We thank Anessa Allen Santos, member of Technology Law Committee of The Florida Bar, and The Florida Bar News for this guest post.

In the 1990s, when the internet was undergoing rapid expansion and adoption, it was nearly impossible for the average person to anticipate what the internet might become. The technology was unlike anything we’d ever seen, and most of us had little idea how it might be used. If you had a crystal ball then that allowed you to see into the future, what might you have done differently? Would you have invested in Netscape, Cisco Systems, or some other dot.com?

What if you had a second chance to capitalize on the next wave of innovation? “The world’s most valuable resource is no longer oil, but data.”^[1] Consequently, it is data management and related analytics tools that are receiving the lion’s share of attention from innovators, financiers, and regulators, and therein lies great opportunity for investment as these industries grow.

Blockchain in Banking and Finance

In spite of the wild fluctuations associated with blockchain-issued virtual currencies, blockchain is now undergoing rapid adoption faster than any technology we have ever seen. Blockchain, at its heart, is really an innovative and interesting data management system, and it is what blockchain does with all that data that really matters. In particular, banking and financial services are experiencing dramatic change due to the impact of blockchain. Payment rails, or how to move money among people, businesses, or accounts, is the principal driver of evolving financial technology (FinTech), and for this reason, it has received the most regulatory attention, including from the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), the Financial Crimes Enforcement Network (FinCEN), the Internal Revenue Service (IRS), and related state agencies.

On January 3, 2009, the world’s first blockchain was authenticated with the mining of the Bitcoin genesis block for a reward of 50 Bitcoins.^[2] Not surprisingly, the launch of Bitcoin was met with little more than a whisper. Bitcoin was not the world’s first decentralized payment system, nor would it be the last. Prior to Bitcoin, there were several digital cash technologies successfully created, but that developed into nothing. Ecash,^[3] Hashcash,^[4] B-money,^[5] and Bit Gold^[6] were all early forms of electronic cryptographic payment systems, and none of them ever proved a threat to traditional banking. So, what made Bitcoin different? Why did Bitcoin grow to such strength and magnitude where earlier systems had failed?

The collapse of the U.S. housing market in 2008 caused economic ripples throughout the world.^[7] When top executives at big American banks were rewarded for financial mismanagement with $1.6 billion in bonus payments,^[8] faith in the U.S. banking system took a dive. Meanwhile, worldwide access to high-speed, low-cost bandwidth expanded, and global human migration increased to unprecedented levels.^[9] However, the cost of international money transfers via traditional bank SWIFT systems remained comparatively high. With the proliferation of smartphones and digital wallet applications, it became easier for the average person to learn about the new banking alternative called Bitcoin. This new tool allowed people to easily convert their money into a trusted digital currency and send it to their friends and family around the world where it could be converted into the local currency within minutes and for a fraction of what banks charged.

Western Union, the world’s largest provider of cross-border payments, generates $4 billion in revenues from remittances each year,^[10] and its business model is now under attack from new market entrants. Meanwhile, there is some argument over how much big banks make on money transfers. JP Morgan Chase, the world’s second largest bank outside of China,^[11] reports less than. 5% of its consumer bank revenue comes from money transfers.^[12] A recent internal memo reports Santander’s money transfer revenue at 10% of their overall profits, and they charge six times more than their rival TransferWise, whose numbers have since been challenged.^[13] Nevertheless, the traditional banking business model is built on cross-subsidies that impact fair competition and price discrimination,^[14] but new entrants can attack profitable banking divisions by unbundling services, a strategy the United Kingdom’s Financial Conduct Authority (FCA) has thoroughly explored.

In a recent article in Disruption magazine, Senior Staff Writer Laura Cox reports that “[i]n the last five years, FinTech startups like Monzo, Starling, N26, and Atom Bank have revolutionized the UK’s banking sector.”^[15] These online-only banks increased pressure on existing industry giants while demand for innovative financial products grew. Recognizing the importance of supporting innovation for financial services and the challenges with the time and cost required to obtain a banking license, the UK FCA developed a solution called a “FinTech regulatory sandbox.” Similar to a software development sandbox, a FinTech sandbox is a framework created by financial regulators to allow small-scale, live testing of new financial products using real customers with limited regulatory supervision and without requiring full regulatory licensure.^[16]

The FCA sandbox model of financial innovation has proven remarkably successful, with 90% of participating companies going on to market.^[17] Consequently, other nations have followed suit by implementing their own sandboxes, including Australia, Canada, the Netherlands, Hong Kong, Singapore, and South Korea.^[18] Notably, the United States has not, but select states within the U.S. have implemented their own sandboxes, including Arizona and Wyoming, and several more are considering similar measures, including Florida. According to a recent study by the Inter-American Development Bank and Finnovista, Latin America and the Caribbean are part of the FinTech transformation with more than 700 platforms introduced throughout the region, with the majority located in Argentina, Brazil, Chile, Colombia, and Mexico.^[19] Through a Regional Technical Cooperation, the governments of several Latin American nations are also developing policy frameworks for alternative finance and regulatory sandboxes.^[20] In addition to payment solutions, FinTech companies throughout Latin America (LATAM) are also responding to gaps and asymmetries that continue to affect the allocation of credit, mainly to micro, small, and medium-sized enterprises.^[21] As a result, the alternative finance market in LATAM saw triple growth in 2016 as compared to 2015, with business lending accounting for 71% of all loan origination activity.^[22]

More recently, as an international initiative, the UK FCA and 11 additional financial regulators formed the Global Financial Innovation Network to create a universal FinTech sandbox.^[23] With key themes centered around artificial intelligence, blockchain, the regulation of securities and identity, this platform aims to facilitate cooperation between financial service regulators on matters of innovation.^[24] Having only one year under its belt, the network has grown to include 46 financial authorities, central banks, and international organizations.^[25] As of October 25, 2019, now among them are the four primary U.S. financial regulatory authorities: the SEC, the CFTC, the Office of the Comptroller of Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC).^[26] Consequently, where banks were first responsible for depressing the adoption and integration of virtual currencies, they are now partnering up with innovative startups and government sandbox programs to provide guidance, experience, and even funding.

Taxation of Virtual Currency Transactions

In stark contrast to the explosive expansion of virtual currency use overseas, the U.S. has suffered recent market contractions due in large part to the way these transactions are taxed by the IRS. In 2014, the IRS issued Notice 2014-21, explaining the application of existing tax principles to transactions involving virtual currencies. While most of the world taxes virtual currency transactions as they do fiat (government-backed currency), the IRS taxes virtual currency as property.^[27] Taxpayers receiving virtual currencies as payment for goods or services must note the value of the virtual currency in U.S. dollars on the day received as determined by its fair-market value.^[28] Consequently, the cost of figuring gains and losses on virtual currency microtransactions, like using Bitcoin to purchase a Starbucks coffee, can often exceed the cost of the transaction at play. Further problematic to the unwary taxpayer is the application of capital gains tax to an unliquidated asset resulting in a problematic scenario known as “phantom taxation.” In other words, taxpayers are expected to pay taxes on gains realized when virtual currency is spent on transactions that never converted into cash. This unwieldy tax treatment has not only put the U.S. out of lockstep with the rest of the global economy, but it has caused quite an uproar among American innovators and users of virtual currencies.

For the most part, the IRS treatment of virtual currencies as property went largely unnoticed by the industry until early-2016 when the virtual currency exchange company Coinbase received a John Doe summons from the IRS demanding the production of records relating to some 500,000 Coinbase customers, subsequently reduced by court order to approximately 13,000.^[29] In response, virtual currency exchanges around the world began blocking U.S.-originated accounts, shuddering the industry at large — especially for U.S. participants.

In 2018, the IRS launched a virtual currency taxation awareness campaign that evolved into a targeted compliance effort in 2019 aimed at taxpayers with virtual currency transactions that potentially failed to report the resulting income and pay associated taxes.^[30] Also issued in 2019 was IRS Revenue Ruling 2019-24 providing guidance on the taxation of “hard forks” and subsequent “air drops.” Generally speaking, a hard fork acts as a blockchain software update used to correct security flaws, add new functions, or even reverse transactions, the most famous of which was implemented on Ethereum’s blockchain to reverse an illegal hack that resulted in the theft of $50 million in investor funds.^[31] While hard forks don’t unwind a network’s transaction history, they do create a permanent divergence from the previous blockchain that often, but not always, requires the forced exchange of the old network’s virtual currency for the virtual currency of the new network. IRS Rev. Rul. 2019-24 explains that taxpayers who receive an “airdrop” of units of a new virtual currency to their digital wallet address after a hard fork realize ordinary gross income on the date the new currency is received regardless of whether that currency is converted into U.S. dollars. The challenge with this treatment is taxpayers may not be aware that an airdrop has occurred, and if they don’t liquidate the new asset before it loses value, they may not be able to later raise the funds to pay the tax owed.

Smart Contracts

Virtual currencies like Bitcoin and Ethereum, often called cryptocurrencies because cryptography is employed in the transaction process, or digital currencies because they only exist as digital representations of value, are only one use case for blockchain. A much larger use case that is presently taking the world by storm is smart contracts — common, legally enforceable contracts translated into programming code and then written to a blockchain for autonomous execution and enforcement. In fact, many of us regularly use smart contracts already. For example, if you have any of your recurring bills set to autopay on a certain date of the month, like your electric bill for example, that is a kind of smart contract. You identify the parties, you set the terms of payment, and then you walk away, fully trusting that the system will deduct the amount owed from your account on a date certain.

Since the launch of the Ethereum blockchain about five years ago, there has been a great deal of exploration on how smart contracts can be augmented and further applied with a broader stroke to all industries imaginable. In a recent publication reporting on active blockchain use cases across 55 big industries, CB Insights explained:

Banking isn’t the only industry that could be affected by blockchain tech….What began as the basis of cryptocurrencies such as Bitcoin, blockchain technology…is now spreading across a wave of industries…. In 2019, businesses are expected to spend $2.9B on the technology, up almost 90% from 2018, according to IDC. Industries from insurance to gaming to cannabis are starting to see blockchain applications…. Ultimately, the use cases for a transparent, verifiable register of transaction data are practically endless….^[32]

What most industries have in common is that due to disparate database systems, they generally produce siloed information, making it difficult to automate or even streamline interaction with other industry participants. For example, in the food industry, ecosystem stakeholders like farmers, producers, and transporters often use different systems for recordkeeping, with some operating on paper, others with locally managed IT infrastructure, and still others in the cloud. No one system talks to any other system, and the same problem is repeated through the global trade industry, in government agencies, and among insurance providers, healthcare networks, and real estate companies.

As reported by the joint efforts of IBM and the global shipping giant Maersk, in a recent test, shipping flowers from Kenya to Rotterdam resulted in a stack of nearly 200 communications — a nightmare that blockchain is especially equipped to resolve.^[33] However, as each of these industries implicate a growing global reach, they require an increasingly global solution. Consequently, while private companies are producing blockchain-based solutions to address smaller, regional problems, global consortiums have organized with larger organizational participation from stakeholders around the world to develop international standards and protocols per industry for the recommendation and adoption of enterprise blockchain solutions.

Businesses and governments around the world are actively working to integrate blockchains to track records and manage supply lines of all kinds. For example, Dubai aims to be the first government to be entirely managed on a blockchain.^[34] Estonia has built a digital society offering e-citizenship on a blockchain.^[35] In Latin America, the InterAmerican Institute for Cooperation on Agriculture maintains 34 offices dedicated to helping farmers implement blockchain and other technologies to support sustainable farming. The U.S. federal government, however, continues to make it extremely challenging to tokenize assets by attaching securities treatment, by default, to nearly every effort to build a utility into an existing asset through tokenization on a blockchain — a complicated subject that begs its own article. Nevertheless, certain states like Arizona, Delaware, and Wyoming have recently passed comprehensive legislation providing clear rules on how to manage digital securities offerings, and other states are following suit.^[36]

However, integrating smart contracts does introduce new problems. For instance, what happens when the data entered for a smart contract is wrong, but the contract has been uploaded for auto-execution on a blockchain? How do you change the terms when blockchain-recorded data is immutable? Or, how do you stop a smart contract from self-executing once it has been put in motion without killing the whole blockchain? These are the kinds of questions that legal authorities and regulators are just now starting to ask, but because we do not yet understand enough about how blockchains work or what they can do, we cannot produce reliable answers. As recently explained in a poignant article from the Harvard Business Review, the era of “move fast and break things” is over.^[37] A new era of stakeholder accountability for businesses is at hand. “Minimum viable products” must be replaced by “minimum virtuous products” that assess the overall social impact and build in protections against potential harms,” and venture capitalists must participate in driving this much-needed change.^[38]

Self-Sovereign Identity

The most common objection to the use of blockchain and its lead use case, virtual currencies, is that they are tools used to commit crimes; therefore, opponents advocate the eradication of these tools. By that logic, we also should eliminate every nation’s fiat, for it is and always has been the primary currency of criminals. Not surprisingly, this rationale is never promoted. While banks implement increasingly intrusive Know Your Customer (KYC) and Anti-Money Laundering (AML) tools to identify customers and combat money laundering, they too are guilty of extreme corruption. Deutsche Bank is currently under investigation for the biggest money laundering scheme in history spanning two decades.^[39] In the last five years, Wells Fargo created 3.5 million fake bank and credit card accounts using customer data,^[40] and U.S. Bancorp was fined $613 million by the U.S. Justice Department for willful money laundering violations.^[41] Meanwhile, in Australia, several of the nation’s biggest banks charged fees for services never provided, resulting in a total of more than AUS $1.150 billion payable in compensation;^[42] and an international banking cartel comprised of Deutsche, Bank of America, and UBS illegally fixed global commodities prices.^[43] Notably, all these bank crimes were committed in fiat.

As a former criminal defense attorney, I concede that law enforcement has a point. Organized criminal enterprises will take advantage of any means possible to further their activities, and digital currencies helped them spread their nefarious operations with anonymity. For this reason, global regulatory authorities have increased the proof of identity required to open a bank account or access financial services. Consequently, hardworking, law-abiding people are facing greater barriers to access the world’s economic infrastructure, and with it, the opportunities that access affords.

Documentation that establishes one’s legal identity is the gateway to modern life. Without legal proof of your identity, you can’t vote or drive; nor can you open a bank account or access government services.^[44] “According to the World Bank, more than a billion people have no way to prove their identity,”^[45] and among them are 24.5 million refugees.^[46] While refugees protected by the 1951 Refugee Convention are issued identity and travel documents by host nations,^[47] these documents may be forgotten, destroyed, or stolen.^[48]

The value of storing identities on the blockchain extends both to the recipients and to their respective governments. Blockchain-registered identities tied to biometrics create an indestructible record traceable only to the particular individual. By using banking applications built on the chain, a person’s financial transactions recorded on the chain build a credit history over time, serving as a form of identity for later use, “essentially creating the trust they need to interact with the world, without depending on a centralized authority…to vouch for them.”^[49] Within this structure, governments and organizations that provide funds and services can better track spending, detect fraud and unauthorized use, and avoid bank transaction fees.^[50] Further, expenditures can be directly audited, thereby reducing funds lost to corruption, and it can streamline government services that are typically plagued by “overlap — or gaps — in the services they provide.”^[51]

In 2016, the UN World Food Program launched the Building Blocks blockchain in Jordan.^[52] An Ethereum-based private blockchain, this program has registered more than 100,000 Syrian refugees using biometric authentication that enables users to make cash transfers for food and other purchases using retina scans.^[53] Saving the World Food Program up to $150,000 each month in bank fees alone,^[54] the program is under expansion to cover all refugees with a digital ID wallet, fully accessible via smartphone, designed to improve refugee transactional mobility.^[55] While placing total control over a person’s digital ID in the hands of a government-operated, private blockchain questions the integrity of this project’s decentralization, and its applicability beyond financial savings, it does prove the feasibility of the concept.

Although there are a number of identity-based blockchains in development, one notable project is the ID2020 Alliance. A collaboration of public and private sector giants including Accenture, Microsoft, Hyperledger, The Rockefeller Foundation, UN agencies, and other leading nonprofits,^[56] the alliance is committed to addressing the UN Sustainable Development Goals to provide a digital identity to more than a billion global citizens who don’t have one.^[57] However, it can be a dangerous proposition for a government to have that kind of control over a person’s identity. As aptly explained by David Shrier, associate fellow at the University of Oxford, “genocide is about identity,” but identity that is self-sovereign, controlled by you, preserves the sanctity of your privacy while still enabling you to access the world. As smaller projects like the World Food Program have successfully proven the concept works on a functional level, larger initiatives are under way with the World Wide Web Consortium and The Sovrin Alliance to develop international standards and protocols for decentralized identifiers for systems of verifiable, decentralized digital identity to be deployed nationally.^[58]

Conclusion

While not a panacea, blockchain does solve many problems inherent to data security and privacy, data management, and information sharing. It creates new market efficiencies by streamlining transactions and supply lines. By restoring ancient systems of trade where people can exchange items of value directly with one another, blockchain dilutes the power of central banks and the governments that support them. Moreover, as it grows in influence and integration in private and public sectors, it can provide a means of financial inclusion for the world’s bottom billion. As blockchain is built into existing and prospective business processes, industry participants will enjoy efficient, fraud-resistant transactions that are secure, immutable, and auditable. Yes, blockchain is here to stay, and with it, perchance, a second opportunity to capitalize on another round of explosive economic growth.

This column is submitted on behalf of the Tax Law Section, Janette M. McCurley, chair, and Taso Milonas, Charlotte A. Erdmann, and Jeanette E. Moffa, editors.

VIEWS AND CONCLUSIONS EXPRESSED IN ARTICLES HEREIN ARE THOSE OF THE AUTHORS AND NOT NECESSARILY THOSE OF FLORIDA BAR STAFF, OFFICIALS, OR BOARD OF GOVERNORS OF THE FLORIDA BAR.