Have you heard? Gas prices are up.
As of early November, it cost an exorbitant $50-$94 to conduct a single transaction on the Ethereum blockchain.1 If you want to transfer a non-fungible token (NFT), the cost is as much as $190 per party to the transaction.2 On the Ethereum blockchain, the computing resources necessary to make or otherwise interact with a block on the chain, that is, the resource that makes the blockchain run, is called gas.3 The price of gas is tied to the price of Ether, the coin underlying the Ethereum blockchain; when coin value increases, the cost of gas increases, too.
In the abstract, blockchain technology is relatively easy to understand. It’s basically a log sheet on the world’s fanciest legal pad. You can think of it this way. Draw three lines vertically down the length of a legal pad. Each row is a transaction. In the first column is the sending user; the second column is the receiving user; the third column is the thing being transferred. Add a date and time stamp for each transaction. The one unassailable rule is that you are not allowed to erase any of the entries. You get paid to add entries to the log (this is the “gas”).
When you get to the end of a legal pad, you give it a unique number and encrypt it. Encryption requires a really big, absolutely unique number, and calculating the number requires a lot of computing resources and complicated math. For the use of your resources to calculate the number (called “mining”), you receive a coin.4
Now, imagine that every person in your network is also keeping a yellow legal pad on which they are recording transactions. Each time a person finishes a legal pad, you make a copy of the whole legal pad and give it to every person in the network, and each person verifies that they got it from you. On a new legal pad, note the unique number of the block – that is, the legal pad – that came before it and start all over again.
You created a blockchain. The legal pads are the “blocks”; noting the last number of the last block on the new one makes it a “chain.” It is immutable (transactions are always added, they are never removed). It is public (anyone in the world can view it). And it is trusted (everyone has verified the exact same copy; this is called “consensus”). It would be very difficult to hack this system to alter a recorded transaction.
Of Coins and Contracts
Bitcoin is a blockchain. So is Ethereum. For purposes of this article, both operate in the same way except for one major difference. In the third column on our legal pad, we noted “the thing being transferred.” On some networks you can send only one type of thing – a “coin.” A coin is simply a digital representation of value5 – just like a dime or a quarter. And just like a dime or a quarter, each coin has a value.6 For example, a Bitcoin is currently valued at $49,119.40.7 On the Bitcoin network you can only send Bitcoins (or fractions of a Bitcoin).
On the Ethereum network, “the thing being transferred” is less like a coin and more like a bottomless bucket. You can put whatever you want into that bucket. Just as important, you can continue to interact with the bucket after you register it on the blockchain. You could put a coin (or lots of coins) in it.
Put Tokens in the Bucket
A token is like a coin, except that it is not created as a reward for mining. There are two (basic) classes of tokens: security tokens and utility tokens.
Security Tokens. Security tokens are tokens received in exchange for investing in an application on the network; the process is similar to receiving stock in exchange for investing in a company. A user purchases a token (and its associated rights, if any), holds it for some period of time as its price fluctuates, then sells the token for a loss or a gain.
When security tokens are issued to fund the start of a blockchain network (or other business), somewhat confusingly, this is called an initial coin offering (ICO) even though what is being offered might, technically, be a token, not a coin. Just like in a stock raise, the company gets to use the funds raised in the token sale for whatever purposes it discloses in the investment documents.
Security tokens are regulated by the U.S. Securities and Exchange Commission (SEC) as securities. The issuers of security tokens must comply with securities regulations in their respective jurisdictions, and the platforms selling security tokens must be registered securities-trading platforms.8
Utility Tokens. On the other hand, utility tokens are not issued in exchange for investment but are issued for the use of the network (or other resource) itself. For example, a company might use a blockchain network as a platform for settling international banking transactions.9 The service might settle transactions very quickly but only be able to settle so many transactions in a day before it starts slowing down. So the company issues a token for each transaction that it can process in the day and makes a rule that only people holding a token are allowed to use the network. Utility tokens are not securities.10
Or maybe an artist puts 1,000 different unique drawings of bored apes on 1,000 different tokens along with a license or assignment of the character’s associated intellectual property rights. Each token that has an ape (and its rights) is unique; it is not a fungible good. It is, therefore, an NFT. Now, the artist can sell the tokens that each have a picture of a bored ape on it and its associated intellectual property rights. The purchaser can do whatever they want with the character – they now own it and its intellectual property rights.11 The character (and its associated intellectual property rights) is a token, in a bucket, on a blockchain. It’s no pony on a boat, but I think Lyle Lovett would be proud.
Put a Contract in the Bucket
One of the first uses for contracts on a blockchain was for flight insurance.12 In this case, the contract was straightforward – if a passenger’s flight is delayed by more than some predefined time, the passenger would receive the cost of the flight back. The contract is placed in an Ethereum bucket along with a small piece of code that detects official flight times. When a passenger purchases insurance from a kiosk at a participating airport, the flight is registered with the blockchain insurance contract, which then monitors official times; if the flight time is delayed by more than the set time, it automatically pays out. This is called “parametric insurance.”
Combine the Power of Tokens with the Power of Contracts
Consider, for example, an investment club13 that puts a membership agreement and utility tokens on the blockchain. The membership agreement says that anyone who buys a utility token can use the token to vote to collectively decide on an asset to purchase with all money raised as a result of the token sale. The membership agreement also states that each member gets the member’s pro-rata share of the proceeds when the purchased asset is sold. All token holders then vote to use the proceeds of the token sale (hypothetically, maybe it’s $47 million) to purchase an original copy of the U.S. Constitution.14 This is a decentralized autonomous organization (DAO).
Because the technology is relatively easy to replicate, new blockchain networks, DAOs, and tokens can pop up overnight. And because the technology is inherently decentralized, the networks are not necessarily based in any particular jurisdiction.15 There are real and unique legal questions posed not only by the automated nature of blockchain networks but also by the fundamentally decentralized nature of the systems and the new kinds of property that are being generated. Blockchains are commonly cited as having the potential to disrupt almost every industry, from content creation to banking to shipping to insurance.
When are tokens security tokens and when are they utility tokens? Is a DAO a corporate entity or is it more like a partnership? How can nefarious uses of this technology be tracked? What kind of oversight can feasibly be exercised over networks that are so ephemeral? Whose law should apply when networks, users, and assets are spread around the globe? How can countries work together to create a system that makes sense for such a decentralized, global technology?
The Internal Revenue Service, SEC, Federal Trade Commission, and numerous other United States and international agencies are scrambling to understand the technology and its legal implications. In the next part of this article (coming in April 2022), I will look in depth at the legal issues raised by tokens, decentralized organizations, and decentralized finance.
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1 Jamie Redman, While Ethereum Prices Skyrocket, Ether Gas Fees Surge Fueling Costly Transfers, Bitcoin.com, https://news.bitcoin.com/while-ethereum-prices-skyrocket-ether-gas-fees-surge-fueling-costly-transfers/ (Oct. 30, 2021).
2 Mark R. Hake, Fees Threaten Ethereum’s Perch as King of NFTs, InvestorPlace, https://investorplace.com/2021/10/ethereum-crypto-gas-fees-threaten-nft-king-perch/ (Oct. 11, 2021).
3 Gas and Fees, https://ethereum.org/en/developers/docs/gas/ (last updated Jan. 5, 2022) (“… every block has a base fee, the minimum price per unit of gas for inclusion in this block, calculated by the network based on demand for block space. As the base fee of the transaction fee is burnt, users are also expected to set a tip (priority fee) in their transactions. The tip compensates miners for executing and propagating user transactions in blocks and is expected to be set automatically by most wallets.”).
4 For example, a Bitcoin (BTC) or Ether (ETH), the coins for the Bitcoin and Ethereum networks, respectively. One ETH was worth $3,196.62 on Jan. 9, 2022, and the IRS considers this taxable income.
5 Coins are unique to a blockchain, so a miner on the Bitcoin network would receive one Bitcoin and a miner on the Ethereum network would receive one ETH. There are many different networks, hence many different coins. But coins are not infinite; there are only as many as there are encryption numbers generated by miners on the network over its history.
6 Unlike American currency, however, the price of a Bitcoin is set by supply and demand, not by the Federal Reserve.
7 Market price as of 4:13 p.m. on Dec. 15, 2021.
8 U.S. SEC, Spotlight on Initial Coin Offerings (ICOs), www.sec.gov/ICO (last modified July 14, 2021); SEC v. Ripple Labs, No. 1:20-cv-10832 (S.D.N.Y. Dec. 22, 2020), www.sec.gov/litigation/complaints/2020/comp-pr2020-338.pdf (unregistered securities offering); In re Poloniex, LLC, Admin. Proc. No. 3-20455 (SEC Aug. 9, 2021), www.sec.gov/litigation/admin/2021/34-92607.pdf (unregistered trading platform).
9 https://ripple.com/company (last visited Jan. 12, 2022).
10 See Release No. 81207, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (July 25, 2017), www.sec.gov/litigation/investreport/34-81207.pdf.
11 https://boredapeyachtclub.com/#/ (last visited Jan. 12, 2022).
12 Miranda Wood, AXA Withdraws Blockchain Flight Delay Compensation Experiment, Ledger Insights, www.ledgerinsights.com/axa-blockchain-flight-delay-compensation/ (Nov. 11, 2019).
13 U.S. SEC, Investment Clubs and the SEC, www.sec.gov/reportspubs/investor-publications/investorpubsinvclubhtm.html (last modified March 20, 2018).
14 Nilay Patel, From a Meme to $47 Million: ConstitutionDAO, Crypto, and the Future of Crowdfunding, The Verge, www.theverge.com/22820563/constitution-meme-47-million-crypto-crowdfunding-blockchain-ethereum-constitution (Dec. 7, 2021).
15 Thousands of mining nodes are scattered across the world on just the Ethereum blockchain. Etherscan, Ethereum Node Tracker, https://etherscan.io/nodetracker (last visited Jan. 12, 2022).
» Cite this article: 95 Wis. Law. 14-16 (February 2022).