Demystifying Cryptocurrency for Lawyers

Episode Notes

Transcript

[Music]

Intro: Welcome to the State Bar of Texas Podcast, your monthly source for conversations and curated content to improve your law practice with your host, Rocky Dhir.

Rocky Dhir: Hi, and welcome to the State Bar of Texas Podcast.  One thing that adulthood has taught me is that I suck at identifying the next viral trend.  It’s true.  Here’s a true story.

Back in college, in the early 90s, I remember thinking how dumb it was when other students were talking about this thing called email.  Seriously, I was one of the last ones to adopt it.  I was like, why not just call someone or drop them a note under their door?  Remember that?  Or like, the Internet.  Oh, this seems kind of silly.  I seriously thought these things.  Back in to 80s.  Remember Cabbage Patch Dolls?  Remember those?  Okay, those actually were kind of stupid.  And honestly, they were kind of creepy if you ask me.  But I missed all of those.  I also missed another one at that time that I neither understood nor kind of appreciated.  It was called Bitcoin.

You might remember that back in 2009, I remember hearing and reading about it and thinking, this just sounds like another newfangled gimmick.  Boy, was I wrong.  Had I bought a few Bitcoins back then.  This podcast would have had a different name.  Tales from the Crypto.  Okay, sorry.  You know, guys, let’s talk seriously for a second.

Cryptocurrency is now part of our vernacular.  You might have heard of Bitcoin, Ethereum and Doggone that coin with the dog on it.  Okay, you know what?  I couldn’t resist.  There’s just too much material with this.  But maybe I should invent my own cryptocurrency.  It’ll be the dad coin.  Also known as the Punisher.  Okay, I’m going to stop now.  Okay, we need to get down to business.  Nelson Ebaugh from Houston is a board certified criminal appellate law specialist, and he holds an LL.M. in securities and financial regulation.  His article on cryptocurrency appears in the May 2023 edition of the Texas Bar Journal, and it’s worth a read.  I highly recommend it.  In it, he walks us through an overview of cryptocurrency and the efforts underway in Texas to regulate it.  That’s right, lawyers.  We have to finally pay attention to cryptos, not just as a possible get rich quick scheme, but as part of our day jobs.

So, let’s talk with Nelson a little more deeply about cryptocurrencies and how we regulate them.  So, Nelson, welcome to the podcast.

Nelson Ebaugh: Thank you.  Glad to be here.

Rocky Dhir: So, you know, I must confess that I know vaguely what cryptocurrency is.  And I know, my friends always sit around, they talk about what the next crypto is and what to invest in.  And then all that sounds great because we all want to make money and figure out a shortcut to success.  But your article was very generous and that it actually gives a bit of background on what these things are and kind of how they came about.  So, thank you for that upfront, but let’s kind of talk about some of those basics, because as you know, lawyers don’t always learn the backgrounds.  We just want to know what it means to our practices.  So, Bitcoin, as I understand, was the first cryptocurrency.  What is a Bitcoin, how is it made, and what exactly does it represent?

Nelson Ebaugh: Good question.  As explained in the article, Bitcoin actually kind of started as an anarchist project.  After the 2008 financial crisis, people were really disenchanted with the big banks and really frustrated that these large banks were getting bailed out.  And so, an anonymous person or an anonymous group came up with an idea for an alternative that would skip the middleman.  In other words, skip banks.  There’s an interesting comparison I’ve heard repeated a number of times here in the United States, we’re used to talking about separation of church and state.

Rocky Dhir: Right, right.

Nelson Ebaugh: The object of Bitcoin and cryptocurrency is to likewise separate currency from state.  Separate currency from government.

Rocky Dhir: Okay.  So, I was always raised to believe that the government backs up the currency which gives it an inherent value.  It used to be the gold standard, and then it eventually became the currency itself or the backing of the government.  How do you know what a Bitcoin is worth?  I mean, I know that the value keeps changing, but how do you value a Bitcoin given that we don’t know there’s nothing backing it up?  There’s nothing to say, “Hey, this government is backing it, or this particular security is backing it, or this collateral is backing it.”  How do you know what a Bitcoin is ultimately representing?

Nelson Ebaugh: That’s a good question.  First of all, I want to give this disclaimer.  I am crypto agnostic.

Rocky Dhir: Sure.

Nelson Ebaugh: I have no idea if this is really going to succeed decades from now or if it’s going to be a complete waste of time.

Rocky Dhir: Sure.

Nelson Ebaugh: You know, who knows?

Rocky Dhir: Right.

Nelson Ebaugh: But basically, I would suggest that whenever Bitcoin goes up in value, that indicates a whole lot more trust in the system.

(00:05:05)

You’re right.  There is nothing that backs up one Bitcoin.

Rocky Dhir: Sure.

Nelson Ebaugh: It’s not like 50 years ago when the dollar, US dollar was pegged to a certain amount of gold.  It’s not like that.  The value of Bitcoin, it just depends upon how much trust people have in the system.

Rocky Dhir: And which system is that?  Is it this kind of ephemeral concept of people out there who are trading in Bitcoin?  Are we trusting in that?  Because we’re not trusting the banking system.  That was the reason Bitcoin came about, right?

Nelson Ebaugh: Right, right.  There’s a pushback against the banking system.  So, it’s just a trust in the fact that millions and millions of other people throughout the world will continue to use this as a type of currency.

Rocky Dhir: Interesting.  Okay.  And then, do you know how Bitcoin is made?

Nelson Ebaugh: Well, the way Bitcoin is added to the system is that there are miners out there, and these miners are verifying transactions, and there’s an incentive system built in there.  And if you succeed and are the first one that’s able to verify these transactions, then you are rewarded by the issuance of new Bitcoin.  And I have to admit, because I don’t have a deep background in intellectual property.  I can’t go into the exact details of it.  I’m just giving the layman’s explanation of it.

Rocky Dhir: That’s okay.  I’ve not known anybody who can actually give a full explanation of it that helps me understand it.  I’m like, I need Bitcoin for dummies, and it just doesn’t exist.  You have to be pretty smart to figure this out.

Nelson Ebaugh: Well, what’s interesting is that for lawyers, though, you don’t really have to understand the verification process to understand 99% of how it operates as far as what lawyers need to know.

Rocky Dhir: Okay.

Nelson Ebaugh: If I can back up a step, let me explain to you a little bit about the blockchain.

Rocky Dhir: Yes.

Nelson Ebaugh: Because if I can explain the blockchain to you, then I think the whole concept of cryptocurrency is a lot easier to understand.  I think the best analogy to use is think about, for instance, I’m here in Houston, Harris County.  In Harris County, we have real property records, and the real property records have records of all the real estate transactions going back for 150 years plus.

Rocky Dhir: Sure, sure.

Nelson Ebaugh: That is a record of transactions.  And it’s very difficult to change that record of transactions.  With blockchain, think about 10,000 plus different copies of those records in different locations throughout the world.  That’s what the blockchain is like.  It’s a distributed record that everyone agrees is correct.  So, if you have 10,000 copies of the Harris County real property records spread out throughout the world, and everyone agrees that those are accurate, it’s kind of a trustless way of keeping records.

Rocky Dhir: Got it.

Nelson Ebaugh: Does that make sense?

Rocky Dhir: Well, I understand what you’re saying.  I think for a lot of lawyers, we’d say, “No, it doesn’t make sense.”  But I understand what you’re saying and I understand the concept.  To me, it still doesn’t feel like it makes a lot of sense, because we’re always used to thinking that there’s one person or one entity or one body that is changing those records and adding new participants and recording transactions.  But if you’ve got 10,000 copies of it, how do you know which one is accurate amongst those 10,000?  Who’s ultimately in charge of keeping the blockchain accurate?

Nelson Ebaugh: There’s a consensus verification method.

Rocky Dhir: Okay.

Nelson Ebaugh: And so, now, we’re swinging back towards the miners and the verification. So, there’s a verification process, and you have to have a consensus.  The majority of people that have these over 10,000 records all have to agree it’s 100% correct.  Say, for instance, if I’m sending one Bitcoin to you, that transaction is going to be recorded on over 10,000 different ledgers at the same time.

Rocky Dhir: Okay.

Nelson Ebaugh: And so — and because it’s being recorded, so to speak, on over 10,000 different ledgers at the same time, if there’s a miner that tries to mess with the records, the 9999 other people say, “No, that’s not right”, and ignore their record keeping.

Rocky Dhir: I got you. Okay.

Nelson Ebaugh: The majority controls.

Rocky Dhir: For lawyers, I guess, we don’t have to necessarily know how these are made. We have to know how they’re regulated and how they’re to be managed once these coins as we call them exist.  Is that a pretty accurate statement?

(00:10:06)

Nelson Ebaugh: Don’t have to worry about how they’re created.

Rocky Dhir: Okay.

Nelson Ebaugh: I would leave that to the computer scientists.

Rocky Dhir: Okay.

Nelson Ebaugh: Instead, what the law is concerned with is for instance in the securities law arena, the SEC and the Texas State Security Sport, they’re concerned about people being fleeced in cryptocurrency investment schemes.

Rocky Dhir: Okay.

Nelson Ebaugh: And then as far as, for instance, in business transactions go, people are concerned about whether you can have a secured interest in a Bitcoin or not.  That’s what lawyers should be concerned about.

Rocky Dhir: We do need to talk about the regulation and I want to make sure we get into that.  Let’s get an ad break and when we come back, let’s talk a little bit about the regulation not just a Bitcoin but of all cryptocurrencies.  We’ll be right back.

[Advertise]

Rocky Dhir: So, guys, recently I was reading Clio’s legal trends report, and I found something surprising.  There’s a lot of turnovers in the legal profession due to work life balance issues, so I brought with me Joshua Lenon, Lawyer in Residence at Clio, to talk to us more about this.  So, Joshua, what’s going on?

Joshua Lenon: Bottom line is, firms that want to stick together need cloud-based legal practice management software.  Lawyers using cloud-based software were 29% more likely to be happy in their professional lives, 34% more likely to be happy working at their firm, and they’re 27% more likely to perform well at their jobs.

Rocky Dhir: Wow.  Happy lawyers, happy lawyer, happy life.  Who knew?  So, Joshua, if I want to dig into this a little deeper, where do I go?

Joshua Lenon: Oh, we make the report free for everyone at clio.com/trends.  That’s C-L-I-O.com/trends.

Rocky Dhir: The Texas Lawyers Assistance Program provides confidential help for Texas lawyers, law students, and judges who have problems with substance use and mental health issues.  TLAP offers 24/7 confidential support and can connect you to peers and providers for assistance.  TLAP can also connect you to the Sheeran-Crowley Lawyer Wellness Trust which provides financial help to Texas lawyers, law students, and judges who need treatment for substance use, depression, and other mental health issues but can’t afford to pay for services.  Call or text TLAP anytime at 1800-343-8527.

And we’re back with Nelson Ebaugh from Houston talking to us about cryptocurrencies and the law and specifically about regulating cryptocurrencies.  Now let’s talk about the regulations.  So the first question, I think for a lot of lawyers if this sounds so decentralized, you’ve got people saying, well, we’re doing this and the blockchain is based on what.  What all the blockchain user, the 10,000 people as a kind of amorphous term agree is an actual transaction.  It seems to be all very decentralized.  Can we regulate these bitcoins, these currencies, I should say these cryptocurrencies or the transactions involved in cryptocurrencies?  So is regulation even possible?  Becomes I think a threshold question.  What’s your view on that?

Nelson Ebaugh: Absolutely, it’s possible.  But right now, there’s a turf war and probably the biggest example of that is the turf war between the SEC, Securities Exchange Commission and the CFTC, the Commodities Future Trading Commission.  Cryptocurrencies arguably depending upon how they’re used and structured can fall under either agency’s jurisdiction.  But neither one has complete authority over cryptocurrency.  It’s hard to believe but believe it or not there are derivatives on Bitcoin and so those are regulated by the CFTC.

Rocky Dhir: Okay.

Nelson Ebaugh: Now, the SEC they feel that a lot of cryptocurrencies, I’m not talking about Bitcoin or Ethereum right now at least a lot of what are code called “altcoins”.

Rocky Dhir: Okay.

Nelson Ebaugh: A lot of these altcoins tend to resemble securities.  The word securities is a term of art that has been defined by congress and interpreted by the U.S. Supreme Court.  And under these interpretations, the SEC has claimed that a large number of cryptocurrencies are actually securities.  So you have this system where you have the SEC regulating some of the cryptocurrencies and you have The CFTC regulating the cryptocurrencies in a different context.  And people that issue these cryptocurrencies, they want some regulatory clarity to know whether they have to abide by the CFTC’s rules, by the SEC’s rules.  And of course, they don’t want to abide by both because they would just be adding additional expense that they want to avoid.

(00:15:02)

Rocky Dhir: They’d have to hire lawyers so we want them to follow both.  But no, I get you.  I understand.  Is there any federal legislation or any state legislation that kind of helps to further define this and further narrow down how this is going to be enforced and regulated or is this still I mean, you said there’s a turf war, but couldn’t that be solved if there was some kind of legislation that came down from congress to kind of say, hey, here’s how the U.S. is going to handle these types of currencies and the transactions derived therefrom?

Nelson Ebaugh: Absolutely.  I mean, if congress passed a law defining this it would make things a lot simpler.

Rocky Dhir: There’s nothing underway.  Nothing underway in that direction.

Nelson Ebaugh: There are proposals.

Rocky Dhir: Okay.

Nelson Ebaugh: Yeah, there are proposals but no law has been passed by congress yet to regulate this so there are things that are being considered.  Nothing adopted yet.  Nothing passed yet.

Rocky Dhir: So your article talks about the efforts to regulate here in Texas.  You talk about some of the Texas agencies.  You talk about the Fifth Circuit Court of Appeals.  It talks about it from a more Texas oriented standpoint which makes sense because it’s in the Texas Bar Journal.  But what do you think will happen with these types of transactions as more and more states and actually more and more countries start to regulate crypto?

I mean, in essence could we start having turf wars between say the E.U. and the U.S.  Or the U.S. and countries in Asia over how these are going to be regulated and how you manage cryptocurrencies and cryptocurrency derived transactions.  What happens then?  Has there been any thought leadership on that type of turf war?

Nelson Ebaugh: Absolutely.  In fact, that’s a really big issue right now.  A lot of cryptocurrency companies that operate in the United States are incredibly frustrated by the slow pace that legislatures that congress has taken towards regulating the industry.  So it’s interesting, for instance, in the SEC there’s five commissioners in the SEC and these commissioners help set policy for the agency and some of them are more interested in protecting the development of cryptocurrencies than others.

Some of them think that there should be some room to breathe for these cryptocurrencies so that they can naturally develop and so the United States can be a leader in this new innovation.  However, there’s other commissioners that feel that cryptocurrencies just simply rife a fraud and that the fraud should be stamped out as soon as possible so they kind of pull a different direction.

Rocky Dhir: We’re going to talk a little bit more about these regulatory efforts especially the ones in Texas.  And if we can, we’ll talk about maybe some of the more national issues as well.  We do need to take another ad break and when we come back, we’re going to talk a little bit more deeply about that.  So we’re going to be back in just a few seconds.  And then continue this amazing discussion with Nelson Ebaugh.  We’ll be right back.

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Rocky Dhir: Okay.  And we are back with Nelson Ebaugh.  So this has been an eye opening discussion on cryptocurrencies.  I wish I knew more about it and I wish I was smart enough to understand it but at the end of the day that’s why I went to law school, people.  I don’t want to have to deal with this kind of high-tech stuff.

Now, your article talks about the Texas approach to regulating cryptos and what’s going on here.  I want to talk in just a little bit about anonymity and there’s this thought that a lot of criminals are using cryptocurrencies to try to get away with under the table types of transactions.  But before we get there, as I understand it and as I understand your article, the Texas authorities aren’t regulating the currencies themselves.  But rather the transactions that involve the currencies.  Is that an accurate reading or did I misread you?

(00:20:00)

Nelson Ebaugh: I’d say on the whole that’s accurate.

Rocky Dhir: Okay.

Nelson Ebaugh: Yeah.  For instance, the Texas State Securities Board, they’re vigorously enforcing the state securities laws to stamp out fraud with regard to investments involving cryptocurrency.  It’s interesting for one reason or another, they have decided that they’re not going to try to decide whether any particular cryptocurrency is a security or not.  But, yeah, the Texas State Security Board, they’ve been a leader in the nation as far as bringing enforcement actions against fraudulent investments in cryptocurrency.

Rocky Dhir: When you talk about the blockchain, it sounds very decentralized and that people can kind of — they might be able to do a cryptocurrency type transaction and then it just becomes untraceable.   Nobody can find them.  And I think there’s at least the thinking from a lot of sectors is that this is just a way for people to commit crimes by using these currencies as opposed to using actual hard government backed currencies.  Can you talk a little bit about that?  Is this really a way for people to do anonymous transactions that law enforcement can never trace and track?

Nelson Ebaugh: A couple of weeks ago I was visiting with some law students and I was talking to them about cryptocurrency, and it’s interesting.  Apparently one of the big things to use cryptocurrency for in college nowadays is to buy a fake ID.  And that’s not the only illicit items that are purchased with cryptocurrencies.  You’ve probably heard about silk road, which is a website where you could purchase narcotics and other illegal items on the dark web.  And then unfortunately, people that sell child pornography a lot of times will use cryptocurrency to accept payment because they feel it’s untraceable.  Anyway, the bottom line is that nothing could be further from the truth.  The blockchain, as I mentioned to you earlier, it’s over 10,000 ledgers.  They’re all identical.  And by the way, they’re all searchable.

Now, for instance, if I send you one bitcoin for me to you, I’m going to send it from a coded account that doesn’t have my name on it, and then I’ll send it to your name that has a coded account and it doesn’t have your name on it.  But once investigators figure out which coded account is associated with Nelson Ebaugh and which coded account is associated with you, it’s like having your Bank of America bank statement available on the internet.

Rocky Dhir: And how do they figure out the coded name that we’re using?

Nelson Ebaugh: The government, from what I understand right now, the United States government is essentially putting together an enormous phone book.  And so they see all these thousands and millions of addresses, bitcoin addresses.  And whenever they figure out that this coded address is associated with this person.

Rocky Dhir: Is there the potential for identity theft?  Somebody steals my coded address and then goes about doing things with it, and then I get blamed or it, or they steal from me by doing that because in normal banking transactions, we’ve heard of banks getting hacked and accounts getting hacked.  Can that happen with the blockchain and with cryptos?

Nelson Ebaugh: Yes, it can.  And unfortunately, it’s happened periodically.  Of course, people that want to stay in business handling cryptocurrency accounts, they’re taking great efforts to protect their accounts, but they’re not always foolproof.  So sometimes these hacks do happen.  But just because, for instance, someone knows your Bitcoin address, that doesn’t mean that they can access any of your bitcoins unless they have a private code to activate it and to operate it.

Rocky Dhir: Is there a way they can hack my system and get that private code, or is there a way for them to reverse engineer and get that?  The reason I ask is I’m thinking, is this the next frontier?  Is this a current frontier in cryptocurrency-related fraud?

Nelson Ebaugh: Well, probably not, because the code my understanding is it’s very hard to get the access code to a Bitcoin account.  Now, mind you, people will have their code, and maybe they’ll keep it in a drawer in their home office desk.  And as long as no one has access to it, it’s virtually impossible to break into their account.  But then as soon as somebody does find it in your home office drawer, it’s all over.  Then they can have complete access to your account.

Rocky Dhir: So that code is sitting.  That’s actually a physical piece of paper you guard and make sure it stays safe from prying eyes.  That’s not something that’s floating around on the internet unless you have chosen to put it there.

Nelson Ebaugh: Yeah, absolutely not.  They call it a key, and that key, in fact, it doesn’t have to be on a piece of paper.  You can memorize it if you have a memory that’s good enough to remember a code that’s probably over 10 digits long.

(00:25:04)

Rocky Dhir: Got it.  Okay.  Yeah.

Nelson Ebaugh: That’s not as big a deal.  What’s a bigger deal is when, in my opinion, is when the government or anyone else discovers which Bitcoin address is associated with your identity, then all your transactions are open for the entire world to see.  Because this blockchain that I was telling you about, kind of like the Harris County deed records.  Anyone in the entire world can go and view them and see all the transactions you’ve done in the past.  It’s fascinating.  There’s what’s called Blockchain Explorer.  A Blockchain Explorer, you can go onto the Internet and view one, and you can actually see all the transactions that are occurring.

You’ve probably seen the Matrix movie.  Remember the opening scene where you have all those numbers coming down in a cascade?  That’s what it looks like when you look at a Blockchain Explorer, you can actually see the blockchain being built, and each transaction that comes through is another series of numbers that’s falling down across your screen.  And so you can actually see the blockchain being built.  Not only that, you can see the historical blockchain that’s been made.  Like I said, it’s like a public deed record that you can go back and view at any time.

Rocky Dhir: Interesting.

Nelson Ebaugh: And understandably, the government has used this as a tool to solve crimes.  You were talking about hacks earlier.  They’re actually able to solve who committed some of these hacks or who stole a certain amount of Bitcoin by going back and looking through at the blockchain records.  It’s kind of like you could solve a real estate fraud, like who fraudulently transferred this real estate to their name.  It’s not too hard to do.  You just start your investigation by going and looking at the real property records.

Rocky Dhir: Wow.  Okay.  We only have maybe a minute or two left, Nelson.  So let me ask you this as kind of a final question.  What do you see as the future of cryptocurrency, both as a form of legal tender and from a regulatory standpoint?  Where do you see this going since you’ve studied it more than probably most of us have?

Nelson Ebaugh:  Well, for the time being, there’s going to be a lot more enforcement actions from regulators like the CFTC, SEC, the Texas State Securities Board, and other state securities board, which is understandable, because congress and legislators, they need more time to mold these issues over.  Those agencies, they need to jump on it and stop fraud involving cryptocurrency going on right now.  In the future, I certainly do expect that congress and state legislatures will start passing laws that give more clarity to how cryptocurrency transactions should be structured and operated.  And when congress and the SEC start adopting more laws and regulations, I’m sure that they’ll put in some prophylactic measures or measures to make the transactions clearer to follow in other words to prevent fraud from happening in the future.

Rocky Dhir: Well, it’s going to be an interesting thing to keep watching and sounds like I need to do some studying.  But Nelson Ebaugh, this was absolutely interesting and fascinating.  Thank you so much for taking the time to join us and for explaining your perspective on cryptocurrencies and the law.  This is cool.  Thank you.

Nelson Ebaugh: My pleasure.  Delighted.  Anytime.  Thank you, Rocky.

Rocky Dhir: And of course, I want to thank you for tuning in.  I want to encourage you to continue to stay safe and be well.  And do check out Nelson’s article in the May 2023 issue of the Texas Bar Journal.  It’s called Cryptocurrency Jurisprudence.  It is fascinating.  You’ll be glad you read it.  And if you like what you heard today, please rate and review us in Apple podcasts, Google podcasts, or your favorite podcast app.  Until next time, remember life’s a journey, folks.  I’m Rocky Dhir, signing off.