Blockchain is far more than Bitcoin and presents a unique set of legal hurdles for the banking sector.

What is Blockchain?

Blockchain is a method of storing, transmitting and preserving data in a (1) decentralized, (2) self-validating, and (3) trustless system.

Traditional data organization on a hard drive saves only one copy of the data together in a linear string of ones and zeros, which, while simple and convenient, is also very prone to being stolen if the hard drive is compromised. In contrast, Blockchain uses a peer-to-peer network (people connected using a specific sharing software via the internet, aka P2P) to store a copy of the entire Blockchain data with multiple peers on their storage drives.

The data is “decentralized” because there is never just one copy of the data to be lost/corrupted/stolen as there are multiple, identical copies of the data across numerous storage drives.

Blockchain data is also “self-validating” because each copy of the chain can verify itself against other copies of the chain on the P2P network to ensure there have been no changes to either the chain as a whole or to the individual blocks of data in the chain. If a block is found to be changed when checked against the system the offending block is rejected and replaced with a correct copy of the block from another peer's chain in the P2P network.

Finally, the data is “trustless” because each block itself contains two bits of important information: (1) the location of that block within the larger chain (known as the “hash”) and (2) the hash of the previous block in the chain. For reasons outside the scope of this discussion, if a hash changes and doesn't validate with the other copies of the chain, then the block with the invalid hash is rejected. This ensures that the data in the block always stays the same or at the very least, a user is made aware of any changes to the data — hence “trustless.”

This only scratches the surface of how Blockchain works, but the key to remember is that Blockchain is a superior algorithm for data organization in our current technological landscape as it allows data to be decentralized and thus much less vulnerable to attack, loss, or corruption.

Current Legal Hurdles Inhibiting the Blockchain-Banking Evolution

Blockchain's potential benefits to all industries, but especially in banking, could result in fundamental changes to how banks operate. So why aren't banks diving in? It's complicated, but among the key reasons for hesitation are the murky legal issues surrounding this new area.

Applicable Law

One obvious legal issue with Blockchain and the banking industry is which state's (or country's) law applies to a decentralized, distributed, encrypted Blockchain network. When storage drives and clouds across the United States all have identical copies of a particular Blockchain, it highlights the antiquated and obsolete nature of the law applied to the evolving Internet. A new way of thinking about territories, borders, and most importantly, jurisdiction, will be forced by the mainstream adoption of Blockchain.

SEC Regulation

Given banking's likely use of cryptocurrency as one form of Blockchain's implementation, it is important to note that the Securities and Exchange Commission (SEC) has yet to state whether cryptocurrencies like Bitcoin and Ethereum fall under its purview.

However, in the Zaslavskiy v. SEC case, Zaslavskiy, who launched two allegedly fraudulent cryptocurrencies in 2018, tried to argue that the case should be dismissed, as cryptocurrency was outside the SEC's regulation. However, the U.S. District Court for the Eastern District of New York disagreed, stating that there was a basis for interpreting cryptocurrency as a security under the SEC's jurisdiction.

If the SEC were to acknowledge cryptocurrency as a valid security (perhaps in response to Congress requesting clarification on its position just a few weeks ago), then banks would undoubtedly feel more comfortable jumping into the Blockchain world.

Data Protection

Why is data protection a concern when dealing with a trustless system? Because although one of the benefits of Blockchain is that its verification system ensures it cannot be tampered with, it also means the data, once on the chain, cannot be kept private due to Blockchain's transparency. Arguably, the transparency component of Blockchain, as it stores copies on all participating peers' storage drives, is incompatible with the banking industry's privacy requirements. Further encryption of Blockchain data or restricting who can join a bank's Blockchain network to trusted peers only are important first steps but not the end of the data-protection debate.

Liability

Another legal issue for the banking world is liability. If a bank creates the Blockchain which its customers utilize, would the bank be liable if a transaction ends up being fraudulent? One of cryptocurrency's biggest draws is the anonymity it gives its customers – what if the Blockchain is used for an illegal transaction? Would the bank be required to disclose its customer and expose the transaction from the chain, resulting in additional data privacy issues? Would the bank be liable, along with the customer, for the illegal transaction and if so, doesn't the invasion of the privacy and anonymity of the Blockchain negate the usefulness of the Blockchain algorithm, as well?

All in all, Blockchain and banking are inevitably going to be interwoven and interdependent, but significant legal issues, uncertain regulation and woefully outdated definitions stand in its way.

Michael Holmes is a senior business and technology attorney at Godwin Bowman PC in Dallas, where he represents scrappy start-ups and mature Fortune 500 players across the United States in corporate transactions and complex dispute resolution matters. His practice focuses on emerging and disrupting technology, enabling him to position his clients' businesses to minimize risk and maximize potential success. He may be reached at [email protected].