Source: https://www.lawandblockchain.eu/stable-coin-regulation/
Timestamp: 2019-11-17 22:53:08
Document Index: 527227311

Matched Legal Cases: ['§ 221', '§ 78', 'UKHL ', 'ART 3', '§ 2', 'EWCA ', '§ 1']

Stable Coin Regulation: How the Paxos and Gemini Model Endanger the 'Trustless Dream'
Trainee Solicitor at Pinset Masons LLP
Rory Copeland is a trainee solicitor in Pinsent Masons LLP. His personal research interests include blockchain, payments and financial services, from both public and private law perspectives. All opinions expressed are his own.
Latest posts by Rory Copeland (see all)
Stable Coins and the Law: The Dangers of Unbundled Blockchain Banking - February 22, 2019
This piece was originally published in The Crypto Law Review on Medium, on 14 January 2019.
The New York Department of Financial Services (‘NYDFS’) announced on 8 September 2018 that it had approved the launch of two blockchain-based banking platforms, ‘Paxos’ and ‘Gemini’, and their respective cryptocurrencies. ‘Another day; another cryptocurrency’, some might say, but what these platforms have in common (as well as their ancient Greek etymology) is that they are subject to a regulatory scheme of stable coin regulation so thorough that an ordinary consumer could be forgiven for mistaking Paxos and Gemini for traditional banks with added functionality. [1]
Part I: The Roles Performed by Traditional Banks
When a bank takes a deposit, a relationship of debt is established between the bank and the depositor. An ordinary depositor is entitled to demand the return of that money at any time. [2] The role of the bank as the safe-keeper of customer funds is not based merely on goodwill: a bank which loses its depositor’s money will become subject to an enforceable action by the depositor to recover the value of that debt.
When a bank transfers money to another account on the instructions of its customer, the performance of that task involves a process of creating, altering and extinguishing legal duties owed by the bank to different parties. The role which the bank plays is that of a central counterparty (‘CCP’) who establishes a legal relationship with both the transferor and the transferee and owes obligations to both during the course of the transfer. The transferor has certainty that, from the moment they instruct their bank to transfer funds until the moment at which the transferee has full access to those funds, the transferor will have legal recourse against their bank. Not only is this recourse guaranteed in private law, but those who undertake transfers of funds are regulated as CCPs. [3]
Blockchain technology has been widely hailed as having the potential to revolutionise banking. Blockchains are distributed ledgers which update simultaneously each time a transaction decreases the value held by one participant and increases the corresponding value held by another. Each participant’s ledger is ‘append only’, which means that the existing record of transactions can be only added to, not retrospectively altered. The best-known example of a blockchain platform is Bitcoin, on which anyone can transact. ‘Miners’ – parties who provide the computing power required to communicate with and achieve consensus amongst the millions of ledgers – are paid a small commission on each transaction.
It is apparent that blockchain technology could revolutionise banking by removing the need for a central depositary of money. Banks are unlikely to die out, given participants’ probable reticence at paying unknown individuals to process each transaction. It is more likely that any blockchain banking platforms will involve an operator who updates the blockchain. Crucially, however, no legal relationship between participant and operator is integral to the system, because the operator merely communicates amongst all the participants in order to update the ledger after each transaction. In contrast to the process of contractual novation which characterises a traditional payments system [4], blockchain banking more closely resembles the ‘CREST’ securities settlement system which is used in the UK to record the ownership of shares, bonds and other intangible assets.[5]
In order to be able to transact on a blockchain platform, each participant must buy the ‘cryptocurrency’ of that platform. The fundamental premise of distributed ledger systems is that the ledger is authoritative, which is to say that the balance of accounts on the ledger is determinative of, rather than declaratory of, the relative spending power of each participant. A cryptocurrency is nothing more than the flip-side of the blockchain record – the unit of value in which distributed ledger updates are recorded. Cryptocurrencies such as Bitcoin and Ethereum are widely circulated but also subject to remarkable price volatility, such that they are not at present useful as a store of value. In a blockchain which allows only a single and specially issued cryptocurrency to be transferred amongst participants, an arbitrary and fixed price can be attached to each unit in order to maintain price stability. The primary ambition, and indeed attraction, of many blockchain platforms is, however, to facilitate the trading of multiple cryptocurrencies and digital representations of tangible or intangible assets, some of which will have volatile price fluctuations.
The seller of whatever cryptocurrency is used by the blockchain plays the role of ‘issuer’ in much the same way that a company does when it issues shares which can be exchanged on secondary markets. The issuer and the operator may be the same legal entity, but this does not necessarily have to be the case. The issuer might characterise themselves as a seller of securities or even simply of access tokens which grant quantified rights of participation in the payments system. As such, blockchain payments platforms present the possibility of ‘unbundling’ the legal nature of banking. With this unbundling comes the opportunity to uncouple the roles which previously were necessarily all performed by the same party. The operator and deposit-holder could, for example, locate themselves in different jurisdictions for bona fide commercial reasons. This freedom, however, is not necessarily one that will always be used to the advantage of participants. There is no suggestion, of course, that Paxos or Gemini have anything other than the best interests of their clients at heart. But it is important to recognise that the impetus which currently drives open banking reforms around the world is the desire to diversify the sources of banking services, and so one that also brings the risk of the entry of bad actors into the market. Proper stable coin regulation is of great importance.
Part II: Banking Regulation
Such an operator cannot be liable in the tort of conversion, both because conversion cannot be brought in relation to intangible assets [6] and because the operator is not in possession of any goods in any event. A claim in negligence will be subject to any disclaimers or exclusions of liability [7] made by the operator. The operator cannot be said to have been unjustly enriched by the act, unless it also holds an account on the platform. Arguably, the deposit-holder has been enriched: as a result of the operator’s action in reducing the depositor’s account balance, the value of cryptocurrency which that depositor could redeem as fiat currency with the deposit-holder will be reduced, leaving the deposit-holder with an undue surplus of fiat currency. But because no payment has been made or liability discharged, such an action would constitute a novel ground of unjust enrichment which the court will be loath to recognise. A wronged participant in a blockchain banking platform may therefore find themselves without any legal recourse against the operator.
Similarly, there are acts which, if performed by a traditional bank in its role as deposit-holder, would constitute actionable wrongs against its customer, but against which a participant in a blockchain banking system may have no recourse against the deposit-holder. The first of these is a failure to maintain the value of customer deposits. A bank has no duty to segregate each customer’s deposits, and most deposits are sold as loans (including mortgages) in order to generate income, but cannot lawfully put itself in a position in which it is unable to service its debts. [8] Doctrinally this is unsurprising, because each customer’s deposit establishes a contractual obligation on the part of the bank to repay the debt upon demand. Where the roles of the traditional bank can be split into the operator of the payments system and the recipient of participant funds, the cryptocurrency issued in return might simply be characterised as an intangible asset. The consideration used to buy the cryptocurrency is pure profit in such an instance, to be allocated as the cryptocurrency issuer choses, and no contractual relationship need exist between the buyer and issuer after the transaction. Unlike in a traditional banking relationship, there is nothing inherent to a blockchain banking platform that would give any recourse to a participant who subsequently wishes to leave. Just as a shareholder in a publicly listed company cannot force the company to buy their shares, [9] a participant in a blockchain banking platform might find that they have no right to redeem their cryptocurrency or convert it back to fiat currency other than through a third-party cryptocurrency exchange.
Part III: The Regulation of Recent Stable Coins
Under Section 200.9 of the NYDFS Code governing virtual currencies, Paxos and Gemini must hold deposits within a diversified portfolio of “cash, virtual currency, or high-quality, highly liquid, investment-grade assets, in such proportions as are acceptable to the superintendent.” [10] This provision is similar to that concerning e-money providers in the European Union, which must keep all customer funds in a segregated account or must insure the value of those funds.[11] In addition, both Paxos and Gemini are holding their customer deposits in accounts at US banks which are insured by the Federal Deposit Insurance Corporation. The effect of this measure is that, even in the event that the bank at which the deposits are held becomes insolvent, the deposits will be guaranteed by the government. A similar level of safety could be achieved in all EU jurisdictions, where deposit insurance (up to €100,000) is provided by governments pursuant to the Deposit Guarantee Scheme Directive.[12]
An alternative to compulsory or controlled deposit-holding may be for the courts or regulation to recognise a fiduciary relationship existing between the operator of a blockchain payments system and each participant. Although the record of transactions is distributed amongst all of the participants, a relationship of trust and reliance [13] arguably exists between the participant and the operator whenever the former entrusts the latter to effect a transfer by updating the ledger. A traditional banking relationship of debtor-creditor does not give rise to fiduciary duties because the cause of action for debt prevails. Banks do, however, act as agents for their customers [14] and it is well established that agents have a fiduciary relationship with their principals. [15] As such, this would give a participant a cause of action for breach of the operator’s fiduciary duty to act in the participant’s best interests when dealing with the participant’s assets [16], were their account value to be reduced without a corresponding transfer having been performed.
A second fiduciary relationship could be recognised to require the deposit-holder (and cryptocurrency issuer) to maintain a stable cryptocurrency value. Paxos and Gemini have been approved by the NYDFS as New York trust companies, as a result of which they are under a statutory duty to hold participant deposits on trust and as fiduciaries. This measure enforces the 1:1 ratio of assets to issued stablecoins, the result of which ought to be a constant stablecoin value. The trust company structure is, however, a statutory creation which exists in the US but not in other jurisdictions such as the UK, rather than the product of a fiduciary duty recognised at common law. [17] Courts in the UK may well be reluctant to recognise a duty to maintain a constant stablecoin value given the potential future argument by analogy that States owe a duty to maintain a constant currency value. In addition, such a duty alone, without complementary fiduciary duties such as to act in the participant’s best interests, would not prevent an issuer from disposing of the profits from the cryptocurrency sale, as envisaged above.
Part IV: How Stable Coin Regulation Marks the End of the Trustless Dream
Any cryptocurrency purist following the announcement of Paxos and Gemini’s launch as banking and stablecoin providers surely could not help but weep at the centrality of regulation and trust to the development of a potentially viable blockchain banking industry. The vision of the Bitcoin whitepaper [18], published in 2009 by the pseudonymous Satoshi Nakamoto, was of a system which did not rely on government authority or guarantees in order to function, and which did not place users at the mercy of the institutions perceived to have created the 2008 financial crash. The scheme adopted by Paxos and Gemini is the opposite – it requires participants to deposit their money with a holding company in the faith of its continued solvency or regulatory compliance, or that of its insurer. As if to add insult to doctrinal injury, both Paxos and Gemini will undergo a monthly audit rather than rely solely on the promised transparency of distributed ledger systems. The participant is effectively in exactly the same position as that of a traditional banking customer. This might be described as an travesty, but it might also suggest an acceptance by blockchain developers that trust and regulation are essential features of banking as an economic activity.
1. DFS CONTINUES TO FOSTER RESPONSIBLE GROWTH IN NEW YORK’S FINTECH INDUSTRY WITH NEW VIRTUAL CURRENCY PRODUCT APPROVALS https://www.dfs.ny.gov/about/press/pr1809101.htm
2. Foley v Hill (1848) HLC 28; N Joachimson v Swiss Bank Corporation [1921] 3KB 110
3. Regulation (EU) No 600/2014 of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Regulation (EU) No 648/2012; Federal Reserve Act 1913 (12 U.S.C. §§ 221 to 522) and Securities Exchange Act 1934 (15 U.S.C. § 78a et seq.)
4. Phillip Wood QC Set-Off and Netting, Derivatives, Clearing Systems, Sweet & Maxwell, 2nd Edition, 2007
5. https://www.euroclear.com/services/en/settlement/settlement-euroclear-uk-ireland.html Settlement Euroclear UK and Ireland
6. OBG v Allan [2007] UKHL 21
7. And the relevant general contract law, such as the Unfair Contract Terms Act 1979; Uniform Commercial Code › U.C.C. – ARTICLE 2 – SALES (2002) › PART 3. GENERAL OBLIGATION AND CONSTRUCTION OF CONTRACT › § 2-302. Unconscionable contract or Clause
8. See for example the Basel III liquidity rules: https://www.bis.org/publ/bcbs238.pdf
9. Unless there is a specific provision to that effect in the company’s constitution.
10. https://www.dfs.ny.gov/legal/regulations/adoptions/dfsp200t.pdf
https://www.dfs.ny.gov/banking/iaus1b.htm
11. Directive 2009/110/EC of the European Parliament and of the Council of 16 September 2009 on the taking up, pursuit and prudential supervision of the business of electronic money institutions
12. Directive 2014/49/EU of the European Parliament and of the Council of 16 April 2014 on deposit guarantee schemes Text with EEA relevance
13. as described in Bristol and West Building Society v Mothew [1996] EWCA Civ 533
14. Owen v Tate [1976] QB 402
15. “[a]gency is the fiduciary relationship that arises when one person (the ‘principal’) manifests consent to another person (the ‘agent’) that the agent shall act on the principal’s behalf and subject to the principal’s control.” Restatement (Third) of Agency § 1 (St. Paul: American Law Institute Publishers 2007). In English law, the case is Aberdeen Railway Co v Blaikie
16. Cowan v. Scargill [1984] 2 All E.R. 750, 760, per Megarry V.-C.
17. See for example Keech v Sandford (1726) Sel Cas Ch 61
18. Bitcoin: A Peer-to-Peer Electronic Cash System Satoshi Nakamoto 31 October 2008 https://bitcoin.org/en/bitcoin-paper
Posted in ArticleTagged gemini, Regulation, stable coins