Blockchain and the Law

The Merge Is Upon Us: What It Means for Ethereum

As of this writing, the Ethereum “Merge,” one of the most anticipated events in blockchain history, is finally expected to occur in September 2022. The “Merge” will shift the Ethereum blockchain (native token ETH, or ether) from a proof-of-work (PoW) consensus mechanism to a proof-of-stake (PoS) consensus mechanism that uses over 99.9% less energy. Technically, the Merge involves transitioning the current Ethereum proof-of-work Mainnet protocol (the blockchain used for ETH-based transactions) to the Beacon Chain proof-of-stake network.  As a result, transactions will be conducted on the new proof-of-stake network and new ETH tokens will be minted by nodes on the network staking a fair amount of ether tokens into a pool to secure the network and validate transactions. Post-Merge, the practice of ether cryptomining on the Ethereum 2.0 network will end, either forcing miners to pivot to mining on Ethereum Classic or find a new endeavor.

While the move to Ethereum 2.0 is being closely-watched, akin to the countdown to the New Year’s Eve Times Square ball drop, it’s a little more complicated and more of a series of actions (and accompanying benefits) that will happen over time. The Merge is but the first step in a series of five (notably followed by upgrades titled ‘the Surge,’ ‘the Verge,’ ‘the Purge,’ and ‘the Splurge’) that intend to make Ethereum faster, more scalable, more powerful, more energy efficient and more robust.

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New York Financial Regulator Brings First AML and Cybersecurity Enforcement Action against Licensed Crypto Trading Entity

In what is the New York Department of Financial Services’ (NYDFS) first enforcement action against a NYDFS-licensed “virtual currency business,” on August 1, 2022, the agency announced $30 million settlement with cryptocurrency investing platform Robinhood Crypto, LLC (“RHC”).  The settlement addressed  charges stemming from what the NYDFS cited as various deficiencies during 2019-20 of RHC’s Bank Secrecy Act (BSA) and anti-money laundering (AML) program and RHS’ cybersecurity obligations under the agency’s Virtual Currency “BitLicense” regulation (23 NYCRR Part 200) and Cybersecurity Regulation (23 NYCRR Part 500), among other things

NYDFS has been active in crypto regulation for many years. In 2015, New York was the first state to promulgate a comprehensive framework for regulating virtual currency-related businesses. The keystones of the BitLicense regulations are consumer protection, anti-money laundering compliance and cybersecurity rules that are intended to place appropriate “guardrails” around the industry while allowing innovation. In addition, NYDFS’s Cybersecurity Regulation went into effect in March 2017 and generally requires all covered entities, including licensed virtual currency businesses, to establish and maintain a cybersecurity program designed to protect the confidentiality, integrity, and availability of its information systems. Licensed virtual currency companies are subject to the same AML and cybersecurity regulations as traditional financial services companies. Continue Reading

Rise of Financial Crime in the NFT Market Elicits New Scrutiny from Regulators

With the enduring popularity of certain NFTs and the promise of their use in the Metaverse and beyond, the hype around the new technology has been accompanied by rising concerns over NFTs being the centerpiece of traditional financial crimes like money laundering and wire fraud.  For example, on June 30th, 2022 the Justice Department indicted six individuals in four separate cryptocurrency fraud cases, which altogether involved over $130 million of investors’ funds. These indictments include allegations of a global Ponzi scheme selling unregistered crypto securities, a fraudulent initial coin offering involving phony associations with top companies, a fraudulent investment fund that purportedly traded on cryptocurrency exchanges, and the largest-known Non-Fungible Token (NFT) money laundering scheme to date. Continue Reading

The Other Side of The Coin: Cryptocurrency Assets in Bankruptcy

On July 5, 2022, cryptocurrency brokerage Voyager Digital filed for chapter 11 in the Southern District of New York Bankruptcy Court, citing a short-term “run on the bank” due to the “crypto winter” in the cryptocurrency industry generally and the default of a significant loan made to a third party as the reasons for its filing.  At Voyager’s first day hearing on July 8, 2022, the Bankruptcy Court asked the critical question of whether the crypto assets on Voyager’s platform were property of the estate or its customers.  Voyager asserted the crypto assets were assets of the estate pursuant to the terms of its customer agreements, but the question of ownership was more problematic in the context of a liquidation.  In that context, Voyager’s plan of reorganization proposes to resolve any mystery of ownership by delivering the reorganized company to its customers.

On July 13, 2022, cryptocurrency lender Celsius Network filed for chapter 11 in the Southern District of New York Bankruptcy Court.  Celsius had frozen customer withdrawals on June 12, 2022 and, at the time of its chapter 11 filing, indicated that it would not be requesting court authority to allow customer withdrawals.  Celsius noted in a press release that customer claims would be addressed through the chapter 11 process.

Voyager’s and Celsius’ chapter 11 bankruptcy filings highlight the question of whether crypto assets held by an exchange, or similar platform, may be considered property of a bankruptcy estate and, therefore, not recoverable by the customer, who would then likely be an unsecured claimholder of the debtor.

While some commentators have suggested that crypto assets might be considered property of the exchange’s bankruptcy estate, existing common law, existing provisions of Uniform Commercial Code (UCC) Article 8, and proposed amendments to the UCC recognize that if the arrangement and relationship between the exchange and its customers is one that is characterized as “custodial,” the crypto assets held by the exchange should remain property of the customer and, hence, not subject to dilution by general unsecured claimholders. Continue Reading

Senators Ask USPTO and US Copyright Office to Conduct NFT Study, with a Focus on IP Issues

UPDATE: On July 8, 2022,  the USPTO and the Copyright Office responded to the Senators’ letter and indicated that they would conduct a joint study on the current and potential future applications of NFTs and their respective IP-related challenges.

With a market capitalization forecast of over $35 billion for 2022, there is no question that non-fungible tokens (NFTs) are hugely popular. Despite this, the intellectual property rubric underlying these NFT offerings are inconsistent, confusing, and in many cases in conflict with applicable law. These issues apparently came to the attention of Senator Thom Tillis of North Carolina and Senator Patrick Leahy of Vermont, who, in a June 9, 2022 letter (as per their roles as the Ranking Member and Chairman of the Judiciary Subcommittee on Intellectual Property), requested that the USPTO and the Copyright Office undertake a joint study that addresses a number of IP legal issues around NFTs. Citing those roles and their broader interest in the “continued development and use of emerging technologies,” the Senators requested that the study address the following non-exclusive list of questions: Continue Reading

ESG Issues and Opportunities Arise as Companies and Asset Managers Hone in on Blockchain-Based Technology Investments

Beyond the wider adoption of cryptocurrencies by consumers in recent years, companies and organizations have also shown increased interest in crypto-assets in the past year. A myriad of industries, from sports to fashion to art to videogames to music, are entering NFTs, which, depending on the marketplace, may be minted on a PoW or PoS blockchain. Financial institutions are exploring how to compete with decentralized finance products by offering services on blockchains to provide more security and less friction in an effort toward safer and faster transactions. Depending on how such platforms are structured, such services will also be on a PoW or PoS network. This increase in investments in blockchain-based products and services by numerous and varying shareholders has resulted in increased due diligence on how much investments are complying with ESG mandates.  Corporate balance sheets are increasingly filled with cryptocurrencies, presumably as an inflation hedge or broad investment strategy, potentially impacting their ESG practices. At least one financial firm has announced that employers may soon have the option to offer workers the option to place a portion of 401(k) retirement savings in Bitcoin. Also, potential ESG issues can arise not only when investing in a cryptominer or in cryptocurrencies verified with a PoW consensus mechanism, but also with an investment in an exchange that transacts in certain energy-intensive cryptocurrencies.

Simply put, with the increased use of these types of emerging technologies, ESG concerns are likely to arise. It remains to be seen how such emerging technologies will balance innovation, while complying with ESG issues.   Continue Reading

New York Financial Regulator Publishes Stablecoin Guidance

There have been a number of developments swirling around stablecoins in the past month, including, earlier this week, the recent introduction in the U.S. Senate of a bill (the “Responsible Financial Innovation Act”) that would put in place a regulatory framework for digital assets and enact certain requirements and consumer protections surrounding stablecoins. The topic of stablecoins’ utility and risk has been in the headlines and on the minds of both legislators and state and federal financial regulators. In a timely move, the New York Department of Financial Services (NYDFS), released its “Guidance on the Issuance of U.S. Dollar-Backed Stablecoins” meant to set foundational criteria for USD-backed stablecoins issued by DFS-regulated entities on the issues of redeemability, assets reserves and attestations about such reserves. The NYDFS is the first state regulator to release such guidance. With the fate of Congressional action on stablecoins this year uncertain (and equally uncertain whether federal agencies or banking regulators will step in to offer certain guardrails), it will likely be left to the states (and the industry itself) to establish certain baselines that offer consumer protection and stability without harming innovation. Given NYDFS’s experience in the virtual currency space and its prominence, its latest guidance may be influential to other regulators around the country.  Continue Reading

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