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Hard Fork Conspiracy Treacherous

By Daniel S. Friedberg
February 11, 2016

Daniel FriedbergBitcoin, a peer-to-peer electronic cash system, is intended to allow online payments to be sent directly from one party to another without going through a financial institution. The platform has blossomed with over US $100 million of bitcoin transacted each day. Vocal groups of developers are now advocating a replacement of the current Bitcoin platform with more robust software through a consensus fork commonly referred as a “hard fork”.  One group calls their replacement software “Bitcoin Classic”; and another calls its replacement software “BitcoinXT”.

A “hard fork” by nature is not backward compatible and requires network participants to adopt new software changes. Failure of all applicable network participants to take such action will result in the Bitcoin network validating different sets of consensus rules. This will result in bitcoin users following different ledgers (called blockchains). There will be a variance in the decentralized truths about bitcoin transactions, as the replacement software will result in a new replacement virtual currency. “Hard forks” are not to be confused with software forks in Open Source, which is a copy of an existing project.

If either the Bitcoin Classic or the BitcoinXT plan (or both) goes forward, the creators of the replacement software could face serious legal consequences and potentially criminal liability for their actions. Surprisingly, unlike Satoshi, the mysterious creator of the original Bitcoin software who has remained anonymous and therefore outside the reach of law enforcement, the developers of both Bitcoin Classic and BitcoinXT are publicly named, many of whom reside in the United States.

Requirement for Creators to Register with FinCEN

The Financial Crimes Enforcement Network (“FinCEN”) is a bureau of the United States Department of Treasury that is charged with combatting domestic and international money laundering, terrorist financing, and other financial crimes. FinCEN has issued numerous guidance and interpretations of the applicability of regulations implementing the Bank Secrecy Act (“BSA”) to persons creating virtual currencies.

Bitcoin Classic and BitcoinXT (meaning in this case the new resulting currency itself rather than the software) would likely be considered by FinCEN to be a new convertible virtual currency. FinCEN has made it clear that a creator of such convertible virtual currency, who issues such currency in order to sell those units for either real currency or its equivalent (including presumably an exchange with current bitcoin), is deemed to be a money transmitter. In the case of BitcoinXT, a website names the specific developers who have final say over the currency. The Bitcoin Classic development team is also publicly named. Under this approach, the creators of Bitcoin Classic or BitcoinXT would need to register with FinCEN as a Money Service Business (“MSB”). Failure to register can result in imprisonment of not more than 5 years, as well as civil penalties. 31 U.S.C. § 5330(e) and 31 C.F.R. § 103.41(e); 18 U.S.C § 1960(b)(1)(B). This is in addition to potential state penalties, as certain states also regulate virtual currency creators.

Requirement to Include AML Protocols in Bitcoin Classic or BitcoinXT

In addition to the registration requirements, an MSB is required to maintain effective anti-money laundering (AML) programs, recordkeeping, and reporting of suspicious activities. In order to do so, the MSB must know who its customers are.

These requirements will require the replacement Bitcoin protocol to maintain the personal identifying information of its users. This can presumably be done through the software code, and is similar to the current information and processes currently maintained by exchangers of bitcoin.

The adherence to such requirements will be a large deviation from the current Bitcoin protocol which does not maintain personally identifiable information about its users. The inclusion of such information would make Bitcoin Classic and BitcoinXT much more accepted by financial institutions, but runs counter to the essence of bitcoin. Bitcoin’s creator designed bitcoin to allow peer-to-peer financial exchange without the use of financial intermediaries and all the complexities involved with such intermediaries, such as identifying the users.

Issues for Exchanges and Wallets

Exchangers of bitcoin not only create a platform to sell and purchase bitcoin, but like wallet providers, also hold bitcoin on behalf of their customers. The implementation of a “hard fork” would require exchanges to differentiate between bitcoin and “Bitcoin Classic” or “BitcoinXT” bitcoin, as its customers would inherently have rights to either one or the other. Exchanges could not mix or intermingle the two, as each has its own rights. In addition, the market price of each coin would likely differ, complicating the decision-making of investors and users.

The “hard fork” would hurt the liquidity of bitcoin, and impair exchanges ability to legally operate. No doubt the market price of bitcoin would be drastically impacted. The market ramifications of a “hard fork” are completely unpredictable.

Potential Liability for Miners who Adopt New Protocol

Miners who unilaterally adopt the new replacement software could face liability under either tortious or statutory claims. A tort is a wrongful act or an infringement of a right leading to civil legal liability. A trespass to chattels is a tort whereby a party intentionally interferes with another person’s personal property. To the extent that a recipient of bitcoin expects normal bitcoin but instead receives “Bitcoin Classic” or “BitcoinXT” virtual currency due to the actions of a miner, that recipient could argue that the actions of the miner resulted in a dispossession. To the extent that the market value of the two types of virtual currency differ, damages would be easy to prove.

There are also numerous state statutes prohibiting computer crimes which could be applied to miners who unilaterally convert bitcoin into a new type of virtual currency. Bitcoin users have a business expectation that their Bitcoin transactions will be processed by miners using the established Bitcoin protocol, and miners should be cautious about interfering with this expectation.

Conclusion

The current proposed “hard fork” replacement software seems at first blush to be a reasonable way to solve Bitcoin’s growth issues. However, due to the lack of consensus of applicable Bitcoin network participants, the enactment would create serious legal consequences for the creators of the new replacement software, unless the creators adhere to the rules of MSB registration and compliance. In addition, the “hard fork” would create serious operational issues for exchanges and wallet operators, the risk of liability for participating miners, and unnecessary confusion in the marketplace.



Daniel Friedberg (dfriedberg@riddellwilliams.com) is a principal at the law firm of Riddell Williams PS in Seattle. Daniel specializes in the representation of Fintech businesses, including virtual currency creators, wallets, blockchain companies, miners and exchangers, as well as peer-to-peer lenders, crowd-funders, payment companies, and data security companies. Daniel is an advocate and a holder of Bitcoin.