Bitcoin first came into public existence in 2008 with the first coins “mined” by a person/group named Satoshi Nakamoto.  As you are probably aware, Bitcoin is a method of transferring value electronically and without the need for any money issued by a sovereign entity.

The first thing to know about Bitcoin is that it is totally decentralized.  There is no master server and no bank vault with anything tangible in it.  Bitcoin exists only as complex mathematics on random computers around the world.  However, once you own a Bitcoin, you can spend is like money with anyone who will accept Bitcoin.

What is the Public Ledger

The driving factor for most Bitcoin believers is the lack of centralization or government oversight.  There is no actual coin and there is no government keeping track of who owns any particular coin.  However, this begs the question: How do does anyone know who actually owns a Bitcoin.

The answer is the Public Ledger.  To overly simply the Public Ledger, it’s a spreadsheet that exists on private computers all over the world known as nodes.  These nodes run on personal computers of people who download Bitcoin mining applications.  All of these random computers around the world share the Public Ledger and confirm not just ownership of a particular Bitcoin, but also the transfer of a Bitcoin from one wallet to another.

When a transaction of Bitcoin occurs the Public Ledgers are notified.  The transaction causes several things to occur.  Among them, the hashing on the blockchain is updated, there is a proof of work, and if all of the math checks out, then the Bitcoin is transferred to the recipient’s wallet.

What is a wallet?

A wallet is exactly what is sounds like.  It is a person’s repository of Bitcoin.  Wallets are held at recognized exchanges online.  Something like a deposit account, but with no rules and no FDIC.  Importantly, the wallet doesn’t actually hold anything.  Rather, the wallet is simply something a Bitcoin is assigned to in a Blockchain.  A bit like signing your name on a bike and then letting your kids play with it with the rest of the neighborhood kids.

What is Bitcoin Mining

So, to recap, there is no government regulation and the records of the transaction are on the Public Ledger that maintained by random people, including the local 14 year olds.  Why would anyone actually bother to keep the system working?  The answer is Bitcoin mining.

Bitcoin mining is the act of processing the transaction of a Bitcoin from one wallet to another.  For reasons discussed below, this takes a lot of computer power.  However, each time a transaction is processed a new block in the Blockchain is hashed and in return, the Bitcoin miner is awarded a fee in bitcoin for the work.  As more transactions are completed, these bit coin fees diminish.  These fees are the source all bit coin, including the “genesis” Bitcoins from 2008.

What is the Blockchain and Hashing

The short version is: the idea is simple but the execution is very complicated.  The Blockchain is the lineage of each Bitcoin from inception to the current owner as reflected on the Public Ledger.  Again, to over simplify, think of the Blockchain as stacking wooden blocks with a new block added everyone a new Bitcoin owner owns a particular Bitcoin.  The rub is proving ownership on a network of nodes, which is where the Hashing comes in.

You can think of the Hashing as the glue between the wooden blocks making up the Blockchain.  This where the complex math comes in and we circle back to the Bitcoin miners.

Each block gets a new Hash. If you looked at a Hash, it would look like a long string on random numbers and letters; but they act as a public encryption password for the owner of the Bitcoin.  You can (loosely) think of the Hash as a lock on a bike.

Every time a Bitcoin is transferred to another wallet the miners will process that transaction and add a new block to that Bitcoin, and that will give rise to a new Hash.  This new Hash can be though of as an additional lock on the bike.  So, if the new owner wants to access its Bitcoin it must know the prior bike lock combination and the new lock combination.  Meaning, every new transaction adds to the level of mathematical complication.

Here is why is gets harder and hard for computers to mine Bitcoin.  As Bitcoins are transferred over and over again Bitcoin miners are forced to compute more and more complex mathematics as they encrypt lock after lock. (Think bike locks on bike locks).

What is a Bitcoin?

Its very complicated mathematics.  In fact, its cryptology.  But more importantly – is Bitcoin “currency”?  Of course, currency and its production is regulated by a governing body.  Here the creation of Bitcoin is regulated by processing power of random computers to compute the complicated cryptology that I simplistically refer to as a bike lock.  Moreover, Bitcoin is mathematically designed to max out at 21 million Bitcoin.

A prevailing question is how to legally characterize Bitcoin: is Bitcoin a “currency”, a “commodity” or a “security” for the purposes of regulation by an actual government?

At this point is important to recall that the genesis of any Bitcoin is the mining process.  There is no sovereign currency that can simply be created by the acts of a citizen.  A citizen can earn a dollar, but cannot simply print a dollar.  In terms of being a security, the owner of a Bitcoin has not bought into anything other than the belief in the nodes and others belief in the Bitcoin.

Perhaps then the Bitcoin is a commodity?  However, for this or any cryptocurrency I would caution against using a legacy legal term to describe Bitcoin except for analogy.

Encryption is Key

I have glossed over a lot of the very complicated encryption that goes into Bitcoin.  Like anything complicated, it is difficult to include everything relevant in a blog post.

One thing I would like to mention is that the Bitcoin wallet has become less and less confidential.  Rather, even with Tor masking it is appearing that movement of Bitcoin can be more easily tracked by a sovereign entity, which strikes at the heart of the purpose of Bitcoin.

In meetings with senior executives and their in-house counsel, I hear this consistent cry: due to ever-increasing regulations, costs associated with compliance are soaring at commercial banks and at financial institutions that own banks (such as life insurance companies).  As a result, “regulatory cost collaboration” is becoming a key strategy for financial institutions with their key vendors.  It is a strategy that overlooks a very familiar and expense vendor: lawyers.

 

Puzzle missing legal

This omission will not last for long.

The impact of compliance costs is well documented (look at this report by Thomson Reuters; and this survey of small banks by Hester Peirce, Ian Robinson and Thomas Stratmann at the Mercatus Center [George Mason University]).

It is a story that I hear 100% of the time from senior executives.  Here are two examples:

  • Regional Bank (top 70 in asset size): it spent over $35million last year in regulatory compliance costs, such as rent, new employees, software and hardware
  • National Bank  (top 20 in asset size): the compliance group has grown from 100 employees to over 700 employees in the last several years

In response to the growth in regulations, financial institutions are striving to streamline processes, both internally and with their vendors.

In the context of third-party vendors, I call this “regulatory cost collaboration.”

Financial institutions with innovative leadership use “regulatory cost collaboration” like this:

  • the financial institution associates specific information, furnished by a specific vendor, with information needed under (or impacted by) regulations or compliance rules; and then
  • the scope of work for the vendor expressly requires performance of the vendor’s service or product in a form or format that minimizes the associated regulatory costs to be incurred by the financial institution

Vendors who implement this approach (or better yet, for a vendor who independently identifies a way to do this) are recognized as a “value-add vender” by the financial institution.

Of course, regulatory cost collaboration does not include the lawyers.

No one is surprised.

Collaboration from Lawyers: The Elephant in the Room
Collaboration from Lawyers:
The Elephant in the Room

 

Lawyers are one of the few “industries” where little has changed since I started in 1981.  “What” lawyers do and the “product” that lawyers deliver remains astonishingly unchanged since 1981.  Sure, today we have computers (and no secretaries), email (and no life) and instant access to everything (the internet is magical); and instead of paper closing binders, we e-mail the closing documents in a PDF format.

None of these changes meets my definition of the phrase “regulatory cost collaboration.”   Indeed, the changes remain lawyer-centric – even the PDF.

Unless the financial institution has specific rules governing the use of PDFs, the use of PDFs actually might be “anti-collaborative” in that it creates MORE work for the financial institution –

  • the PDF still must be “searched” in order to locate specific terms and provisions (since lawyers will “drop” a key provision in any location and in any document);
  • the PDF might not be in a searchable format;
  • even if searchable, the provision might be difficult to locate because the reader may fail to use the “correct” search term or phrases;
  • the identifier or name of the PDF itself might be unrecognizable (since it was generated by the law firm document management system); thus forcing the recipient to “open” it and then rename it

Of course, Richard Susskind and others continue to predict some sort of disruptive change, where the legal industry will deliver the product (be it paper or expensive advice) in a manner that assists Companies in conducting business.  There were numerous conferences and meetings on the topic in the past year (Harvard Law; Suffolk University Law [Kennedy-Mighell podcast summary]); and various legal tech thought-leaders closely monitor the topic (the ABA Law Practice Magazine, July/August 2014 issue is wonderful; and the ABA Legal Rebels is interesting).

Of course, nothing addresses the practical, real time (right now) need for regulatory cost collaboration by lawyers.

Yet.  Stay tuned.

If you see this differently or have something to add, please comment below.