Is bitcoin the risky option?

Shona Ray Ferguson considers the practical problems for lawyers in property transactions involving cryptocurrencies. December 2017 saw reports that two houses had been bought from a developer using bitcoin. Knowing what we know – that bitcoin is an unregulated, volatile cryptocurrency that hides the user’s identity – how can lawyers act in transactions involving bitcoin and other cryptocurrencies without inviting excessive risk? What is bitcoin? Most people are aware that bitcoin is a digital currency, existing only online. It is produced through “mining” by supercomputers, and its transactions are stored using blockchain technology, in which a transparent, immutable ledger of information is held in thousands of locations, making it extremely secure (see “Could blockchain make buying and selling property simpler?”, EG, 10 November: www.egi.co.uk/legal/could-blockchain-make-buying-and-selling-property-simpler/). The nature of mining is complex, but suffice to say no central bank controls the supply. Bitcoin is increasingly widespread: some websites such as Microsoft now allow bitcoin purchases. Some supporters believe it will replace normal currencies, but it is by no means mainstream yet. Detractors claim it is inefficient and over-hyped. For solicitors, bitcoin carries particular risks, especially in property transactions. Volatility Bitcoin is infamously volatile. From $0.10 in 2011, its value rocketed to more than $19,000 in December 2017, prompting the FCA to issue warnings about it. For property lawyers, this creates difficulties with price fluctuations. Offering to buy a property for a certain number of bitcoins might look less attractive if their value doubles in the time it takes to get a local search result. One solution is to agree the price in sterling, with payment made in bitcoin according to the exchange rate at an agreed date and time (meaning the buyer takes all the risk). This would assist the Land Registry: while it can record the price in bitcoin, it still needs a sterling value to determine its fee. In addition, the buyer could make a single payment, without a deposit. This is best done with a simultaneous exchange and completion. Otherwise, changes would be needed to the Standard Conditions of Sale, and the solicitor might advise the seller that if the sale aborts between exchange and completion, they might get no money at all. Alternatively, the bitcoins could be converted to sterling during the process, making it more like a traditional purchase. Although one would hope that clients paying in bitcoin are sophisticated users of the currency, cautious solicitors might remind their clients about its volatility and recommend financial advice. Association with criminality By acting in bitcoin transactions, could a law firm be associating itself with criminals? Academic research suggests that nearly half of all bitcoin transactions are associated with crime, most likely because the currency hides users’ identities. However, already criminals are shifting away from bitcoin as it becomes mainstream – perhaps a reflection that authorities have found ways of identifying users. Regulation might put solicitors’ minds at rest. In September, the House of Commons Treasury Committee issued a report on all crypto-assets, which strongly recommended regulation. In October, the government’s “Cryptoasset Taskforce” report promised consultations on specific issues. Despite Brexit, the UK is also expected to adopt the EU’s Fourth Anti-Money Laundering Directive, which seeks to bring cryptocurrency exchanges within the anti-money laundering (AML) regime. By bringing bitcoin into the mainstream, regulation could encourage reputable institutions to get involved, deter criminals and improve its reputation. Inefficiency Blockchain and bitcoin are incredibly inefficient because of the huge number of computers required to process them. A recent BBC report indicated that Iceland’s bitcoin mining activity in 2018 will use more energy than the entire country’s homes. While not a transactional risk, endorsing bitcoin might not help a law firm’s green credentials. Reports suggest programmers are working on solutions, so it may be a case of waiting for more refined technology. Anti-money laundering regulations The anonymity of bitcoin and its association with criminal activity mean solicitors should treat bitcoin transactions as “high risk” for AML checks. This means that, as well as verifying the client’s identity, establishing the source of funds will be critical. If the client’s funds for the purchase are held in bitcoin, how can solicitors establish a legitimate source so they can continue to act? The Law Society has no formal guidance on this issue, but an informal call to its practice advice service has yielded some useful tips. Although it stresses that a solicitor would need to consider the individual risks and how to mitigate them based on information from their client, its suggestion was to trace the money through all the relevant transactions back to a legitimate source. For example, if that source is the client’s salary, evidence could be obtained in the form of payslips, a bank statement showing the transfer to a bitcoin exchange, and trading statements from the exchange showing the trading activity and profit made. Alternatively, it suggested instructing an accountant to carry out a “source of funds analysis”, which would come at a cost. Another solution might be to act only where the client can prove they are the original miner of the bitcoins, so the solicitor can be sure there have been no criminal transactions. How they prove this is a question for a specialist IT professional. Direct payment One of the advantages of bitcoin is that, theoretically, it removes the need for trust: a transaction occurs between two individuals without the need for a bank or other mediator. Leaving aside the question of whether trust is merely transferred from regulated banks to anonymous coders, the removal of the intermediary conflicts with the standard mechanics of property transactions, which assume payment between solicitors. Examples include the Standard Conditions of Sale and the Law Society’s Code for Completion by Post and Conveyancing Protocol. These can be amended or dispensed with by agreement, but this adds to the complexity of the matter and, in the case of Conveyancing Quality Scheme accredited firms, specific client instructions would be needed to diverge from standard procedures in residential transactions. Apart from procedural issues, the solicitor won’t know whether the payment has been made, between which parties and for how much. This automatically raises alarm bells for fraud and money laundering. The solicitor could obtain evidence of the payment, perhaps from the bitcoin exchange – but it might take an IT professional to conclude that it can be relied on. A direct payment is not appropriate where a lender is involved, because the solicitor needs to be in control of the monies to effect payment of a loan or the redemption of a mortgage. Solicitors’ wallets Could solicitors open bitcoin exchange accounts, known as “wallets”, so a payment could be made through them? Possibly, although for the parties that might defeat the point of using bitcoin in the first place. It is also unclear whether bitcoin in particular will endure – other cryptocurrencies are gaining popularity and new ones are being created all the time. In any case, this would come with its own risks, not least that wallets are vulnerable to hacking. If solicitors are not mining the bitcoin themselves, how would they know that the currency they acquire is not derived from criminal activity? In the early days of bitcoin property purchases, there could be transactions where only one of the solicitors has a wallet, so they might be the only intermediary for the payment. Aside from further amendments to the contract and standard procedures, this brings into play AML regulations again, since the solicitor might want to verify the identity of both the buyer and the seller. However a solicitor arranges a bitcoin transaction, the additional complexity will undoubtedly lead to higher legal costs for the parties. How soon will law firms routinely act in bitcoin transactions? Only time will tell, but regulation might be the key. For the moment this firm is keeping a watching brief. Illegal activity and cryptocurrencies Approximately one quarter of bitcoin users and half of bitcoin transactions are associated with illegal activity The level of illegal activity is likely to be a factor in bitcoin’s value The illegal share of bitcoin activity (but not the amount) declines with mainstream interest and with the emergence of more opaque cryptocurrencies Source: Sex, Drugs, and Bitcoin: How Much Illegal Activity Is Financed Through Cryptocurrencies? published October 2018, by Sean Foley (University of Sydney), Jonathan R Karlsen (University of Technology Sydney) and Tālis J Putniņš (University of Technology Sydney and Stockholm School of Economics in Riga) Main image © Rex/Shutterstock Shona Ray Ferguson is a knowledge lawyer at Farrer & Co LLP