transaction.
Licensing is another consideration, especially in financial services, as they may need to obtain a specific license, such as a Money Services Business (MSB) license through FinCEN. As observed with Coinbase registering as an MSB, operating without licensing may lead to fines or discontinuation of an enterprise.
Tax implications should be considered, and indeed the IRS has declared cryptocurrency to be property, which means every transaction could have tax event implications (the subject of capital gains taxation is merely one example). International tax law becomes ever more complicated regarding cross-border blockchain transactions as the user must comply with taxes collected in various jurisdictions.
Blockchain systems, particularly decentralized finance (DeFi) blockchain protocols should provide some form of governance; however, in the case of a system with no centralized authority, achieving compliance in legal matters could be nearly impossible. Uniswap is an example of a decentralized exchange, whereby repeated interactions or transactions of the same type can clearly be traced back to the same address, there is no central authority overseeing enforceability or compliance; and it raises serious questions of liability and consumer protections.
It should be noted that such a system is not without checks; blockchain systems should also demonstrate AML and KYC processes to detect and mitigate illicit activity, as seen with Binance and Coinbase’s commitments to encapsulate processes upon design.
Cross-border blockchain applications like Ripple must maneuver through various regulatory environments, with different countries either fully adopting and embracing blockchain while others (China and India) apply strict limitations or outright bans. Financial institutions looking to embrace blockchain must consider the differences related to the regulatory approaches in various jurisdictions to ensure compliance and consistent application internationally.
In conclusion, the integration of blockchain into financial systems requires navigation of legal complexity while ensuring compliance with regulatory, privacy, tax, liability laws, and addressing specific challenges related to decentralized systems. A successful integration requires continual collaboration among legal, regulatory, and technical professions to adhere to evolving legal standards.
