Smart contracts and other related topics, such as proof-of-stake, have begun to raise several new questions about how to understand and address compliance. They represent an important frontier for blockchain innovation.
At the same time, new use cases and related considerations in these areas go beyond meeting the familiar compliance requirements for purchasing, selling, and account management for cryptocurrencies such as Bitcoin.
As a result, businesses exploring blockchain beyond Bitcoin (including Ethereum, Ether-based applications, and DeFi) need to examine the potential compliance implications of smart contract regulations. Tax issues related to proof-of-stake also present compliance nuances that companies using it must address.
To begin with, a couple of definitions of these terms may be helpful. Even as they become more familiar in the context of digital ledger technology (DLT), it helps to define them in ways that help shed light on their compliance implications.
What are ‘proof-of-stake’ and ‘proof-of-stake rewards’?
Blockchains have two primary ways of making sure that new entries, or blocks, are legitimate: proof-of-work and proof-of-stake. Because blockchains are distributed, it is important to ensure that new blocks are valid.
Keep in mind that in the context of financial blockchain, blocks are records of ownership and ownership transfers, so they are the equivalent of buying, holding, and selling equities or purchases using fiat currencies.
Both proof-of-work and proof-of-stake provide mechanisms so that every blockchain user can trust these transactions.
Proof-of-work (also commonly known as “mining”) is most commonly associated with currency applications. Per ethereum.org, “proof-of-work is done by miners, who compete to create new blocks full of processed transactions. The winner shares the new block with the rest of the network and earns some freshly minted [cryptocurrency].”
Such transactions have their own compliance implications, including securities and money transmitter law questions. However, there are other applications of DLT beyond cryptocurrency. Blockchains that power DeFi applications include Ethereum and Cardano. Ethereum is moving from proof-of-work to proof-of-stake. Cardano is natively proof-of-stake.
Proof-of-stake is a consensus mechanism for processing transactions and creating new blocks in a blockchain. In other words, it is a method for validating entries into a distributed database and keeping the database secure.
As Cardano defines it, in proof-of-stake, “as a user's value increases, the opportunity to maintain the ledger also increases. This means a higher chance to produce new blocks that can be added to the blockchain and timestamped accordingly. Participants accumulate the transaction fees, thereby adding to their wealth as they go.”
In other words, proof-of-stake allows users to grow their holdings. Below, we will highlight the tax and compliance implications of that increase.
What Are Smart Contracts?
Smart contracts are a feature primarily enabled by proof-of-stake (although it is not entirely absent from proof-of-work ledgers). Smart contracts are digital protocols that facilitate, verify, or enforce the negotiation or performance of a contract when specific terms are met.
A smart contract represents a set of terms and conditions in code and stored on the blockchain. When those terms or conditions are met, the contract is triggered automatically.
For example, a smart contract could trigger a sale when a certain price threshold is reached, or could fully transfer ownership of an asset paid for via credit once the total amount plus agreed interest has been received.
As such, smart contracts can entail many compliance risks, raising fundamental questions such as:
- Are the terms of the contract allowed under regulation?
- Does the contract include sufficient AML and KYC controls?
- Does the smart contract support recordkeeping requirements?
- Does the smart contract include sufficient provisions to prevent fraud or manipulation?
Proof-of-Stake: Compliance Considerations
Unlike smart contract regulation discussed below, most of the considerations around proof-of-stake relate to the valuation and taxation of assets. Still, companies should be aware of such considerations in order to avoid surprises or lapses in reporting.
The U.S. infrastructure bill passed in 2021 calls for amendments to the tax code that require any entity considered a “broker” of transactions in digital assets—i.e., cryptocurrencies—to report their customers to the Internal Revenue Service so they can be taxed. This requirement could “potentially encompass miners, validators, and developers of decentralized applications,” essentially including anyone who sells, trades, borrows, or lends via smart contracts.
According to a report from the Proof-of-Stake Alliance, any business or person receiving more than $10,000 in digital assets must record and verify the sender’s personal information, including their social security number, and sign and submit IRS Form 8300 to the government within 15 days. This requirement applies to every single transaction. Failure to comply results in mandatory fines of at least $25,000 for each violation and a felony conviction with up to five years in prison.
Smart Contract Regulations: Compliance Considerations
Companies and their compliance departments can tremendously benefit from smart contracts, as they can be used to simplify or automate many complex and tedious processes. However, the benefits of innovative technologies can only reach their full potential when appropriate smart contract regulations and international standards are in place.
At present, smart contracts come with many advantages, but they are also subject to certain risks and limitations. One disadvantage of smart contracts is that the technology is still in its infancy, which means that it can create unexpected risks (such as hacks and breaches).
In addition, smart contract regulation continues to be surrounded by legal uncertainty as most jurisdictions have not yet established appropriate legislation or rules for their taxation. Emerging smart contract regulations may create requirements that need enhanced compliance capabilities.
As a result, businesses should carefully understand how their smart contracts relate to the world of traditional, non-digital contract law and regulation. This process can involve understanding various national and local regulatory authorities.
Existing laws and regulations apply equally regardless of the form a contract takes. In other words, smart contracts are subject to otherwise applicable laws and regulations from multiple entities, including:
- Commodity Exchange Act and CFTC regulations
- Federal and state securities laws and regulations
- Federal, state, and local tax laws and regulations
- The Uniform Commercial Code (UCC), Uniform Electronic Transactions Act (UETA), and Electronic Signatures in Global and National Commerce Act (ESIGN Act)
- The Bank Secrecy Act
- The USA Patriot Act
- Other Anti-Money Laundering (AML) laws and regulations
- State and federal money transmission laws
Each smart contract differs in the terms and conditions it represents. In addition, each business using smart contracts may have operational and compliance requirements that vary based on whether they engage in trading, lending, options, derivatives, or any other financial scenario.
Managing Smart Contract Regulations and Risks
Despite those differences, companies can rely on a few steps that help them identify and manage smart contract regulations and risks.
- Ensure that all smart contracts are documented in a way that allows your leadership team and board to understand what they do
- Carry out a legal review to ensure that your smart contracts would be legitimate and enforceable if they existed in non-digital, non-automated forms
- Identify the entities that could scrutinize or investigate smart contract activity, even if they do not provide explicit smart contract regulations
- Define the appropriate compliance workflows and processes to meet the requirements of all relevant regulators and laws
- Review your compliance operations to ensure they can meet current smart contract regulations and requirements
- Monitor the quickly-changing regulatory and legal environment related to crypto
- Partner with reliable legal and compliance experts to help you find and fix current risks while keeping an eye on future threats as well
Broader Compliance Benefits of Blockchain Technology
Proof-of-stake and smart contracts also offer the potential for innovation within compliance in three main areas: reduction of fraud, knowing your customer rules, and auditability.
- Fraud Prevention: Creating new banks on top of a blockchain or distributed ledger will help prevent false information from being replicated as the records held in a blockchain are encrypted and verified every time a transaction occurs.
- KYC: With the advent of blockchain and the development of new compliance platforms on top of these networks, banks will be able to reduce existing operational costs while increasing their efficiency to comply with the existing regulations. It will also help build a healthier relationship between the institutions and the regulators as they would be working together instead of against each other.
- Auditability: Blockchain and DLT technology will help reduce fraud by giving the network participants the chance to fully audit the trail of funds of all transactions through a transparent, secure, and immutable process.
Conclusion: Uncapping the Potential Promise of Smart Contracts
It is undeniable that smart contracts have the potential to become an integral part of finance and society more broadly with a significant impact in many areas, including compliance. They have the potential to relieve compliance officers of many operational burdens by making complex processes less tedious and ensuring that all conditions of a contract are met.
With time and increasing use of the technology, appropriate legislation and smart contract regulation will likely follow.
However, because proof-of-stake and smart contracts do not yet fall under a stable regulatory regime, businesses and individual investors alike should remain alert and open to a wide range of possible outcomes to avoid being caught by surprise with an unworkable or illegal business model in the future.
If you use proof-of-stake and smart contracts within your fintech, InnReg can be a valuable resource to understand the potential risks for your business. Contact us today to learn more about the risks and how to protect yourself.
InnReg is a team of over 30 Regulatory Compliance and Innovation Consulting experts helping fintechs succeed in highly regulated markets since 2013. InnReg specializes on mitigating regulatory risk while helping clients launch and grow innovative fintech products and services.