Decentralized Bitcoin Exchanges: A Solution with Three Big Challenges

The author, Addison Cameron-Huff, is a lawyer who serves as part-time in-house counsel for Decentral. Decentral is Canada’s main decentralized application business development centre.

 

Bitcoin Exchanges

Bitcoin exchanges are businesses that connect buyers and sellers of Bitcoin to each other and the banking system. Exchanges pose three problems:

  1. they sometimes go out of business and lose everyone’s money + bitcoins (“counterparty risk”); and,
  2. they are easy targets for regulation that can be easily and suddenly shut down by authorities (they are “centralized”); and,
  3. they have a limited number of options for accepting payment (e.g. a US exchange is unlikely to support M-Pesa transfers).

Decentralized Exchanges: Solution?

Many cryptocurrency enthusiasts think decentralized exchanges are the solution to the problems that Bitcoin exchanges currently pose.

 

A decentralized exchange is an exchange that uses peer-to-peer (P2P) networking technology to enable users to directly trade with each other. Although a regular Bitcoin exchange allows users to trade with each other they can only do so with the exchange as an intermediary.

 

When thinking about the difference between a decentralized exchange and today’s exchanges, it’s helpful to think about the difference between Napster and BitTorrent. Napster worked by having a central server that every user’s computer checked in order to see what files were available to download from other users. Napster was shut down in 2001 by a court order that forced them to turn off the central servers. BitTorrent can’t be shut down because users connect directly to each other and not through an intermediate central server.

 

A decentralized Bitcoin exchange would solve problem #2 (see above) because there wouldn’t be a central server. Problem #1 would be solved with respect to the exchange itself but a decentralized exchange would (depending on how it works) probably introduce a new form of counterparty risk: the risk of dealing with other users. Problem #3 would probably also be solved because users could find the payment methods that work for them in their jurisdiction.

 

At a high level it would appear that decentralized exchanges are the solution to the problems identified at the beginning of this post but the devil is in the details. The devil lies especially in the details of how a decentralized exchange would handle the interface between “fiat” currency (e.g. Canadian dollars) and Bitcoin.

 

Canadian Dollars to Bitcoin

A hypothetical decentralized Bitcoin exchange would probably operate along these lines for a $ to BTC transaction:

  1. Alice and Bob agree on price and quantity (e.g. $3000 for 2 bitcoins) through the decentralized order matching system
  2. Alice sends $3000 to Bob
  3. Alice sends a message indicating payment sent
  4. Bob receives $3000
  5. Bob sends a message indicating payment received
  6. Bob sends 2 bitcoins to Alice
  7. Bob sends a message indicating the bitcoins have been sent
  8. The system marks the transaction as complete

 

The steps above pose at least three big challenges:

  1. What does step #2 mean? How will Alice send the money to Bob? Will the decentralized exchange interface with the thousands of payment systems around the world?
  2. How can Bob be sure that the money he receives in step #4 won’t be taken back by Alice after step #8? If Alice uses a payment method like a credit card then Alice can later reverse the transaction and potentially get back her money and keep the bitcoins. There are very few methods of payment that can’t be reversed.
  3. How will disputes be handled? What if Alice didn’t actually send the money? What if Bob doesn’t send the bitcoins? How can Alice prove she sent the payment? What if Alice backs out of the transaction before sending payment? Who will be responsible for offline enforcement?

 

Flickr photo shown on laptop is by @jalavega

What is a Compliance Officer?

This blog post explains what a compliance officer is within Canada’s money laundering regime. It was written by Addison Cameron-Huff, a lawyer who specializes in Bitcoin. He highly recommends that you seek legal advice when faced with money laundering compliance issues.

 

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Photo from http://www.flickr.com/photos/[email protected]/2962194797/

 

Compliance with the Proceeds of Crime (Money Laundering) and Terrorist Financing Act may require the appointment of a “compliance officer”.

 

A compliance officer typically performs the following roles:

 

“Puts in place and maintains the compliance regime.

Ensures that all employees are trained as required.

Monitors and observes that all policies and procedures are respected and applied.

Reports on a regular basis to the board of directors or senior management, or to the owner or chief operator.”

 

http://www.fintrac-canafe.gc.ca/msb-esm/compliance-conformite/officer-agent-eng.asp

 

In a small business the compliance officer could be the owner/operator of the business. At a larger organization (e.g. a bank) a compliance officer is typically a full-time role.

 

FINTRAC also refers to their own inspectors as compliance officers: http://www.fintrac-canafe.gc.ca/publications/brochure/05-2005/4-eng.asp.

A Smart Property Real Estate System for Ontario

This blog post is about how the ideas of Bitcoin could be applied to Ontario’s land ownership records system (POLARIS). It was written by Addison Cameron-Huff, a lawyer retained by Decentral in Toronto.

 

“Smart property” is a concept of great interest in the cryptocurrency industry. Smart property is property for which:

 

the ownership can be verified through a decentralized trust system (like the Bitcoin protocol); and,
transfers can take place using the electronic system.
Could Ontario adopt a smart property system for land records?

 

Knowledge of how Bitcoin works is a prerequisite to thinking about how a property system based on it could function.

 

Explaining Bitcoin: Provable Transactions + Ownership

The Bitcoin protocol allows anyone to verify the transactions that have taken place within the system (the “blockchain”). This is possible because Bitcoin creates a snapshot every ten minutes of the last ten minutes of activity and adds that to the list of transactions that have happened since the start of Bitcoin (this is called “mining”). The records can’t be changed after the fact due to the use of hashing functions.

 

Bitcoin allows the holder of bitcoins to prove that they are the owner because they are the only person with the password (see this explanation of public key cryptography for details). The person with the password can “sign” a transaction with their password to prove that they are the owner.

 

If anyone can prove that they are the holder of a certain item and everyone else can see the history of transactions that led to them being the holder, then you have the basis of a system of provable ownership and secure transfer.

 

Real Estate Smart Property: POLARIS

How could smart property concepts be applied to real estate?

 

At the heart of smart property is the idea of electronic records that prove ownership. For most kinds of property there is no official record of ownership that can be consulted – it’s generally up to the buyer to ascertain who the owner of something is. One notable exception is POLARIS: the database of ownership of real property in Ontario.

 

POLARIS is a part of the Land Titles System, the legal regime for property ownership that covers most land in Ontario. It is is the central repository for all records of who owns what real estate. You can read more about it here: http://www.teranet.ca/node/131.

 

POLARIS and smart property are complicated concepts so the following discussion can only touch on a few points of comparison but will hopefully illustrate the contrast between the two systems. This blog post considers a block chain-based smart property system.

 

POLARIS: Disadvantages

POLARIS has a few disadvantages:

  1. it is centralized and access is provided only through a private company called Teranet (they bought the right to run the system until 2067 for $1 billion + royalties and are owned by Borealis, the investment arm of OMERS); and,
  2. it’s very difficult to prove that the person transferring land is the possessor of that land (the problem is currently handled by only lawyers doing transfers); and,
  3. it’s expensive to look up ownership of property (about $30 per search + $600 to register); and,
  4. it’s not possible to build new applications that use property records.

 

Smart Property System: Benefits

A smart property system for land ownership could improve upon POLARIS in a few ways:

  1. anyone could inspect any property record in real-time (because everyone has an up-to-date version of all of the records); and,
  2. access to records would cost almost nothing (<1 cent); and,
  3. authenticating the holders of property would be easy (because the holder is the one with the password) so owners could transfer land without using lawyers; and,
  4. transactions fees could be very low; and,
  5. anyone could build applications on top of the property system to provide new ways of accessing records (e.g. an automated mortgage fraud detection system).

 

Despite the upsides of a smart property system, changing the real estate database system would pose a number of significant challenges.

 

Smart Property Real Estate System: Challenges

POLARIS has been in place since the 1980s. It may not be ideal but a new system is likely to introduce “bugs” that would have enormous costs for some people (e.g. a bank might foreclose on the wrong person).

 

There would also be problems that are specific to switching to smart property:

  1. passwords would have to be distributed to the current owners of land; and,
  2. if a user loses their password they’d lose ownership of the land (and if they didn’t, the ownership database would be out-of-sync, defeating the purpose of having the system); and,
  3. theft of real estate passwords would become a massive fraud issue (although real estate fraud is currently a major problem for banks, consumers and insurers).

 

Any sane system that follows smart property principles would have to figure out a method of “recovering” ownership when the password is lost. (This problem could be mitigated by implementing “multisignature transactions”).

 

Although there would be advantages to a smart property system, many of them would be hard to quantify, such as the benefit from new applications that are impossible to create under the current system. In 1980 no one could have calculated the value of the Internet (and what is Wikipedia worth?). Furthermore, many people misplace their car keys – they’re not going to be able to keep track of the password for their home ownership record.

 

In addition to the practical issues of switching to smart property the province would be forced to pay billions to Teranet (the operator of POLARIS) if it cancelled its 57 year monopoly agreement.

 

Conclusion: Looking Forward

2014 isn’t going to be the year of smart property real estate records. That said, it will be a year where these ideas move closer to application, and the power of decentralized crypto trust systems gains wider recognition. By 2067 we’ll probably have something better than POLARIS.

 

Discussion

Smart property and real estate are big, challenging topics. Please do contact the author ([email protected]) if you think a mistake has crept in or there’s an aspect you’d like to see explored in a follow-up blog post.

It’s legal to do business in bitcoin

This blog post discusses the legality of doing business using bitcoins. It was written by Addison Cameron-Huff, a lawyer who specializes in Bitcoin. He highly recommends that you seek legal advice when considering Bitcoin legal issues.
http://www.flickr.com/photos/10710442@N08/4034636727/

Businesses are adopting bitcoin (BTC) as a payment method at an ever faster rate (20,000 merchants use the BitPay network and coinmap.org has mapped >3000 businesses). Despite the growing adoption, some people wonder whether “it’s legal”. This blog post takes a look at the legality of doing business with Bitcoin.

The starting point for any discussion about what’s legal or illegal is this default principle in Canadian law: it’s legal unless it’s not. You are permitted to do anything so long as there isn’t a (valid) rule that prohibits/ regulates that conduct.

There have not been any laws passed in Canada that specifically address Bitcoin (although there will be). But there are laws of general application that apply to all transactions, and more specifically, barter transactions (trading good X for good Y). Canada has always taxed barter transactions and the Canadian Revenue Agency has provided guidance on bartering with digital currencies.

Beyond tax implications, the question of whether it’s legal to use Bitcoin can usually be rephrased as whether the transaction is legal. The use of bitcoins doesn’t affect a transaction any more than substituting soybeans for dollars would. Legal business remains legal and illegal business remains illegal.

The technology may be new but the legal principles are not.

Source: posts

Setting up a Bitcoin Business in Canada

This blog post is an overview of the steps required to set up a Bitcoin business in Canada. It was written by Addison Cameron-Huff, a lawyer who specializes in Bitcoin. He highly recommends that you obtain your own legal advice before starting a Bitcoin-related company.

 

Every business is different but the following steps are an overview of the general process that many businesses take in order to get started.

 

Step 1: Identify Legal Issues with Your Proposed Business

There may be laws that restrict your ability to do business or might direct you to carry out your business in a certain way. The Bitcoin space is filled with misunderstandings about the law and some businesses may be subject to complex regulatory schemes (e.g. anti-money-laundering rules).

 

Step 2: Sole Proprietorship vs. Partnership vs. Corporation

The first step is to consider the business organization that you’d like to set up. This can be deceptively complex and hiring a lawyer may be quite helpful.

 

The provincial organization that regulates lawyers (Law Society of Upper Canada) provides this document with issues for lawyers to consider: http://www.lsuc.on.ca/For-Lawyers/Manage-Your-Practice/Practice-Area/Business-Law/How-to-Choose-the-Right-Business-Vehicle/.

 

The simplest form is the sole proprietorship where you do business in your own name. A partnership is a business that’s similar to a sole proprietorship but with several individuals who jointly own the business. A corporation is a business that has an existence separate from that of the people running it.

 

Most startups choose to create a corporation for a variety of reasons (many entrepreneurs cite “limited liability” as their motivation). Often if incorporation isn’t chosen it’s because the sole proprietorship/partnership results in a more favourable tax scenario. An accountant or lawyer can help you understand the best structure for your circumstances.

Step 3: Federal vs. Provincial Incorporation

Corporations may be created at either the federal or provincial level. While there is often no practical difference between federal and provincial corporation there may be reasons to select one or the other for your circumstances. A federal incorporation is $50 cheaper.

Step 4: Business Name

Do you want to create a named company or a numbered company? A named company would be something like “ABC Inc.” A numbered company is one that looks like “12345678 Canada Limited”. Numbered corporations are issued faster and may better reflect how you wish to interact with business partners, government, banks, etc.

If you opt for a numbered corporation then you will have to register any other names that you’d like to do business under (e.g. “12345678 Canada Limited” doing business as “Ottawa Bitcoin Consultants”). Business name registration in Ontario can be done online using the Integrated Business Services Application.

Step 5: Registration Steps

If you are registering a federal corporation then you should consult the Guide to Federal Incorporation before beginning the registration process.

Online incorporations are done through Industry Canada’s Online Filing Centre: https://www.ic.gc.ca/app/scr/cc/CorporationsCanada/bs/crp-wz.html.

Step 6: Meeting of Initial Directors and Shareholder Meetings

Once a company is created, the initial directors will have a meeting to decide on how the company should be run. The long-term directors will be appointed and shares granted.

Following the initial directors meeting there will be a meeting of the shareholders.

Step 7: Banking, Accounting, Legal, Compliance, etc.

Depending on your business there may be a host of issues that you should consider once you have created your company including: setting up a bank account, registering for HST, considering how people who work for you will be paid, WSIB registration, corporate tax returns, corporate record keeping, bookkeeping, anti-money-laundering compliance, leasing space, drafting contracts with customers, domain registration, etc.

Step 8: Join Canada’s Largest Bitcoin Business Community

Decentral Toronto at 64 Spadina Ave. operates a co-working space and rents private offices.

What is Money Laundering?

This blog post discusses the definition of money laundering. It was written by Addison Cameron-Huff, a lawyer who specializes in Bitcoin. He highly recommends that you seek legal counsel to obtain advice about money laundering.

 

“Money laundering is the process used to disguise the source of money or assets derived from criminal activity” according to FINTRAC, Canada’s money laundering regulator.

 

Money laundering is how criminals earn money illegally and convert it, through a series of steps, into money indistinguishable from legitimately earned income. The “series of steps” that money launderers use are diverse and constantly changing as they attempt to outwit law enforcement/tax authorities.

 

The OECD’s Financial Action Task Force explains the reason why criminals need to launder money:

“In order to be able to spend money openly, criminals will seek to ensure that there is no direct link between the proceeds of their crime and the actual illegal activities. They may also seek to construct a plausible explanation for an apparent legal origin of the money that they possess. In this way, criminals seek to “launder” their proceeds of crime before spending or investing it in the legal economy.”

 

The primary source of law in Canada regarding money laundering is the Proceeds of Crime (Money Laundering) and Terrorist Financing Act. There are also Criminal Code offences (to be covered in future posts).

Deducting Expenses Related to Bitcoin Mining

Deducting Expenses Related to Bitcoin Mining

This blog post was written by Addison Cameron-Huff, a lawyer who specializes in Bitcoin. He highly recommends that you obtain legal advice before acting in the Bitcoin space.

 

Bitcoin mining is the process by which new bitcoins are generated. It requires buying hardware (“ASIC miners”) to mine bitcoins and power to run the hardware.

 

If you’re mining to make a profit then you may be able to deduct your business-related expenses.

 

According to the CRA: “As a rule, you can deduct any reasonable current expense you paid or will have to pay to earn business income.” There are many exceptions to this “rule” and a tax advisor should be able to help you determine whether you are operating a business for which you can deduct mining expenses.

Selling Bitcoins: Do You Need to Charge HST?

This blog post looks at the issue of whether sellers of bitcoins need to charge HST. It was written by Addison Cameron-Huff, a lawyer who specializes in Bitcoin. Tax is a complex area and you should seek accounting/legal advice before acting.

 

Most stores in Ontario that sell goods are required to charge 13% HST. According to the CRA:

“Almost everyone has to pay the GST/HST on purchases of taxable supplies of property and services (other than zero-rated supplies). A limited number of sales or supplies are exempt from GST/HST.”

 

One transaction that is exempt from HST is the sale of “gift certificates”, as provided for in s. 181.2 of the Excise Tax Act:

“… the issuance or sale of a gift certificate for consideration shall be deemed not to be a supply and, when given as consideration for a supply of property or a service, the gift certificate shall be deemed to be money.”

 

The Excise Tax Act does not define “gift certificate” but in 2012 the CRA issued a policy statement that explains their view on what a gift certificate is. The CRA’s definition of gift certificate requires the following five attributes:

“1. It has a monetary exchange value that is evident on the certificate or that is easily determined by the parties involved in the transaction. The monetary exchange value may, for example, be specified on the face of the certificate or it may be stored on the certificate electronically. In certain cases, the customer may be permitted to add additional amounts to the monetary exchange value of the certificate. Alternatively, the gift certificate may be for a particular supply of property or a service that is identified on the certificate.

  1. It is issued or sold for consideration by the supplier of the property or service or another party for use at a particular supplier. The consideration paid for the certificate may not necessarily be the same as the monetary exchange value.
  2. It is accepted as payment or partial payment of the consideration for a supply of property or a service offered by the supplier of that property or service.
  3. It does not require the bearer to do anything to redeem the certificate other than to present it as a means of payment or partial payment for the property or services being acquired. The holder of the certificate should not be required to meet other conditions, such as, making a purchase of a particular value (i.e., a required minimum value) or purchasing one item to exchange the gift certificate for another item (e.g., buy one, get one free) in order to redeem the certificate.
  4. It does not have any intrinsic value. The certificate should not have any value other than its monetary exchange value.”

 

In addition to the CRA’s policy statement there is case law that helps to explain what “gift certificate” means in Canadian law such as Royal Bank of Canada v. The Queen, 2007 TCC 281.

 

There are severe penalties for failing to comply with tax obligations. A seller of goods who fails to charge HST could be liable for the entire amount that should have been charged (with interest and penalties) and, if the seller is a corporation, liability may extend to the director(s).

 

It is possible to request from the CRA a tax ruling or interpretation regarding HST obligations: http://www.cra-arc.gc.ca/E/pub/gp/rc4405/rc4405-e.html, but this please note that interacting with the CRA may result in negative tax consequences. You are strongly advised to seek the advice of a tax professional before starting to sell bitcoins or charging/not charging HST.

Do the Consumer Protection Act Gift Card Rules Apply to Bitcoin Sales?

This blog post discusses the applicability of the Ontario Consumer Protection Act, 2002 gift card rules to the purchase of bitcoins. It was written by Addison Cameron-Huff, a lawyer who specializes in Bitcoin. He highly recommends that you seek legal advice when deciding whether the Consumer Protection Act, 2002 applies to your transactions.gift cards and bitcoins

 

The Consumer Protection Act, 2002 (CPA)is the main consumer protection law in Ontario. Among its many provisions are rules about “gift cards”, a concept that sounds like it could include bitcoins. If the sale of bitcoins is considered the sale of gift cards under the CPA then there could be fee limits for sales (ss. 25.4(2)(a) & 25.4(2.1)(b)) and potentially a consumer refund right (s. 25.4(3)-(4)).

 

Gift card is a defined term in the CPA:

“gift card” means a voucher in any form, including an electronic credit or written certificate, that is issued by a supplier under a gift card agreement and that the holder is entitled to apply towards purchasing goods or services covered by the voucher; …“gift card agreement” means a future performance agreement under which the supplier issues a gift card to the consumer and in respect of which the consumer makes payment in full when entering into the agreement; …“open loop gift card agreement” means a gift card agreement that entitles the holder of a gift card to apply it towards purchasing goods or services from multiple unaffiliated sellers.Consumer Protection Act, 2002, OR 17/05, s. 23.

 

The definition of gift card requires that the “holder is entitled to apply [it] towards purchasing goods or services covered by the voucher”. When a consumer purchases bitcoins they are not entitled as the holder of those bitcoins to apply them towards good or services. There are some merchants who accept bitcoins but this isn’t any different than merchants willing to barter for other goods. Since there’s no entitlement it seems unlikely that a bitcoin purchase could be considered a gift card purchase under the CPA.

 

Photo from http://www.flickr.com/photos/[email protected]/6710889059/

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