Blockchain 101

Stuart Haber and W. Scott Stornetta first outlined the concept of blockchain technology in 1991. Blockchain, as its name suggests, consists of a series of blocks that store information. It is a digital, decentralized, and unchangeable ledger that enables the recording and tracking of transactions and assets in a business network. These transactions are recorded in a network of servers called nodes. All transactions conducted within a business network are grouped into blocks and then added to the nodes. Each block is only added to a node after it is confirmed to be valid. Since it is a distributed ledger system, every person within the network has access to it, and no individual can theoretically hack the system.

The main advantages of blockchain technology are as follows:

1. It is a secure and reliable database as it lacks a central database, eliminating the possibility of hacking or fraud. Additionally, it operates as a peer-to-peer electronic transaction system without the involvement of any third party, thereby establishing its trustworthiness.

2. Although in private blockchains access may be restricted to specific individuals, transparency is generally ensured by blockchain technology as it allows all individuals in the network to access the distributed ledger. Additionally, no changes can be made to the transaction history without the agreement of all parties involved. The wide accessibility and requirement for consent from all parties contribute to the transparency provided by blockchain technology.

3. Traceability and accountability are ensured through the recording of all transactions, making it easy to verify the authenticity of the information.

4. Blockchain is a non-manual, self-operating system. Transactions can be made instantly and efficiently. Additionally, everyone must approve the transaction. Separating parties before grouping them into blocks ensures the accuracy of transaction history.

Hybrid Blockchain combines elements of both public and private blockchains. Public Blockchain is an open blockchain that allows participation from any member of the public. It is generally characterized by anonymity, facelessness, and the absence of centralized control. Examples of public blockchains include Bitcoin and Ethereum. These blockchains serve as the foundation for various crypto assets, operating without the need for a central authority.

For instance, Bitcoin is the world’s first decentralized digital currency, enabling direct peer-to-peer transactions without intermediaries. A consortium or federated blockchain is similar to a hybrid blockchain, involving both public and private blockchains. However, in consortium blockchain, multiple organizations collaborate on a decentralized network. Private Blockchain, on the other hand, is a permissioned network that only allows specific individuals to join. Unlike public blockchains, there is no anonymity and centralized control is present.

Intellectual Property 101

Intellectual Property (“IP”) is a form of property that encompasses intangible creations of human knowledge such as inventions, artistic and literary works, logos, commercial images, etc. The protection of IP allows creators to profit from their contributions. Intellectual Property Rights (“IPR/s”) refers to the legal rights exclusively granted to creators for their mental creations for a specified period of time.

IPR includes rights arising or in connection to patents, copyrights, trademarks, design rights, plant variety rights, circuit design rights, semiconductor topography rights, trademarks, trade secrets, geographical indications, and more. Among these IPRs, patents, copyrights, and trademarks are the most widely recognized forms of IPRs. In today’s digital age, protecting IP is more complex due to its intangible nature. Blockchain has the potential to clarify copyright ownership, reduce online piracy, and establish a fair market for digital property. It can also enable creators to receive compensation through crypto asset payments and smart contracts. If certain challenges are overcome, blockchain could revolutionize the IP and copyright industry.

Importance and Development of IP Rights

With the advancement of technology, almost every aspect of human life has undergone change, some of it harsh, some of it gentle. Law, like other fields, has received its share of this change and transformation, and therefore has had to, or will have to, change. The law’s close tracking of the technology sector, where new developments occur almost daily, and its adaptation to these developments play a critical role in the economic, social, intellectual, and technological advancement of societies. Since its emergence, humanity has survived and taken its place at the top of the food chain thanks to its more advanced and complex intelligence structures compared to other species. It has fathered many technological and intellectual products that have fundamentally shaken social life, with some empires rising through these products while others have fallen behind in these areas and thus found their place in the dusty pages of history.

The precious and indispensable role of technological and intellectual products in human life was eventually recognized, and they began to be protected and encouraged. In ancient times, intellectual leaders protected and supported scientists and literary figures, while today, under intellectual and industrial rights, the promised gains and efforts of these individuals are sought to be protected both in national legal systems and in international law. A beautiful example of this is the second paragraph of Article 27 of the Universal Declaration of Human Rights, adopted by the United Nations General Assembly on December 10, 1948, and later approved by the Grand National Assembly of Turkey: ‘Everyone has the right to the protection of the material and moral interests resulting from any scientific, literary, or artistic production of which he is the author.”

Humankind, driven by curiosity, needs, and the urge to surpass its rivals, has produced and will continue to produce countless works. To encourage people to create new works and to protect their efforts, lawmakers have granted certain rights and freedoms to these works and their owners. These are broadly categorized as copyright and industrial property rights.

Although it is essential to protect the intellectual products of humankind, not every intellectual product can or should be protected; because every protection granted to the work and its owner actually restricts the freedoms of third parties. This is precisely why regulations have been established to determine which intellectual products can be considered works and benefit from copyright protection or industrial property rights such as trade mark, patent, etc.

Where do Blockchain and Intellectual Property Meet?

The relationship between blockchain and IPRs is mutually beneficial. On one hand, IPRs safeguard blockchain, while on the other hand, blockchain can improve the effectiveness of the IPRs system.

The blockchain can improve the system of IPRs by serving as a technology-based registry. This would enable IP owners to store encoded electronic proof of their ownership and use the network to receive royalties from those who use their work.

The lengthy approval processes of patent and regulatory authorities can pose a risk to industries that need to protect their inventions and stay competitive. Decentralized registration platforms using blockchain technology can simplify the process of enrolling new IPs, making revisions, and exchanging ownership. This can help regulatory organizations achieve more with limited resources.

When copyrights exist automatically and do not require registration, creators often struggle to keep track of their own work and establish ownership. This can make it difficult for third parties to obtain the necessary licenses and for creators to monitor the usage of their work. Additionally, creators may face challenges in preventing infringements and effectively monetizing their creations. The complex process of approving and defining IP ownership across different countries further complicates the issue. Registering works on a blockchain can provide definitive proof of copyright ownership since the data entered into a blockchain cannot be lost or altered. This would allow anyone to access information about a work’s ownership history, including licenses and assignments.

In order to protect IPRs, the IP system needs to be very powerful. Transparency and verification are important for a strong IP policy. Third-party multifactor authentication is used in some jurisdictions to monitor these rights, with most of these verification systems being run by governmental or institutional organizations worldwide. However, the scattered nature of the data can lead to a lack of synchronization and accuracy. Using blockchain technology can greatly benefit global IP offices in keeping track of their IP registrations.

The important aspects of blockchain technology include resilience, trustworthiness, immutability, productivity, and safety. These attributes can be protected by IPRs at every stage, from filing to implementation. Moreover may be used to protect IPRs themselves.

Governments or agencies in charge of IPRs often fail to adequately protect individual rights due to limitations in their systems. The rise of online sharing tools has exacerbated copyright piracy, and as the market becomes more global, the problem will worsen and require more effective solutions. Blockchain technology offers potential solutions that were previously unthinkable.

Before diving into further detail, let’s see the IP applications and blockchain technology in general.

Blockchain and Applications of Intellectual Property Law

IPRs are currently regulated locally, by government agencies and ministries in relevant jurisdictions. However, with the rise of online media and digitalization, there are challenges such as lack of transparency, piracy threats, and difficulties in fair compensation for creators. Blockchain technology can address these issues by providing a simple way to prove the existence and originality of a product, making it easy for law enforcement to detect counterfeit goods.

IPR plays a crucial role in a world that is increasingly adopting blockchain technology. Nowadays, many organizations prefer to use blockchain as the foundation for securing patents. Blockchain technology facilitates various aspects of IP, including processing IP applications, licensing, smart contracts, maintaining IP records, and enforcing IPRs. To establish a reliable IP system, it is essential to have strong, verifiable, traceable, and accountable IP records, which can only be achieved through blockchain. Unlike manual methods, where data synchronization is prone to errors, blockchain ensures the accuracy and accountability of data, thereby reducing risks and improving efficiency. The remarkable features of blockchain technology, such as immutability, security, traceability, and accountability, have the potential to bring about a revolutionary change in the field of IP.

Registration and Management of Intellectual Property Rights and Blockchain

Blockchain technology has the potential to simplify and expedite the registration process for IPRs. Currently, IP protection mechanisms like trademarks, designs, and patents require registration, which can be time-consuming and costly.

In jurisdictions like the EU and the UK, it is necessary for trademark holders to demonstrate genuine use of their trademark after registration, which is a difficult and expensive task. Additionally, registration typically only grants protection within the country where it is registered, limiting the interests of right holders in today’s global trade environment. However, blockchain technology could address these challenges by streamlining the registration procedure and reducing costs, thereby alleviating the burdens faced by IPR holders. Moreover, blockchains can help overcome technical barriers by analyzing the novelty and innovativeness of submitted works and determining their similarity to existing works through the use of external artificial intelligence software.

By consolidating national, regional, and international data into a single application, blockchain can also simplify operations for IP registration. Ultimately, blockchain has the potential to enhance IP protection by addressing the limitations and complexities associated with the current registration process. Another solution to overcome this challenge is smart contracts which can be utilized as proof of initial and subsequent use of the trademark. Additionally, these contracts can be presented in court as admissible evidence. We will be giving more details below on smart contracts.

The second use of blockchain for IP protection is managing IP contracts. Blockchain technology also has significant impacts on different aspects of IPR management. Currently, certain tasks related to managing IPRs, like licensing, identifying right holders, and investigating IP infringement, are typically done by third parties. By eliminating the need for these third parties and reducing the costs of managing IPRs, blockchain technology can once again be valuable in this area. Additionally, if the program detects that a user has used or requested to use the work, the owner can choose to sign a license agreement, which will be handled by the smart contract. The smart contract will execute the licensing agreements and collect payments for the work whenever it is used or displayed by a user, without any intervention. As a result, smart contracts can ensure that the rights of right holders are protected, their work is not used without permission, and they receive prompt and fair compensation for their efforts, all without requiring a middleman.

In addition, blockchain technology can offer various benefits to end-users. They can utilize the registration process to ensure that their use of digital resources does not violate any publicly available rights or to verify the authenticity of a product. The potential for blockchain to manage IPRs is immense. Using a distributed ledger instead of a traditional database to track IPRs can be highly advantageous. This approach would also address practical challenges in gathering, storing, and delivering evidence.

Another possibility is for IP offices to utilize distributed ledger technology to create centralized IP registries, which would be overseen by the IP office as a trustworthy authority. This would create an unchangeable record of events throughout the lifespan of registered IP rights. The ability to trace the complete life cycle of a right would offer numerous benefits, including simplified IPR audits. It could also facilitate due diligence for transactions such as mergers and acquisitions. Additionally, concerns about confidentiality for IP owners could be resolved through an optional participation scheme.

If blockchain is to be used for securing IPRs, it is necessary to establish a theoretical framework that can provide a thorough understanding of the technology, its potential applications, and the challenges it may present. A comprehensive understanding of the subject will assist in the creation of new legislation and innovative tools for the protection of IPRs. As blockchain technology becomes more widespread, industry participants and developers will need to collaborate in order to establish standards and interoperability protocols. Government organizations and IP registries, such as the European Union Intellectual Property Office (EUIPO), are actively exploring the capabilities of blockchain. It is only a matter of time before the legal system addresses the significant obstacles that may arise in the widespread implementation of the technology, such as governing laws and jurisdictions, concerns regarding data security and privacy, and the establishment of reliable rules and definitions for smart contracts within IP law and practice.

Smart Contracts and Intellectual Property

For more information please see our paper on Smart Contracts, namely In Blockchain We Trust: The Legal Paradigm of Smart Contracts Across Borders.

A smart contract is a computer program that automatically manages and carries out an event or action in accordance with a contract or agreement. In simpler terms, it is a contract that executes itself based on lines of code that define the terms agreed upon by the parties involved. These lines of code are then stored as a block in the blockchain network, making the transactions traceable and irreversible. Unlike traditional contracts, smart contracts generally are not controlled by consumers; they can submit their transactions on the smart contract. Smart contracts define rules similar to ordinary contracts, but the key difference is that smart contracts are executed automatically through code.

When it comes to IP, the process of purchasing a patent involves various steps such as inspecting the assignment and validity of the patent, negotiating a sale agreement, completing the transaction, and informing the patent offices about the transaction. These complex steps can be simplified by using smart contracts. As blockchain technology continues to advance, smart contracts can be widely integrated into the field of IPR as they promote trusted relationships with uncompromising security.

Smart contracts can help protect and manage matters like ideas and inventions related to IP. They can ensure that people who create IP get compensated for their work. Smart contracts can also keep track of who owns an IP and decide how it can be used and what rights can be attached to it.

Furthermore, smart contracts may be effectively used for keeping track of royalties. Royalties are kinds of payments that are made to the intellectual property rights holders by the user of such intellectual property. Although each royalty agreement may differ in nature, generally the owner of the IP grants permission to another party to use their work, often in exchange for a negotiated percentage of the revenue generated from that work. For example, a musician might receive a percentage of the sales from each copy of their song sold.

Last but not least, for consumers, it is essential to understand what rights have been granted under a smart contract. IP rights may not include copying, selling, or altering an IP, which means that consumers can be left with what they bought. This topic will be more clear in our following section under NFTs since smart contracts are generally used within the sale of an NFT.

Ownership of Intellectual Property and Blockchain

Blockchain can be used as a confidential platform that verifies the genuineness of IP ownership. When it comes to patents, inventors can visit a patent office to apply for patent protection. However, for copyrights, the creator must bear the responsibility of proving ownership due to the lack of official documentation. In the internet era, anyone can freely download and utilize created content. Blockchain acts as a timestamping authentication tool, allowing IP owners to store a hashed digital certificate as proof and authentication of a specific digital asset at a specific time. These hashed certificates are secure and inaccessible to unauthorized parties. Furthermore, blockchain aids in differentiating between counterfeit and genuine products through its ledger, which uncovers the true owners of these products. In today’s digitally advancing world, having a system like blockchain is crucial in providing evidence of IP ownership.

Enforcement of Intellectual Property Rights and Marketplace

Enforcing IPRs is an important characteristic, and it is especially significant as it is the final step for IP to have legal value. For IPRs to have legal value, IPR holders must effectively work with customs officers to enforce their rights. However, counterfeiting poses a major issue for law enforcement agencies, resulting in substantial costs for the IP world. As per many encountered daily cases, unfortunately, customs officers lack the necessary resources and equipment to determine the authenticity of a product as in the manners of an IP. In this case, blockchain technology can be highly beneficial by serving as a trustworthy ledger.

Storing information about items on blockchains would enable interested parties to instantly and continuously verify their authenticity, benefiting not only customs officers but also users. By having a ledger that indicates ownership, authorized licenses, and other relevant details, the entire supply chain, including consumers, can certify the authenticity of a product or an IP and distinguish it from a counterfeit. Because blockchain ledgers can contain objectively verifiable information about the manufacturing process of a product, such as when and where such product is made, as well as details about the materials used, it is possible to authenticate the provenance.

The effectiveness of the IP mechanism in protecting the rights of consumers/inventors in case of infringement is crucial. Blockchain, just like the other challenges previously mentioned, can be used to enhance the enforcement of IPRs by addressing counterfeit items and content in an IP. Blockchain has the ability to store and share data related to a brand, product, or service, including its origin and history, with the owner, buyer, or customs officers or authorities responsible for combating counterfeit goods. In addition to being a database, as mentioned above, smart contracts can also serve as a supply-chain management tool, ensuring traceability even after the product is sold. By adopting these blockchain solutions, various stakeholders can effectively mitigate IPR infringements. These solutions have gained popularity as they allow consumers to verify the authenticity of a product and provide confidence to businesses, governments, users, and insurers.

Nodes in distributed ledger technology, such as blockchain technology, record and synchronize transactions in separate ledgers. By utilizing blockchain, inventors can publish their inventions as ledgers, creating an IP marketplace. Additionally, blockchain assists inventors in locating licensees for their inventions, serving as a means of transferring IP assets.

Some of the Intellectual Property Categories and Blockchain

Trademark

For many jurisdictions, a trademark may be sought to be registered with the relevant governmental authorities for acknowledgment. A registered trademark will give its owner every legal right that they have under such applicable law. Using blockchain technology can simplify the trademark registration process and reduce the burden of evidence and administration for IPR holders and offices as aforementioned. This would also be applicable for maintaining registered IPRs, particularly in jurisdictions where additional evidence of use is needed for maintenance, renewal, or incontestability of a right.

As per blockchain technology, gathering data about the use of a trademark on a blockchain ledger would allow the appropriate officers of the relevant intellectual property registry to be notified quickly when the trademark is used. This would provide reliable evidence and information about the actual use and frequency of the trademark, which could easily be shared and accessed on the official trademark register. In fact, using blockchain could potentially lead to shorter and more concise trademark specifications for goods and services.

If blockchain technology is deemed legally acceptable, it could simplify the process of providing evidence of trademark use. This technology could also create a smart trademark register that reflects the state of the market, which is important for assessing infringement risk. However, trademark owners may have concerns about the confidentiality of their data. The newest generation of blockchain technology can address these concerns by combining public and private elements, or by making data sharing optional. Implementing this system may require a significant upfront burden for trademark owners, which could reduce its adoption if it is voluntary. However, the benefit of having instant access to information could save time, resources, and money for trademark owners.

Patents

Blockchain technology has generated a lot of interest, leading to a significant number of patent applications. Initially, most of these applications were made by financial institutions, but now there is a growing trend of applications from various industries. China is leading in terms of the number of blockchain and distributed ledger technology patent applications filed, surpassing the US. Although few patents have been granted so far, it is expected that applicants will face challenges in proving the patentability of their inventions.

A product that falls under the patent laws, must obtain a patent registry, in order for acknowledgment. And this patent registry is considered and has to be made from jurisdiction to jurisdiction. E.g: as a rule, if you have obtained a patent registry in Türkiye, you will need to apply for another registry in the U.S. However, there are patent registry applications that allow an IP owner to apply for a collective registry for patents in other jurisdictions. As we consider this, the patent registry is highly costly and challenging, due to jurisdictional applications of IP and IPR transfers since the requirements of a local law differentiate severely.

Blockchain technology has the potential to be utilized alongside certification marks to verify that products meet specific criteria or standards. This would help to quickly identify fake certificates, benefiting both trademark or patent owners and consumers. However, due to varying national requirements, it may be more suitable to use permissioned blockchains rather than open blockchain solutions for certification trademarks or patents, as the entity owning the trademark or patents may be “competent to certify”.

To obtain a patent for blockchain technology, applicants must show that it is unique and innovative. Patent applications for blockchains must be carefully worded to cover patentable subject matter and not violate restrictions on patenting business methods and computer programs. Ideas that are abstract or lack a technical effect may not be eligible for patent protection.

For example: in the case of Alice v CLS Bank, the US Supreme Court ruled that patents for computer-based escrow systems were too abstract to be considered valid as a patent. The court did acknowledge that certain additional elements could make an abstract idea eligible for a patent, but it did not provide clear guidance on what those elements might be. After this decision, US federal courts have ruled that numerous computer-related inventions are not eligible for protection because they are too abstract for patent protection. This makes it harder to obtain a patent and increases the likelihood of competitors challenging the validity of already granted patents.

There is concern that the race to obtain patents for blockchain technology will result in patent wars. The Chinese Ministry of Information Technology and the European Commission are working on blockchain standards that may lead to the creation of standard essential patents, which must be licensed on fair and reasonable terms.

There are different opinions on whether filing patents is the best way to protect blockchain technology. Some developers choose not to apply for patents due to the cost and delay in bringing their technology to market. These companies may instead rely on trade secret protection. However, for companies seeking investment, obtaining a registered patent may be necessary. Others believe that developing blockchain technology on an open-source basis will support its success by allowing interoperability.Some developers take a hybrid approach by applying for patents and then licensing them under open-source licenses. Patent pools have also been established to enable cross-licensing of patents.

Trade Secrets

Blockchain technology is well-suited for protecting trade secrets because it can encrypt data and securely store and share information. Trade secret protection has become more important recently, thanks in part to new laws in the US and EU.

Blockchain technology has the potential to help protect and enforce trade secrets by providing a way to prove that the information has been kept confidential. Traditionally, creating an inventory of trade secrets and recording who has access to them has been seen as a reasonable step to maintain confidentiality. Using blockchain to record trade secrets could meet this requirement under the EU Trade Secrets Directive and similar laws.

The use of blockchain technology can help protect trade secrets by providing a secure and immutable way to prove their existence and keeping these trade secrets confidential.. It can also impact how trade secrets are enforced and shared with third parties. Confidentiality agreements and non-disclosure agreements (NDAs) are currently the primary defense against trade secret misappropriation, but blockchain technology can enhance their effectiveness. By linking a “smart NDA” to the blockchain, confidential information can be kept secret and only accessed through the blockchain, providing proof of access. Additionally, blockchain technology can verify the signing of an NDA and confirm the identity of the parties involved. Smart contract technology can also be used to document the transfer of trade secrets to another party.

Computer Programs and Software

The leading international authority on intellectual property law matters is the World Intellectual Property Organization (“WIPO”) and its main objective is to establish and protect IPRs on a global scale. This is achieved through collaboration with nations and international organizations, aiming to create a consistent infrastructure and standards worldwide. WIPO manages 26 treaties that cover various IP concerns, including the Patent Prosecution Highway program, which requires cooperation with other IP authorities. WIPO applies to its signatories.

While some information about IP assets is publicly available, it can be challenging to gather and compile. However, blockchain technology simplifies this process by providing a unified platform where different parties can automatically submit their adherence to the appropriate authorities. This framework benefits offices such as the International Searching Authority, the International Preliminary Examination Authority, and the PCT Receiving Office, as it allows them to easily monitor registered patents, trademarks, and copyrights.

When it comes to software, specifically blockchain components, copyright laws apply. This is based on the Trade-Related Aspects of Intellectual Property Rights (“TRIPS”) agreement and the WIPO Copyright Treaty (“WCT”), which classify computer programs as “literary works” under the Berne Convention. These regulations have had an impact on international software protection. In the EU, electronic programs are protected by copyright according to Directive 2009/24/EC.

Both Article 9(2) of the TRIPs agreement and Article 2 of the WCT state that copyright protection only applies to specific expressions and not general ideas, procedures, methods, or mathematical concepts. This exception is meant to prevent the monopolization of ideas and promote technological progress and industrial development. Directive 2009/24/EC protects computer programs and their design material that can be used to reproduce or create programs.

Computer programs are made up of source code and object code. Source code is the algorithm that guides the program’s operation and is written in a programming language. Object code is the compiled version of the source code in binary machine language, which can be executed by the computer hardware. The design work done by the programmer, such as structures or organizational charts, can be translated into source code and object code to create the program. However, elements like ideas, principles, logic, algorithms, programming languages, data file formats, graphic interfaces, and program functionality are not protected by copyright.

According to Directive 2009/24/EC, software can be protected by copyright if it is considered “original” and reflects the individuality of its creator. However, the threshold for originality is relatively low in the case of software. As long as a computer program is not a direct copy or extremely basic, it can generally be eligible for copyright protection.

Based on the information provided, it seems that all computer programs in the blockchain ecosystem can be protected by copyright, as long as they are not copies of existing software. This protection includes the program’s code before and after compilation, as well as any design material used in its creation. However, the copyright does not cover the program’s execution or the underlying concept. As a result, competitors can reproduce the program’s functionality by observing, studying, and testing it. As long as they use different codes, they will not be infringing on the copyright of the original program. This suggests that copyright offers limited protection for blockchain-related software, and other forms of intellectual property protection should be considered.

The U.S’s Stance

Copyright law in the US is established by the Copyright Clause of the Constitution and is further governed by the Copyright Act of 1976, which is outlined in Title 17 of the U.S. Code. Throughout history, governments have required creators to follow certain formalities in order to protect their works. However, unlike patents or trademarks, copyright protection in the United States is automatically granted once the original work is fixed in a tangible form. Mandatory registration would be illegal and go against international agreements such as the Berne Convention and TRIPS. These requirements would contradict the idea that copyright is granted at the moment of creation.

When the United States joined the Berne Convention, it had to get rid of its own copyright formalities, such as requiring a copyright notice. This made it easier for creators to protect their work, but it also created the challenge of proving the date of creation without formal registration. Some solutions include a copyright notice on the work or mailing a copy of it to oneself and keeping the unsealed envelope. However, the U.S. Copyright Office does not recognize these methods as valid for establishing the date of creation. To file a copyright infringement lawsuit, the creator must register their right with the U.S. Copyright Office and receive a certificate of registration, which allows them to take legal action against those who copy or misuse their work.

Currently, in order to protect their work, people often have to provide evidence of copyright registration, even though it is not necessary for the creation of the right. Registration is sought after because it creates a legal presumption of ownership if done within five years of publication, which can be used as proof in a lawsuit. However, it is ironic that registering one’s work is necessary to enforce rights, even though mandatory registration is illegal according to the Berne Convention. This issue may not be resolved by blockchain technology.

According to U.S. law, trade secrets do not require registration to be protected, but certain conditions must be met for them to be legally protected. These conditions include the information being kept secret, having commercial value and reasonable efforts being made to keep it confidential. Trade secrets can be protected indefinitely, similar to trademarks. The Uniform Trade Secrets Act is a law that is adopted by most states in the U.S. It provides protection against various actions such as theft, bribery, misrepresentation, breach of secrecy, and espionage. Additionally, trade secrets are also governed by the federal law called the Defend Trade Secrets Act of 2016.

For patents, the USPTO is currently responsible for examining and publishing inventions in the US, but they are overwhelmed by the workload and this may lead to a decrease in patent quality. As a result, several initiatives have been introduced to address the issue of low-quality patents, with artificial intelligence being considered as a potential solution to reduce the administrative burden on the USPTO.

A potential use of blockchain technology is to create a decentralized patent system. Instead of submitting patent applications to the USPTO, inventors would submit them to a shared patent record. This would reduce the administrative burden on the USPTO and speed up the application and examination processes. The shared record would eventually be made public, improving the quality of patents. This decentralization could also lead to an international patent database.

There are some innovations that could be used alongside the USPTO, such as blockchain technology. Blockchain could help the USPTO combat counterfeit patents and also be used as proof of the filing date for patent applications. This technology has the potential to reduce administrative tasks and simplify the patent system.

Türkiye

Türkiye has implemented legal structures to safeguard IPRs, encompassing patents, trademarks, copyrights, industrial designs, etc. The legal framework in Türkiye adheres to global norms, and the nation is affiliated with diverse international agreements and treaties concerning IP.

The Turkish Patent and Trademark Office, also known as TurkPatent, is the primary regulatory entity responsible for supervising IP issues within the nation. If you have a desire to apply for patents, trademarks, or any other industrial property rights in Türkiye. While industrial property rights are subject to registry within TurkPatent, intellectual property rights arising from or in connection with works such as literature, cinematics, etc. do not require registry. Rights will commence from the moment the work is created without any need for a registry or application.

Türkiye has yet to pass any specific laws directly related to blockchain technology which is related to IP. However, similar to numerous other nations, Turkish authorities have been closely observing advancements in the field of blockchain and crypto assets.

Generally speaking, the utilization of crypto assets and blockchain technology in Turkey is governed by the existing financial and regulatory frameworks. The Banking Regulation and Supervision Agency (BRSA) and the Capital Markets Board (CMB) are regulatory authorities responsible for overseeing financial operations within the nation.

NFTs: Unveiling the Pinnacle of Intellectual Property in Blockchain Technology

For more information on NFTs, please see our paper Changing Paradigm of NFTs: littlefish Action NFT.

NFTs are perhaps the newest, but no less popular, of crypto-assets. Legally, there is no widely accepted definition. Given its characteristic structure, an NFT can be described as a unique cryptographic asset. NFT differs from other assets produced by blockchain cryptography in that it has no duplicate. While other cryptographic entities can be substituted for each other, NFTs are unique and singular. Therefore, one cannot replace the other. NFTs are produced in conjunction with or integrated into intellectual products such as games, paintings, photographs, etc.

NFTs are commonly perceived only in relation to intellectual property. However, any entity can be expressed in NFT form. Since uniqueness and originality are the characteristics most needed by intellectual and artistic works, producers of intellectual property products are much more interested in NFTs. This is expected to increase further. This is because NFTs ensure and protect the authenticity of a work with the blockchain. In this case, the work-as-creation character of the NFT itself and the effect of the NFT registration in proving authorship are other noteworthy legal effects.

Usually, an NFT and its associated digital asset are separate entities. The creator of an NFT project usually names the series and creates the digital assets that the NFT represents. These digital assets are likely protected by copyright law as they are considered creative works. The name of the NFT series may also be protected by copyright and/or trademark law, depending on certain criteria. When it comes to NFTs, owners can have different creative works and names available for sale. However, it’s important to note that NFTs themselves do not automatically grant IPRs. Owning an NFT is not the same as owning the actual IP assets that are associated with the NFT.

When someone buys an NFT that references art, they are usually getting legal ownership of the NFT and a license to use the digital asset associated with it. These rights are usually agreed upon through a clickwrap or browsewrap agreement in the form of a smart contract designated on the creator’s website where the NFT is bought.

Ownership of NFTs

NFTs are units on the blockchain that are not controlled by third parties and can be recreated and sent multiple times. NFTs do not provide ownership benefits like IPRs by themselves. They are meant to protect the originality and ownership of a work. Owning copies of a work does not grant IPRs, creating a dilemma for NFT purchasers.

NFT purchasers must obtain a license from the original creator or owner of the rights to replicate and share the original work of such NFT. An example of this is the NBA’s NFT of a slam-dunk video by Lebron James, which can be bought and sold on the ‘Top Shot’ market platform. However, the NBA still retains the copyrights and sets certain conditions for the license, such as not being able to change the content or captions of the video without consent. Violations of these terms can result in account suspension or removal of the NFT. The original owners of NFTs have more freedom to reproduce their work without licensing restrictions.

Copyright & NFT

The main issue with NFTs is determining whether the purchaser of an NFT has copyright ownership of the original asset or just the digital copy. This depends on the terms of the smart contract between the creator and the NFT purchasers. Copyright is legally separate from the object or file that contains the protected work. This distinction is important because copyright includes various rights that can be exercised or sold separately. Additionally, it is important to understand that the product containing the work can be sold separately from the copyright itself.

It is widely accepted that a physical or digital copy of a work can be sold without selling the copyright. Copyright law assumes that the buyer of the copy does not automatically own the copyright unless it is intentionally licensed or transferred. This is done to protect the rights of copyright holders and make sure their creative works are adequately protected.

In most cases, the copyright for a piece of artwork remains with the original creator, but the purchaser of the NFT is given limited rights to use, reproduce, and display the artwork for non-commercial purposes. The terms of the smart contract will determine whether the NFT operates as a license agreement or an agreement for assignment. In an assignment agreement, the owner of the IP transfers all rights to the assignee, while in a license agreement, the owner authorizes the licensee to use the rights associated with the IP in specific circumstances. However, regardless of the type of agreement, the original creator still retains their moral rights, which cannot be transferred.

NFTs are not to be considered artworks, as they serve the purpose of recording the creation and ownership of an asset that may, in fact, be an artwork. Rather, NFTs are a tool of cryptography, governed by a smart contract. Utilizing blockchain technology, this contract verifies the documents the existence and ownership of both digital and three-dimensional assets.

As an NFT buyer, you gain full control over the smart contract that governs the functions of the NFT. This contract registers your ownership on the blockchain, providing indisputable evidence of your possession of the asset associated with the NFT, whether it’s a stunning artwork or a valuable piece of property. It is important to note that owning an NFT doesn’t grant you copyright or control over the artwork automatically.

Copyright safeguards “the work,” but it is not synonymous with the creation or expression conceived by the author. This distinction is vital in understanding why NFTs do not inherently confer copyright. It is worth noting that the copyright is an autonomous property distinct from the work it protects.

It is widely accepted by the United States and the world at large that, from a legal standpoint, copyright is a distinct form of property from the object or file that contains the protected work. This is because copyright entails several individual rights that can be exercised or even sold separately. It is crucial to note that the object containing the work can be sold independently of all the copyright rights.

When purchasing digital art, it is important to note that unless the copyright is transferred to the buyer, they cannot make copies or derivative works of the original. Additionally, they cannot prevent others from making copies, whether authorized or not. However, owning an NFT linked to the artwork still designates the buyer as the registered owner of the original copy. Obtaining the copyright to the artwork can provide the buyer with several attractive rights, such as the right to copy, sell, and distribute the work. This is especially important if the art is to be used in future projects or activities that require copies to be made. By owning the copyright, the buyer can have a say in preventing unauthorized copying of both digital and physical art.

As a result, when someone purchases an NFT, they do not automatically obtain the copyright of the underlying asset linked to the NFT. NFT and its underlying asset are two separate distinct things. In order to obtain copyrights of the underlying asset there has to be explicit written transfer between the copyright owner and the obtainer. Thus, purchasing an NFT does not mean that you obtain the copyright.

Resale Royalties

NFTs represent a groundbreaking technological advancement, particularly in the art communities, as they provide a means for artists to receive resale royalties. By incorporating a royalty payment system directly into the NFT’s underlying “smart contract,” artists can rest assured that they will receive a ten-to-twenty percent cut of any future resales. This automated process eliminates the need for purchasers to comply with individual royalty agreements and ensures that payments are promptly delivered to the artist’s digital wallet. Overall, NFTs offer an elegant and persuasive solution for promoting fair compensation within the art industry.

Royalty is a right granted to authors of copyrightable work. Authors are entitled to have a percentage of the resale of their work. NFTs constitute a reliable way of enabling authors to track the ownership of their work and, therefore the royalty they may be entitled to.Trademark & NFT

Trademark law is applicable to the use of a mark in business to identify the source of goods and/or services and differentiate them from those of other sellers. The NBA, as a right holder, has filed a trademark application for “NBA Top Shot,” which includes downloadable virtual goods related to digital collectibles using blockchain technology and smart contracts. These collectibles feature players, games, records, statistics, information, photos, images, game footage, and highlight reels.

The sale of an NFT does not include the sale of the rights associated with it. This raises the question of whether reselling an NFT with a prominently displayed trademark would be considered infringement. To determine if infringement has occurred, the elements of direct infringement need to be examined, including whether the alleged infringer used the trademark without authorization in connection with the sale of goods and if this use is likely to cause confusion in the marketplace. However, identifying the infringer can be difficult due to the nature of blockchain transactions and the anonymous ownership of NFTs. This makes it challenging to pursue trademark infringement cases.

Sale, Licensing, and Monetization of an NFT

Sale

NFT sellers have the option to sell the intellectual property rights of the asset associated with the NFT to the buyers. However, this transfer of rights needs to be explicitly stated in the smart contract or any other agreement.

In rare cases, the original owners of NFTs can sell both the NFT and the underlying asset together. The buyer of the NFT can then use it as proof of ownership for the underlying asset. However, in these situations, it is important for the buyer to consider who truly owns and possesses the underlying asset, especially when it is a digital file.

Licensing

The person who owns the rights to IP can give permission for others to use that IP through licenses. This applies to NFTs and the assets they represent. The owner can set specific terms and conditions for the use of the intellectual property, and they have the freedom to create those conditions as they see fit.

There are two main types of licenses: exclusive and nonexclusive. An exclusive license gives the licensee complete access and use of the licensed rights, with no chance for the copyright owner to give those same rights to someone else. A written agreement is necessary to transfer exclusive rights that have economic value. On the other hand, a nonexclusive license allows the licensee to use the rights, but the copyright owner can give those same rights to other people.

There are different ways to communicate license terms for copyrighted artwork, and we have ranked them based on their likely legal validity. This refers to an agreement that is made between a buyer and seller before a purchase is made, and it is reached through mutual negotiation.

The option of a mutual agreement allows the seller and buyer to communicate effectively and come to an agreement on the terms of the sale. They can then formalize their agreement by signing a written document, which can be done electronically. This creates a contractual agreement that gives the buyer the rights to the artwork.

Including the terms of a license directly into the smart contract of an NFT is a reliable way to ensure legal compliance. This is done by incorporating the license terms into the code of the smart contract, which can be accessed and controlled by the NFT owner. It is a common practice to include license terms within smart contracts, and this can be achieved by including the terms or a link to them in the metadata of the smart contract. This ensures that each owner of the NFT is aware of and bound by the license terms.

License terms are displayed in a pop-up window when making a purchase. This option is advantageous because it requires a clear and active acceptance, like clicking a button to agree to the terms of use when buying something. This type of license, known as “clickwrap,” is generally preferred by the law compared to “browsewrap” licenses, which assume consent. Although implied consent is still considered, actively clicking to agree is a stronger indication of agreement, similar to signing a contract. However, it’s important to understand that both types of licenses only apply to the original buyer of the NFT.

The NFT sales platform provides details about the licensing terms in the listing and item description. When selling an NFT on a sales platform as a creator, you have the ability to create a captivating and informative description of your artwork in the listing. You can also include the license terms or a link to it, which allows the buyer to have all the necessary information before making a purchase. This demonstrates transparency and helps the buyer understand the terms and conditions of their purchase.

The website of the NFT creator shows the terms and conditions of their license. The creator’s website is a popular way to share license terms for NFTs, allowing for easy adjustments as the project evolves. However, there is no official agreement from the buyer, making it difficult to enforce the terms. Despite this, it is still preferable to have no disclosed terms.

When creating a license agreement, it is important to consider certain rights in order to design appropriate terms for the agreement. The summary of these points is that the person has the right to display, copy for specific purposes, create derivative works, and commercially exploit their artwork. They also have the option to share everything using Creative Commons licenses and the possibility of selling everything by transferring the copyright to someone else.

By carefully considering these rights, the person drafting the agreement can create a well-crafted and convincing license agreement that satisfies the requirements of all parties involved.

Monetization

NFTs are a significant technological advancement, especially for artists, as they allow them to receive royalties from resales. By integrating a payment system into the NFT’s smart contract, artists can be confident that they will receive a percentage of future sales. This automated process eliminates the need for buyers to negotiate separate royalty agreements and ensures timely payments to the artist. In summary, NFTs provide a fair and efficient way to compensate artists in the art industry.

Artists have the right to receive a royalty from the resale of their NFTs, known as “Droit De Suite.” Smart contracts make it easier for artists to manage this right without relying on collecting societies, giving them more control and power. It’s important to note that if the creator of the NFT is also the initial owner, they can benefit from the resale royalty.

LEGAL DISCLAIMER

THE INFORMATION PROVIDED IN THIS PAPER PROVIDES GENERAL INFORMATION AS TO THE POSSIBILITIES IN MULTIPLE JURISDICTIONS. PLEASE KEEP IN MIND THAT LAWS THAT APPLY TO THE SUBJECT HEREIN MAY DIFFER IN EACH JURISDICTION. THUS, NOTHING CONTAINED HEREIN CONSTITUTES ANY LEGAL OPINION OR SUGGESTION OF ANY KIND. PLEASE CONSULT TO LOCAL EXPERTS IN RELEVANT AREAS BEFORE TAKING ANY ACTION BASED ON ANY INFORMATION CONTAINED HEREIN.

Building solutions on the blockchain come with many legal questions that need to be answered. Legal frameworks around blockchains are constantly being updated with new laws being drafted globally.

Users, developers, and decentralized organizations need to be aware of the developments, and the legal obligations that come with participating on blockchain. This is why one of our main topics of research is to understand the regulatory landscape.

All research here are outlined in our Project Catalyst proposal. See that here:

Research

Our research covers a broad spectrum of thirteen key areas:

1. Legal status of littlefish Action NFTs: Action NFTs are our own technology. They are the records of work, stored as NFTs. What the concept. This new method of doing business, of getting paid, raises questions about its legal implications. Learn about it here:

2. Legal status of earning through Project Catalyst: There are many earning opportunities in Project Catalyst: proposals, proposal assessments, Challenge Teams, etc. What tax and other obligations earning in this environment is not obvious for all. Learn about it here:

3. Legal frameworks for Decentralized Organizations: What legal frameworks are available for Decentralized (Autonomous) Organizations? What should be considered? At what point does a DAO/DO need a legal standing? What challenges will new DAOs face if they don’t have legal standing? What legal ramifications are there for organizations and participants of decentralized organizations? Learn about them here:

4. Legal framework for tokens and coins: What regulations must blockchain projects adhere to in regards to their tokens and coins to minimize scrutiny by regulators? Security vs commodity classification and its implications. Learn about them here:

5. Legal status of smart contracts: Legal status of smart contracts, its validity and the way the smart contracts are performed are some of the crucial challenges and ambiguities that blockchain community faces everyday. Learn about them here:

6. Legal status of real world-asset backed tokens and coins: How the economic value of the crypto assets are determined is still a vague problem. Some crypto assets’ values are supposedly determined according to the value of the real world assets. In some cases, the question whether these tokens and coins may be considered as option agreements due to the classical approach of legislation in force arose. Learn about them here:

7. Legal status of the data stored in blockchains: Due to the storage of massive amounts of data in blockchain, the question whether these data could be considered as personal data or not arose. Learn about them here:

8. Crowdfunding through ICO-ITO and Crypto Assets: Due to its global nature, crypto assets and their initial offerings are inevitably suitable and convenient ways for crowdfunding. In the event that initial offering of these coins or tokens are considered as crowdfunding, the legal regulation that these offerings may be subjected to may dramatically vary. Learn about them here:

9. Taxation of crypto assets: As the amount of capital that shifts to the crypto assets and relevant platforms, states’ focus inherently shifts towards taxation of these crypto assets. Due to crypto assets’ global and decentralized nature, various serious legal problems may arise such as double taxation, income tax and VAT. Learn about them here:

10. AML/KYC Regulations: One of the most solid reasons why states tend to look sideways at crypto assets and blockchains is due its mostly unregulated status and its ability to conduct transactions between peers without need of any intermediaries. As the states’ ability to track and control transactions decrease, states tend to take more preventive measures. Learn about them here:

11. Legal meaning and status of whitepapers: During the classification of crypto assets, their whitepapers and the statements in these whitepapers are often instructive. Therefore, how the whitepapers are concluded and the possible interpretation of the meanings thereof play a vital role in the classification of these crypto assets. Learn about them here:

12. Intersection of Intellectual Property and Blockchain: As the application and usage of blockchain technologies and its derivative products, infringement of intellectual property of the relevant persons may become widespread. Even though there is no specific regulation on blockchain in many states, classical legal doctrines and rules still find application in developing technologies. Learn about them here:

13. Metaverse and Law: As the technology continues to rapidly develop, even the understanding of what is real and what is virtual becomes vague. It is observed that many people believe that real world legal norms do not apply to Metaverse. On the contrary, legal norms must be strictly taken into account. Learn about them here:

The rapid growth of the technology industry, which is becoming more global and decentralized, conflicts with current national laws that aim to provide legal certainty. The emergence of blockchain technology has the potential to change our understanding of legal norms and challenge traditional concepts of jurisdiction and territoriality. However, the blockchain’s decentralized nature and lack of regulatory principles make it difficult to reconcile with national civil law systems. Crypto assets, such as Bitcoin, have become a significant source of wealth and have attracted the interest of investors and regulated financial institutions. However, the decentralized nature of crypto assets poses challenges in terms of combating money laundering and terrorist financing. Additionally, the lack of liability regimes in technological ecosystems like the blockchain raises questions about who is responsible for damages. Understanding the role of crypto assets in money laundering requires familiarity with the underlying technology of Blockchain.

In this paper, we do our best to first introduce the concepts of Know Your Customer and Anti-Money Laundering principles with the perspective of blockchain technology and crypto assets. Our primary goal with this paper is to help members of the crypto asset community understand what risks and challenges await them.

What is “Know Your Customer”?

In the financial sector, “Know Your Customer” (KYC) is a standard procedure that businesses use to confirm the identity of their clients. Basic personal data like name, date of birth, address, and picture ID are usually gathered and verified as part of the process. In more comprehensive situations, it might also involve financial evaluations, transaction monitoring for anti-money laundering reasons, and background checks.

KYC guidelines are applied as a form of policy by businesses, often in the financial sector, allowing them to avoid money laundering or fraud activities that can take place through the use of their products and services. In the simplest of terms, this is done by knowing who the customer is through a process of their identity.

KYC guidelines came about in the 1980s, however, after a rise in money laundering and terrorist activities, further integrating into the law, KYC rules and guidelines quickly became a standard process.

Recognizing the need to protect the integrity of financial markets, governments, and international organizations resulted in the enforcement of laws requiring financial institutions to know and comprehend their clientele.

The implementation of KYC policies helps verify customer identities, reduces the risks of fraud and illegal financial activities, combats financial crimes, improves compliance with regulatory standards, and refines risk management for financial institutions. Overall, KYC has become essential for creating a secure and trustworthy financial environment.

Importance of KYC Procedures

Financial Crimes

KYC procedures’ main goal is to prevent illicit activities through financial markets. As technology continues to develop and our world becomes more interconnected, even ordinary people are now capable of making international transactions. Since the financial system gets more complicated and interconnected, so do the financial crimes. Therefore, the primary objective of KYC procedures is to combat financial crimes. By verifying the identity of their customers, financial institutions try to prevent criminals from using their financial systems and services to conduct illicit activities such as financing terrorism and anti-money laundering.

Compliance with the Law

As mentioned above, governments and international bodies agree on the need to safeguard the financial systems. In order to do that, many jurisdictions started to pass new bills about this matter. One of the prominent and early adaptations of KYC and Anti Money Laundering (AML) regulation is the U.S. Bank Secrecy Act of 1970, which was later followed by the Money Laundering Control Act of 1986. After which the PATRIOT Act of 2001 was passed. It is important to note that there is a strong connection between the attacks on September 11, 2001 on the World Trade Center and the PATRIOT Act. This terrorist attack led to a heightened focus on combating terrorism and its financing.

The PATRIOT Act was drafted in a way that aims to strengthen law enforcement and intelligence capabilities in the fight against terrorism. In order to accomplish its goals, this new act expanded the KYC requirements for financial institutions. Enhanced KYC regulations were implemented in response to the realization that traditional KYC measures were insufficient to prevent the misuse of the global financial system for money laundering and terrorist financing. Closing gaps that permitted fraudulent or anonymous financial transactions was the aim, as was making financial institutions more responsible for spotting and reporting questionable activity.

Furthermore, all U.S. financial institutions were required by the PATRIOT Act to include formal customer identification programs in their KYC processes. This required careful identity verification of customers, keeping track of the data utilized for identity verification, and, prior to forming partnerships, consulting lists of recognized or suspected terrorist organizations.

Following the events of 9/11, the vulnerabilities in the global financial system that could be used by terrorists were brought to light, which strengthened the implementation of KYC and AML regulations. This change was made possible in large part by the PATRIOT Act, which established strict regulatory guidelines to protect financial transactions from being used for terrorist or other illegal purposes.

Risk Management

KYC is not solely about combating the financing of terrorism or anti-money laundering. By assisting institutions in comprehending the financial habits of their clients, KYC improves risk assessment and management. This is especially crucial when it comes to operational, liquidity, and credit risks. Furthermore, customers are better protected against fraud, identity theft, and unlawful financial activity with the aid of KYC. KYC helps financial institutions detect and intervene in unauthorized sign-ups or transactions via stolen ID.

Challenges that Await KYC

As a result of the need and desire to prevent illicit activities in the financial systems, governmental bodies and international organizations require financial institutions to collect more and more information about their customers and their transactions. The risk of data breaches increases as the amount of data collected regarding natural persons grows. Extensive personal data collection raises the possibility of data breaches and improper use of private client information. Complying with data protection regulations such as the California Consumer Privacy Act (CCPA) in California or the General Data Protection Regulation (GDPR) in the European Union (EU) increases complexity.

Financial institutions may even frequently need customers’ express consent to collect data, so they must make sure they understand what data is being collected and how it will be used.

Secondly, while our financial systems become even more interconnected with each other and cross-border transactions become an ordinary thing to do, the sophisticated technology that is needed to effectively gather, validate, and oversee customer information may require a substantial investment.

Even though technology generally has answers to many of our problems, there are also some risks and concerns regarding technology such as accuracy, privacy, and the possibility of marginalization of those without access to such technology. According to the International Telecommunication Union, there are still 2.6 billion people in the world who do not have internet access. The fact that our technology becomes more dependent on internet access, results in our financial system being unfortunately unavailable to one-third of the entire human population.

Moreover, the technological aspect of these KYC procedures poses some serious cybersecurity risks. Financial institutions, with their vast repositories of personal and financial data, become prime targets for cyber attacks. Unauthorized access to KYC data can lead to identity theft, financial fraud, and significant reputational damage to the institutions involved. Cybercriminals can create sophisticated phishing campaigns using stolen KYC data, fooling victims into clicking on malicious links or disclosing more personal information. Through social engineering, employees who have access to private KYC data may be the target, jeopardizing internal systems. Attackers may encrypt KYC data with ransomware or other malware and demand payment to unlock it. Data breaches may cause non-compliance with the GDPR and other data protection laws, which could result in hefty fines and legal problems.

Thirdly and maybe the most challenging of all, legal compliance and complexity constitute a major challenge for the financial system. There are many new regulations and compliance issues associated with the introduction of KYC requirements. The complexity of putting in place thorough KYC procedures, the dynamic nature of financial regulations, and the nature of international financial operations all contribute to these difficulties.

Financial institutions that operate in various jurisdictions encounter diverse regulatory frameworks. AML and KYC regulations can differ greatly between nations in terms of their enforcement strategies, reporting obligations, and degree of strictness. In reaction to new financial innovations and threats, financial regulations — particularly those pertaining to KYC and AML — are always changing. Staying on top of these changes calls for ongoing awareness and flexibility.

KYC regulations frequently require an approach that is risk-based, meaning that institutions must evaluate each customer’s risk profile and apply due diligence appropriately. In order to effectively classify customers and ascertain the necessary level of scrutiny, this approach requires the development of intricate algorithms and systems, which can be a complex and subtle process.

Strong systems and procedures are needed for institutions to continuously monitor customer transactions for questionable activity. Maintaining accurate records is essential to complying with reporting requirements, which include timely submission of suspicious activity reports (SARs).

What is “Anti Money Laundering”?

Anti-Money Laundering (AML) is a form of policy, a set of rules and regulations. AML rules and regulations are followed in order to prevent entities from disguising illegally obtained money as legitimate income earnings.

AML policies cover various activities such as detecting and reporting money laundering, monitoring customer transactions, and keeping detailed records.

The Bank Secrecy Act of the United States in 1970 first introduced AML policies, however, these rules gained more application ground in the 1980s and 1990s due to concerns about drug trafficking, money laundering, and organized crime. Similarly to KYC guidelines, a rise in terrorist attacks led to even stricter AML regulations worldwide, focusing on combating terrorism financing.

The aim of applying AML policies is to prevent and detect money laundering, combat and fight terrorism and terrorist organization financing, protect financial institutions, and ensure compliance with legal standards and regulations. Therefore, oftentimes AML policies and KYC guidelines can go hand in hand.

Organizations like the Financial Action Task Force (FATF) coordinate global AML efforts, incorporating advanced technologies for better monitoring and analysis of financial transactions.

Consequently, there are four types of potential money laundering activities that can occur through the use of crypto assets. The first type involves frequent withdrawals of large amounts of cash from bank accounts, combined with frequent non-cash receipts of large sums of money into the same accounts, which come from the sale of virtual currencies on the virtual currency exchange. The second type is when a buyer anonymously offers their services online to an unknown seller, and then pays in cash for Bitcoins in a public space, with a high commission fee and no clear legal or economic explanation for the transaction, in an amount that exceeds the seller’s typical needs. The third type is when a buyer or seller uses Bitcoin “mixer” services before or after selling Bitcoins. Lastly, the fourth type involves the owner of illegally obtained Bitcoins investing in NFTs and using multiple cycles of purchasing and selling NFTs to hide the trail of illicit money.

The Blockchain and its Characteristics

Blockchain technology allows for consensus in a decentralized network without the need for external authority. It solves technical issues and addresses societal concerns of trust, authority, and consensus. A blockchain is an immutable chain of hashed blocks where transactions are recorded. This history is stored in a decentralized manner, and network nodes verify and reach consensus on transactions through a proof of work algorithm. This algorithmic consensus eliminates the need for intermediaries and gives blockchain the nickname of a “trust machine”. Transactions occur directly between participants, bypassing financial institutions, and the creation of money is determined by the protocol rather than government intervention. Bitcoin broke the idea that the government needs to manage the money supply, and its creation is built into the code through mining. As a result, various crypto assets and tokens have emerged with innovative ideas and successful ventures.

Mining is a crucial aspect of creating crypto assets, as it involves verifying transactions through a competitive process called proof of work. This process introduces economic dynamics and incentives to deter potential attackers. Miners solve complex computer problems and are rewarded with crypto assets. This also determines the rate at which new crypto assets are created. The consensus reached through this algorithm is not a true agreement but rather an incentive-driven settlement. Public key cryptography ensures secure communication.

Decentralization, a concept integral to network culture, involves the use of distributed systems that are resistant to control, censorship, or interference by any authority. This idea can also be referred to as disintermediation. In technical terms, peer-to-peer systems like Bitcoin consist of network participants who communicate directly with each other. Unlike server-to-client models, where servers hold and deliver content to clients, peer-to-peer networks do not rely on such intermediaries. It is important to note that there is a distinction between decentralization in blockchain network protocols and decentralization as an ethical, political, social, or economic goal or principle, which may or may not be supported by such protocols.

Trust is another important aspect of decentralized and open systems, but it is important to note that these systems are designed to minimize the level of trust required. The goal is to reduce trust as much as possible, even to the point of complete distrust, in order to enhance security. Unlike relationships based on trust, some crypto assets solely rely on verification rather than trust. Openness is a key characteristic of a decentralized system, as it allows individuals to freely join the network without any entity being able to stop them, unlike in traditional institutions. This concept of neutrality is particularly emphasized in decentralized systems.

The immutability of the crypto asset blockchain is essential for it to operate independently from external authorities. It relies on the concept of code that cannot be altered and is executed exactly as written.

Privacy is the ability to communicate anonymously through computer technology, allowing individuals and groups to selectively reveal themselves online using cryptography. This is particularly important in a time when the internet is being used for mass surveillance, limiting freedom. For example, in the case of Bitcoin, the entire network keeps records of transactions instead of a third party, making all transactions public. To maintain privacy in this transparent system, the computers involved remain anonymous.

Anonymity is a concept closely associated with crypto assets. Initially, various crypto assets were thought to be anonymous and gained notoriety as a payment method for illicit online markets. However, it is now possible to track transactions up until the point of exchange and uncover the identities of those involved. To prevent this, coin mixers are utilized to obscure the origin of funds. Additionally, advancements in cryptography and zero-knowledge proofs have led to the creation of more secure and anonymous digital currencies.

Who Has to Complete KYC Procedures?

Businesses subject to KYC compliance are generally banks, insurance companies, virtual asset vendors, gaming and gambling websites, payment solutions, etc. KYC compliance is also required for crypto asset service providers and Non-Fungible Token (NFT) and gaming websites.

In Türkiye, entities who must report to the Turkish Financial Crimes Investigation Board (MASAK) are obliged to perform KYC as of May 01, 2021. This is because crypto-asset service providers (CASPs) are obliged pursuant to Article 2, paragraph 1, clause d of Law №5549 on the Prevention of Laundering Proceeds of Crime. Pursuant to the Law and the applicable legislation, among the obligations of crypto asset service providers are the obligations regarding the recognition of the customer.

KYC and AML for Crypto Asset Service Providers

KYC and AML regulations quickly became relevant for crypto asset service providers and the cryptocurrency industry as of their emergence in the 2010s. This is an expected result of the nature of blockchain technology and crypto assets as there were concerns of illegal activity and money laundering.

The FATF issued guidelines in 2019 that suggested the regulation of crypto asset service providers in line with AML and KYC policies. This brought with it the regulatory compliance of CASPs wherein they are required to perform customer due diligence and monitor transactions that may be deemed suspicious. CASPs have to also keep records of transactions made by customers and report any suspicious activity to the determined authorities.

Following the FATF’s guidelines, there was a surge in applying AML and KYC practices to CASPs and many countries implemented these guidelines into their national legislation. The implementation varied across countries, with some being more proactive than others.

The United States had already been enforcing AML regulations on certain crypto asset businesses, but the FATF’s guidelines expanded and strengthened these regulations. Overall, the FATF’s guidelines marked a significant advancement in the global harmonization and enforcement of AML and KYC regulations for crypto assets that led to widespread adoption in many jurisdictions.

The US’s Approach

The United States has a wide framework of federal laws for AML and KYC regulations and their implementation. As aforementioned, the Bank Secrecy Act (BSA), mandates financial institutions to assist in detecting and preventing money laundering.

The obligations set out include record-keeping and reporting large transactions and suspicious activities by private individuals, banks, and other financial entities. For example, banks are required to report transactions exceeding $10,000 and any suspicious activities that could indicate money laundering, tax evasion, or other criminal endeavors.

This act introduced additional anti-money laundering protocols, including more stringent KYC requirements. As a result, financial institutions are obliged to implement customer identification programs to verify and maintain records of their customers’ identities.

The Anti-Money Laundering Act, which is part of the National Defense Authorization Act (NDAA), broadened the scope of the BSA even further. This act introduced significant reforms, such as enhancing whistleblower rewards establishing national priorities for AML, and countering the financing of terrorism, representing an ongoing commitment to evolving and strengthening AML and KYC efforts in the U.S. financial system.

In the U.S., while the overarching framework for AML and KYC regulations is set by federal mandates, individual states often have their own additional or specific requirements. For example, in New York, financial institutions face stringent regulations enforced by the New York State Department of Financial Services including regulations such as Part 504, which mandates banks to maintain robust transaction monitoring and filtering programs. Additionally, New York requires certain financial institutions to annually certify their compliance with these regulations.

In California, the Money Transmission Act necessitates licensing for businesses involved in specific financial services, including money transmission, and compliance with the state’s AML requirements. These often align with federal standards but may include unique state-specific reporting or operational demands. These state-level regulations often focus on areas such as licensing, compliance certification, and maintaining anti-money laundering programs tailored to the state’s specific financial landscape.

For CASPs, KYC and AML regulations are more complex and involve more than one federal law and different regulatory bodies. Digital assets and who regulates them depend on the type of asset. To summarize briefly, the Financial Crimes Enforcement Network (FinCEN) oversees digital assets for anti-money laundering and countering the financing of terrorism. On the other hand, the Securities and Exchange Commission (SEC) deals with the monitoring of digital assets that it classifies as securities as per the Securities Act and the Securities Exchange Act and the implementation of the Howey Test. Lastly, the Commodity Futures Trading Commission (CFTC) regulates digital assets that are considered commodities or derivatives according to the Commodity Exchange Act.

The Anti-Money Laundering Act expanded on what is defined as a “financial institution”. Financial institutions now include entities involved in exchanging or transmitting value that can be used as currency. This means that entities that engage in digital currencies, i.e. crypto assets, are obligated to comply with the BSA and must also register with either the FinCEN, the SEC, or the CFTC, depending on the type of assets that they are categorized as. Financial institutions are required to perform risk evaluations, establish an AML program that corresponds to the size and nature of the business itself, and establish rules for recordkeeping and reporting. Furthermore, such financial institutions, according to the PATRIOT Act must implement a Customer Identification Program (CIP), which can be called similar to KYC.

To briefly sum it all up, The U.S. Department of Treasury’s FinCEN bureau is crucial to the regulation of cryptocurrency assets for AML purposes. Exchanges and wallet providers, among other providers of crypto asset services, must register as Money Services Businesses (MSBs). These organizations have to put in place AML programs, carry out KYC to confirm the identities of customers, and report any suspicious activity. Customers who pose a greater risk, such as those involved in large transactions or operating in areas recognized to carry greater risk, must undergo enhanced due diligence.

Furthermore, it is mandatory for providers to keep comprehensive documentation of all transactions and client identification details. Through Suspicious Activity Reports (SARs) and Currency Transaction Reports (CTRs), they are required to report suspicious activities and transactions exceeding specific thresholds to FinCEN.

Besides federal regulations, state-level regulations also contribute to the complexity of operating businesses involved with digital assets. Each state may have its own set of regulations and licensing procedures, which results in varying requirements for crypto asset service providers. This diverse regulatory landscape poses challenges for CASPs to ensure compliance with both federal and state-level requirements.

The EU’s Approach

In recent years, the European Union has strengthened its regulations on KYC standards in order to combat money laundering and terrorist financing. The implementation of the Fifth Anti-Money Laundering Directive in January 2020 has been a key part of these efforts. This directive expanded the rules to include virtual currency platforms (which basically refers to the crypto assets service providers as well) and wallet providers, recognizing the importance of digital currencies in the financial sector. It also required more transparency in the ownership of companies and trusts to prevent their misuse for illegal activities. Public registers were established to make it easier to track the ownership of corporate and legal entities.

The EU introduced the Sixth Anti-Money Laundering Directive (AMLD6) in December 2020, following the AMLD5. AMLD6 expanded the definition of money laundering offenses and increased the range of criminal activities covered. It also made it possible to hold companies, not just individuals, responsible for money laundering and impose harsher punishments.

In addition, these instructions have required financial institutions and other obligated entities to not only perform initial investigations but also to continually monitor their business connections. This ongoing monitoring is crucial for identifying any uncommon or questionable transactions that may take place once a business relationship is established.

Furthermore, the EU has been giving priority to improving collaboration and the exchange of information among its member countries in order to effectively combat financial crimes that occur across borders. A move towards centralizing automated systems for identifying individuals who have bank and payment accounts is a significant step toward achieving this goal.

The EU’s regulatory changes in the KYC framework are part of a worldwide movement towards more transparency and stricter regulation in financial transactions. Financial institutions are now required to have strong systems in place to identify customers, understand their financial activities, and report any suspicious behavior. It is crucial for institutions to comply with these regulations, as non-compliance can lead to severe penalties and harm to their reputation.

It is necessary for any organization operating in the EU’s financial system to stay updated on regulatory changes and understand their significance. The EU’s commitment to fighting financial crime and ensuring the integrity of its financial markets is evident in its active and strict regulatory environment.

Moreover, the AMLD6 aims to strengthen existing laws and regulations by requiring due diligence on customers, transparency of beneficial owners, and regulating anonymous instruments like crypto-assets and crowdfunding platforms.

AMLD6 was created to expand on the 5th Anti-Money Laundering Directive. The new Directive aims to improve supervision at the national level and access to information related to money laundering.

The Directive introduced the creation of the European Anti-Money Laundering Authority (AMLA). The AMLA would be granted powers to supervise and investigate high-risk entities for compliance with anti-money laundering and counter-terrorism financing measures. Banks, asset managers, and real estate agents have to check the identities of their customers and evaluate the potential risks of money laundering and terrorist financing.

This new authority is expected to improve the effectiveness of the efforts to combat money laundering and terrorist financing by creating a system that integrates national supervisors and ensures that entities in the financial sector comply with their obligations.

The authority will also support efforts in non-financial sectors and coordinate financial intelligence units in member states. The Authority will impose financial penalties on obligated entities that repeatedly and seriously violate the requirements, in addition to its supervisory powers, to ensure compliance. The temporary agreement grants AMLA the authority to directly oversee specific credit and financial institutions, such as CASPs, if they are deemed high-risk or operate internationally. AMLA will oversee a group of high-risk credit and financial institutions in multiple member states. They will supervise these entities through joint supervisory teams, conducting assessments and inspections. The agreement allows the AMLA to supervise up to 40 groups and entities in the initial selection process. Supervision for entities not chosen would mainly be done at the national level for anti-money laundering and counter-terrorism financing.

The FATF’s” Travel Rule” which mandates that crypto asset service providers gather and exchange transaction parties’ personal data for transfers exceeding a specific threshold, is also being implemented by the EU.

FATF’s Approach and Travel Rule

The Financial Action Task Force (FATF), an international organization that establishes guidelines for preventing money laundering and the funding of terrorism, has proposed the “Travel Rule”. It is formally known as Recommendation 16 in the FATF’s guidelines. The Travel Rule, which was first implemented for conventional financial institutions, has been modified to encompass the crypto asset industry and their CASPs.

In accordance with the Travel Rule, financial institutions must provide specific details about transactions and the parties involved to the financial institution following them in the transaction chain.

The names, account numbers (if applicable), physical addresses, national identity numbers, dates and places of birth, and originator and beneficiary (recipient) information must be gathered and sent for each transfer of funds that exceeds a predetermined threshold (first set by FATF at $1,000 USD/EUR). In order to help identify and stop money laundering and the funding of terrorism, the rule attempts to increase the transparency and traceability of financial transactions.

Wallet providers, and crypto asset service providers must put in place systems to gather, store, and send the data needed for transactions that exceed a certain threshold. This is a major technological and operational challenge, especially considering that many blockchain transactions are pseudonymous. It is necessary for CASPs to create or incorporate new technologies that can manage the safe and effective transfer of transactional data along with customer information.

In conclusion, the FATF’s Travel Rule’s implementation in the crypto asset ecosystem represents a major step toward increased regulatory oversight and compliance within the sector. Although it seeks to stop financial crimes, it also poses a number of difficulties for companies that provide crypto asset services, such as technological difficulties, privacy issues, and the requirement for international regulatory cooperation.

TÜRKİYE’s Approach

Türkiye has been making efforts in combating money laundering in an attempt to improve its laws and meet international standards, hence money laundering activities are criminalized within the Turkish Penal Code. Turkey’s involvement with international organizations such as the FATF has greatly influenced its anti-money laundering (AML) efforts.

The main focus of Türkiye’s efforts to combat money laundering is Law №5549, which was enacted in 2006 and has since been amended to strengthen its effectiveness. Law №5549 puts forth the responsibilities of financial institutions as well as reporting entities and supervisory bodies.

MASAK is prominent in the efforts to make Türkiye a country safe from money laundering and financing of terrorism. Serving as the main authority in this area, MASAK is responsible for enforcing AML regulations, carrying out investigations, and exchanging information with key parties.

There is a comprehensive legal framework set in place to effectively combat money laundering and terrorist financing within Türkiye. This framework includes several important laws, such as Law №5549 enacted in 2006, which establishes the responsibilities of financial institutions, reporting entities, and supervisory bodies in preventing and detecting money laundering.

The Turkish Penal Code (Law №5237) also criminalizes various forms of money laundering and outlines penalties for those involved. The Banking Law №5411 imposes specific anti-money laundering regulations on the banking sector, including customer due diligence and reporting suspicious transactions.

The Law on the Regulation of Payment Services and Electronic Money Institutions №6493 sets AML obligations for payment services and electronic money institutions. Lastly, Capital Markets Law №6362 addresses money laundering in the securities sector, creating a strong set of regulations to protect Turkey’s financial system from illicit activities.

As aforementioned, it was decided that CASPs have to report to MASAK. Article 3 of Law №5549 states that; “Within the scope of the principles regarding customer identification, obligors are obliged to determine the identities of those who make transactions and those on whose behalf or accounts transactions are made and to take other necessary measures before the transactions are made in the transactions made before them or in the transactions they intermediate.

The Ministry is authorized to determine the types of documents for identification, and the types of transactions requiring identification, their monetary limits, and other procedures and principles regarding the identification of the customer shall be determined by regulation.”

There are also MASAK General Communiqués published by MASAK in this regard. These communiqués are a must-read for details on reporting and compliance. In accordance with the FATF recommendations, it is inevitable for crypto asset service providers to implement KYC and AML practices.

In May of 2021, MASAK released their guidelines for crypto asset service providers titled “Basic Principles for Crypto Asset Service Providers on Obligations Relating to the Prevention of Laundering Proceeds of Crime and the Financing of Terrorism”. The obligations are collected under 4 categories as follows:

(i) the recognition of the customer

(ii) suspicious transaction notice

(iii) maintenance and submission and

(iv) providing continuous information and documents.

This guideline underlines the importance and the obligation of crypto asset service providers to identify their customers under which KYC is set out as a clear obligation.

According to the guideline, if there is a constant business relationship between a crypto assets platform and its users, they can engage in multiple transactions without needing to provide identity information each time. However, if there is no constant business relationship, the platform must verify the identity of the user in certain situations, such as when a suspicious transaction is noticed or when the transaction amount exceeds a certain threshold. It is important to complete the identification process before starting the business relationship or conducting any currency transactions.

For real persons, the information to be obtained is as follows;

a. Name and surname

b. Date of Birth

c. T.R. ID No

d. Type and number of the identity document

e. Address

f. Nationality

g. Father’s and Mother’s name (Only for Turkish Nationals)

h. Place of birth

i. Signature sample

j. Information related to job and profession

k. If any, phone number, fax number, electronic mail address

The accuracy of the information mentioned in paragraphs (a, b, c, and d) will be confirmed for Turkish Nationals through their T.R. identity card, driver’s license, or passport, whilst for non-Turkish nationals; passport, residence document, or another identity document seen appropriate by the Ministry will suffice.

To confirm a constant business relationship, a residence document or invoice issued within the three months prior to the transaction date can be used. This can be a document related to services like electricity, water, gas, or phone, or a document given by a public institution. The Ministry will decide which other documents or methods can be used for confirmation. Once the original or notarized copies of the documents are submitted, a photocopy or electronic image will be obtained or the relevant information will be registered.

Information that will be obtained during the identification of legal entities registered to the trade registry is as follows:

a. Title of the legal entity

b. Trade registry number

c. Activity matter

d. Open address

e. Taxpayer identity number

f. Telephone number and, if available, fax number and e-mail address,

g. The name, surname, place, date of birth, nationality, information on the type and number of identity documents and a signature sample of the person authorized to represent the legal entity and, additionally, mother’s name, father’s name, and T.R identity number will be obtained for Turkish nationals.

The process of identifying foreign legal entities is done by comparing their documents to the equivalent ones required for Turkish legal entities, which have been approved by Turkish consulates or endorsed by the relevant authority of the country that is part of the Convention for Abolishing the Obligation to Certify Foreign Official Documents. Additionally, in cases where necessary, the identity information is verified through notarized translations of these documents, following a risk-based approach.

Crypto asset service providers will determine if a transaction is suspicious by considering the behavior of the customer, their previous information, and the compliance of the transaction with the customer’s financial profile. The responsibility of notifying suspicious transactions lies with the legal representatives of the entity. Multiple transactions can be covered under one notification form. Suspicious transactions must be reported to the MASAK within 10 business days or immediately if the delay is inconvenient.

The information required to be confirmed by MASAK within the scope of identification includes name, surname, date of birth, Turkish ID number (for Turkish citizens), and the accuracy of the information regarding the type and number of identity documents is ensured through the Turkish identity card, Turkish driver’s license or passport for Turkish nationals, and identity documents with the Turkish ID number on it and clearly stated in special laws to be official identity documents, and passport, residence certificate or identity document deemed appropriate by the Ministry for non-Turkish nationals.

A readable photocopy or electronic image is taken after the submission of the original or notarized copies of the identity documents to be presented when requested by the authorities, or information regarding the identity should be recorded.

The accuracy of the address declared in the establishment of a permanent business relationship must be confirmed by means of a certificate of residence, an invoice issued in the name of the relevant person for a service requiring a subscription such as electricity, water, natural gas, telephone, etc. and issued within three months prior to the transaction date, or other documents and methods deemed appropriate by MASAK.

Compliance with KYC/AML Frameworks

The need for strict adherence to global KYC and AML frameworks highlights how interconnected international financial systems are. KYC and AML compliance are crucial for financial institutions, legal entities, and designated businesses. These regulations require thorough customer due diligence, including identity verification, assessments of ownership, and continuous transaction monitoring to prevent illegal financial activities.

These frameworks promote a risk-based approach, allowing entities to customize their compliance protocols based on the level of risk associated with their clients, financial products, or transactions. They emphasize the importance of conducting thorough due diligence when dealing with high-risk situations, such as transactions involving Politically Exposed Persons (PEPs), and the need for continuous monitoring of these individuals on a global level. Maintaining accurate and up-to-date customer information is not only a regulatory requirement but also crucial for internal oversight and external regulatory scrutiny.

Complying with KYC and AML regulations is crucial for maintaining global financial stability and protecting against money laundering and terrorist financing. It not only prevents legal consequences for organizations but also strengthens the international community’s ability to combat these threats. Adhering to strict global standards in KYC/AML demonstrates a shared dedication to creating a secure and transparent global financial system that operates within the law.

KYC/AML Regulations’ Impact on the Crypto Sector

The intersection of KYC/AML regulations with the crypto asset industry involves various legal, technological, and philosophical considerations. The expansion of KYC/AML rules to cryptoasset service providers and exchanges reflects a global trend to address potential risks and illegal financial activities. While the goal is to increase transparency and reduce risks, this shift has sparked debate as it goes against the decentralized and private nature of crypto assets.

The debate is about finding a balance between regulations and preserving the unique aspects of the crypto asset industry. Some people believe that introducing regulations like KYC/AML is important for legitimizing and protecting against illegal activities. However, others argue that these regulations may go against the principles that make crypto assets attractive, such as anonymity and user autonomy.

The global and decentralized nature of crypto assets makes it difficult to regulate them. To effectively enforce regulations, countries need to work together to create coherent frameworks. As the crypto industry continues to grow, it is important to consider the impact of KYC/AML regulations on preventing financial crimes, as well as their potential effects on innovation, user adoption, and the decentralization of crypto assets.

Continuously evaluating how KYC/AML regulations affect the crypto industry highlights the importance of creating flexible and well-informed legal frameworks that encourage compliance while still allowing for the innovative nature of crypto assets. Finding the right balance between regulatory oversight and maintaining the core principles of the crypto ecosystem is essential for the sector’s continued growth and credibility worldwide.

Report Studies- Conclusive Thoughts — Recommendations

Numerous studies have developed various techniques to uncover the users concealed behind Bitcoin addresses. One notable example is BitIodine, an application created by three Italian scholars, which can identify “addresses in clusters that could belong to the same user or group of users, classify these users and their nicknames, and even display complex data extracted from the Bitcoin network”. A team at the University of California has also produced similar results.

Additionally, a study conducted by AgiproNews in collaboration with the Polytechnic University of Milan demonstrated that using Bitcoin for illicit purposes is even riskier than using electronic money or bank transfers. The study emphasized that Bitcoin is one of the most traceable currencies and that every transaction, regardless of legality, can always be viewed at no cost. At the same time, asserting that Bitcoin lacks transparency in tracking exchanges is a denial of how the entire system operates.

All Bitcoin transactions are public and recorded in a freely accessible distributed database. Anyone can verify who sold a specific amount of crypto asset to someone else and trace the history of every transaction. It is not particularly difficult to determine which wallet contains a particular crypto asset or the route a certain amount took to reach a specific destination.

The report cites a 2015 report from HM Treasury and the UK Home Office, which evaluated the risk of cryptocurrencies for money laundering and financing terrorism as “low”. This conclusion was also reached by Elliptic, a company specializing in cryptocurrency risks, and the Centre on Sanctions and Illicit Financing, a program by the Foundation for Defense of Democracies, a non-profit organization focused on foreign policies and national security.

An in-depth analysis of a narrow sample of transactions between 2013 and 2016 revealed that the number of illicit operations involving Bitcoin is quite low, accounting for only around 1% of all transactions on the network. The alleged anonymity that Bitcoin provides to its users, which concerns authorities in various sectors, is more of a myth than a reality.

Bitcoin is not truly anonymous; rather it is pseudonymous. This means that each user is linked to a unique nickname or pseudonym composed of a long string of numbers that forms the address associated with a specific wallet. Consequently, it is possible to identify the originator of a particular operation once their pseudonym is known. Many companies have recently specialized in this area, including those that provide consulting services to law enforcement agencies. Notably, Neutrino S.r.l., an Italian company, evaluates the risk of money laundering for each specific Bitcoin transaction. The Blockchain Intelligence Group in Vancouver is also well-known for conducting similar analyses.

It is fundamentally incorrect to claim that Bitcoin was invented by criminals. Bitcoin originated from a community of computer activists known as Cypherpunks who had been working on a digital money project since the 1990s. These individuals were computer experts who were deeply committed to preserving privacy. Some had university experience while others were already wealthy, thanks to the Internet. For them, anonymity was not a way to evade police control, but rather a means of countering the tyranny of surveillance. There are multiple reasons why many disagree with the considerations outlined above.

Primarily, a careful reading of the various warnings issued by authorities in different sectors reveals that many of them either completely ignore the historical and cultural context in which Bitcoin was created or greatly misunderstand the actual characteristics of this new technology. Therefore, it is not a risky proposition to argue that large criminal organizations still prefer dollars over Bitcoin. This is partly because Bitcoin lacks market liquidity and is not easily used for money laundering purposes.

The report utilizes various computer techniques to identify suspicious Bitcoin movements through Bitcoin forensics and Bitcoin intelligence. The former involves using statistical tools to analyze transactions and identify users, while the latter involves monitoring the blockchain to identify addresses at risk for money laundering and provide a probabilistic estimate of the risk associated with each specific transaction.

LEGAL DISCLAIMER

THE INFORMATION PROVIDED IN THIS PAPER PROVIDES GENERAL INFORMATION AS TO THE POSSIBILITIES IN MULTIPLE JURISDICTIONS. PLEASE KEEP IN MIND THAT LAWS THAT APPLY TO THE SUBJECT HEREIN MAY DIFFER IN EACH JURISDICTION. THUS, NOTHING CONTAINED HEREIN CONSTITUTES ANY LEGAL OPINION OR SUGGESTION OF ANY KIND. PLEASE CONSULT TO LOCAL EXPERTS IN RELEVANT AREAS BEFORE TAKING ANY ACTION BASED ON ANY INFORMATION CONTAINED HEREIN.

The Formation of Traditional Contracts

Before examining smart contracts, one should primarily lay out the fundamentals of traditional contracts. According to Article 1 of the Law of Obligations №6098 of Türkiye, a contract is formed when parties declare their wills mutually and in accordance with each other. For this, there must be a declaration of intent, which can be made explicitly or implicitly. An offer is a declaration of will that is directed to the offeree by the offeror for the purpose of forming a contract. However, for a statement of will to be considered an offer, the offeror must declare that he/she wishes to conclude the contract upon accepting the offer.

On the other hand, acceptance is a declaration of will directed to the offeror by the offeree in response to the offer made. A response in accordance with the offer will constitute an acceptance and establish the contract, but if the offeree’s response is not in accordance with the offer, this response will not constitute an acceptance. In terms of the conditions for the formation of the contract, it is necessary for the will and intent of the parties to be mutual.

Further conditions for the validity of a contract include the competence of the parties, i.e., their legal capacity to act, the subject matter of the contract must not be contrary to mandatory rules of law, public order, moral standards of society, and personal rights. Further, the subject matter of the contract must not be of an impossible nature, and the declaration of will of the parties must be healthy, devoid of deception and intimidation.

As a rule, unless otherwise explicitly stated in relevant legislation, there is no requirement as to form regarding contracts. Contracts may be formed in various ways, for example, written or orally. However, for some matters lawmakers tend to determine a specific form for contracts. In such cases, if the parties do not comply with the required form, these contracts may be considered void and null.

Legal Definitions and Smart Contracts in General

Smart contract, as a term, was first used by Nick Szabo in 1994, being defined as a computer processing protocol that enforces contract terms. Ultimately, a short definition of smart contracts can be stated as a self-executing legal agreement generated on digital platforms in which the contract terms are embedded in the code.

Various scholars and legislations have their unique definitions of smart contracts. For example, in 2019, Italy defined smart contracts by law as a computer program that operates on technologies based on distributed ledgers and whose execution automatically binds two or more parties based on predefined effects.

On the other hand, in Arizona, United States of America, smart contracts are defined as an event-driven program, with state, that runs on a distributed, decentralized, shared, and replicated ledger and that can take custody over and instruct transfer of assets on that ledger. On the other hand, in Illinois, smart contracts are defined in a far simpler way, as contracts stored as an electronic record which is verified by the use of a blockchain.

In the perspective of Türkiye, as of September 2023, there is no legal definition of smart contracts or any expected definition from lawmakers. In conclusion, smart contracts may simply be defined as self-executing digital contracts of which the terms and conditions of the agreement between the parties are predetermined.

Characteristics of Smart Contracts

Smart contracts are administered by computer programs on a blockchain infrastructure. The technical process involves creating smart contracts as code and storing them on e.g. the Cardano blockchain, allowing for features like immutability, decentralization, lack of intermediaries, peer-to-peer interactions, adherence to specific digital logic, and transparent anonymity.

Due to their nature of being written in code, smart contracts pose a security when it comes to the execution of transactions. Furthermore, once a smart contract is formed, the contract cannot be modified and is implemented automatically.

All actions taken within the contract are easily visible, giving smart contracts a quality that ensures transparency in transactions. This transparency also contributes to reducing both transaction and court costs, streamlining processes and reducing expenses. Since smart contracts function independently, they operate without the need for parties to have any prior knowledge of each other or an established trusting relationship. This also eliminates the need for any third party or intermediary that must oversee the execution of elements of the contract which enhances efficiency.

Smart contracts enable parties of an agreement to not concern whether the other party will satisfy their end of responsibilities. The obligations and responsibilities of each party will be automatically executed.

Smart Contracts vs. Traditional Contracts

The structure of smart contracts presents a challenge in comparison to traditional contracts. Certain provisions that are typically included in traditional contracts may not written in the code of a smart contract**. As a result, creating complex contracts using smart contract code can be difficult.** However, this issue can potentially be resolved by using mixed contracts, where only certain provisions are written in computer code.

Smart contracts require the use of electronic digital signatures, but according to Turkish Law, contracts that are not within the scope of electronic signatures cannot be executed with them. This means that certain smart contracts will not be valid under Turkish Law or in jurisdictions with similar restrictions. The Electronic Signature Law №5070 needs to be amended to meet the requirement of electronic signatures for these contracts. Currently, in Türkiye, blockchain-based digital signatures are not considered electronic signatures as of September 2023.

At first, it may seem like smart contracts only apply to blockchain-based assets. However, it is far from true. Smart contracts are based on IFs and SOs simply meaning that if condition X occurs, do Y. But how does a smart contract know if such X condition is satisfied? There are some external information providers called Oracles. Oracles are third-party services that provide smart contracts with external information. With the help of Oracles, even assets that are not on blockchain may be subject to smart contracts, provided that these smart contracts follow relevant applicable law.

Legal Nature of Smart Contracts

The term smart contract generally refers to processes that envisage the transfer into computer code not only the rules that govern the contractual relationship between the parties, but also the conditions under which a contract will be automatically performed. On the other hand, some smart contracts only realize the execution of a pre-existing contract; that is, the obligatory acts are fulfilled with the help of code.

Smart contracts are well-suited for the automatic execution of certain types of transactions already found in many contracts. Nowadays, the practice of using smart contracts is mainly focused on partial automation of certain parts of contracts (e.g., the transfer of digital assets).

One approach to smart contracts suggests that it is the execution phase of a traditional contract established between parties. In line with this approach, a contract is established between the parties in the traditional sense, and it is accepted that all or part of the provisions of this contract are decided to be automatically executed in the form of a smart contract. In practice, it is seen that many smart contracts are designed in this way and made for this purpose.

Indeed, considering that the computer programmers who write the smart contract cannot decide on the commercial and legal aspects of the contract, there may need to be a document explaining the essence of the agreement between the parties. It can be argued that such a perspective would be compatible with the traditional contract law structure. In this case, a basic contract in accordance with the existing legal order is concluded between the parties, and the parties can agree that the performance of the debts arising from this contract will be carried out through the code to be run on the blockchain. Thus, legal problems that may arise regarding smart contracts will be easier to solve, as they will concern the execution of the contract, not the contract itself.

However, this approach is not applicable to all smart contract structures. Because there is no legal or practical obstacle for people to establish smart contracts in the form of “direct coding” without any prior written or verbal agreement between them.

TL;DR:

Some scholars argue that smart contracts are not a contract but a means of performance of a contract. Even though this approach may be acceptable for some cases, we strongly believe that as long as follows the applicable law, smart contracts may in fact be actual contracts in legal sense.

Legal Developments in Smart Contracts in General

As in Turkish law, there is no legal regulation addressing smart contracts and blockchain technology in all aspects in other countries’ legal systems. The reason for this may be the complexity of these technologies and the inability of modern states to keep up with the pace of technology in the process of making legal regulations. However, especially in Europe and the United States of America (“the U.S.”), important studies are being carried out in this field, and some of them are becoming legal regulations.

Developments in Europe

Belarus was the first country in the world to legislate on smart contracts. According to a 2017 presidential decree, a smart contract is defined as a program code intended to function in a distributed ledger for the purpose of performing various transactions, automated execution or other legal actions.

Studies are being conducted in the EU to determine the legal framework for smart contracts and blockchain technology. A report from the Legal Affairs Committee of the European Parliament highlights the increasing use of smart contracts but raises concerns about their legal validity and enforceability. The committee calls on the European Commission to establish a legal framework to provide certainty for businesses and consumers, particularly regarding the legality of smart contracts, their use in cross-border transactions, and meeting formal requirements. The committee also recommends implementing mechanisms in smart contracts to halt their execution in certain situations, such as protecting the weaker party or creditor rights. However, there is currently no legal regulation on smart contracts within EU legislation.

In recent years, Russia has made notable progress in the field of blockchain. A significant development was the amendments made to the civil code in 2019, which acknowledged the possibility of self-executing contracts through electronic means. This has opened opportunities for smart contracts without the need for manual intervention from the involved parties.

Developments in the United States

The U.S. does not have a consistent national regulation on blockchain or smart contracts. However, federal agencies like the Commodity Futures Trading Commission (“CFTC”) and the U.S. Securities and Exchange Commission (“SEC”) have released reports stating that they do not believe special regulations are needed and are instead applying existing laws to smart contracts.

Arizona has become the first state in the U.S. to acknowledge the legal validity of blockchain technology and smart contracts. The 2017 legislation states that smart contracts executed on a blockchain are legally binding, even if they do not follow the traditional format of a contract written in human language. This recognition is a significant step forward and sets a precedent for other states to follow.

The state of Tennessee passed a law in 2018 called Senate Bill 1662 that defines blockchain technology and smart contracts. This law, like the one in Arizona, states that smart contracts are legally valid and enforceable.

In 2019, Arkansas and North Dakota implemented regulations like Arizona’s, legally recognizing blockchain technology and smart contracts. This makes it safer for parties to choose Arizona or similar states that acknowledge smart contracts as legally valid and binding when entering a smart contract relationship.

The state of Illinois has taken a significant step by passing the Illinois Blockchain Technology Act, which allows the use of smart contracts. This law defines smart contracts as contracts that are verified using blockchain technology and stored electronically. This is important because it legally recognizes smart contracts as valid contracts.

Wyoming has a comprehensive set of laws and regulations, including the definition of smart contracts as automated transactions that fulfill contract terms. This definition aligns with the belief that smart contracts are a means of enforcing legally binding contracts.

Developments in the United Kingdom

In November 2021, the United Kingdom Law Commission issued its report on smart contracts. In this report, the Law Commission defined smart contracts as legally binding contracts in which some or all of the contractual obligations are defined in and/or performed automatically by a computer program. The Law Commission strongly emphasized the increasing usage of smart contracts in areas such as DeFi, real estate transactions, managing supply chains, etc.

In their report, the Law Commission stated five main criteria shall be met to consider smart contracts legal and valid under England and Wales laws.These criteria are agreement, consideration, certainty, completeness, intention to create legal relations, and compliance with formalities.

Agreement Requirement for Smart Contracts

Agreement between the parties of a contract generally consists of offer and acceptance, quite like Turkish law. An offer may be defined as a clear statement of the terms on which one person is willing to be bound. It is a declaration of intent to enter a contract on the stated terms, made with the understanding that it will become enforceable as soon as the recipient accepts it. Contrarily, acceptance is a complete and unequivocal acceptance of an offeror’s terms. If there is contemplation, a purpose to establish a legal relationship, and other necessary elements, this results in the creation of the agreement.

Consideration Requirement for Smart Contracts

Contractual promises generally cannot be given “gratuitously” — that is, for nothing in exchange — according to English and Walsh law. In our opinion, smart contracts won’t pose any special difficulties in determining the pertinent consideration. In most circumstances, the wording of any natural language agreement or the way the code itself operates could be used to determine the consideration (such as payment in money or tokens).

Certainty and Completeness Requirements for Smart Contracts

Certainty generally relates to the sufficiency of the terms of a contract. The terms of a contract shall be clear and precise so that each party to a contract shall be aware of its responsibilities and obligations. It is important to keep in mind that ambiguous terms may render a contract unenforceable or even invalid.

Completeness, on the other hand, is quite like certainty. A contract must be complete to be legally enforceable. This means that all pertinent conditions must be agreed upon by the parties. There might not be a legally enforceable contract if parties agree on some conditions but leave other crucial aspects up in the air.

In terms of smart contracts, these requirements may be met depending on the complexity of the subject matter of the agreement. If parties can state and agree upon the fundamental terms of an agreement via a smart contract, the smart contract shall be deemed to meet these criteria.

Intention to Create Legal Relations Requirement for Smart Contracts

This condition is intended to distinguish between contracts with the intent to be legally enforceable and those that are just social or domestic in character and are not intended to be subject to legal examination.

The Law Commission emphasized in the case of an agreement being reached on a DLT system or other smart contract platforms, it may be difficult to determine if parties meant to enter into a contract with legal force**. It would be wise for parties who do intend for these transactions to establish legal connections to make this explicit in plain language.**

Formality Requirement for Smart Contracts

Like Turkish law, the fundamental rule is that contracts need not be made in a specific form unless a particular form requirement is foreseen by the law. For matters that do not necessitate a specific form requirement for contracts, smart contracts constitute no challenges. However, for matters that require form requirements such as in writing, shall be examined in terms of smart contracts.

The Interpretation Act 1978 defines writing as including all modes of “representing and reproducing words in a visible form” and writing is drawn up in an inclusive way meaning that if words of a contract can be represented and reproduced.

A smart legal contract would meet the “in writing” criteria if its provisions were laid down in a document written in natural language. Which contractual words defined in code could meet this need is the trickier question. This relies on whether the code is presented in a way that a person can read. On this matter the Law Commission believes that source code qualifies as “writing” under the Interpretation Act of 1978. It will be more challenging to claim that a smart legal contract is “in writing” if the terms are said to be stored in machine code or a lower level of code than source code.

Validity of Smart Contracts and Valid Use Cases

The validity of smart contracts mainly depends on their sufficiency to satisfy the requirements of traditional contracts. The main challenges in the validity of smart contracts converge upon form requirements.

Regardless of whether smart contracts are considered as a means of performance of an agreement or an agreement itself, for matters that do not require a particular form for contracts, it is safe to say that smart contracts are as valid as traditional contracts.

However, there are some cases where lawmakers require strict form requirements to be met. For example, according to Article 706 of Turkish Civil Law, the validity of contracts aiming at the transfer of real estate ownership depends on whether these contracts are officially constructed and accepted by the parties. The term “officially constructed” basically means that a contract shall be in written form and signed in the presence of relevant public officials, namely notary public. In conclusion, specific contracts that require a particular format shall not be constructed as smart contracts to avoid any legal risks.

In cases where no written or even stricter form requirement is not sought, smart contracts may be deemed valid and enforceable. For instance, transfer of a certain digital asset such as Bitcoin or some type of crypto asset constitutes an agreement between the parties of such a transaction. This agreement is made and executed simultaneously via smart contracts which are in fact legally valid, binding, and enforceable.

Specific matters that require contracts to be written are another story. In Turkish law and many other jurisdictions, written format rule comes with a need for the signature of the parties. Upon the signature of the parties of a contract, the contract becomes valid and enforceable. However, the need for signatures in smart contracts is tricky. For example, in Turkish law, not all but some electronic signatures are considered equal to traditional signatures.

According to the Electronic Signature Law of Türkiye, a secure electronic signature is an electronic signature that is exclusively linked to the signatory, generated with the secure electronic signature creation device only under the control of the signatory, based on a qualified electronic certificate that identifies the signatory and, allows for the detection of any subsequent change made in the signed electronic data.

In conclusion, it is safe to say that in Turkish law, smart contracts cannot be valid for matters that require a particular format, such as a written format**. On the other hand, on matters that do not require a specific format, smart contracts may be constructed. These smart contracts shall be considered valid and enforceable under Turkish law.

Legal Implications of Different Smart Contracts

Depending on the function a smart contract constitutes, there may be various legal implications to be considered. Smart contracts may be used to mint new tokens such as NFTs, to vest some crypto assets for a period, or to act as a governance instrument in some governance tokens, and etc.

Minting New Crypto Assets and Smart Contracts

Many crypto assets such as NFTs are minted via smart contracts. When producing tokens or Non-Fungible Tokens (NFTs) on platforms like Ethereum, Binance Smart Chain, and others, smart contracts are essential to the minting process. The smart contract for a token or NFT often includes a method for minting (or creating) new tokens. When invoked, this function raises the overall supply of the token and allocates newly produced tokens to a specified address. When new tokens or NFTs are created, the smart contract can trigger events that alert external observers (such as dApps or wallets) about the operation. This can help with real-time tracking and visualization of token creation.

In conclusion, smart contracts included in the minting process must be extensively audited and tested. Because blockchain transactions are irrevocable, any error in the minting process or weaknesses in the contract could result in a loss of cash or other undesirable results. Due diligence and proper security measures are essential.

Vesting Crypto Assets and Smart Contracts

Smart contracts are very crucial in the vesting process for cryptocurrencies and tokens. They can enforce and automate vesting schedules in a transparent and dependable manner. The smart contract will gradually release tokens according to the vesting schedule. These tokens can then be claimed by the beneficiary.

Any smart contract that deals with vesting must, as always, be thoroughly audited and tested. Because blockchain transactions are irreversible and frequently involve vast sums of money, any errors could result in significant losses or legal issues.

Moreover, since there is no form requirement for vesting agreements in Turkey, it is safe to say that smart contracts may be valid and enforceable.

Governance Tokens and Smart Contracts

One of the main usage areas of smart contracts is Decentralized Autonomous Organizations (DAOs). After the establishment of DAOs, the funding process starts. In this period, people across the globe who wish to participate in the DAO purchase the tokens of the said DAO. Sometimes, these tokens are called governance tokens because they enable their holders to participate in the voting procedures of the DAO and, therefore, have a say in its governance.

In DAOs, the rules agreed by the community are applied via smart contracts, voting is done and the codes containing all these rules and operations are made publicly available. After forming its smart contracts and therefore the governing rules and principles of a DAO, tokens of the said DAO are generally offered. With the token offerings people become a member of the DAO which mainly gives its holder the right to vote and to be entitled to profit generated by the DAO.

Smart contracts constitute an essential part of DAOs and their governance tokens. Even though these smart contracts create the necessary infrastructure for the application of DAOs, it is important to note that the legal qualification of DAOs in different jurisdictions may adversely affect the validity of smart contracts. For instance, in the event of accepting DAOs as joint stock corporations, then, many of the governance decisions of such joint stock corporations shall be in written form and include signatures of authorized personnel.

In conclusion, our recommendation is that before executing a smart contract, parties of the agreement shall primarily check if the subject matter of the agreement between the parties requires a particular format.

Legal Risks in Smart Contracts

There have been certain legal issues and risks that smart contracts may constitute. The format and the degree of automation used in smart contracts can influence the potential for legal disputes or complexities to arise associated with their implementation.

Further, it may be difficult to interpret a contract in which the terms are predominantly or solely defined in code which can lead to issues. Also, there is room for mistakes to likely be made when translating contracts from code to a natural language, leading to disputes to arise and confusion in meaning and intent. Since amending code on a distributed ledger may pose to be difficult, rectifying such misalignments can also prove difficulties and broaden the legal risks that are associated.

The “oracle” problem also comes up as an issue to consider in which the performance of a smart contract depends on information from an external database. Here, an external data source malfunctioning or providing unreliable or false data becomes a cause for concern.

Court Decisions on Smart Contracts

The German Federal Court of Justice decided on a case wherein a French bank offered lease agreements for batteries to be used in electric cars. This has been seen as an example of a smart contract used in car lease agreement.

The discussion of smart contracts is seen in the Federal Court of Justice’s assertion that digital intervention in controlling a rental object is equivalent to any physical intervention. Meaning, whether the battery (which later gets blocked) is accessed manually or automatically is not relevant and an automated intervention can be attributed to the technology provided by, in this case the bank, making no essential difference for legal assessment. Thus, this assessment made by the court suggests that using a smart contract to automate a lease agreement can give rise to legal disputes.

Blockchain, Smart Contracts and Future Notarial Services

Public notaries, also known as notary publics, are essential in many legal transactions since they offer services for verification and fraud prevention. Their main responsibility is to serve as unbiased witnesses at the execution of specific types of papers, verifying their validity and the consent of all parties concerned. Furthermore, in many jurisdictions, notaries may act as a formal intermediary between the parties when it comes to issue formal protest and declarations. In some cases, usage of public notaries as an intermediary is even required by law.

Since public notaries generally act as a formal and public record keeper and act confirmatory to various legal transactions and documents, many scholars started to recommend application of blockchain and smart contracts to notary services. The fact that there are various incidents such as misconducts, fraudulent actions and bribery perpetrated by public notaries, even urges people to ask for a more secure and transparent system of notary services.

Some of the prominent features of blockchain technology are its ability to record the transactions securely, immutably, and transparently. Its underlying technology distributed ledger is used to log transactions across numerous computers in a way that prevents changes to the record from being made retrospectively without changing all blocks behind them and receiving network consensus. Therefore, any transaction that is recorded on the blockchain is as a rule may not be altered. Since the data regarding the transaction is distributed amongst various computer systems and databases, it offers quite reliable data protection.

Considering explanations provided above, blockchain technology and smart contracts may effectively be used in record keepings such as notary services. In fact, the World Intellectual Property Organization (“WIPO”) has shown a great interest in blockchain’s ability to protect data. WIPO argues that intellectual property (IP) offices may be able to take advantage of these traits to improve the registration of IP rights by making it more efficient, quick, accurate, and secure.

Background of White Papers

White papers, which have been used since the 1990s, can be defined as sales and marketing reports or guides that are used to showcase, introduce, and inform potential customers to a certain product, service, or technology. A white paper will often inform its readers about the issuing body’s philosophy, core concept and ideas and explain any complex issues relating to their product, service, or technology. White papers have been commonly designed for business-to-business marketing objectives between manufacturers and wholesalers or between wholesalers and retailers, offering comprehensive reports on how-to about the product, service, or technology, supported by statistical and cited information.

White papers can vary in types and format regarding project documentation. For example, problem-solution types of white papers identify a particular issue that the target audience may have and propose a solution, while others may be written to focus solely on an issue or debate and inform the reader. Others may just provide technical assessments and provide promotions for a certain product or service or be purely technical analysis of a product or service or technology. Another type of white paper may be one that provides market research based on the new or relevant research provided by the organizer for potential customers.

How Crypto Asset White Papers Distinct from Other Project Documentations?

White papers regarding crypto assets or blockchains mainly focus on the technical, economical, and philosophical aspects of an innovative crypto asset or a blockchain. Their primary concern is generally about tokenomics, consensus mechanisms, cryptography, etc. On the other hand, traditional white papers generally examine specific technology or a proposed solution to a complex challenge.

More importantly, crypto asset white papers have a non-negligible effect on the fundraising aspect of the underlying project. While traditional white papers generally are not used in a way that calls for a fundraising, sometimes the main reason for issuing a white paper for a crypto asset is fundraising. When it comes to evaluating whether a crypto asset / blockchain project is worthy of investing in, white papers of such a project are generally all there is to evaluate. Because investors and even ordinary customers’ unfortunately only piece of information regarding a project is the white papers of said project, the white papers of crypto assets play a vital role in the success of a project.

Furthermore, traditional white papers are generally issued by established and well organized traditional legal entities. On the other hand, the developers of a crypto asset / blockchain project generally lack legal entities. Most of the time, these crypto asset projects are developed by individuals who are subject to different jurisdictions and lack a legal entity. The lack of legal entities sometimes causes trust problems. In this regard, crypto asset white papers are useful tools for building trust between the developers and the investors.

Why Do White Papers Matter?

Most importantly, since issuers of most crypto asset / blockchain projects lack legal entities, and the only piece of reliable information regarding a crypto asset is white papers of such a project, white papers play a crucial part in legal evaluation of a crypto asset. Governmental authorities tend to examine the white papers when it comes to legal qualification of a crypto asset. Any miswording may result in legal ramification and therefore hinder the development of the project.

For example, in the event of drawing up a white paper in a way that may be against the laws of a jurisdiction may consequently result in governmental intervention. For example, jurisdiction such as Türkiye bans the usage of crypto assets in payment systems in any way. Therefore, a crypto asset project whose white paper foresees usage of the project’s crypto assets in payment systems will automatically draw attention to the project and ultimately may result in taking adverse action on the project by the state.

Furthermore, many jurisdictions are concerned with customer protection when it comes to crypto assets. The European Union, for example, has prepared a regulation called Markets in Crypto Assets, in which it determines some guidelines for crypto asset issuers to properly inform the customers and investors of such crypto assets. For the sake of the future of the project, it is important to closely examine whether the jurisdiction you are subject to has laid out some ground rules or guidelines for white papers.

Characteristics of Crypto Asset White Papers

Crypto asset white papers may be defined as documents on which underlying blockchain technology, smart contracts used in the project if any, the scope and aim of the crypto asset, the rights, and opportunities to be granted to the buyers if any, timetable for the project, and the project in general, and people who are working on the project are explained. White papers are like but not same as offering circulars used in public offering in the capital markets.

First to come across in white papers is stating the problem. Clearly determining the problem is the first step to catch the investor and to solve the problem. Second most common characteristic of crypto asset whitepapers is proposing a reasonable and achievable solution to the determined problem. Afterwards, the main idea is how to convince people to invest in the crypto asset and therefore in the project.

Since white papers are commonly used in the ICO process, crypto asset white papers almost always propose a business plan. The main questions to answer when it comes to tokenomics in this regard are as follows:

• When and how many coins/tokens will be issued?

• How will the coins/tokens be distributed amongst the purchasers?

• How will the purchasers acquire the crypto asset they will be entitled to?

• What are the main features of the crypto assets and what rights and utilities will it grant to its purchasers?

• How much capital is needed and if the project fails to collect the required capital, how will the collected funds be returned to the purchasers?

• What is the estimated and desired schedule / timeline for the project?

• How and on what will the collected capital be spent?

Legal and Regulatory Disclaimers

Every white paper must include a disclaimer for its readers at the very start. This disclaimer can be vital for the white paper in indemnifying the party that has made the white paper against legal claims.

It would be advised to list, concisely, that the company and its team members behind the project are not to be held liable against claims arising from the issuance of the white paper. It should be stated that the company or entity behind the project of the white paper as well as the team members, distributors etc. are not to be held liable. This statement should also address that the aforementioned shall not be held liable for any loss or damages incurred or possibly suffered as a result of accessing the white paper.

Especially in the context of crypto assets service providers, white papers must include a disclaimer stating that the white paper does not constitute any financial, legal or tax advice. It may also be necessary to include that the white paper and its contents have not been reviewed by a governmental entity.

Furthermore, some jurisdictions may ban crypto assets altogether. That’s why, it is important to address the people of such jurisdictions about the matter and ask them to not read, distribute or share the white paper in this jurisdiction, and if they happen to be subject to such jurisdiction, then, warn them that it is their responsibility to cease their relations to the crypto assets or its white paper.

Risk Appraisal

Risk appraisal or risk assessment is a process evaluating and analyzing potential risks, uncertainties or vulnerabilities associated with a project. Although not all crypto assets or blockchain projects bare extreme risks that must be evaluated and result in a white paper needing such a risk appraisal, for a crypto asset or blockchain project, a form of risk appraisal can be included in the white paper that identifies, analyzes risks and poses ways that the project team will combat them.

The goal of a risk appraisal is to systematically identify, quantify and understand the potential consequences of risks and aid in making informed decisions for potential investors.

A risk appraisal for the project may include an analysis of regulatory risks, as crypto assets have varying regulations, some only in developmental stages and some prohibiting their use in some nuanced way.

Another important factor that can be identified and evaluated is market volatility as crypto assets markets are known for their high volatility. For example, it can be stated that the value of the crypto asset may fluctuate significantly and impact investors’ confidence and that to manage this the project aims to establish strong partnerships and a community that will work on stabilizing the crypto assets’ value in such events.

The Role of a White Papers in Crypto Asset Launch

The white paper can be a sort of drawing board for potential investors or users of the crypto asset or token that is being launched. Meaning that the educational aspects of the white paper can help the users or the crypto assets to come and refresh their knowledge on the project. Here, the white paper will serve as an educational resource, explaining the underlying technology and the goals and vision behind the crypto asset project. The white paper also helps form transparency between potential investors and the project’s aims, its team members, and the roadmap that the project has adapted.

The white paper can provide the technical details that investors should be aware of before investing. Further, the white paper will usually include information on the tokenomics, meaning the distribution of tokens, the supply, mining and creation and the incentives of miners, developers, or stakeholders.

The whitepaper can also serve as a promotional or marketing tool that attracts investors or community members by effectively communicating the value propositions of the crypto asset project. All of this results in a roadmap to the crypto asset launch, building investor confidence and growing the community which can result in effectively competing in such a competitive market.

Established Guidelines for White Papers

Markets in Crypto Assets regulation, MiCA, is the leading legislation regarding crypto assets, their offerings, documentations regarding offered crypto assets, etc. Since MiCA will have a huge impact on the regulatory aspect of blockchain technology and crypto assets in various countries and jurisdictions, it is important to closely examine MiCA.

Utility Tokens White Papers and MiCA

The European Union’s Markets in Crypto Assets Regulation (“MiCA”) mandates that market participants must publish a White Paper before making any crypto-assets available to the public. MiCA holds an important place as, once fully adopted by EU member states, it will be setting out clear cut requirements that every White Paper must include in terms of the offer of crypto assets or utility tokens. Another important factor is that, often, the EU is seen to be the first that regulates new legal areas with the development of technology, having other countries follow in tow of the EU directives and regulations.

According to Article 4 titled Offers to the public of crypto-assets other than asset-referenced tokens or e-money tokens, for a person to make an offer to the public of a crypto asset other than an asset-referenced token or e-money token within the European Union, a crypto asset white paper in respect to that crypto asset must be drawn in accordance with Article 6 of MiCA. Further, the crypto asset White Paper must be notified in accordance with Article 8 and published in accordance with Articles 9 and 12.

Article 4 of MiCA further states that, if the offer to the public of the crypto asset concerns a utility token that provides access to goods and services that don’t yet exist or have not been put into operation, the duration of the offer to the public described in the white paper mustn’t exceed 12 months from the publishing date of the white paper. This limitation regarding the duration period of the offer to the public is not related to the moment when the goods or services come into existence or start operating and can be used by the holder of the utility token after the expiry date of the offer.

It is important to note that the requirement of issuing a white paper prior to the offering to the public is not mandatory for crypto assets that are not asset-referenced or tokens or e-money tokens, in cases where (i) offer to the public is made to less than 150 natural or legal persons per EU member state, or (ii) over a period of 12 months, starting with the beginning of the offer, the total consideration of an offer to the public of a crypto-asset in the Union does not exceed EUR 1 000 000, or the equivalent amount in another official currency or in crypto-assets; or (iii) an offer of a crypto-asset addressed solely to qualified investors where the crypto-asset can only be held by such qualified investors.

According to Article 6 of MiCA, a crypto asset white paper must contain information on:

• the one offering or seeking admission to trading,

• the issuer if the issues is a different person,

• the operator of the trading platform for the crypto asset in cases where it draws up the White Paper,

• information on the one who has drawn up the White Paper if it is a different person,

• detailed information about the crypto asset project,

• the offer to the public or its admission to trading,

• detailed information on the crypto asset itself,

• Information on the rights and obligations attached to the crypto asset,

• information on the technology that underlines the project,

• clear information about the potential risks,

• information on the principal adverse impacts on the climate and other environment-related adverse impacts of the consensus mechanism used to issue the crypto asset.

Liability Arising from Information in Utility Token White Papers

According to the Article 15 of the MiCA, in the event of information contained in the white paper is contrary to the rules set out in Article 6 of the MiCA, meaning that information given is not complete, inaccurate, fair, clear; the offeror of the ICO or other relevant natural or legal persons will be held liable to the holders of the issued crypto asset for any loss incurred due to such infringement. Furthermore, it is important to state that any contractual exclusion or limitation of liability stated in a white paper will have no effect in accordance with the infringement.

Asset-Referenced Token White Papers and MiCA

MiCA has regulated different types of tokens and their corresponding white papers separately. According to Article 19 of MiCA, an asset-referenced crypto asset’s white paper must contain:

• Information about the issuer of the asset-referenced token,

• Information about the asset-referenced token,

• Information about the offer to the public of the asset-referenced token or its admissions to trading,

• Information on the rights and obligations attached to the asset-referenced token,

• Information on the underlying technology,

• Information on the risks,

• Information on the reserve of assets,

• Information on the principal adverse impact on the climate and other environment-related adverse impacts of the consensus mechanism used to issue the asset-referenced token.

Furthermore, it is expressly forbidden to provide any assertions regarding the future value of the asset-referenced crypto asset. However, white paper must clearly and unambiguously state that:

• The asset-referenced token may lose its value in part or in full,

• The asset-referenced token may not always be transferable,

• The asset-referenced token may not be liquid,

• The asset-referenced token is not covered by the investor compensation schemes under EU Directive 97/9/EC,

• The asset-referenced token is not covered by the deposit guarantee schemes under EU Directive 2014/49/EU.

Liability Arising from Information in Asset-Referenced Crypto Asset White Papers

According to the Article 26 of the MiCA, in the event of information contained in the white paper is contrary to the rules set out in Article 19 of the MiCA, meaning that information given is not complete, accurate, fair, clear; the offeror of the ICO or other relevant natural or legal persons will be held liable to the holders of the issued crypto asset for any loss incurred due to such infringement. Furthermore, it is important to state that any contractual exclusion or limitation of liability stated in a white paper will have no effect in accordance with the infringement.

E-Money Token White Papers and MiCA

The content and form of the white paper needed for e-money tokens are specified under the Article 51 of MiCA. According to Article 51, a crypto asset white paper for an e-money token shall contain the following information:

• Information about the issuer of the e-money token,

• Information about the e-money token,

• Information about the offer to the public of the e-money token or its admission to trading,

• Information on the rights and obligations attached to the e-money token,

• Information on the underlying technology,

• Information on the risks,

• Information on the principal adverse impacts on the climate and other environment-related adverse impacts of the consensus mechanism used to issue the e-money token.

Furthermore, it is essential for the crypto-asset white paper to contain the following clear and prominent statement on the first page that “This crypto-asset white paper has not been approved by any competent authority in any Member State of the European Union. The issuer of the crypto-asset is solely responsible for the content of this crypto-asset white paper.”.

One other requirement foreseen by MiCA is that e-money crypto asset white papers shall contain a clear warning stating that: (a) the e-money token is not covered by the investor compensation schemes under Directive 97/9/EC; and (b) the e-money token is not covered by the deposit guarantee schemes under Directive 2014/49/EU.

National Regulations Regarding White Papers

Certain EU member states have already established laws regarding digital assets, with a focus on the legal details outlined in a white paper. The Maltese Virtual Financial Assets Act defines a white paper as a document that must contain specific information and follow certain requirements. This includes stating the date, providing the information outlined in the First Schedule, and including a statement from the board of administration confirming compliance with the Act. The First Schedule specifies that the white paper should include details about the issuer, VFA agent, development team, advisors, and other service providers involved in the project. It should also include information about taxes, risks associated with the virtual financial assets and investment, pre-emption rights, anti-money laundering procedures, and intellectual property rights.

The PACTE law in France introduced a new regime for ICOs, allowing the AMF to approve them. This regime aims to encourage the growth of ICOs and applies only to utility tokens, not security token offerings. Token issuers can apply for approval from the AMF if they want to conduct an ICO. Before granting approval, the AMF ensures that an information document (referred to as a white paper) is prepared in accordance with Article 712–2 of the AMF General Regulation and AMF Instruction DOC-2019–06. which outlines the content of the white paper and specifies the information that should be included in different sections. According to paragraph 1.3. of AMF Instruction DOC-2019–06, the white paper should provide all relevant information about the offering and the issuer of the token.

The contents of Annex II to Instruction AMF DOC-2019–06 outline the specific sections that must be included in a white paper, to be presented in a predetermined order. Alongside the commercial and technical information typically found in a white paper, there are also crucial sections that address legal matters. These include details about the token issuer, such as their company description, legal structure, ownership, background, and activities. It is important to outline the procedures for the custody and refunding of funds and digital assets collected through the initial coin offering, as well as the subscriber reimbursement process. The white paper should address systems for verifying subscriber identities, as well as anti-money laundering and security measures. It should also specify the applicable legal framework and competent courts in case of disputes and outline the tax regime for holding tokens in France for French subscribers. Lastly, the white paper should include a declaration from the individuals responsible for its content.

Swiss law has regulations regarding the content of a white paper for initial coin offerings. The Swiss Financial Market Supervisory Authority (FINMA) is responsible for overseeing financial matters in Switzerland and has published guidelines for ICO regulations. These guidelines include a section outlining the minimum information that must be provided in a white paper, such as details of all individuals involved in the ICO and whether they have obtained financial market licenses in other countries. The white paper must also specify the rights acquired by investors and how they are documented, as well as whether a financial intermediary will be hired to fulfil due diligence requirements.

Since different countries have different regulations for ICOs, there are no consistent legal requirements for the content of white papers. However, all countries emphasize the need for disclosure of information about the issuer and project developers, which is important for investor protection. Additionally, certain legal provisions in white papers are influenced by the unique characteristics of blockchain technology.

In United Arab Emirates, Securities and Commodities Authority has issued a regulation on crypto assets offerings. In this regulation amongst other matters, white papers are also regulated. However, the regulation does not use the term white paper and instead it calls the document “Offering Documentation”. These Offering Documentations shall be clear, fair, accurate and not misleading, truthful and not omit essential information.

Furthermore, the Offering Person must ensure that all asset rights and features are recorded in the supporting technology, regularly update investors about progress towards project milestones and specify update intervals in the Offer Documentation, notify and explain to investors if technology development or other obligations aren’t met, update Offering Documentation, and inform investors about redemption rights if relevant, inform investors promptly of significant changes in software relevant to their rights, clearly disclose to investors if the crypto asset does not provide a claim right against an Offering Person for default in performance benefits.

The Securities and Commodities Authority of UAE foresees a list of information that is required to be present in the Offering Documentation. Offer Documentation for Crypto Assets must include, where relevant:

1. Clarity on fund handling until Crypto Assets are issued, and details about issuance after funding.

2. Description of all major technology-related investment risks.

3. Explanation of the software, protocols, developer engagement, software control, and implications for changes, including rights and obligations of crypto asset holders. If open source, a link to the code is needed.

4. Milestones or dependencies behind crypto asset development, failure implications, and potential refund mechanisms.

5. Timeframes for achieving project goals, manager commitments, and incentives.

6. Financial data about the offering entity/business for the last three fiscal years.

7. Information about crypto asset custody arrangements and how investors access and manage them.

8. Technology/software requirements for investors to exercise rights related to crypto assets.

9. Notice about investor rights to refunds, and refund mechanism details.

10. Information about disaster recovery, back-up, and/or insurance/guarantee strategies, or confirmation if none are present.

11. Intellectual property details, including ownership of software, patents, and copyrights.

12. Details of the team’s existing business operations and relevant personal and project history.

13. Identification of the Offering Person and, if different, the Offering entity, with details about governance and legal notification addresses.

14. Previous investor obligations for the related project.

15. Information about the outstanding token provision, token burning, token release, token reserve requirements, and third-party audit details.

16. Details of compensations for management, developers, or other contributors.

17. Liability and risk allocation between the Offering Person and the software service provider, including disruption risks.

Additionally, a “key investor information” section must succinctly present crucial crypto asset characteristics in non-technical language, ensuring understandability for non-qualified Investors. Please be aware that this list of information may vary depending on the nature and the feature crypto asset presents.

Potential Pitfalls and Red Flags

Certain aspects in a white paper can serve as a red flag or be pitfalls. This becomes relevant both from the reader or potential investors perspective, meaning that they should take note of such red flags, and from the team members working on the white paper, meaning that they should show care when producing the white paper.

The main aspect to take note of would be a lack of technical detail in the white paper as a legitimate white paper would, and should, provide detail on the technical aspects of the project, the underlying technology, consensus mechanism, cryptography, tokenomics… etc. Having a lack of technical detail and depth can be a major red flag to potential investors. Although it’s important to be able to simplify the difficult concepts behind the technological aspects of the project, it is equally, if not more, important to not be overly simplistic.

Since transparency is very important to build trust with potential investors or community members, the white paper should not be completely devoid of the identities and backgrounds of the project’s team members. A lack of transparency in this aspect can raise some red flags. The white paper also shouldn’t have any plagiarized content since this will be a major red flag, hindering the professionality behind the team and the quality of the project.

Another aspect to investigate is if the white paper is giving any unrealistic promises. It is important to be able to market and promote the crypto asset that is being launched but especially in the context of the volatility, making extravagant claims or promises of high returns can come off as a major red flag. This can also happen when a white paper claims that the technology being introduced is revolutionary or game changing, and combined with, for example a lack of technical explanation, this will be a major pitfall. Ultimately, the white paper shouldn’t just be a document that hypes the potentials of the project without providing proper and substantial information.

The tokenomics section of the white paper should be drafted very carefully and there should be a transparent token distribution. If a significant portion of the tokens is held by a single or small group of individuals or the team, this can serve as a red flag. Also, a non-detailed, dismissive section on tokenomics will not build trust with potential investors or community members.

If the white paper does not explain the utility and purpose of the project’s token within the ecosystem, it may lack a clear value proposition. This also leads to the role that the white paper plays as a road map. The credibility of the project lies in its ability to serve as a road map, building trust with potential investors and community members. A lack of detail regarding how, when and what the plans of the project are, and what the future goals are can be a red flag.

The white paper should also have adequate risk disclosure as this will legitimize the project. Outlining potential risks and challenges can provide a balanced view of the project and a lack of this will result in mistrust. The white paper should also be clear with its legal compliance. For example, if the project is conducting token sales or ICOs, it should give information on their legal and regulatory compliance. Lacking such elements will be a red flag and the project must consider legal requirements.

Consequences of Misrepresentations in White Papers

From the legal aspect, misrepresentation can lead to actions by investors, regulatory bodies or any party affected by the misrepresented information. An investor who finds that they have been misled may very well sue the project company or its founders for claims such as fraud or misrepresentation. The project may also be subject to regulatory sanctions by authorities. Regulatory authorities may investigate and impose fines or halt the project if they find misleading or false information contained in the white paper. In extreme cases, this may even result in criminal charges against the individuals involved in the project.

Misrepresentation will erode the trust of investors and hinder their confidence in the project. If the investors find that they have been misled, they won’t be very likely to keep supporting the project or invest in the future. This would also be very negative publicity, and this would result in negative backlash towards the project and its future offerings. All this can essentially lead to the downfall of the project as this is a very community support-based area. If investors purchase tokens based on misrepresented information, this will lead to loss of investment and a major market reaction such as a sharp decline in value.

Misleading information in a white paper can potentially lead to the crypto assets exclusion from exchanges, criminal liability and perhaps abandonment of the project once the misrepresentation yields consequences that are not compensable. If legal actions are taken against the individuals behind the project, the project members may be required to financially compensate for the damages incurred by investors. Therefore, to avoid these consequences, the white paper should be transparent and provide accurate information and comply with the relevant laws and regulations.

Please see the Annexes I, II and III of MiCA regarding the content and specifics of each type of crypto assets.

LEGAL DISCLAIMER

THE INFORMATION PROVIDED IN THIS PAPER PROVIDES GENERAL INFORMATION AS TO THE POSSIBILITIES IN MULTIPLE JURISDICTIONS. PLEASE KEEP IN MIND THAT LAWS THAT APPLY TO THE SUBJECT HEREIN MAY DIFFER IN EACH JURISDICTION. THUS, NOTHING CONTAINED HEREIN CONSTITUTES ANY LEGAL OPINION OR SUGGESTION OF ANY KIND. PLEASE CONSULT TO LOCAL EXPERTS IN RELEVANT AREAS BEFORE TAKING ANY ACTION BASED ON ANY INFORMATION CONTAINED HEREIN.

Beware! You might be subject to self employment income tax especially in Turkey and other countries as well. Even though there is generally no specific piece of legislation regarding crypto assets, this does not mean that there is no relevant legislation that might be applicable to your situation. In case of the absence of specific regulation, you shall look for general rules of law that might be applicable to the type of taxable income that you generate. If the nature of the work results in income for you, then it is taxable in principle.

INTRODUCTION

Cryptocurrencies, or more accurately crypto assets are one of the most promising technologies of our time, and possibly of the future. Its unique features and rebellious nature to the classic financial system, forces people to reconsider the way our classic financial system generally works. The fact that it takes so much time and money to conclude a simple oversea transaction only amplifies the exponentially-growing attention that crypto assets get. This attention is no coincidence. Some believe that with solutions that they promise, crypto assets and blockchain technology rocked or at least have the potential to rock the classical financial system’s foundations.

Despite the benefits crypto assets and blockchain technology provide or promise to provide, by some they are unfortunately perceived as a “wild west”. This is due to the fact that these new crypto assets and blockchain technology generally lack a complete regulation. In addition to foretold, blockchain technologies’ anonymous, independent and unsupervised nature raises some serious concerns, especially regarding money laundering, combatting the financing of terrorism and tax evasions. When it comes to these concerns, it is only natural for states to wave the red flag.

In this situation, states generally tend to follow one of the two ways. They are either going to find crypto assets a place in its classic regulations and make crypto assets subject to general legal norms or they introduce a new legislation specific to crypto assets and blockchain technology. Each tendency has applications in different states. It is possible and pleasing to find discrete legislation processes throughout different countries, as well as the tendency to regulate crypto assets and blockchain technology in law currently in force.

However, it is still common to come across a state or a jurisdiction which neither have discrete regulation for crypto assets and blockchain nor a tendency to find those a place in their legal structure. Even though this situation is suggestive of a wild west, it is substantially inaccurate. Because, it is only natural for law to be one or two steps behind of developing technology. States neither can nor shall regulate something that they cannot comprehend and classify. In order to properly regulate, states must closely examine and understand the possible benefits and threats of new technologies and their products. Then, they shall decide whether they are in need of a new legislation or it is better to interpret and evaluate them amongst the legal norms that are currently in force.

One other thing that shall be crucially stated is the fact that when there is no specific regulation, people tend to think and even believe that there is no rule regarding these new technologies and that they can do whatever they want. It is neither possible nor longed-for for lawmakers to come up with a specific piece of regulation for each new technology. So, while conducting business and earning an income through these new technologies, one shall always look for a specific regulation, if there is none, then, one shall go look for possible regulations that he/she/they and their act may be subjected to.

During 2017-2018, after the rise of demand and supply in crypto assets, International Organization of Securities Commissions (IOSCO) and Financial Stability Board (FSB) has concluded that the total volume and technology of crypto assets has not yet reached a size that would affect the financial system and thus, rather than implementing regulations on crypto assets, observing its technology and informing users would be sufficient. However, as the economy that revolves around crypto assets continues to grow even bigger, this “wait and see” approach started to slowly fade away. One of the main reasons that this “wait and see” approach is gradually forsaken is the possible tax evasions and state’s desire to tax this fast-growing sector.

TAXATION OF CRYPTO ASSETS IN GENERAL

Due to its enormous economic aspect, taxation is one of the hottest topics when it comes to crypto assets. As the crypto assets and blockchain technology shook the classic economic structure, they also created new methods of income, payment, employment and business models. However, taxation of the crypto ecosystem is not always so easy. Because in some jurisdictions, crypto assets currently do not have a clear regulation nor definition in the legislations, this creates hesitations in terms of defining these assets and related transactions in tax law.

The main determining factor in taxation of the crypto ecosystem is how they are legally qualified. In order for an asset or transaction to be taxable in terms of tax law, it is essential to reveal its legal nature first. In terms of taxation, the classification of crypto assets as money, investment instruments, securities, commodities or otherwise causes different consequences. In this respect, the definition of crypto assets is important in terms of revealing the elements of legal qualification. However, in the OECD report, it was stated that the very different characteristics of crypto assets make it impossible to make a single definition valid for all of them. Instead, by adopting the approach that it would be appropriate to consider the common features of crypto assets, the use of distributed ledger technology, namely blockchain, and the revealing of financial assets based on cryptography formed in this way are determined as common features.

Although the said regulations are not yet found sufficient and satisfactory by the public, it seems that they have made the necessary qualification in terms of taxation and revealing the definition in this regard. On the other hand, taxation of the crypto-assets or their trading is not complete with the formation of the definition. The most important obstacle to taxation in this area is that different approaches continue to exist in different countries. Some countries treat crypto assets as intangible assets, while others treat them as money or commodities, and some as financial instruments and derivatives. That's why it is crucial for taxpayers to closely examine the approach of their jurisdictions which they are subject to.

ANALYSIS OF EARNING METHODS OF PROJECT CATALYST

Since we are done with laying out the basics of the taxation of crypto assets, it is time to investigate earning methods through Project Catalyst. We investigate these earning methods through Project Catalyst, namely, earning through accepted proposals (aka funding), participating in the voting processes, as a proposal assessor (“PA”) and as a veteran proposal assessor (“vPA”).

Earning Methods

First earning method from Project Catalyst is through creating an impactful proposal. Cardano enables its community and blockchain ecosystem to propose creative and innovative ideas. This funding project is crucial for many members of this ecosystem. In these times, ideas are free to come up with but most of the time it requires a significant amount of capital, which some members of this community unfortunately don’t have access to. In this regard, Project Catalyst’s main function is funding those proposals which are worthy of funding.

Second earning method from Project Catalyst is to become an assessor and assess proposals based on the guidelines. The assessors are categorized in two as PA and vPA. PAs assess proposals which are in the assessment phase and determine whether the proposals carry the relevant criterias which are different for each proposal. The assessments of PAs are very important since it carries the role of guidance for the voters in making decisions regarding the proposal. The vPAs role is to review the assessments of PAs and make sure the PAs’ assessments are accurate and in line with the guidelines.

Third earning method from Project Catalyst creates a relatively democratic process for the voting process. Experts and those with valuable experience take an active role in assessing proposals and community members vote on proposals based on the proposals’ impact value. And those who participate in these processes get rewarded for their precious contributions.

Discussion of the Legal State of these Earnings

In our opinion, earning methods that are briefly examined in previous paragraphs fall under the scope of a self-employment income and our opinions will be built upon that assumption regarding the issue of taxation of crypto assets.

In order to name the earning method as an employment relationship, one has to carefully examine and bear the necessities listed below:

• There has to be a command chain between the employer and employee, meaning the employees are obliged to follow instructions and orders of the employer,

• The employee is paid on a monthly or regular basis in return of their work,

• For the employment relations that exceed one year, there must be a written employment contract between the employer and employee.

If there is an employee-employer relation between project assessors and Catalyst, then, it would be considered as income tax. However, as far as we know, the relationship between the veteran proposal assessors and proposal assessor and Catalyst does not fall in the category of employment relation. Also, income tax in such situations is paid by the employer as a deduction at source, which means the employer pays the relevant income taxes on behalf of the employee.

After this brief introduction, firstly, we will examine the taxation approaches of Turkish Law, US Law, and EU Law regarding crypto assets. As we examine those, we will also evaluate the possible taxation situations of foretold earning methods through Project Catalyst.

POSSIBLE TAXATION OF PROJECT CATALYST FUNDING ACCORDING TO TURKISH LAW

First of all, in Turkish Law, like in other similar law systems, tax can only be applied in accordance with the legislation. Like no punishment without law, there can be no tax without law. In the earning through Project Catalyst context, the aforementioned incomes of the proposers shall be regarded as self-employment incomes. According to the article 65/1 of the Income Tax Law (numbered 193): “Earnings arising from all kinds of self-employment activities are regarded as self-employment income.” Also, subparagraph 2 of the same article states that “Self-employment activity is the performance of non-commercial works based on personal work, scientific or professional knowledge rather than capital, under personal responsibility, on its own behalf and account, without being subject to the employer.” From the definition itself, one shall look for four criteria. These are as follows:

• Self-employment activity shall be performance of a non-commercial work

• This non-commercial work shall be based on personal work, scientific or personal knowledge and it shall not be based on capital.

• This self-employment activity shall be performed under personal responsibility and on behalf and account of the one who performs the self-employment activity.

• The one who performs the self-employment activity shall not perform that activity as being subject to the employer.

In order to be considered as self-employed, all of these four criterias that are explained below shall be adhered to.

For the first criteria, as we closely examine the nature of earning through Project Catalyst as a proposer, we can argue that the performances that the proposer undertakes are not of commercial nature but more of a donation or a grant. So, the first criteria is clearly met.

For the second criteria, the proposed activity is generally based on personal work or scientific or personal knowledge. Proposers are generally using their personal or professional knowledge during the performance of their proposal. Therefore, it is clear that proposers fall in this criteria.

For the third criteria, these proposals are proposed and performed under personal responsibility and on behalf and account of the proposer himself/herself/themselves.

For the forth criteria, there is clearly no employment relationship between the proposer party and the Project Catalyst or its funder. As a conclusion for this part, since the proposers, veteran proposal assessors and proposal assessors adhere to all the criterias set forth above, it is clear that this kind of earning method is regarded as self-employment income.

All these assessments are also valid for the other earning methods, namely, veteran proposal assessor and proposal assessors mentioned above.

Who is the taxpayer of such income?

In Turkish Law, there is a distinction such as fully fledged taxpayer and limited taxpayer. Fully fledged taxpayers are as follows:

• Those who are resident in Turkey

• Those who continuously resided in Turkey more than six months within a calendar year

• Turkish citizens that reside in foreign countries due to the works of offices, establishments, associations and undertakings, which are affiliated with official offices and institutions or establishments and undertakings headquartered in Turkey

Real persons who are not resident in Turkey are considered as limited taxpayers and they are only taxed on their earnings and revenues in Turkey.

When and how to pay the self-employment income tax?

In order for one to pay self-employment income tax, one shall issue an annual income tax form. This form is to be issued to the Turkish Revenue Administration to declare one’s income during a fiscal year. This form shall be issued till the evening of the last day of March, otherwise one may face a serious fine. Fines to be applied due to not issuing annual income tax form, or tax-evasions in some sort, are basically as follows:

• Fine due to not issuing income tax form,

• The tax that has not been paid,

• Interest of default or late fee (%2,5 per month)

If one is accused of tax evasion, then, one may be subject to carry out the listed three payments.

What is the Tax Rate of Self-Employment Income?

Tax rates gradually rise, and here is how:

Till 32.000 Turkish Lira (TL) tax rate is 15%

32.000 - 70.000 TL tax is 4800 TL + (income-32.000) * %20

70.000 - 170.000 TL tax is 12.400 TL + (income-70.000) *%27

170.000 - 880.000 TL tax is 39.400 TL +(income-170.000)* %35

880.000 and above tax is 287.900 TL + (income- 880.000) * %40

Relevant Regulations Regarding Transferring Crypto Assets

With the recent amendments made in relevant legislations, crypto asset service providers are now subject to the anti-money laundering, prevention of financing of terrorism regulations and etc. The Financial Crimes Investigation Board (aka “MASAK”) is the leading public authority on the application and audition of the legislation related to these matters. The main obligation of the crypto asset service providers is to report suspicious transactions to MASAK. Thus, according to the legislation, crypto asset service providers are obliged to report suspicious transactions of their users. Such suspicious transactions can be related to the amount of transfer, the frequency of transaction, sides and nature of the transaction and ID confirmations etc.

POSSIBLE TAXATION OF PROJECT CATALYST FUNDING ACCORDING TO U.S. LAW

First of all, the USA makes a differentiation between virtual currencies and cryptocurrencies. According to the IRS (Internal Revenue Service) virtual currencies are a digital representation of value that functions as a unit of account, a store of value and medium of an exchange. These virtual currencies are treated as property. There, it concludes that general tax principles applicable to property transactions also apply to transactions of virtual currencies.

Crypto currencies on the other hand are recognized as a type of virtual currency. Difference in categorization is mainly due to the fact that crypto currencies generally use cryptography to secure the transactions.

Since we laid out how the USA treats virtual and crypto currencies, now, it is time to examine their possible taxations. The IRS states the possible transactions that may result in tax consequences. These are as follows:

• Sale of a digital asset

• Exchange of digital assets for property, goods or services

• Exchange of trade of one digital asset for another

• Receipt of a digital asset as payment for goods or services

• Receipt of a new digital asset as a result of mining and staking activities

• Receipt of a digital asset as a result of an airdrop

• Use of digital assets to pay for goods and services

• Any other disposition of a financial interest in digital asset

• Receipt or transfer of a digital asset for free (without providing and consideration) that does not qualify as bona fide gift

Additionally, we shall examine the approach of the IRS in regards to income purposes. Here is how the IRS sees incomes through crypto currencies (with direct quotes):

“When you receive property, including virtual currency, in exchange for performing services, whether or not you perform the services as an employee, you recognize ordinary income.”

“The fair market value of virtual currency received for services performed as an independent contractor, measured in U.S. dollars as of the date of receipt, constitutes self-employment income and is subject to the self-employment tax.”

“The medium in which remuneration for services is paid is immaterial to the determination of whether the remuneration constitutes wages for employment tax purposes. Consequently, the fair market value of virtual currency paid as wages, measured in U.S. dollars at the date of receipt, is subject to Federal income tax withholding, Federal Insurance Contributions Act (FICA) tax, and Federal Unemployment Tax Act (FUTA) tax and must be reported.”

By receiving crypto currency in exchange for performing services, whether or not performing the services as an employee, this would be considered recognizing an ordinary income. Following this, the fair market value of the crypto currency received for services performed as an independent contractor would constitute a self-employment income and can be subject to self-employment tax.

So, as one may clearly see, the IRS does not generally make a differentiation depending on which medium of exchange the income is earned. What it really focuses on is whether there is a taxable income or not. In conclusion, similar to the Turkish Law, earning through Project Catalyst as a proposer has a strong probability of being treated as an income. So, where there is income, there is also income tax.

Activities of the voters or proposal assessors are not really different. Their earnings through such activities are also subject to taxation due to the fact that the IRS sees “receipt of a new digital asset as a result of mining and staking activities” taxable.

How to Calculate Your Income Received in Cryptocurrency?

For U.S. tax purposes, transactions using crypto currency must be reported in U.S. dollars. The calculation of income is the fair market value of the crypto currency in U.S. dollars at the date it is received.

Additional Information Such as Reporting and Fines Regarding This Issue

Information reporting requirements apply to payments made in crypto currency as they do to payments made in other forms of property. For instance, if someone pays a U.S. non-exempt recipient fixed and determinable income in crypto currency worth at least $600 throughout the course of a trade or company, they must notify both the IRS and the recipient of the payment. Rent, wages, premiums, annuities, and compensation are a few examples of payments of fixed and determinable income.

In general, anybody who pays an independent contractor for services rendered in the course of their trade or company $600 or more in a tax year is obliged to record that payment to the IRS and the payee on Form 1099-MISC, Miscellaneous Income. Crypto currency payments that must be reported on Form 1099-MISC shall be reported using the crypto currency's fair market value in US dollars as of the payment date.

Tax law violations may result in fines for the taxpayer. For instance, fines like accuracy-related penalties under section 6662 may be applied to underpayments linked to transactions involving crypto currencies. Additionally, information reporting fines under sections 6721 and 6722 may apply if crypto currency transactions are not immediately or accurately reported when obliged to do so. Taxpayers and individuals required to file information returns, however, may be eligible for penalty relief if they can demonstrate that an underpayment or improper filing of information returns was caused by a valid reason.

POSSIBLE TAXATION OF PROJECT CATALYST FUNDING IN DIFFERENT JURISDICTIONS

EU LAW

Through the markets in crypto assets framework, policymakers in the European Union have advanced efforts to regulate the crypto currency industry. EU authorities use the term "virtual currency" instead of the term "crypto currency", while it is considered, among other things, as a means of payment. Depending on the type of cryptocurrency transaction, the taxation of crypto currencies and transactions using them is governed by the national regulations of each Member State. In this instance, a digital currency is typically considered for tax reasons as an intangible asset or commodity rather than as money or currency. Value added tax is not applied to the exchange of crypto currencies for conventional currencies in either the buying or selling process. Also, according to the Markets in Crypto-assets (MiCA) (dated 05.10.2022) proposal, crypto assets are recognized as “digital representations of a value or a right which may be transferred and stored electronically, using distributed ledger technology or similar technology”. However, these proposals are yet to enter into force. Since there is no common decision to cover EU countries yet, EU countries apply their local legal regulations as aforementioned.

Recently, on 4 October 2022, the European Parliament adopted the resolution on the” impact of new technologies on taxation: crypto and blockchain”. First of all, the text states that different types of crypto assets may result in different types of tax treatments. With that being said, it also states EU member states lack of uniform tax legislation regarding crypto assets. Since the binding legislation for taxation of crypto assets is yet to be found in the EU, the text states that Member States are responsible for determining how to tax crypto assets in accordance with the treaties. Additionally, it calls for authorities to take into account a simplified tax treatment for sporadic or small traders. The text also states that crypto assets must be subject to fair, transparent, and effective taxation in order to ensure fair competition and a level playing field between financial services providers and the tax treatment of assets and financial products.

Since there is currently no internationally agreed-upon standard definition of crypto-assets and the types of assets that the term should include, The EU understands the need for such a definition as a main priority in the European legislative framework in order to guarantee a leading position for the Union at an international level and that the OECD is tasked with defining the tax base for crypto assets.

Even though the EU calls on Member States to treat different types of crypto-assets in a manner that is consistent with the tax treatment of similar non-crypto assets, there is no uniform approach throughout EU states. Since there is no uniform approach or legislation, one shall carefully examine the specific and individual approach and legislation of the relevant state which the one is subject to.

AUSTRALIAN LAW

According to the Australian Taxation Office, crypto assets are treated as digital representations of value that one may transfer, store or trade electronically. Since we laid out how the Australian Tax Office treats crypto assets, it is time to examine taxation of these crypto assets.

First of all, it is safe to state that there is no specific or discrete legislation in Australian Law regarding taxation of crypto assets. However, this does not mean that these crypto assets are not taxable. Even though these crypto assets generally operate differently than classical instruments, they are taxable. After all, these crypto assets neither function nor operate under central banks or governments. Despite their differences, these crypto assets are subject to the same tax rules as other general assets. Tax treatment of crypto assets will be determined according to their nature and how and why they are acquired.

Additionally, it is worthwhile to note that there is a tendency to tax crypto assets as capital gains taxed assets. However, this tendency is generally applied to acquisitions of crypto assets for investment purposes. Also, rewards that members of the ecosystem may get for staking their crypto assets are eligible to be taxed as ordinary income.

As a conclusion, one who earns crypto currency and is subject to Australian Tax Law shall act in the same way as one who does not earn crypto. Their tax regime is the same. So, it is possible for proposers and participants of the Project Catalyst to be subject to relevant income tax rules.

CANADIAN LAW

Like in Australia, crypto assets are accepted as digital representations of value in Canada. They may be used as a medium of exchange if the parties are willing. The Canada Revenue Agency on the other hand, has the tendency to treat crypto assets as commodities.

When it comes to taxation of crypto assets in Canada, the Canada Revenue Agency generally assumes incomes that arise from transactions concluded with crypto assets as business income or as capital gain. However, this assumption may differentiate depending on the circumstances and nature of that said transaction. Additionally, it is important to state that as earnings through crypto assets may qualify as business income or capital gain, it is possible for losses to be treated as business losses or capital losses. Furthermore, taxpayers who are subject to Canadian Tax Law shall establish the nature of their crypto asset activity. Whether these activities result in income or capital gain directly affects the way these revenues are treated for tax purposes.

As a conclusion, it is possible for proposers and participants of the Project Catalyst to be subject to relevant income tax rules.

UK LAW

According to the Her Majesty’s Revenue and Customs (HMRC), crypto assets are considered as digital representations of value or contractual rights which can be stored, transferred or traded electronically. Also, it clearly states that tax treatment of crypto assets depends on the nature and use of these crypto assets. So, it is not really important how the issuer or user of the crypto asset defines that asset. What really matters when it comes to taxation is how and why these crypto assets are used.

Additionally, it is worthwhile to note that there is neither specific nor discrete legislation for taxation of crypto assets. Earnings through crypto assets are basically subject to general tax rules and principles, such as income tax or capital gains tax. Furthermore, it is crucial to state that as earnings through crypto assets may qualify as taxable revenue.

So, for one who is subject to UK Law, it is essential to determine the nature of his/her/their revenue through crypto assets. If the nature of their relationship or transaction constitutes a taxable action, then they are subject to general tax rules and principles of the UK, regardless of whether they earn through a crypto asset or not.

As a conclusion, it is possible for proposers and participants of the Project Catalyst to be subject to relevant income tax rules.

GERMAN LAW

Crypto assets are taxed in Germany. In Germany, crypto assets are viewed as a private asset unlike property. The Bundeszentralamt für Steuern (“BSZt”) states that any additional income from crypto assets, such as mining, staking or airdrop, as well as short-term capital gains from crypto assets which are held for less than a year are subject to income tax. Therefore, rather than being subject to capital gains tax, crypto assets are subject to individual income tax.

When you dispose of a private asset such as a crypto asset, the tax rules change depending on how long you held the crypto asset. In addition to taxation on disposal of a crypto asset, you might be subject to pay income tax on crypto received or earned.

All short-term crypto asset gains are subject to income tax in Germany at the applicable individual rate. This implies that you are subject to from 0 to 45% tax on your crypto asset gains, also depending on your total income for that tax year. Germany won’t require you to pay any tax at all on your crypto asset gains if the assets are held for a year.

Tax-free situations in Germany are as follows:

• If you hold your cryptocurrency for one year or longer

• If your total profits from short-term gains are less than €600 during the tax year

• If your total income from crypto (staking, mining, airdrop etc) is less than €256 during the tax year

BZTs clarified that receiving or earning crypto assets are taxed as income tax only if it has been received in exchange for a service. This means that if one received or earned the crypto asset without providing any service or doing any specific action, such earning can be considered tax-free. In conclusion, it is possible for proposers and participants of the Project Catalyst to be subject to relevant income tax rules.

BELGIAN LAW

In Belgium, crypto assets still remain unregulated and raising questions regarding their taxation. The Special Tax Inspectorate (STI) treats incomes which are subject to taxation from the sale of crypto assests as “miscellaneous income”. According to Belgian Tax Law the categories for taxable income is as follows:

• Earned income (eg: employment income)

• Self-employment, retirement, business income

• Investment income

• Other miscellaneous income

• Real estate income

As of today, Belgium has an ongoing implementation of 33% taxation policy on capital gains or speculating on crypto assets. Such income is subject to declaration under the section of “miscellaneous income” on their tax returns. Nevertheless, the implementation of such taxation is difficult since such transactions take place over foreign platforms.

For individuals such as exchangers, payment processors, traders, miners and other service providers which are not working with a company or an establishment could potentially be subject to Belgian personal income tax. For personel income tax, the tax rates are between 25% and 50% plus communal tax.

One should examine the Prudent Man principle in order to remain tax-free. Prudent Man principle can be considered by the following conditions:

• The individual has never been active in finance;

• The individual’s education or profession is not related to crypto assets;

• Such investment is made with her/his own gains and a loan is not used in this manner;

• The individual didn’t use any automated software or engage in mining;

• The crypto assets had never been sold;

• The transactions over the years cannot qualify as a business activity;

• “Buy and hold” method has been used and the crypto asset was kept for several years.

If the conditions are met, one can remain tax-free. This being said, it should also be considered that these conditions are evaluated by the relevant authorities in order to be deemed tax-free from transactions of crypto assets.

LEGAL DISCLAIMER

THE INFORMATION PROVIDED IN THIS PAPER PROVIDES GENERAL INFORMATION AS TO THE POSSIBILITIES IN MULTIPLE JURISDICTIONS. PLEASE KEEP IN MIND THAT LAWS THAT APPLY TO THE SUBJECT HEREIN MAY DIFFER IN EACH JURISDICTION. THUS, NOTHING CONTAINED HEREIN CONSTITUTES ANY LEGAL OPINION OR SUGGESTION OF ANY KIND. PLEASE CONSULT TO LOCAL EXPERTS IN RELEVANT AREAS BEFORE TAKING ANY ACTION BASED ON ANY INFORMATION CONTAINED HEREIN.

Crypto assets are considered to be a highly promising technology with the potential to disrupt the traditional financial system. Their distinctive features and defiance of the conventional financial system have led people to reevaluate how financial transactions are typically conducted. The inefficiencies and costs associated with international transactions have further increased the interest in crypto assets. Many believe that these assets, along with blockchain technology, have the ability to significantly impact or even revolutionize the foundations of the traditional financial system.

Many people see crypto assets and blockchain technology as unregulated and risky. The anonymity and independence of blockchain technology also raise concerns about illegal activities like money laundering and terrorism financing. It is understandable that governments are worried about these issues.

In this scenario, states typically adopt one of two approaches. They either include crypto assets within existing regulations and subject them to established legal norms, or they create new legislation specifically for crypto assets and blockchain technology. Each approach is implemented in different states. It is interesting to note the diverse legislative processes in various countries, as well as the current trend towards regulating crypto assets and blockchain technology through law.

However, it is still common to find states or jurisdictions that do not have specific regulations for crypto assets and blockchain technology, and they also do not show a tendency to include them in their legal framework. This may give the impression of a lawless environment, but would not be entirely accurate. It is natural for the law to lag behind technological advancements. States cannot and should not regulate something they do not understand or cannot categorize. In order to regulate properly, states need to thoroughly examine and comprehend the potential benefits and risks of new technologies and their products. They should then decide whether new legislation is necessary or if existing laws can adequately address these technologies.

When there are no specific regulations, people may assume they can do whatever they want with new technologies. However, it is also unrealistic for lawmakers to create regulations for every new technology. Therefore, individuals should always seek out any existing regulations or potential regulations that may apply to their actions when conducting business or making money with these new technologies.

Taxable Events

When crypto assets are used for transactions, a taxable event may occur, and the taxation of crypto assets depends on how they are held and utilized. Please note that the following analysis of events, their definitions, and whether they can be taxable can change according to the tax regulations of any relevant jurisdiction and their understanding of such events.

Staking

Staking is a method of earning rewards for holding crypto assets and validating transactions. There are two main categories of staking, on-chain and off-chain, which can further be divided into subcategories. This complexity can make the analysis of staking methods challenging.

Staking is the active participation in transaction validation on a proof-of-stake (PoS) blockchain. Here, the participants lock up a specific amount of the crypto asset they hold as a stake, in other words as a collateral, to be eligible to create new blocks and verify transactions. The participant is also referred to as a validator, and the likelihood of being chosen as a validator is often proportional to the amount staked. Validators get rewarded with additional crypto assets for performing duties successfully. However, they may also face penalties like the loss of part of their staked funds if there is malicious behavior. Ultimately, staking is a key matter in PoS consensus mechanisms.

Generally, if a taxpayer uses their own hardware to validate transactions within a decentralized network, it can be considered active income. This requires an initial investment, technical knowledge, and a professional structure that generates charges. On the other hand, if the taxpayer uses a crypto assets trading platform to engage in staking and earn income, it can be considered passive income. This can be done without using personal hardware and can be accessed through a mobile device.

Airdrop

An airdrop is the distribution of tokens or coins to a group of wallet addresses as a form of promotion of community building initiated by blockchain projects that seek to raise awareness, reward loyal members, or attract new participants. Airdrops usually mean delivering a certain amount of tokens directly to the wallet of an eligible recipient, based on predetermined criteria like holding a specific crypto asset or even participating in an online activity or project with the goal of fostering engagement, increasing user base, and creating community within a project. Airdrops can be small in scale such as small giveaways but they can also vary to larger-scaled distributions tied to a project.

When it comes to airdrop activity, unless there is a consistent and stable promotional task that generates charges, it seems that we are not dealing with a business activity. Instead, it is the use of crypto-assets that generates occasional and irregular passive income.

Sometimes, taxpayers become beneficiaries of crypto-assets without intending to, and they may not even be aware of it. In these cases, there is no intention to make a profit from these assets.

Mining

When new units of digital assets are generated and transactions are added to the blockchain, this is called mining. In a proof-of-work system, miners compete, solving complex mathematical puzzles. The first to solve the puzzle gets granted the right to add a new block of transactions to the blockchain. Miners are then rewarded with newly created crypto assets and transaction fees for their efforts.

When crypto asset miners are paid for verifying transactions and adding them to the blockchain, it can lead to a taxable event. This means that the compensation they receive can be taxed as regular income, similar to how salaries are taxed. If the mining is done as part of a business, miners may be able to report the crypto asset as business income and deduct any expenses related to their mining operations from their tax obligations.

Capital Gains, Selling and Trading

If a person sells or trades crypto assets and makes a profit or loss, it is considered a capital gain or loss. This means that they may be required to pay taxes on the gain, similar to how investors are taxed on gains from other capital assets. Just like with stocks and other investments, if a person sells their crypto asset for a profit, they may be subject to capital gains taxes. However, if they sell the crypto asset at a loss, they do not owe any taxes, but they may still need to report the loss to the appropriate tax authorities.

Taxable events occur when investments are sold or exchanged, and also when different crypto assets are traded. The evidence indicates that the taxpayer is actively buying and selling crypto-assets with the goal of making a profit.

When selling crypto assets, individuals are required to report the income they made from the transaction based on the crypto asset’s value at the time of the sale. It is also taxable if the crypto asset is exchanged for fiat currencies like yen, euro, or U.S. dollars.

The cost basis of crypto assets traded for fiat money is determined by the amount of money and fees paid by the exchange. To calculate the capital gain or loss from the transaction, the cost basis is subtracted from the fair market value of the crypto asset.

Creation, Selling, Purchase, and Resale of NFTs

If someone consistently and intentionally creates and sells NFTs for profit, it can be considered a business or professional activity. In some cases, this can give the original creator similar rights to a copyright holder, and any income earned from this activity may be classified as intellectual property income.

Individuals who regularly buy and sell NFTs as their main business activity, and earn commissions or royalties through smart contracts, can be considered as generating income from intellectual property.

Depending on the country, such income may be exempt from taxes if certain conditions are met (e.g.: Türkiye).

The wide range of crypto-assets, including NFTs like digital collectibles and online game tools, raises questions about the taxation of gains from their sale. For example, if two children exchange NFT game tools and make a profit, it is unclear whether this should be considered a taxable event or just a personal transaction.

General Legal View on Taxation of Crypto Assets

Taxation is a major issue in the crypto asset industry because it has disrupted traditional economic structures and created new ways of earning and conducting business. However, the lack of clear regulations and definitions for crypto assets in certain jurisdictions complicates the process of determining how these assets should be taxed.

The tax implications of the crypto ecosystem depend on how crypto assets are legally classified. To determine if an asset or transaction is taxable, it is important to understand its legal nature. The classification of crypto assets as money, investment instruments, securities, commodities, or something else has different consequences for taxation. However, the OECD’s Crypto-Asset Reporting Framework and Amendments to the Common Reporting Standard acknowledges that it is difficult to have a single definition for all crypto assets due to their diverse characteristics. Instead, the report suggests considering the common features of crypto assets, such as their use of blockchain technology and the creation of financial assets through cryptography.

Taxation of crypto assets is still incomplete due to the differing approaches taken by different countries. Some countries consider crypto assets as intangible assets, while others view them as money, commodities, financial instruments, or derivatives. It is important for taxpayers to understand how their own jurisdiction treats crypto-assets.

The OECD’s Crypto Asset Reporting Framework and Amendments to the Common Reporting Standard

The OECD Committee on Fiscal Affairs approved the Amendments to the Crypto Asset Reporting Framework (“CARF”) and the Common Reporting Standard (“CRS”), through the International Standards for the Automatic Exchange of Information in Tax Matters for 2022/2023. The amendments to both the CARF and the CRS were adopted as part of a review of the International Standards for the Automatic Exchange of Financial Account Information in Tax Matters.

Unlike traditional financial products, without any central administration, crypto assets can be owned and transferred without the intervention of traditional financial intermediaries such as banks. New, unregulated intermediaries and service providers, such as crypto-asset exchanges and wallet providers, have also emerged as a result.

The OECD aimed to create a complementary compliance structure and this resulted in the emergence of the CARF, which contains model rules and interpretations similar to the CRS that can be enacted in national legislation that follows common reporting standards.

The CARF is designed to enable the collection and automatic exchange of information on transactions in Relevant Crypto Assets. According to the OECD report, “crypto asset” means a digital representation of value that relies on a cryptographically secured distributed ledger or a similar technology to validate and secure transactions.

“Reporting Crypto-Asset Service Provider” refers to any individual or Entity that, as a business, provides a service effectuating Exchange Transactions for or on behalf of customers, including by acting as a counterparty, or as an intermediary, to such Exchange Transactions, or by making available a trading platform.

On the other hand, a “Relevant Crypto Asset’’ is defined as any crypto asset that is not a Central Bank Digital Currency, a Specified Electronic Money Product, or any Crypto-Asset for which the Reporting CryptoAsset Service Provider has adequately determined that it cannot be used for payment or investment purposes. This term excludes three categories of crypto assets from reporting requirements that pose limited tax compliance risks.

“The first category is those Crypto-Assets which the Reporting Crypto-Asset Service Provider has adequately determined cannot be used for payment or investment purposes. This exclusion builds on the scope of the virtual asset definition of the Financial Action Task Force (“FATF”) and seeks to exclude Crypto-Assets that do not have the capacity to be used for payment or investment purposes.

The second category is Central Bank Digital Currencies, representing a claim in Fiat Currency on an issuing Central Bank, or monetary authority, which functions similarly to money held in a traditional bank account.

The third category covers Specified Electronic Money Products that represent a single Fiat Currency and are redeemable at any time in the same Fiat Currency at par value as a regulatory matter, in addition to meeting certain other requirements. Reporting on Central Bank Digital Currencies and certain Specified Electronic Money Products held in Financial Accounts will be included within the scope of the CRS.”

The CRS was introduced as a new information collection and reporting standard for financial institutions, and it envisages the collection of information from financial institutions in jurisdictions and the automatic sharing of this information with other jurisdictions every year, aiming to help combat tax evasion and protect the integrity of tax systems. It sets out the financial account information to be exchanged, the financial institutions required to report, the different types of accounts and taxpayers, and the common due diligence procedures to be followed by financial institutions.

The CARF is mainly composed of three main components;

• Rules and related Commentary that may be transposed to collect information from Reporting Crypto-Asset Service Providers that have a relevant connection to the jurisdiction implementing CARF. Reporting Crypto-Asset Service Provider indicates any person or entity that, as a business, provides a service that executes exchange transactions for or on behalf of clients, including acting as a counterparty or intermediary to exchange transactions or offering a trading platform. These Rules and Interpretations consist of four pillars:

a. The framework of Crypto Assets to be covered;

b. Legal Entities and natural persons subject to data collection and reporting requirements;

c. Transactions subject to reporting and the information to be reported in relation to these transactions; and

d. Due diligence procedures to identify users and controlling persons of crypto-assets and identify relevant tax jurisdictions for reporting and exchange purposes.

• CARF (CARF MCAA [Multilateral Competent Authority Agreement on Automatic Exchange of Information pursuant to the CARF]) and related Interpretations (or bilateral agreements or arrangements); and

• An electronic format (XML schema) that Delegated Authorities will use to exchange CARF information, as well as an XML schema that Reporting Crypto Asset Service Providers will use to report information to tax authorities, to the extent permitted by domestic law.

The reporting obligation under CARF applies to entities or individuals involved in the exchange of crypto-assets for clients. This includes exchanges, intermediaries, brokers, and dealers in Relevant Crypto Assets. The reporting obligation is determined based on factors such as tax residency, incorporation, management, regular place of business, and place of transaction in a jurisdiction that has adopted the standard.

The CARF defines three types of reportable transactions as (a) Exchange transactions between crypto-assets and fiat currencies, (b) Exchange transactions between different forms of crypto assets, and © Transfers of crypto assets, including large retail payment transactions.

Reporting is done on an aggregated basis, distinguishing between crypto-asset-to-crypto-asset and crypto-asset-to-fiat currency conversions.

The CARF also requires the reporting of holding and transfers of crypto-assets outside the scope of reporting, providing the number of units and aggregate value of transfers to wallets not associated with virtual asset service providers or financial institutions. Tax authorities may request further information on wallet addresses through the channels indicated by the OECD if they have compliance concerns.

Reporting Crypto Asset Service Providers will be subject to the rules set out in Section I (B) if they (i) are tax resident, (ii) are incorporated or organized, and have legal personality or are subject to tax reporting requirements, (iii) are managed, (iv) have a regular place of business, or (v) conduct Relevant Transactions through a branch located in a jurisdiction that has adopted the rules.

Legal Challenges of Double Taxation, Income Tax, and Value-Added Tax

Double Taxation

Double taxation occurs when a taxpayer gets subjected to a tax, on the same income or assets, in more than one jurisdiction. This can happen both on an international level and a domestic level. An international form of double taxation means two different countries or tax jurisdictions try to tax a taxpayer, at the same time or at different times, for the same income or asset.

A domestic form of double taxation can happen when different levels of government tax the taxpayer for the same income or asset. Double taxation can prove inefficient and burdensome results on taxpayers and often, most jurisdictions have laws preventing double taxation, and double taxation treaties are signed by governments to avert double taxation. International double taxation treaties are entered into with the aim of allocating taxing rights between the countries.

Double taxation of income occurs when the same income or profit made by a person is taxed by two or more tax authorities, either internationally or domestically. Double taxation of assets occurs in areas of real estate or financial assets. For example, if a person inherits an asset, they may be subject to an estate tax and later when the asset is sold or transferred, they might also be subject to a capital gains tax, thus taxing the same asset twice, at different times.

Commonly, tax credits, exemptions, and deductions are put in place to avoid double taxation of income or assets. It is also important to note that different jurisdictions may have different approaches to double taxation.

Double taxation of crypto assets can also occur when multiple jurisdictions impose taxes on the same crypto asset income or capital gain. Due to the global and decentralized nature of crypto assets, this also yields a more complicated playing ground. For example, when crypto asset transactions cross international borders, there is a likelihood of the taxpayer being subjected to tax liabilities in both their home country and where the transaction occurred. Here the existence of tax treaties that can offer tax credits, deductions, or exemptions can help avoid double taxation. Yet, this is not a given either as specific treaties may have different provisions depending on the countries involved. Therefore, taxpayers should keep records of their transactions, thoroughly, in order to avoid any penalties.

If a crypto asset is sold for profit, and is taxed as a capital gain, once the proceeds of the sale turn to fiat currency, the taxpayer may also be subject to income tax on the capital gains, which is seen in the US. Mining rewards are received typically as newly created crypto asset coins or transaction fees, which are also generally considered taxable income at their fair market value upon their receipt. Such mining reward being subject to income tax may later be subject to capital gains tax if the mined crypto asset is sold.

It is vital to keep detailed records of mining activities, with dates and values of rewards, expenses, etc. This will make it easier for compliance and reporting as well as international considerations. This means that if a crypto asset is mined in one country and sold in another, the taxpayer may be subject to tax obligations in both of these countries. Therefore, it is important to keep the details of the events.

Income Tax

Income tax is a tax that is imposed on the income of persons and entities within a certain jurisdiction. Wages, salaries, capital gains, interests, and business profits can all be forms of income that are taxed. Higher earners are often subject to higher taxes.

In order for income tax to be calculated, entities or individuals must report their income and their tax liability periodically in tax returns, determined by their specific jurisdictions. Then the tax authorities will determine the taxable income with, if any, specific deductions, exemptions, or credits to be applied. For example, in Türkiye and other jurisdictions, employers or financial institutions withhold taxes from the wages of employees and directly forward payments to the governmental tax authority on behalf of the employee/taxpayer. This can be helpful as missing filing deadlines or failing to comply with regulations will result in penalties or interests.

In the context of crypto assets, there can be a taxable event. Income tax is taken due to taxable events like receiving payment for services in the form of crypto assets or receiving mining rewards. These events can be considered taxable income. Further, the value of the crypto asset at the time of the taxable event is important in the determination of the taxable income. Again, it is important to keep records of the dates and details of the transactions in order to ensure accuracy and compliance.

In certain jurisdictions, deductions are made according to expenses. Therefore, taxpayers may be allowed to deduct certain expenses that occur as a result of activity relating to crypto assets. According to regulation or the approach of the tax authority, mining costs, transaction fees, expenses… etc. can be deducted from taxable income.

The actual payment of income tax resulting from crypto asset earnings is typically paid in the regulating country’s fiat currency. Here, the date of receipt and dates of transactions are highlighted again as the fiat currency equivalent of transactions being calculated accurately will save taxpayers from losses.

Value Added Tax

Value Added Tax (VAT) is a consumption tax put on the value added at each stage of production and distribution of goods and services, typically collected from end consumers. However, businesses in the supply chain can also pay VAT to the government. VAT offers a source of revenue for governments and, therefore, is based pretty broadly amongst jurisdictions. VAT is similar in most countries but can vary in its rate, exemptions, and requirements.

VAT differs from income tax in that it is levied based on the destination where the final consumption of the good or service being taxed occurs and is not based on the location of the taxpayer. There are double taxation treaties that address VAT and aim to avoid VAT being paid in multiple countries. In international trade, for example, VAT is imposed on the imports of goods and services, and the VAT payment is often made by the importer. Ultimately, VAT compliance can be complex, especially within the context of cross-border compliance.

The treatment of VAT on crypto assets can vary from jurisdiction to jurisdiction. In some countries, goods and services cannot be purchased with crypto assets thereby eliminating a conversation on VAT altogether. However, if the purchase of goods and services through crypto assets is allowed, the transactions may be subject to VAT, making the seller and the buyer have VAT obligations.

The Court of Justice of the European Union has previously issued an opinion in 2015 in the case of David Hedqvist where it ruled that the services of a Bitcoin Exchange in exchanging Bitcoin for a fiat currency is exempt from VAT on the basis of the currency exemption. In the VAT Committee Working Paper №892, it is stated by the EU Commission that this exemption could apply to the transfer of crypto assets. However, there are also events that don’t involve the transfer of an asset per se.

Article 135 of COUNCIL DIRECTIVE 2006/112/EC of 28 November 2006 on The Common System of Value Added Tax is as follows,

“Member States shall exempt the following transactions:

(a) insurance and reinsurance transactions, including related services performed by insurance brokers and insurance agents;

(b) the granting and the negotiation of credit and the management of credit by the person granting it;

© the negotiation of or any dealings in credit guarantees or any other security for money and the management of credit guarantees by the person who is granting the credit;

(d) transactions, including negotiation, concerning deposit and current accounts, payments, transfers, debts, cheques, and other negotiable instruments, but excluding debt collection;

(e) transactions, including negotiation, concerning currency, bank notes, and coins used as legal tender, with the exception of collectors’ items, that is to say, gold, silver, or other metal coins or bank notes which are not normally used as legal tender or coins of numismatic interest;…”

It can be argued that still, a majority of transactions can fall under this article of the VAT Directive, thereby exempting them from VAT payments.

EU countries have different views on the taxation of mining activities. In Germany, Ireland, Slovenia, and Sweden, mining activities are not subject to VAT. However, in France, income from mining activities is taxed as a provision of services.

The EU Member States have different approaches to taxing certain services related to digital assets. For example, Germany considers wallet services and clearing services for crypto assets as taxable events for VAT, while other countries exempt these services from taxation. Slovenia taxes online foreign exchange services but excludes wallet services and virtual currency exchanges from VAT. Italy exempts foreign exchange services from VAT, similar to other foreign currencies.

If we were to give examples of how VAT is applied to virtual currencies in non-EU European countries like the UK, we can see that mining is not subject to VAT because there is no direct connection between the services provided and the price, and there is no customer involvement in mining services.

On the other hand, exchanges involving virtual currencies are not subject to VAT, but VAT can be paid for goods or services that are exchanged using virtual currencies. In Norway, virtual currencies are used as a form of payment, and the exchange of virtual currencies is exempt from VAT if the virtual currency is used as an alternative payment method. Mining rewards are also exempt from VAT, but those who sell data processing power to others for mining purposes are subject to VAT.

In several countries, including Switzerland and Australia, the exchange of virtual currencies for other currencies or goods and services is not subject to VAT. Instead, the purchase of goods and services with virtual currencies is treated as a taxable sale. In Israel, individual investors in virtual currencies are not subject to VAT, but those involved in mining activities are considered sellers and liable for VAT. Overall, virtual currencies are generally treated as tax-oriented financial businesses exempt from VAT.

Prior to July 2017, the sales of virtual currencies in Japan were subject to VAT if the buyer was in Japan. However, a regulation was implemented in July 2017 that exempted stock exchanges from charging VAT on virtual currencies, as long as they met the criteria of being classified as crypto assets under the relevant law. Essentially, virtual currencies in Japan are now treated similarly to government currencies in terms of VAT.

As of January 1, 2020, Singapore does not impose taxes on the exchange of virtual currencies with other virtual currencies or legal currencies, and using virtual currencies as a means of payment for goods and services is also tax-exempt. However, mining services provided to identifiable parties are subject to tax. In South Africa, all transactions involving crypto assets are considered financial services and are exempt from VAT. In New Zealand, the taxation of crypto asset transactions is determined on a case-by-case basis, and crypto asset exchanges are exempt from GST. However, other related services such as mining or computing services may still be subject to GST.

Taxation of Crypto Assets According to Jurisdictions

When creating a legal framework in any area of law, it is important to first define the key terms and entities that will be regulated. This is particularly crucial in tax law, as it is necessary to establish clarity and certainty for taxpayers since tax law inherently restricts the rights of individuals.

To protect the interests of taxpayers and establish clear guidelines, it is important to define the rights and obligations of individuals in the realm of crypto asset taxation. The technical aspects of crypto assets, such as their classification as property or contracts, present challenges for effective tax assessment and collection. Additionally, the treatment of crypto assets varies between global tax systems and schedular tax systems. While gains from speculative trading can be easily taxed under a global tax system, categorizing these gains becomes more difficult in schedular tax systems where they may not fit into specific income categories.

Understanding the definition of crypto assets is crucial in comprehending their alignment with existing tax structures. In a majority of jurisdictions, these assets are deemed as property for tax purposes, falling under the category of crypto assets. However, countries adopt diverse approaches in categorizing these currencies within the established definition. While many refer to them as intangible assets, others classify them as commodities or financial instruments. Interestingly, some countries take a distinct stance, regarding these currencies as “a digital representation of value” (for instance, Poland) or as foreign fiat currencies (like Italy).

For example in South Africa, crypto assets are not seen as official currencies for tax purposes. Any profits made from crypto assets are subject to taxation. The South African Revenue Service categorizes crypto assets as intangible assets rather than currency or property. This means that selling crypto assets is considered a capital gains tax event.

In contrast, several nations advocate for distinct taxation protocols based on the scale of individual crypto asset mining ventures, distinguishing between small-scale endeavors often regarded as hobbies, larger-scale operations, and those conducted on a commercial level. Notably, countries like Finland and Denmark view mining as taxable income only if it surpasses the realm of a mere hobby, whereas Norway imposes taxes on both mining revenues and profits derived from crypto asset sales conducted on a commercial scale. Conversely, engaging in mining as a leisurely pursuit typically remains exempt from taxation.

Once again, it is worth noting that numerous nations have explicitly incorporated provisions in their legislation to exempt individuals who engage in small-scale production of reward tokens or pursue crypto asset mining as a hobby from taxation unless these tokens are subsequently traded or utilized in any manner. For instance, in countries such as Australia and Canada, individuals involved in the hobbyist mining of crypto assets are not subjected to tax obligations until they decide to trade their tokens. However, it is important to highlight that when these tokens are eventually traded, they become subject to taxation under the esteemed “capital gain tax” framework.

In Singapore, mining activities are considered hobbies and not taxed unless the person consistently and intentionally profits from them. In other countries like New Zealand and the UK, taxes may be imposed on mining rewards and the sale of crypto assets. In the US, crypto sales are subject to capital gains tax. Virtual currencies are not widely accepted as a form of currency for tax purposes, and most countries treat crypto assets as property for income tax purposes.

Several countries have different definitions for virtual currencies for tax purposes. Australia, France, Chile, Czech Republic, Luxembourg, Nigeria, Spain, Sweden, Switzerland, and the United Kingdom consider virtual currencies to be intangible assets. Argentina, Brazil, Croatia, Denmark, Israel, Japan, Slovak Republic, and South Africa classify virtual currencies as financial instruments or assets. Austria, Canada, China, and Indonesia define virtual currencies as commodities. Belgium, Côte d’Ivoire, Italy, and Poland view virtual currencies as currency. Japan considers virtual currencies as legal tender. The United States may define virtual currencies as capital assets.

Some countries, including Belgium, Ivory Coast, Italy, and Poland, consider virtual currencies to be similar to traditional currencies for tax purposes. Portugal does not tax crypto asset sales because it sees them as a form of payment rather than an asset. France taxes earnings from converting virtual currencies into traditional currency but exempts transactions between different crypto assets. Overall, there is no uniform approach among countries when it comes to taxing virtual currencies. Let’s have a more detailed look at some jurisdictions.

Türkiye

As much similarly to other jurisdictions, within Türkiye, tax can only be applied in accordance with legislation. There are three main forms of taxation in Türkiye. Income tax, taxes on expenditures (VAT, stamp duty), and taxes on wealth (inheritance tax, real estate tax). Turkish law also distinguishes between a fully-fledged taxpayer and a limited taxpayer. Fully fledged taxpayers are taxpayers who are residents of Türkiye or have resided in Türkiye continuously for more than six months of a calendar year, or Turkish citizens who reside in foreign countries due to the works of offices or establishments which are affiliated with official establishments headquartered in Türkiye. On the other hand, a limited taxpayer is a person who is not a resident of the country and is only taxed on their earnings and revenues in Türkiye.

According to article 65/1 of the Income Tax Law Numbered 193, earnings arising from all kinds of self-employment activities are regarded as self-employment income. The law then goes forward and defines what self-employment activity is, as the performance of non-commercial works based on personal work, scientific or professional knowledge rather than capital, under personal responsibility, on one’s own behalf and account, without being subject to an employer.

In other words, in order to be considered as self-employment there are four elements that the law sets out. Firstly, the performance of the activity should be that of non-commercial work. Secondly, the performance of the activity must be based on personal work, scientific or personal knowledge without being based on capital. Thirdly, the self-employment activity shall be performed under the person’s own personal responsibility, and finally, the person performing the self-employment activity shall not be subject to an employer.

Within the Regulation on the Non-Usage of Crypto Assets in Payments, crypto assets are defined as non-material assets created virtually using distributed ledger technology and similar technology, distributed over digital networks, but not classified as fiat money, book money, electronic money, a means of payment, securities, or other capital assets.

If crypto assets are considered intangible assets, under the Income Tax Law it is still not certain which of the types of income and revenue can apply to crypto assets. However, due to a lack of direct legislative text on this, crypto assets are yet to be evaluated within the scope of Income Tax Law. It can be said that within the framework of the Income Tax Law, the income and revenue of crypto assets falls under the “commercial income” subject to income tax.

Here is a list of gains and revenues that constitute an income in terms of the Income Tax Law of Türkiye:

• Commercial profits,

• Agricultural profits,

• Wages,

• Self-employment earnings,

• Income from real estate capital,

• Income from movable capital (securities, bonds, etc.)

• Other gains and incomes.”

Excluding the special exemptions, if a taxable event falls into the list provided above, then, such income whether it is crypto or not will be most probably taxable.

To sum it up, if a taxable event occurs, then, whether or not such a taxable event occurs via a crypto asset or not is irrelevant. For example, if a person acts in a way that entitles that person to receive a payment that may be considered as a self-employment income, then, self-employment income tax will be most probably applicable to that payment which may in fact be a crypto asset.

In April 2020, the Central Bank of Turkey implemented regulations that banned the use of crypto assets for payments of goods and services. The Banking Regulation and Supervision Agency also stated that crypto assets are not considered virtual money under the relevant laws.

Furthermore, even though it is strictly forbidden for anyone to use crypto assets as a means of payment, if a person or entity sells goods or services via crypto assets, or basically receives payment via crypto assets, then this received payment may be taxable depending on the nature of the transactions.

Crypto assets are considered an asset in Turkey but cannot be used for payments as aforementioned. The country has implemented regulations requiring crypto firms to comply with anti-money laundering and terrorism financing standards in regards to KYC and AML. Previously, these companies were not subject to such regulations, but now they must adhere to the same policies as other financial institutions. The Financial Crimes Investigation Board supervises crypto firms in Türkiye, and according to the new rules, goods and services cannot be paid for with crypto assets. However, trading crypto assets as investment tools is still allowed, while buying, selling, or transferring crypto assets through payment services on crypto platforms is now prohibited.

Türkiye, along with other countries, is still debating how to classify and tax crypto assets. The main concern is determining which earnings should be subject to taxation. We are seeing that such transfers can be subject to income tax within Türkiye for now.

The U.S.A

The Internal Revenue Service (IRS) treats virtual currency as property for federal tax purposes. This means that the general tax rules for property transactions apply to transactions involving virtual currency. The IRS specifically defines convertible virtual currency as any virtual currency that has an equivalent value in real currency or acts as a substitute for real currency. Bitcoin is given as an example of a convertible virtual currency. The reason why Bitcoin is not taxed as a foreign currency in the United States is because it is not considered a legal tender in any country, and therefore cannot be classified as a foreign currency. Although some countries accept crypto assets as legal tenders, the IRS still considers them as property based on the IRS Notice.

The IRS uses guidance from FinCEN to provide a detailed explanation of convertible virtual currencies. This guidance confirms that virtual currencies are legal in the US and defines various entities involved in crypto-asset transactions.

The IRS Notice clarified that crypto assets in the US are considered property, not foreign currency. However, it was uncertain what kind of tax should be paid on purchased crypto assets. The New York State Department of Taxation and Finance answered the question regarding sales taxes in crypto-asset transactions. They stated that although crypto asset trades are considered barter agreements, no sales tax would be applied because virtual currencies are considered intangible property. This tax status does not affect capital gains taxation, which is based on the increase in value of the asset from acquisition to disposal.

The IRS has stated that the type of gain or loss from selling or exchanging crypto assets depends on whether the virtual currency is considered a capital asset for the taxpayer. If it is a capital asset, the taxpayer will realize capital gain or loss. If it is not a capital asset, the taxpayer will realize ordinary gain or loss. Additionally, if a taxpayer successfully mines virtual currency, the fair market value of the currency at the time it is received is considered taxable income.

Profits made from selling crypto-assets that are not considered securities will now be taxed as capital gains at a rate set by the IRS. However, if these profits come from selling crypto-assets that have been held for 365 days or more, they will not be subject to this tax. This rule applies to both assets acquired before and after January 1, 2023. The capital gain will be calculated by subtracting the acquisition value from the realization value. Any losses can be carried forward for up to 5 years.

The meaning of “profitable disposal” is uncertain in this context. It is unclear whether it refers to exchanging crypto-assets for legal tender or stablecoin, converting crypto-assets to other crypto-assets, or only the first option. The answer to this question depends on when the tax obligation begins. If the moment when the crypto-assets gains are available on the platform is considered, then converting crypto-assets to other crypto-assets could be included. However, if only the moment of conversion to stablecoin or exchange of crypto-assets for legal tender within the platform is considered, it does not currently seem possible.

The IRS allows taxpayers to differentiate their transactions with crypto assets, but they must report all of these transactions for the year. Failure to comply with tax laws, including underpayment, may result in penalties. Taxpayers can avoid penalties if they amend their tax returns in accordance with IRS Notice 2014–21 unless they can show reasonable cause to the Commissioner of the IRS.

The US tax system for crypto assets is comprehensive but lacks answers for certain issues. There are arguments against taxing “miners” who earn bitcoins through validating transactions, as their efforts are not directly comparable to artists creating art. It is suggested that the IRS may be too broad in categorizing miners’ rewards as income.

The Tax Authority may ask individuals to provide proof of income obtained through crypto-assets, even if they are not required to report them to the IRS. It is important to keep comprehensive documentation, such as bank account transfers, correspondence with the platform, email confirmations, chat messages, and various file types, including Excel files, screenshots, and statements from the platform.

The treatment of crypto assets by the IRS may seem beneficial to taxpayers, but it creates difficulties in record-keeping and enforcement. This hinders the use of crypto assets as a transactional currency. The IRS’s requirements for crypto asset users to track purchases and calculate the changing value of the relevant crypto asset are burdensome. Additionally, the complex and unclear tax reporting requirements create confusion for consumers, businesses, and service providers. The lack of guidance on determining the cost basis of crypto assets can result in tax penalties for taxpayers. The IRS needs to provide more clarification, which puts strain on an already resource-limited agency. These challenges will ultimately limit the growth and use of crypto assets.

The European Union

The European Commission proposed the establishment of a framework that would make crypto asset service providers (“CASPs”) report transactions conducted by their clients in the European Union, on December 8th, 2022. The primary goal of this proposal is to assist tax authorities in monitoring the trading of crypto-assets and the resulting profits, ultimately reducing the risk of tax fraud and evasion. Subsequently, on October 17, 2023, the Council approved a directive that amends the European Union’s Directive on Administrative Cooperation (“DAC”) in taxation.

The amendments to the DAC come in the form of DAC8 with a focus on reporting and the automatic exchange of information related to income from crypto-asset transactions and advance tax rulings for high-net-worth individuals. The directive’s overarching objective is to enhance the existing legislative framework by expanding the scope of registration and reporting obligations, and promoting greater administrative cooperation among tax authorities.

DAC8 also encompasses a wider range of assets and income sources, including crypto assets. The automatic exchange of information between tax authorities, which must be provided by crypto-asset service providers is mandated. This directive encompasses various types of crypto-assets, building upon the definitions established in the Regulation on Markets in Crypto-Assets (MiCA). It encompasses crypto-assets issued in a decentralized manner, stablecoins, including e-money tokens, and specific non-fungible tokens (NFTs).

The key objectives of DAC8 are:

• Expanding the scope of automatic information exchange under DAC to include data that must be reported by CASPs regarding transactions involving crypto-assets and e-money. This addresses the challenges posed by the digitalization of the economy. The provisions related to due diligence, reporting requirements, and other rules for CASPs will align with the Crypto-Asset Reporting Framework (CARF) and amendments to the Common Reporting Standard (CRS) prepared by the OECD at the G20’s request.

• Extending the current rules on the exchange of tax-relevant information to include the exchange of advance cross-border rulings for high-net-worth individuals and the automatic exchange of information on non-custodial dividends and similar income. These changes aim to reduce the risks of tax evasion, avoidance, and fraud, as the existing DAC provisions do not cover this type of income.

• Modifying various existing provisions in DAC, such as improving the rules for reporting and communicating Tax Identification Numbers (TIN) to facilitate tax authorities’ tasks in identifying taxpayers and assessing taxes accurately.

The directive was unanimously adopted by member states in the Council and will soon be published in the Official Journal. It will come into effect on the twentieth day following its publication.

Germany

The German Ministry of Finance has stated that crypto assets are not electronic money or foreign currency, but rather a measuring unit. While they cannot be considered money in the traditional sense due to their volatility and limited acceptance, individuals can still use them as a medium of exchange if all parties agree. Therefore, for tax purposes, crypto assets may be considered foreign currencies and subject to taxation. Users will be taxed on the income or profit they gain within one year, but any income or profit from selling crypto assets after one year of acquiring them will be tax-free.

In Germany, crypto assets are considered a type of intangible asset with specific tax implications when sold. If individuals sell their crypto assets within a year of acquiring them, it is considered a taxable sales transaction with a minimum tax-free threshold of EUR 600. However, if the sale occurs more than a year after acquiring the asset, it is not subject to taxation as aforementioned.

The UK

The UK did not initially have any specific regulations for crypto assets and instead relied on existing laws. The Bank of England also did not provide any official statements about virtual currencies for a while. However, the taxation of crypto assets was one of the first topics addressed and has been continuously developed by the HM Revenue and Customs (“HMRC”).

The Bank of England acknowledges the three primary functions of money according to modern economics: its use as a medium of exchange, its function as a store of value, and its ability to be used as a unit of account or to price goods and services.

There is disagreement among experts and authorities on whether crypto assets serve the same functions as traditional money. While most agencies are hesitant to consider crypto assets as money, some courts have recognized them as such in order to subject crypto asset transactions to specific regulations.

For tax purposes, crypto assets are considered unique and cannot be compared to other forms of investment or payment. For example: the taxation of bitcoin transactions in the UK depends on the activities and parties involved, with potential taxes including corporate tax, income tax, and capital gains tax. The HMRC recognizes that some transactions may be so speculative that they are not taxable, similar to gambling winnings. The tax treatment of crypto assets has become more refined, with capital gains tax applying to gains and losses and similar exemptions as other types of assets.

The government does not consider crypto assets to be money for tax purposes. The Governor of the Bank of England acknowledges that crypto assets can only act as money for some people and to a limited extent. Other international policymakers believe that crypto-assets do not have the essential qualities of sovereign currencies. Further, there is concern that crypto assets could be used for tax evasion due to their anonymity.

According to UK authorities, crypto assets are a type of asset that is digitally secured and can be transferred, stored, or traded electronically. Crypto assets include different types of tokens, such as exchange tokens, security tokens, and utility tokens. Exchange and security tokens are of particular regulatory interest because they are likely to be traded or generated in ways that have tax implications.

The UK taxation instructions for crypto assets focus on individuals and their income tax obligations. Companies holding crypto assets are subject to corporate income tax rules. The HMRC takes a practical approach to the evolving technology of crypto assets and bases its tax treatment on facts rather than terminology. The HMRC considers crypto assets as a personal investment and charges Capital Gains Tax when they are disposed of. The concept of disposal includes selling, exchanging, using for payments, or donating. The UK system has pooling rules that determine the cost of disposed assets, making it more advanced than the US system. Treating crypto assets as property instead of currency may reduce transaction volume due to increased reporting requirements.

Taxing crypto assets as property requires individuals to keep detailed records of all their transactions, as it is difficult for the authority to gather this information on its own due to the decentralized nature of the tokens. This means that even buying a drink with a crypto asset would be considered a disposal scenario, requiring individuals to calculate capital gains or losses and report any obligations that may arise. Therefore, anyone using crypto assets as currency on a daily basis would need to keep track of all transactions, as the volatility of crypto assets could result in different disposal prices for each transaction. Treating crypto assets as property does have some potential benefits, such as a lower tax rate compared to general income tax.

Firstly, it allows individuals to benefit from the yearly capital gains tax-free allowance of GBP 12,000. This means that they can make up to GBP 1,000 of capital gains each month from selling crypto assets without paying any taxes. This benefit can even be doubled if the crypto assets are donated to a spouse or civil partner. However, these tax advantages primarily benefit investors using crypto assets as investments rather than as a currency. Investors can easily keep track of their transactions and take advantage of reduced tax rates and exemptions.

On the other hand, consumers using crypto assets for transactions may struggle with their reporting obligations, as marketplaces may not have the required transaction record structure. Additionally, the volatility of crypto assets can result in smaller gains or even losses. Treating crypto assets as property instead of as currency may discourage their adoption and usage as a means of exchange, as it could drive out investors seeking long-term tax advantages.

Canada

In Canada, crypto assets are considered to be digital representations of value and may be used as a medium of exchange if the parties wish. The Canada Revenue Agency (“CRA”) often is seen to treat crypto assets as commodities.

The CRA assumes the incomes that arise from transactions made with crypto assets to be business incomes or capital gains. However, depending on the nature and circumstances of the transaction this approach may change. Furthermore, if earnings through crypto assets may qualify as business income or capital gain, then they might as well be considered losses to be treated as business losses or capital losses.

Taxpayers who are subject to Canadian Tax Law must establish the nature of their crypto-asset activity. Whether these activities result in income or capital gain directly affects the way these revenues are treated for tax purposes.

Ultimately, crypto assets are subject to capital gains and ordinary income tax in Canada. In regard to ordinary income tax, when a crypto asset is earned the income will be recognized on the fair market value of the crypto asset at the time of the receipt. This can be seen in staking and mining events. Regarding capital gains tax, depending on how the price of the crypto asset has changed since when it was received to when it was disposed of, the taxpayer can make gains or incur loss.

Australia

The Australian Taxation Office (“ATO”) finds that crypto assets are to be treated as digital representations of value that are transferable, storable, or tradeable electronically. ATO’s Crypto Asset Investments page draws the groundwork for the taxation of crypto assets.

The ATO states that crypto assets used as investments become a capital gains tax (CGT) asset. If a crypto asset is acquired as an investment, transactions like disposal, exchange, and swap are considered CGT and the acquirer may obtain capital gain or capital loss. ATO states that net capital loss cannot be deducted from other incomes but capital gains can be reduced by using the CGT discount if the crypto asset is held by the acquirer for at least 12 months.

Income made from crypto assets can be subject to income taxes at the ordinary marginal rate of the taxpayer. Therefore, income made through mining, staking, airdrops, interest, rewards, etc. is taxable.

Singapore

Singapore has established itself as a major global trade hub and has implemented tax policies to facilitate trade and e-commerce. The legal status of crypto assets in Singapore is not clearly defined. According to the Singaporean Currency Act, crypto assets are not considered legal tender or currency.

The Singaporean income tax law includes crypto assets. Income derived from crypto asset sales and initial coin offerings (ICOs) are subject to taxation. This applies to both individuals and issuing entities. Realization gains from the sale of the issued crypto asset and other crypto assets obtained from an ICO are also taxable.

Singapore does not have a capital gains tax, but if the proceeds from selling crypto assets are considered income, they are subject to income tax. Whether or not crypto asset sales are considered income depends on certain factors, such as the nature of the subject matter, how long it was owned, how frequently transactions occurred, and other relevant circumstances.

If the income from selling crypto assets is considered income in Singapore, the next question is whether this income is sourced in Singapore. However, it may be difficult to determine the source of income for decentralized crypto assets. The Inland Revenue Authority of Singapore (IRAS) will likely consider factors such as the exchange used to sell the crypto asset and the location of the individuals making the decision to sell. If the individuals are located in Singapore, the gains will be considered Singapore sourced income. Additionally, there is no fringe benefits tax (FBT) in Singapore, and all gains and benefits received by an employee related to their employment are considered taxable income, with some limited exceptions.

The IRAS does not clearly define whether crypto assets are considered assets or currencies for income tax purposes. Instead, they state that crypto assets are subject to normal income tax rules and provide guidance on how to determine capital gains and income from crypto-asset exchanges and sales. Generally, individuals who buy and sell crypto assets as a business are taxed based on the profits from their sales. However, if the crypto assets are purchased for long-term investment, any profits from selling them will be considered capital gains and will not be taxed.

UAE, Dubai

The UAE is considered the third-largest crypto asset market in the Middle East, with transactions worth around $26 billion. The Dubai Financial Services Authority has included regulations for crypto assets in its business plan for 2021. The Securities and Commodities Authority in the UAE issued regulations in 2020 to clarify the use of crypto assets as a form of payment for goods and services.

Dubai stands out in comparison to the other jurisdictions that have been discussed. While there have been many steps taken in forming up-to-date regulations on crypto assets in Dubai, as of the date of this paper, Dubai has no income tax, capital gains tax, or staking tax put in place for crypto assets. This makes Dubai a hotspot, with an influx of investors moving to the city to continue their operations.

LEGAL DISCLAIMER

THE INFORMATION PROVIDED IN THIS PAPER PROVIDES GENERAL INFORMATION AS TO THE POSSIBILITIES IN MULTIPLE JURISDICTIONS. PLEASE KEEP IN MIND THAT LAWS THAT APPLY TO THE SUBJECT HEREIN MAY DIFFER IN EACH JURISDICTION. THUS, NOTHING CONTAINED HEREIN CONSTITUTES ANY LEGAL OPINION OR SUGGESTION OF ANY KIND. PLEASE CONSULT LOCAL EXPERTS IN RELEVANT AREAS BEFORE TAKING ANY ACTION BASED ON ANY INFORMATION CONTAINED HEREIN.

What Is Real-World Asset Tokenization and How Does It Work?

Blockchain technology allows for the tokenization of traditional assets, meaning that tokens can be used to represent various types of instruments including stocks, bonds, real estate, consumer loans, art, etc. The concept of real-world assets (“RWA/s”) encompasses both palpable and intangible assets that exist in our physical realm, such as properties, bonds, and commodities. By tokenizing these assets, we gain the ability to seamlessly incorporate them into the blockchain, unveiling a vast array of opportunities for synergy and innovative applications.

Through the process of tokenizing RWAs, market participants are able to experience enhanced efficiency, heightened transparency, and minimized instances of human errors, as these valuable assets can be securely stored and effortlessly tracked on the blockchain.

In order for RWAs to be present on the blockchain, it is crucial to establish their ownership and representation within the blockchain system. Although the specific procedures may differ, the fundamental process entails resolving the contractual terms prior to creating tokenized versions of the asset on the blockchain.

Tokenization is also an emerging trend in finance that allows for the creation of digital tokens backed by RWAs. Tokenization is based on blockchain technology, which is a distributed ledger that ensures data is secure and cannot be altered or accessed without authorization. Unlike a centralized database, blockchain has no single point of failure. Tokenization uses the secure and unchangeable features of blockchain to enable digital fractional ownership and fast settlement processes.

For example: tokenization is becoming popular in the real estate industry, with traditional real estate institutions teaming up with technology providers to explore the tokenization of debt or equity. This collaboration is expected to bring more technology-backed real estate projects to life and provide investors with greater access to high-quality property assets. Both technology providers and traditional real estate stakeholders stand to benefit from this partnership through the origination of quality assets and the financial expertise of a growing network.

Tokenized assets and securities are distinct from cryptocurrencies, utility tokens, and security tokens. While the latter represent value generated within a blockchain network, tokenized assets, and securities are digital representations of assets and securities that exist outside of the blockchain. These tokenized instruments are linked to and reliant on their off-chain underlying assets, retaining their inherent characteristics while incorporating new features from blockchain technology.

Tokenizing traditional assets offers several advantages, including improved efficiency and cost reduction, increased transparency and security, better compliance and traceability, enhanced liquidity, and facilitated innovation. These benefits stem from both the use of blockchain technology and the ability to create smart contracts and ecosystems. We will be further detailing the benefits below.

Tokenization Of RWAs and Securities

Understanding the distinctions between blockchain-based tools and platforms is crucial when it comes to using blockchain and distributed ledger technology for tokenizing assets. Different platforms like Ethereum, Solana, Binance Smart Chain, Polygon, Terra, and Stellar have varying features in terms of cost, security, transaction speed, traceability, and accessibility. The choice of platform for tokenizing an asset depends on its specific purpose and objectives.

The tokenization of assets is a new way to represent and register property, and it is important to understand its legal framework, development level, and future regulatory changes. The upcoming regulatory framework in Europe and the financial sandbox in the UK, and other countries are promising initiatives to embrace these innovative global changes.

A token is a unit of value created by an organization or private entity to empower users and facilitate interactions with their products or services. Tokens can serve various purposes, representing usage rights or ownership rights with intrinsic value. They possess characteristics such as identification, immutability, transferability, and traceability within their respective environments or markets. Each type of token has its own programming code and legal regulations. Tokens operate based on coding and consensus protocols agreed upon by the involved parties. Some tokens may also have a governance system embedded in their code, making them adaptable to changes and providing predictability and scalability. Compared to centralized registries, tokens offer advantages such as improved efficiency, liquidity, trust, and traceability through transparent information sources enabled by blockchain technologies.

Tokenization is a method of storing and utilizing tokens that represent ownership rights of digital or physical assets or rights to specific activities. Essentially, tokenization is the process of digitally representing assets, services, or activities on a blockchain network. Owning a token from a tokenized asset may mean owning a portion or all of the underlying assets registered on a blockchain infrastructure.

The owner or investor holds the tokenized asset generally in a private wallet. The investor is usually the custodian of the token unless someone else provides this service. The token may be traded directly between individuals or through marketplaces, depending on the regulations of the underlying asset.

Role of Oracles in Tokenization

In some cases, blockchains need to connect with non-blockchain systems and applications to exchange information. Oracles act as a bridge between blockchains and other information environments. They monitor and verify real-world information, such as events and identities, that smart contracts initially don’t have access to. Oracles provide a trusted data feed to smart contracts, allowing them to monitor relevant information and automatically execute programmed code. Oracles play a crucial role in ensuring the reliability and versatility of smart contracts. They enable various complex scenarios, such as paying out insurance claims for canceled flights, initiating margin calls for tokenized asset loans when prices change in traditional markets, and facilitating automated betting contracts based on the outcome of sports events.

Identity oracles are used in financial transactions to prevent non-accredited investors and individuals not subscribed to a vetted whitelist or belonging to a blacklisted group from making transactions. They can also block certain age groups and residents from specific countries. Additionally, oracles can restrict transactions to users who have been ID-verified and meet compliance requirements such as KYC, GDPR, and AML.

Although oracles can accurately analyze real-world events, there are potential threats. If the data source outside of the blockchain is tampered with or unreliable, it can lead to incorrect results in the smart contract process. This is known as oracle risk. To address this, a transparent methodology and reliable data sources are needed, along with smart contracts that rely on consensus-based oracles instead of a single oracle. Consensus-based oracles involve multiple connected oracles that compare different data sources to detect and remove any anomalies, thus minimizing oracle risk.

Tokenization Process

The tokenization process may seem complex, but there are many tools and services available to help issuers and businesses. These tools make the tokenization process easier and more user-friendly, simplifying things in this evolving landscape.

The initial step in tokenization involves examining and strategizing the development of a robust network of industry experts for a particular token. Thus, companies looking to tokenize assets should evaluate the lifecycle of digital assets and ensure that each component of the network is suitable. Developers should carefully plan the technical, legal, marketing, business, and financial aspects to meet the requirements of participants and ensure that the network is capable of handling unexpected scenarios in accordance with the smart contract rules.

The RWA token goes through five main stages during its lifecycle.

1- During the initial stage of structuring a deal, it is important to make decisions about the terms and conditions of the RWA token. Deal structuring is a vital component of any token offering, regardless of the technology used. Tokenization should not be used as a way to evade legal and regulatory obligations, but rather to enhance operational processes and enable innovative financial solutions.

2- During the digitization stage, information that was previously stored in physical paper or documents is transferred to the blockchain and encoded in smart contracts, leading to the issuance of tokens.

3- Primary distribution is the method of giving tokens to investors in return for their investment capital or some other resource they provide, and the investors’ details are stored on the digital ROM.

4- Post-tokenization management refers to the processes involved in managing corporate actions such as dividend distribution and shareholder voting. These processes may be automated through the use of smart contracts coded on the token. Post-tokenization management will be ongoing until the token reaches maturity or is redeemed.

5- The last step, where tokenization’s benefit in improving liquidity becomes evident, is secondary trading. This is when a token owner can exchange tokens with another investor either directly or through a trading platform.

Tokens are typically given by an entity or individual and grant the holder certain rights, such as ownership or entitlement to future profits. The structure of a tokenized asset is important in determining the investor’s rights and returns, as well as how taxes should be applied. Tokenization may also impact the asset’s valuation and trading price.

Different types of assets benefit from tokenization in different ways. Asset owners and managers should consider the objectives and structure of the RWA tokens to determine how tokenization technology can enhance their purpose. For example, a bond backed by real estate would benefit from streamlined operations and automated management, while a real estate private equity fund could gain advantages from increased liquidity.

The issuer of an RWA token needs to get professional advice to make well-informed choices about which jurisdictions to involve in the product structure. The regulations and tax systems in different jurisdictions will affect the price and cost-effectiveness of the RWA token. Additionally, the issuer should also consider the location of their target investors, as this will impact the marketing and offering of the RWA token in terms of regulatory requirements.

Determining the category of a token can be complex because it can have rights or features from multiple categories, or its rights and features can change over time. Tokens can be classified as various regulated instruments, such as futures contracts, insurance products, commodities, loans, or bonds, depending on their specific features and rights. If a token is considered to be multiple types of regulated instruments, it will be subject to the regulations of each type.

Tokens that are considered “securities” will be subjected to regulatory frameworks during their issuance, marketing, distribution, and secondary trading. For example: if a token represents ownership or the right to receive income or dividends from a real estate asset, it will most likely be classified as a “security”.

In comparison, tokenization is beneficial for individuals who own only one asset or a few assets because it greatly reduces the time and expenses involved in giving investors the opportunity to own a fraction of the asset and trade it later on.

Benefits of RWA Tokenization

Blockchain technology and tokenization provide significant benefits. Its main benefits include:

• Blockchain technology offers increased efficiency by automating smart contract processes, reducing the need for intermediaries. This leads to faster settlement, auditing, trading, and other business processes, as well as improved product management control. The native tools of blockchain technology also contribute to speeding up these processes.

• The use of blockchain technology can lead to significant cost reductions in various processes such as bond issuance and fundraising compared to traditional methods. Studies have shown that these cost reductions can be as high as 90 percent for bond issuance and 40 percent for fundraising.

• Tokenization and blockchain systems provide increased transparency and security by recording transactions in a public ledger and storing it worldwide, it enhances reliability and minimizes information disputes. Additionally, blockchain allows for easy auditing due to its transparent nature. Tokenization also enables precise tracking of each tokenized asset.

• Programming enables the integration of intricate compliance requirements into every token created. Smart contracts can automatically validate compliance with KYC, AML, age restrictions, or specific local regulations for any transaction.

• Tokenization improves liquidity by allowing investors to offer their previously illiquid or non-fractionable assets in smaller units to a global market. This increases market liquidity compared to assets that can only be traded in large batches. Tokenization also reduces entry barriers for small investors with limited investment power.

• Smart contracts enable innovation by being programmable and adaptable to different industries. They have been used in tokenized assets to create various financial offerings such as fractionalized real estate and dynamic ETFs. Blockchain technology has also shown great potential in creating new financing methods like ICOs, IEOs, and DeFi.

• Tokenization has the potential to revolutionize the market, making investment options more accessible and global, and fostering innovation. Entrepreneurs and innovators now have the ability to tokenize various scarce assets, allowing them to benefit from innovations such as crowdfunding campaigns and ownership stakes. The combination of traditional crowdfunding and blockchain technology has led to the emergence of ICOs.

Valuation of a Tokenized RWA

Tokenized assets have the same ability to generate cash flow as traditional assets. However, tokenization offers added value by improving the asset’s liquidity and decreasing transaction and administrative costs. These advantages should be considered by investors when valuing an asset. But how do you determine the economic value of an RWA Token?

Net Asset Value (“NAV”)

Perhaps the most common valuation method is the Net Asset Value metric. In this financial metric, the economic value of the RWA token is calculated based on the economic value of the underlying and total number of issued tokens. NAV may be categorized into two depending on the nature of the underlying asset that is referenced, namely NAV per Token and Real-Time Asset Pricing.

NAV per Token

For example, if an RWA token is referenced to a real estate, in other words, if a real estate is tokenized, then, one way to determine the economic value of each RWA token is by dividing the price of the real estate by the total number of issued tokens. Assuming that a real estate worth 1.000.000 $ is tokenized and 50.000 RWA tokens are issued, then, the price of each RWA token will be 20$.

Real-Time Asset Pricing

One of the most common usage areas of RWA tokens is the tokenization of market instruments such as commodities, shares, bonds, currencies, etc. These assets are already subject to first and secondary transactions. These assets’ prices are generally determined in accordance with the principles of the free market. In the event of tokenizing these assets, the economic value of such RWA tokens will be determined by the actual real-world prices of underlying assets.

Income Approach

The predicted income that an asset can produce is the foundation of the income approach to valuation, which is especially important for asset-backed tokens connected to income-producing assets. This involves projecting the amount of money that the asset will yield over a specific time frame. This could be the rental income from real estate, the earnings from a business, or the interest or dividends from financial assets.

In conclusion, if the issuer prefers the income approach, then, the economic value of a RWA token will be calculated in accordance with the income that the underlying asset may generate and the amount it entitles its right owners.

Regulations Across Major Jurisdictions

USA

Due to its federal nature, there is no uniform legislation regarding crypto assets in the United States. However, there are some competent public authorities that investigate and sometimes even litigate against crypto asset projects including RWA tokens.

While there are other authorities, the leading authority in the U.S. is the Securities and Exchange Commission (“SEC”). Mainly, the SEC is concerned with the crypto assets that may fall into the category of securities.

SEC’s Approach

For the SEC to be able to take action against a crypto asset, such a crypto asset has to be eligible to be regarded as a security. But how does the SEC determine if a crypto asset is a security? The answer is quite simple but at the same time rather complicated. The Howey Test.

The Securities Act of 1933 and the Securities Exchange Act of 1934 impose disclosure and registration requirements on securities, and the Howey Test was developed by the US Supreme Court to evaluate whether a transaction meets the criteria to be classified as an “investment contract,” making it a security. The Howey Test states that an investment contract is present if and only if: (i) there is a financial commitment, (ii) in a common enterprise, (iii) with the expectation of profit, (iv) to be derived from the efforts of others.

If these requirements are satisfied, the asset subject to the question will in fact be considered as security, and therefore, security law will be applicable.

Tokenizing real-world assets entails transferring ownership or other kinds of rights to a digital token on a blockchain. These tokens frequently stand for investments in precious metals, real estate, artwork, or other financial ventures. We may look at each need in relation to the tokenization of real-world assets and the potential applicability of the Howey Test:

Investment of Money: When real assets are tokenized, tokens representing a portion of the asset are often acquired by investors through financial contributions. Since buying tokens entails exchanging money for the rights or interests in the underlying asset, this need is typically satisfied.

Common Enterprise: Because the value of the individual tokens is linked to the performance of the underlying asset, tokenized assets frequently involve a common enterprise. If the asset’s value rises (for example, real estate or fine art), all token holders benefit proportionally. This element of the Howey Test is typically satisfied by the interdependence between the token value and the performance of the underlying asset.

Profit Expectation: Typically, investors in tokenized assets expect to profit from their investment. This profit could come from token appreciation, rental income from real estate, dividends, or other forms of return. Tokens that are marketed with the promise of profit can meet this criterion.

Others’ Efforts: This is a critical criterion. This requirement is satisfied if the benefit predicted from the tokenized asset is mostly attributable to the efforts of the persons or companies producing, managing, or promoting the asset. For example, if a tokenized real estate investment is dependent on a management firm to remodel a building, recruit tenants, and handle upkeep in order to create rental revenue, the activities of these third parties are vital to achieving the predicted profit for token holders.

If a tokenized asset fits all four elements of the Howey Test, it is likely to be regarded as security and hence subject to the SEC’s or other regulatory bodies’ regulatory obligations, which include registration or obtaining an exemption, disclosure.

Consequences of Being Considered as a Security

When a RWA token is considered to be a security by the SEC, then, the issuance, offering, and even trading of such tokens is quite problematic. If a token is classified as a security, it is subject to the regulatory framework for securities, which is largely controlled by the Securities Act of 1933 and the Securities Exchange Act of 1934, and is monitored by the SEC in the United States.

If a token is in fact a security then, unless they qualify for an exception, securities must be registered with the SEC. Registration entails releasing thorough information about the company’s commercial activities, financial position, and management, as well as the investment risks.

Furthermore, the mere act of offering a token that is eligible to be considered as a security may in fact result in serious violations of relevant securities law. For example, the SEC claimed Binance and BAM Trading, under the leadership and control of Zhao, were unlawfully offering essential securities market functions by operating as an exchange, broker-dealer, and a clearing agency on the Binance platforms (both Binance.com and Binance.US) without a prior registration with the SEC. The SEC claimed that the Binance side was acutely aware of the necessity to register these functions yet actively chose not to, as a means to avoid regulation.

Binance, itself was also considered to have been operating without registering as an exchange, broker-dealer and a clearing agency for the Binance.com Platform, meaning the SEC fundamentally considered the platform to be operating these functions.

The functions of operating as a securities exchange, broker-dealer, and clearing agency without respectively registering as such were in violation of Sections 5, 15(a) and 17A(b) of the Exchange Act. Further, as the control person of Binance and BAM Trading, Zhao exercised power and control over Binance, and by directing and participating in the acts that constituted Binance’s violations of the securities laws, was also violating the same sections.

The offer and sale of BNB, BUSD, Simple Earn, and BNB Vault were claimed by the SEC to be in violation of Sections 5(a) and 5(c) of the Securities Act. The SEC claimed that without a registration statement filed or in effect as to these securities, Binance was directly in violation of the said regulation.

The EU

Asset-Referenced Tokens in the Market in Crypto Assets Regulation

The Markets in Crypto Assets Regulation (“MiCA”) is expected to enter into its stage of application in December of 2024. MiCA yields great importance for both investors and issuers within the blockchain and crypto asset field, especially in the context of RWAs. Within Title III — Asset Referenced Tokens (“ART/s”), MiCA sets out the requirements for asset-based tokens between Article 16 and Article 47. Due to the fact that MiCA shall be implemented in the European Union member states, the field of application for the rules is comprehensive both materially and geographically. Therefore, it is important to be prepared and familiar with MiCA’s regulatory framework in the context of ARTs.

In Article 3(6) of MiCA, asset-referenced tokens are defined as “a type of crypto-asset that is not an electronic money token and that purports to maintain a stable value by referencing another value or right or a combination thereof, including one or more official currencies”.

MiCA’s Title III on ARTs is made up of six chapters;

• Chapter 1: Authorisation to offer asset-referenced tokens to the public and to seek their admission to trading

• Chapter 2: Obligations of issuers of asset-referenced tokens:

• Chapter 3: Reserve of assets

• Chapter 4: Acquisitions of issuers of asset-referenced tokens

• Chapter 5: Significant asset-referenced tokens

• Chapter 6: Recovery and Redemption Plans

Chapter 1 of Title III regulates the authorization of ARTs, requirements for credit institutions, the application for authorization, the content and form of the crypto asset white paper for ARTs, modification of published crypto asset white papers for ARTs, the liability of issuers of ARTs for the information given in whitepapers, the assessment of the application for authorization, cases of grant or refusal of the authorization, the required reporting on ARTs, restrictions on the issuance of ARTs as a means of exchange and the withdrawal of the authorization.

Chapter 2 focuses on the obligations of the issuers of ARTs; by regulating the obligation of the issuers of ARTs to act honestly, fairly, and professionally in the best interests of the holders of ARTs, aspects of the publication of the crypto white paper, marketing communications, ongoing information to holders of ARTs, complaint handling procedures, identification — prevention — management and disclosure of conflicts of interest, notification of changes to the management body, governance arrangements and own funds requirements.

Chapter 3 is on the reserve of assets which regulates aspects such as the obligation to have a reserve of assets, the composition and management of such reserves, custody, and investments of reserve assets, right of redemption, and prohibition of granting interest.

Chapter 4 is on the acquisition of issuers of ARTs, regulating the assessment of proposed acquisition of issuers of asset-referenced tokens, and the content of the assessment of proposed acquisitions of issuers of ARTs. Chapter 5 regulates the classification and voluntary classification of ARTs as significant ARTs and the specific additional obligations for issuers of such significant ARTs. Finally, Chapter 6 is on the recovery and redemption plans that must be taken into consideration.

Authorization

According to Article 16 of MiCA, only issuers of the ART can make an offer to the public or seek admission to trading of an ART and they must be a legal person or undertaking that is established within the European Union and have been authorized by a competent authority at its member state in accordance with Article 21; or must be a credit institution that complies with Article 17 of MiCA. Other undertakings, that aren’t legal persons or other undertakings established within the Union and in accordance with Article 21 may issue ARTs if their legal form ensures a level of protection for third-party interests equivalent to that afforded by legal persons and if they are subject to equivalent prudential supervision appropriate to their legal form.

The aforementioned authorization requirements will not apply if, for over 12 months, calculated at the end of each calendar day, the average outstanding value of the ART issued never exceeds 5 million Euros, or the equivalent amount in another official currency, and the issuer is not linked to a network of other exempt issuers, or the offer to the public of the ART is addressed solely to qualified investors and the ART can only be held by such investors.

An ART issued by credit institutions may be offered to the public or admitted to trading if the credit institution draws up a crypto asset white paper, submits and gets approval for the white paper from the competent authority in its home member state, and notifies the respective competent authority at least 90 working days before issuing an ART for the first time. This notification should include the information listed in Article 17 of MiCA as a programme of operations (business model of the credit institution), a legal opinion that the ART does not qualify as a crypto asset excluded from the scope of MiCA, or as an e-money token and the detailed descriptions of the governance arrangements listed in Article 34 of MiCA.

Obligations of the Issuer

MiCA seeks to ensure that ARTs are issued by trustable entities that are regulated and protect investors. The regulation also seeks to ensure that ARTs have asset reserves and that will protect investors at all costs. Further, through MiCA’s regulatory framework, investors can make informed investments, and track the performance of ARTs and issuers will display a transparent operation.

In this context, MiCA holds the issuer to standard requirements. First, the issuer has to be a legal person established within the European Union, with its headquarters and office in an EU member state. The issuer must be authorized by a national competent authority within an EU member state. The issuer must also hold a credit institution authorization.

According to Article 35 of MiCA, ART issuers are required to also have funds equal to the amount of at least EUR 350,000 or 2% of the average amount of the reserve assets or a quarter of the fixed overheads of the preceding year. Further, issuers are required to publish regular reports, on the ART, the reserve assets, the number of circulating tokens, and charged fees.

The issuers handling and dealing with complaints are also regulated within the framework with issuers expected to implement governance arrangements that include clear business structures with clear lines of reporting. For example, issuers are required to establish effective procedures for the prompt, fair, and consistent handling of complaints. They are required to maintain and implement effective policies and procedures to identify, prevent, and manage conflicts of interest.

According to Article 22 For each asset-referenced token with an issue value that is higher than EUR 100 million, the issuer must report on a quarterly basis to the competent authority the number of holders, the value of the ART issued, and the size of the reserve of assets, the average number and average aggregate value of transactions per day during the relevant quarter, an estimate of the average number and average aggregate value of transactions per day during the relevant quarter that are associated to its uses as a means of exchange within a single currency area. Any material events or breaches of MiCA must also be reported to the competent authority.

Reserve Assets

Article 36 mandates that issuers of asset-referenced tokens shall constitute and at all times maintain a reserve of assets. The reserve of assets shall be composed and managed in such a way that the risks associated with the assets referenced by the ARTs are covered and that the liquidity risks associated with the permanent rights of redemption of the holders are addressed. The reserve of assets shall be legally segregated from the issuers’ estate, as well as from the reserve of assets of other ARTs, in the interests of the holders of ARTs in accordance with applicable law, so that creditors of the issuers have no recourse to the reserve of assets, in particular in the event of insolvency. Issuers of asset-referenced tokens must ensure that the reserve of assets is operationally segregated from their estate, as well as from the reserve of assets of other tokens.

To ensure the safekeeping of these reserve assets, a crypto-asset service provider can be engaged to oversee and manage the custody of crypto-assets on behalf of clients. It’s crucial to emphasize that the custodian of an ART must be a separate legal entity from the ART issuer, preventing them from being the same entity. The custodian should possess the required expertise and a strong reputation in the market to effectively manage these reserve assets, including maintaining detailed records and providing regular reports to the issuer. The custodian’s appointment must be documented in a formal agreement that outlines the custodian’s rights, responsibilities, and protocols for managing the reserve assets.

Significant ARTs

MiCA also makes a distinction of significant ARTs wherein the European Banking Authority shall determine ARTs that are significant. Significant ARTs are determined by factors such as their size, the number of investors, and the level of risk they yield. Although ARTs may be classified as significant voluntarily, it’s important to note that significant ARTs bring additional obligations for their issuers such as complying with further European Banking Authority guidelines regarding the management of reserve assets and protection of investors. Additionally, issuers of significant ARTs are subject to being supervised by the European Banking Authority.

White Papers and Marketing Communications

The marketing aspect of ARTs is also regulated to Articles on white papers, marketing communication, and the publication of white papers. Firstly, MiCA underlines that all information provided in the white paper must be fair, clear, and not misleading, with sufficient disclosure of information that shall benefit the investors. The whitepaper must also be prepared in the official language of the member state that the issuance is being made in or in the language customary in the sphere of international finance. If any changes are made to the business model that may have influence on the purchase decisions of holders or prospective holders of ARTs after the white paper is approved, these changes must be notified to the competent authority.

Although there are no mandatory requirements for the prior approval of marketing communications before publication, it is imperative that marketing communications are presented in a transparent manner, devoid of misleading elements, and ensure that the information provided is fair. These communications should also align with the content outlined in the associated white paper. Additionally, it is essential to note that marketing communications must be promptly disclosed to Competent Authorities upon their request, promoting transparency and regulatory compliance.

In regards to the publication of the white paper, the approved white paper shall be published and made available on the website of the ART issuer. This ensures public access by the commencement of the ART’s public offering or its admission to trading. The information provided must remain accessible for the entire duration that the ART is in public circulation. Furthermore, marketing communications should also be published on the websites of the offerors and entities seeking admission to trading. This publication should take place well in advance of the ART’s public offering, ensuring that relevant information reaches the public in a timely and transparent manner.

Türkiye

Since there is no specific piece of legislation in Türkiye regarding crypto assets, relevant local legislations shall be examined according to the feature and nature of a crypto asset. Depending on the tokenized real-world asset, applicable legislation may in fact vary.

In Türkiye, capital market instruments are defined as securities and derivative instruments, as well as investment contracts and other capital market instruments that are determined by the Board to be within this scope. Furthermore, excluding money, checks, promissory notes, and bonds, securities are defined as shares, other equity-like securities, and depositary receipts related to such shares, debt instruments, or debt instruments based on securitized assets and incomes, and depositary receipts related to such securities.

If a tokenized real-world asset falls into the category of any of the aforementioned assets, then, these tokenized assets as well as the offering and trading them will be most probably subject to securities laws of Türkiye which in fact come with strict and hard-to-follow requirements, almost making it impossible to develop a RWA token.

One of the main usage areas of RWA tokens is actually akin to derivative instruments of capital markets. According to the article 3 (u) of the Capital Markets Law numbered 6362, derivative instruments are defined as derivative instruments that grant the right to purchase, sell, or exchange securities, derivatives whose value is dependent on the price or yield of a security; exchange rate or exchange rate fluctuation; interest rate or change in the rate; price of a precious metal or gemstone or price fluctuation; price of commodities or price fluctuation; statistics published by institutions deemed appropriate by the Board or changes in them; those that provide credit risk transfer, have measurement values such as energy prices and climate variables, and are linked to the level of an index composed of the aforementioned or changes in that level, derivatives of these instruments, and derivatives that grant the right to exchange the listed underlying assets with each other, leveraged transactions to be made on foreign currencies and precious metals, and other assets to be determined by the Board.

In conclusion, if a real-world asset falls into any of the aforementioned assets, then, the capital markets laws will be applicable. The offering of capital market instruments is strictly regulated and subject to the approval of the Capital Markets Board of Türkiye. Any offering or trading of such RWA tokens without necessary compliance processes within the Capital Markets Boards may result in criminal and legal liabilities and risks.

Tokenization of lease certificates and precious metals like gold is a frequently favored practice. According to Article 61 of Capital Markets Law №6362, lease certificates are documents issued by asset leasing companies to finance various assets or rights. Those who hold these certificates receive a certain share of the income generated from these assets or rights. How lease certificates are issued and sold is determined by the Board.

Provided that the necessary permissions and approvals are obtained from the Board within the framework of the procedures and principles envisaged in the Capital Markets Law, and the Communiqué on Lease Certificates issued by the Capital Markets Board on June 7, 2013, it appears possible to tokenize lease certificates as long as they fulfill the required conditions.

Real Estate Tokenization in Türkiye

When a real estate is tokenized, aside from the consequences under capital markets law, the transfer of property ownership or rights over the property through the exchange of the token is a matter of debate under Turkish law. If the land registry is kept on the blockchain, the title deed can be tokenized and converted into a digital certificate. However, as of November 2023, there are no known studies conducted on this matter.

Real estate ownership can be acquired originally or by transfer, with registration or before registration. The transfer of ownership rights or other rights related to a tokenized real estate generally falls within the scope of acquisition by transfer and registration.

To acquire the ownership of a property through registration, firstly a valid cause of acquisition is required, and second, comes the registration process. The registration process, which must be carried out in the presence of a competent official authority and subject to strict formal requirements, currently does not result in the transfer of ownership of the property by merely exchanging a token based on the property.

For now, there is no obstacle to the debtor fulfilling the obligation undertaken with the token at the end of these tokenization and exchange transactions, which are essentially external transactions dependent on the debtor’s initiative. Although the functionality and trustworthiness of these external-character real estate tokens could potentially be resolved through structures similar to Trusts or Escrows, this solution might also lead to debates regarding the compromise of blockchain’s claim of decentralization.

United Arab Emirates, Dubai

The United Arab Emirates is one of the jurisdictions that recently made an impressive move and shows promise for the crypto asset industry. In The Chairman of the Authority’s Board of Directors’ Decision No. (23/ Chairman) of 2020 Concerning Crypto Assets Activities Regulation, security tokens are defined as a security, meaning shares, bonds, and financial bills issued by joint stock companies, bonds and bills issued by governments and public authorities in the UAE, and any other financial instruments accepted by SCA, to the extent issued, transferred or traded in the form of a crypto asset or a Crypto Asset that is deemed to be a security pursuant to Article (4) of this Regulation, subject to the exclusion stipulated in Article (3/ Second/ 3) of this Regulation.

For rules and regulations, issuing securities, even if done on a blockchain platform, is treated the same as any other method. Companies that want to use blockchain or other new technologies to get funding in a legal and clear way should talk to the Financial Services Regulatory Authority early in their fundraising efforts.

Therefore, the first thing to be aware of in terms of issuing an RWA token in the United Arab Emirates is examining whether a real-world asset that is aimed to be tokenized falls into the jurisdiction of capital market laws or not. If so, then, relevant capital markets law will be applicable.

UAE is one of the leading countries in terms of real-estate tokenization. We see that real estate investment funds, also known as REITs, are tokenized. If tokens representing shares in a REIT are classified as securities, they will be subject to the same comprehensive regulatory requirements as traditional securities.

RWAs as Option Agreements

What is an Option Agreement?

An option agreement is an agreement made between two parties to facilitate the potential transaction of an asset at a certain time and date. Options are financial tools linked to the worth of underlying assets, like stocks. These contracts provide the purchaser with the chance to purchase or sell, contingent on the type of contract, the selected underlying asset at a predetermined price specified in the contract, either within a specific time period or at the contract’s expiration date.

Simply, an option agreement gives the right, but not the obligation, to buy or sell a specific asset or property at a predetermined price within a specific period with the party that holds this right being referred to as the option holder/optionee and the other party is referred to as the option grantor/optionor.

Call options and put options are two common types of option agreements. Call option agreements give the option holder the right to buy the underlying asset from the option grantor at the agreed price, which is often used in financial markets. This allows investors to profit from the price appreciation of a stock, commodity, or other financial instrument without their ownership. Put option agreements on the other hand give the option holder the right to sell the underlying asset to the option grantor at the predetermined price. This is commonly used as a form of insurance against the decline in the value of assets and a protection against price falls.

A common option agreement scenario occurs when option agreements are made between landowners and developers wherein the developer is given the opportunity to purchase land from the landowner within a time frame, often with an option fee paid by the developer.

Can RWA Tokens be Considered as Option Agreements?

If an RWA token suffices the nature and requirements of an option agreement, meaning that if it entitles its owner to buy or sell a specific asset in a time with a predetermined price, then, in fact such RWA token can be considered as an option agreement.

Options are normally categorized as securities in the United States. According to the Securities Act of 1933 and the Securities Exchange Act of 1934, the definition of a security comprises a wide range of investment products. Under U.S. federal securities regulations, options are defined as “securities” because they provide the right to acquire or sell another asset (such as shares of stock) at a fixed price before the option expires.

Options are regulated by the SEC and traded on regulated exchanges. Over-the-counter (OTC) options, which are not traded on regulated exchanges, are also considered securities and may be subject to extra regulatory requirements, such as compliance with the registration provisions of the securities laws unless an exemption is granted.

The financial markets in Turkey are governed by the Capitaş Markets Board and the Capital Market Law defines securities as explained above. The rule applies to a wide range of financial products, including derivatives like options. Options are considered capital market instruments in Turkey, particularly those that are standardized and traded on exchanges such as Borsa Istanbul and are regulated by CMB. As a result, they are often regarded as securities and are subject to Turkish capital market laws.

Certain forms of OTC options, which are neither standardized nor traded on a formal exchange, may yet fit under the definition of securities or capital market instruments, depending on their structure and the rights they convey.

Challenges that Await RWA Tokens

Although tokenization offers potential solutions to various challenges and aims to make investment accessible to a wider audience, it is crucial to acknowledge the early development phase of tokenization and take into account any associated concerns.

Unlike traditional asset classes, security tokens are a new and untested area of law and regulation. While some guidance has been provided by regulatory authorities, it is expected that new developments and changes will occur as technology advances and the market grows. Additionally, there is no guarantee that regulators who currently support or do not oppose tokenization will continue to do so in the future.

The laws and regulations governing security tokens may change in the future, which could cause uncertainty and hinder the adoption and liquidity of these tokens for both issuers and investors.

Some jurisdictions distinguish between security tokens and crypto assets. The main difference is how their value is determined. Security tokens are backed by real assets, such as real estate, making their value less volatile and more easily determined compared to cryptocurrencies. Security tokens are also typically regulated under existing securities regulations, even in jurisdictions where crypto assets are unregulated or banned. This means that investors in security tokens may have better protections and rights compared to investors in other crypto assets.

Let’s continue with an example of real estate tokenization. In the real estate industry, it is common for funds and transactions to be kept confidential. This is because managers and participants do not want to share sensitive information with a large number of people. Only a select group of prospective investors who agree to keep the information confidential are typically given access to this information. In certain cases, regulations may also require confidentiality, particularly if the project involves a listed or regulated entity.

In the past, it hasn’t been difficult to keep real estate transactions and funds confidential because they were only available to a small group of institutional, corporate, and wealthy investors who had to wait until the project was completed to access their funds. However, with security tokens that can be traded on an exchange, it will be necessary to disclose sensitive information to a larger pool of potential investors in order to facilitate investments and transactions.

The balance between data transparency and information privacy in financial transactions will be an important focus of development in blockchain technology. Blockchain protocols, such as Zero-Knowledge Proof, can protect data privacy on public blockchains by allowing one party to prove their knowledge of certain data to another party without revealing the actual data. With continued development and careful planning, blockchain protocols will enable data transparency that safeguards against unlawful concealment of information without compromising confidential business data.

Case Studies

Real Estate Tokenization

Liquefy is collaborating with a group of wealthy Gulf families to convert a prestigious hotel in London’s Mayfair area, worth $600 million, into tokens.

The local Special Purpose Vehicle (“SPV”), which is owned by an offshore SPV, is responsible for managing the property. This includes tasks such as collecting rent, hiring employees, and paying fees to the local government. The current owners will maintain a 51% ownership in the offshore SPV, giving them a 51% stake in the property and management company.

Approximately half of the shares in the offshore SPV will be converted into security tokens and distributed to smaller investors. These tokens will represent a 49% ownership stake in both the property and the management company. By participating, investors can invest in the real estate property with a lower initial capital requirement. The details of these investors will be recorded on the digital ROM.

Using blockchain technology will make the process of changing ownership and selling the London hotel quicker and safer. Additionally, investors will have the ability to transfer their real estate tokens to other investors, providing them with liquidity in the secondary market.

Fund Tokenization

Sidley provided guidance and assistance to a fund manager from Hong Kong in creating and organizing the first tokenized fund in Asia in 2019.

The Fund puts money into assets that cannot easily be converted into cash. Like other funds that invest in real estate, this means that the Fund will exist for a long time to give the manager enough time to buy, increase the value of, and sell these investments. Additionally, investors in the Fund cannot sell their shares or take their money out whenever they want.

The Fund is the initial fund in a series that the Manager plans to create for investing in illiquid assets. It has been set up as the first segregated portfolio within a segregated portfolio company in the Cayman Islands, which offers benefits in terms of time and cost.

To appeal to a larger group of investors, the Manager utilized a technology platform to convert all the equity interests in the Fund into tokens, allowing for trading and liquidity in the secondary market.

Investors in the Fund receive digital tokens that represent their ownership in the Fund. These tokens can be stored in a digital wallet that is compatible with ERC20. Although investors are not able to withdraw their investment from the Fund before it matures, they are allowed to sell their tokens to other investors on the secondary market, as long as they follow the transfer restrictions outlined in the smart contract on the technology platform.

The ownership of equity interests in the Fund is recorded in the Fund’s register of members. This register is maintained both in a book-entry ledger by the Administrator and in a blockchain-based ledger on the Technology Platform.

The creation of the Fund has opened doors for other asset managers in Asia to tokenize their funds. It is anticipated that fund managers will adopt tokenization, especially for closed-end funds, as it offers clear advantages that will make these investments more appealing to a broader range of investors.

Current Examples

Reental (Real Estate)

Real estate investments have high barriers to entry and limited liquidity. To secure mortgage financing, investors typically need to make significant down payments and have good credit scores. Unlike other investments, it is challenging to divide direct ownership of real estate among multiple investors due to the need for expensive intermediaries and legal processes.

Reental, a company based in Spain, allows individuals to invest in real estate through a tokenization process. Investors can acquire a property with a minimum amount of €100 and receive monthly dividends from rental income. After two years, the property is sold, and any profits are distributed among token holders. Additionally, Reental increases the liquidity of real estate investments by combining multiple decentralized finance protocols, allowing investors to trade property-backed tokens at market value.

Agrotoken (Commodities)

Agrotoken is a platform that allows for the tokenization of commodities, such as wheat, corn, and soy. Producers deposit their products with a custodian, who then issues tokens equivalent to the amount of grain deposited. These tokens can be traded on the platform or peer-to-peer. Prices are determined by the market and monitored by oracles connected to commodities markets. Token holders can redeem their tokens for the underlying grain, resulting in the destruction of the tokens.

Stander Bank (Debt Issuance)

In September 2019, Santander Bank became the first bank to issue a bond using a public blockchain. The bond was worth $20 million and had a coupon rate of 1.98% per quarter, which was also tokenized. Santander Securities Services acted as the agent for tokenizing and safeguarding the bond. According to the bank, this new process provides benefits such as greater market transparency, faster settlement times, improved security, and reduced reliance on intermediaries.

LEGAL DISCLAIMER

THE INFORMATION PROVIDED IN THIS PAPER PROVIDES GENERAL INFORMATION AS TO THE POSSIBILITIES IN MULTIPLE JURISDICTIONS. PLEASE KEEP IN MIND THAT LAWS THAT APPLY TO THE SUBJECT HEREIN MAY DIFFER IN EACH JURISDICTION. THUS, NOTHING CONTAINED HEREIN CONSTITUTES ANY LEGAL OPINION OR SUGGESTION OF ANY KIND. PLEASE CONSULT LOCAL EXPERTS IN RELEVANT AREAS BEFORE TAKING ANY ACTION BASED ON ANY INFORMATION CONTAINED HEREIN.

The phenomenon of “trust”, which is traditionally established by competent authorities, mediators, and similar third parties, is now being replaced by blockchain technology, which is a decentralized structure with developing technologies. Blockchain, which is a record list that is secured using cryptography methods and continuously grows by connecting the structures called blocks to each other, has developed and continues to develop rapidly since 2008. Blockchain technology, which can perform information and data transfers quickly and securely, aims to solve important problems encountered in daily life and optimize current processes; the technology in question is used in many different sectors today. In this respect, blockchain technology falls within the scope of many legislations.

The blockchain is a secure and transparent system that is designed to securely store valuable data, and allow data exchange and management between two parties without the need for a middleman. Ultimately, it is a technology that can be verified.

Data plays a vital role in blockchain technology. Over the past decade, legislative structures have seen a major focus on data protection and privacy. Although the right to privacy has existed far longer than data protection laws, with the emergence of technological advancements, the importance of data has become inescapable. In its essence, however, data privacy stems from the basic human right to privacy. Some will refer to data as “the new oil” of our age, due to how important it is both politically and economically.

The Basics of Blockchain Technology Elements

Block Structure

A blockchain is a list of records that is continuously expanding, known as a “block”, and is linked and protected through cryptography. The initial block formation is referred to as the “genesis block”. Each block holds a specific number of transactions, and they are appended to the blockchain by connecting to the preceding block.

A block is composed of a block header, which provides a description and summary of the block, as well as transaction records. Each block in the chain is partially derived from the previous block. This is because every block includes the condensed information from the preceding block.

Distributed Network

Distributed networking refers to the practice of distributing the records of blockchain transactions to participants in a network structure, rather than storing them in a single centralized location. Each participant writes the records in a shared system of records called the ledger, and each participant possesses a copy of this ledger. Essentially, the ledger is both shared and distributed. Whenever the ledger is updated, all participants receive a copy of the updated version.

It is widely accepted that a distributed network structure is more secure than a centralized structure. To provide an analogy, the storage location of data can be likened to a house. It is challenging, though not impossible, for someone to enter a house without permission, as long as appropriate security measures are in place. Thanks to the distributed network structure of blockchain technology, the database where data is stored is fragmented into numerous parts and these parts are dispersed across numerous computers. Consequently, it is insufficient for an unauthorized individual to gain access to the data by entering just one house; instead, they would need to access the majority of houses in the database.

Consensus Structure

Consensus is necessary across the blockchain network for all machines to have an identical copy of the data. This means that participants must agree on the validity of transactions in order for them to be considered valid. Different consensus mechanisms are used within the network to achieve this consensus. Various blockchain platforms, such as Bitcoin and Ethereum, offer different solutions for the consensus process. For instance, they employ the proof of work (PoW) consensus approach, where nodes must prove their labor to add a new block to the blockchain. Another common consensus structure is called proof of stake (PoS), where participants who own a certain amount of shares or assets are given the authority to create or verify blocks.

In order for the blockchain to maintain its security, it is necessary to have a system in place that prevents a malicious individual or group from gaining control over the majority of the validation process. In Proof of Stake (PoS), validators possess some tokens from the blockchain, and potential attackers can only execute an attack if they manage to acquire a significant portion of these tokens. Unlike Proof of Work (PoW), PoS primarily relies on the validation mechanism rather than mining. In PoS, blocks are created by a specific individual determined by the PoS algorithm, which introduces an element of randomness. The initial PoS cryptocurrency was Peercoin, and it was followed by others like Cardano, Blackcoin, Nxt, and Algorand. Furthermore, Ethereum is also planning to incorporate a PoS mechanism alongside PoW in the development of new technology by 2021.

Types of Blockchains

Blockchain networks are categorized into two types based on the accessibility of the network: (i) publicly accessible networks, also known as open or public blockchain networks, and (ii) networks that are closed to public access, referred to as closed or private blockchain networks. Typically, organizations opt for closed blockchain networks due to security concerns or other reasons.

Blockchain networks can be divided as in the following.

Permissionless Blockchain Networks

Blockchains, which are referred to as completely permissionless, do not require permission for individuals to access the blockchain network and view stored data. They also allow participation in the consensus process to add new blocks, as long as individuals adhere to the consensus structure of the network. These networks are commonly known as permissionless blockchain networks. Involving as many people as possible in the system by ensuring that the network is more secure. An example of this type of network is the Bitcoin platform.

Partially Permissionless Blockchain Networks

Partially permissionless blockchain networks are networks that allow anyone to access and read stored data on a blockchain network without needing permission. However, permission is required to add new blocks and participate in the consensus process. This entails adhering to the consensus structure of the network. An illustration of such networks is a blockchain platform where all users can listen to music tracks, but only independent musicians have the authority to add new tracks based on the consensus structure.

Blockchain Networks That Require Full Consent

Blockchain networks that require permission to enter a blockchain network to read stored data and then to add new blocks and participate in the consensus process by complying with the consensus structure of that network are called fully permissioned blockchain networks (“Fully Permissioned Blockchain Networks”). Such networks, whose purpose is to make the recorded data accessible only to the relevant parties and to include only selected parties in the reconciliation process among those who are allowed to access the data, include a network established to perform Electronic Funds Transfer (EFT) transactions between banks.

Blockchain networks that require full consent, also known as private blockchains are generally preferred by companies and similar entities to restrict access to third parties to ensure privacy.

Personal Data Protection Law No 6698 (“KVKK”)

The Basis of the Right

The protection of personal data begins with the right to privacy, which is one of the most essential rights for individuals. As technology advances, the recognition of privacy and confidentiality as crucial elements of social values in both individualization and the functioning of democratic societies has necessitated the redefinition of “privacy” as a fundamental human right.

Privacy is a term that encompasses various ideas, including autonomy, individuality, personal space, and anonymity. Consequently, it can be described as the capacity of an individual or a group to keep their personal information private and, as a result, to express themselves selectively. Information privacy, on the other hand, refers to the connection between data collection and distribution, technology, the public’s anticipation of privacy, and the legal and policy concerns that arise from these expectations.

The concept of acknowledging a right to privacy as a fundamental principle was presented in an article authored by Samuel Warren and Louis Brandeis. This article was published in the Harvard Law Review in 1890 and is deemed one of the most influential essays in American legal history. It is also recognized as the inaugural publication to define privacy as a “right”.

One other major event that shaped the right to privacy was World War II and the doomful instances of grave human rights violations. The fact that governmental authorities collected personal information and used that information to discriminate against innocent civilians naturally caught attention. After that, many legal systems agreed upon creating a legal structure that limits data processing regarding people.

In today’s society, the advancement of new information technologies brings up concerns regarding the safeguarding of privacy rights. Essentially, the gathering and manipulation of information heightens the potential for privacy breaches. Therefore, a lack of trust in these technologies may lead consumers to hesitate before adopting new services, hindering the innovative and effective use of such technologies.

At this stage, the unauthorized acquisition of personal data by unrelated third parties, as well as the processing of this data, whether in compliance with laws or not, constitutes a violation of privacy. The right to protect personal data entails individuals having control over their data, including aspects like its acquisition, collection, processing, or transfer. Consequently, it is crucial to gain a deeper understanding of the issues surrounding personal data protection and to ensure the development of appropriate legal regulations in this domain.

What is Personal Data According to KVKK?

In accordance with paragraph (d) of Article 3 of the Personal Data Protection Law (“KVKK”), personal data is defined as any information that pertains to a known or identifiable individual. To be considered personal data under the KVKK, the information must be connected to a specific or identifiable natural person. Based on this definition, personal data exclusively pertains to individuals and data directly associated with legal entities are not included in the definition of personal data and are therefore not subject to the provisions of the KVKK.

Personal data can either directly identify a person or not directly identify them, but it includes any information that can help identify a person when associated with any record. This includes not only information like name, date of birth, and place of birth, but also data like phone numbers, license plates, social security numbers, passports, resumes, photos, videos, audio recordings, fingerprints, email addresses, hobbies, preferences, family information, and health information. The scope of what is considered personal data can be expanded since the KVKK does not provide a limited list. The important thing is to be able to define the individual with the help of the specific data in question.

Sensitive Personal Data

The KVKK distinguishes between “sensitive personal data” and personal data. Sensitive personal data refers to data that, if accessed, could lead to discrimination or harm to the individual. Therefore, sensitive data must be protected more carefully and strictly than other personal data. Special categories of personal data can only be processed with the explicit consent of the individual or in limited cases outlined in the KVKK.

Article 6 of the KVKK provides a limited list of special categories of personal data, which includes race, ethnic origin, political opinion, philosophical belief, religion, sect or other beliefs, appearance, and dress, membership to associations, foundations, or trade unions, health, sexual life, criminal conviction, and security measures, and biometric and genetic data. The KVKK also distinguishes between different special categories of personal data, and the conditions for processing personal data related to health, sexual life, and other special categories without explicit consent are regulated differently.

Data Controller and Data Processor

As per Article 3/I-ı of KVKK, the term “data controller” refers to the individual or entity, whether natural or legal, that decides the objectives and methods of processing personal data and is accountable for establishing and supervising the data storage system.

The entity responsible for ensuring compliance and accountability in the processing of personal data, known as the data controller, plays a crucial role in the data processing process. It is required that the data controller can be identified according to the KVKK. However, when it comes to blockchain technology, the identification of the data controller is often not a straightforward task, as will be explained in detail later.

When considering the KVKK’s perspective, the definition of a data controller implies that determining the data controller in blockchain technology should depend on the unique circumstances of each situation. In a legal system where all definitions are centered around a central data controller, the fact that data is distributed in a decentralized blockchain system requires the identification of the data controller. Particularly in public blockchains, there is no singular entity or organization that centrally decides the purposes and methods of personal data processing.

For instance, if a company specializing in human resources helps another company in the recruitment of staff, and the agreement states that it will exclusively act on behalf of the company in terms of the candidates’ data, then the hiring company will be regarded as the sole data controller in this scenario.

However, in the same example, if the human resources company assesses resumes in its own database and looks for suitable candidates among the resumes received by the hiring company, and charges fees based on the contracts for each employment agreement signed, the aspect of interest becomes relevant. In this scenario, both the human resources company and the hiring company would be regarded as joint data controllers.

Scope of Application of KVKK

As stated in Article 2 of KVKK, it applies to both natural and legal entities who process the personal data of individuals, regardless of whether it is done fully or partially using automated methods or non-automated methods, as long as they are included in any data recording system.

KVKK applies nationwide and specifically to data controllers and processors who handle personal data within Turkey’s borders. In addition, the Personal Data Protection Board (“Board”) introduced a regulation through a decision on 23/07/2019 (2019/225) that applies to foreign data controllers who process personal data either directly in Turkey or through their branches. Although the Turkish Data Protection Law does not include provisions specifically for foreign entities, this regulation now requires foreign data controllers to fulfill certain obligations, such as registering with the Data Controllers Registry (VERBİS) and appointing a representative.

KVKK has caused uncertainties for data controllers located outside of Türkiye due to the lack of specific geographical scope delineation in its application.

Data Processing Principles and Conditions

According to Article 4 of KVKK, personal data can be processed only in accordance with the procedures and principles prescribed in KVKK and other laws. When handling personal data, it’s essential to (i)adhere to legal requirements and maintain integrity, (ii) ensure the data is correct and updated as needed, (iii) process data only for clear, specific, and lawful reasons, (iv) keep the data pertinent, restricted, and in balance with its processing purpose, (v) retain the data only for the duration specified by applicable law or as required for its processing purpose.

The main rule for personal data processing is acquiring the relevant individual’s explicit consent prior to data processing. However, in some instances, data controllers/processors may have the right to process personal data without the explicit of the relevant individual and these cases are as follows:

a) Explicitly stipulated by the laws.

b) Being necessary for the protection of life or physical integrity of the person who is physically or legally incapable of giving consent or whose consent is not legally recognized.

c) Being necessary for the processing of personal data belonging to the parties of a contract, provided that it is directly related to the establishment or performance of the contract.

d) Being necessary for the data controller to fulfill its legal obligation.

e) Being made public by the person concerned.

f) Being necessary for the establishment, exercise, or protection of a right.

g) Being necessary for the legitimate interests of the data controller, provided that it does not harm the fundamental rights and freedoms of the person concerned.

The General Data Protection Regulation (“GDPR”)

The General Data Protection Regulation (“GDPR”) is a law passed by the European Parliament and the Council of the European Union that aims to enhance privacy and awareness of the importance of privacy protection by allowing individuals to know and control the data collected about them. The GDPR was adopted on the 14th of April, 2016, and became fully effective on the 25th of May, 2018.

The GDPR requires companies to obtain consent for data collection and provides options for data deletion. The emergence and adoption of the GDPR has been important due to the growing amount of data being collected and the lack of control individuals feel over their digital presence.

The ability to opt out of data collection, delete personal data, and control its use are all desirable but may conflict with certain business models and digital structures. Businesses often change their privacy policies to comply with the law, but it is unclear how conflicts with hardware and software design will be resolved.

What is Personal Data According to GDPR?

The definition of personal data in GDPR is extensive and specifically regulated. It encompasses any information pertaining to an identified or identifiable individual, whose identification can be established either directly or indirectly through factors like their name, identification number, location data, online identifier, or other factors related to their physical, physiological, genetic, mental, economic, cultural, or social identity.

The introductory provision of Article 30 in the GDPR provides clarification on the notion of online identifiers. It specifically mentions elements like internet protocol addresses (IP), as well as identifiers linked to devices, applications, tools, and protocols used by individuals, such as cookies or other radio frequency identification tags. Within this framework, GDPR explicitly states that IP addresses and cookies are considered personal data if they can be connected to individuals, particularly when combined with unique identifiers or information from servers, in order to create profiles and identify those individuals.

In the GDPR, there is a concept called “pseudonymous data.” This refers to the process of processing personal data in a way that it cannot be linked to a specific individual without additional information. This additional information, such as a decryption key, must be kept separately and protected by technical and organizational measures to prevent it from being associated with an identifiable person. Pseudonymous data processing allows for the processing of personal data without the need for additional information and ensures that it cannot be linked back to a specific individual.

According to GDPR, these data do not qualify as direct identifiers of personal data. Consequently, it will not be feasible to link the data to a particular individual without additional separate information. Additionally, in line with Article 28 of GDPR, it is advised to pseudonymize personal data to reduce risks for the data subject and support data controllers and processors in meeting their data protection obligations. This pseudonymization should be carried out in a way that minimizes risks and assists data controllers and processors in fulfilling their responsibilities for data protection.

In relation to special categories of personal data, there exists a parallelism between the special categories of personal data outlined in the GDPR. Therefore, the special categories of personal data encompassed by the GDPR comprise (i) racial or ethnic origin, (ii) political opinions, (iii) religious or philosophical beliefs, (iv) union membership, (v) genetic data, (vi) biometric data, (vii) health data, or (viii) data pertaining to a person’s sex life or sexual orientation, limited to a specific enumeration.

Data Controller and Data Processor in Terms of GDPR

The GDPR introduces the term “Data Controller” to describe the responsibilities of entities involved in processing personal data. According to Article 4 of the GDPR, a data controller can be an individual, organization, or public authority that decides how and why personal data is processed.

It is important to identify the person or entity responsible for data control as the GDPR assigns them the main responsibility of implementing measures to protect personal data. The data controller must consider the nature, scope, context, and purpose of data processing, as well as the risks to privacy, and adopt appropriate measures to ensure compliance with GDPR standards and principles. Examples of data controllers include medical institutions, law firms, and online shopping platforms.

Scope of Application of GDPR

The scope of the GDPR is not limited to the geographical boundaries of EU member states. Instead, it goes beyond these borders. The article that regulates the regional scope of the GDPR includes provisions that also apply to data controllers and data processors who are not based in the EU.

The territorial scope of the GDPR is set out in Article 3 of the GDPR. According to this article, GDPR applies in the following cases:

• The processing of personal data takes place within the activities of the data controller or data processor located in the European Union, regardless of whether the processing activity takes place within the European Union or not.

• The personal data of the data subject are processed within the European Union by a data controller or data processor that is not established in the European Union, but the processing activities are related to (i) the provision of goods or services to the data subject in the European Union or (ii) monitoring the behavior of the data subject within European Union.

• The personal data is processed by a data controller not established in the European Union, but the processing activity is within the scope of European Union law where international public law applies in the country in which the data controller is established, even if it is not established in the European Union.

The Guidelines on the territorial scope of the GDPR, provided by the European Data Protection Board (EDPB) in Guidance 3/2018, offer additional analysis of the relevant article using the following headings.

As observed, if a data controller or data processor, whether an individual or organization, is not based in the EU but has a presence there through a business or engages in any data processing activities, Article 3 of the GDPR states that these activities are subject to the regulations of the GDPR.

The Criteria for the Establishment of the Data Controller or Data Processor in the EU

The General Data Protection Regulation (GDPR) applies to the processing of personal data, regardless of whether it occurs within the EU, as long as it is done by a data controller or data processor established in the EU. The term “establishment” is important in determining whether GDPR applies. Although GDPR does not provide a specific definition, the introductory provisions of the regulation suggest that a stable and effective activity is required, and the presence of a branch or legal entity is not necessary. This means that GDPR can apply to subsidiaries and branches of companies outside the EU, as well as companies without an establishment in the EU but with subsidiaries, branches, or employees engaged in data processing activities within the EU.

The presence of an establishment determines whether the data processing activities are within the scope of that establishment. The EDPB guidelines state that the assessment of whether the activities are related to a data controller or processor in the EU should consider the specific circumstances. However, it is important to not interpret this too narrowly in order to provide effective protection. Therefore, simply having commercial activities within the EU does not automatically make a data controller or processor subject to EU data protection regulations. For instance, a data processor that is based in the EU is required to comply with the rules and regulations outlined in EU legislation regarding data processing activities.

For example, the ECJ ruled in 2014 that Google Inc., a company based in the United States, was deemed to be “established” in the EU due to the interconnection between its search engine activities and the advertising activities of Google Spain.

GDPR provisions will apply to data controllers and data processors who process personal data within the EU, regardless of their establishment in the EU or the presence of a subsidiary or branch in the EU, based on the evaluation of their activities and the use of effective and consistent practices.

When evaluating the regional scope of the GDPR, what is important is whether the data processor or data controller is based in the EU or, as previously mentioned, has a business presence in the EU. In this context, it is enough for the data controller, data processor, or their establishments to be located in the EU, and the data can be linked to their activities within the EU. The GDPR does not require that the data processing activities themselves occur within the EU for the GDPR to be applicable.

If a data controller, who is subject to the GDPR, decides to have a data processor situated outside the EU, which is not bound by the GDPR, handle the personal data of the data subject within the EU, the data controller must guarantee, either through a contract or another legal method, that the data processor adheres to the GDPR regulations while processing the data. Furthermore, the data controller must abide by the EU regulations concerning the transfer of data outside the EU.

Right to be Forgotten

The right to be forgotten originated from a 2014 court ruling against Google in Spain. Article 17 of the GDPR was created to establish the right to have personal data erased, based on the court’s decision that consent should be just as easily withdrawn as it is given.

Personal data must be deleted promptly if the entity in control of the data no longer has a legal reason to keep or use it. This means that individuals have the right to have their personal data deleted if it is being held by someone else without any valid justification.

Article 17 explains the reasons why a person can request to be forgotten. This includes when their personal data is no longer necessary for its original purpose and when they have withdrawn their consent.

If data processing is not done in accordance with the law, it must be erased. An example of this is when an employee leaves a company and requests their personal information to be deleted after the required retention period. In this case, the company is obligated to delete the data because the individual has withdrawn their consent and the company can no longer rely on the law governing data retention. Even if the employee did not withdraw their consent, the company would still be obligated to delete their personal information if it no longer serves its original purpose.

Privacy by Design and Privacy by Default

The GDPR requires that data processing systems be designed with privacy and data protection in mind. This means that companies must take measures to ensure the security and availability of data during the development phase. The idea is that data protection standards are most effective when built into the technology from the start.

The service provider must develop software for processing HR data that meets data protection standards. They need to consider if they are only processing necessary personal data for each specific purpose, and if they have implemented effective safeguards and technical measures like pseudonymisation or data minimization.

Blockchain and GDPR

The GDPR applies to all personal data, including the transactional data and public keys stored in the blockchain. This means that there may be conflicts between the GDPR and the architecture of blockchain technology. These conflicts will involve important values in both the law and the code. Some of these values can be negotiated or managed, while others are rigid and inflexible. The question is, what conflicts will arise and will they be manageable or will they result in legal disputes or the abandonment of firms and technologies?

Irrevocability of Records on Blockchain

The irrevocability of records on the blockchain constitutes a conflict between the right to be forgotten and the permanence of records.

Changing the data inside the blocks without detection is not possible, and to prevent this, cryptographic hashing and timestamps are employed. Cryptographic hashing is a mathematical algorithm that converts input into output, serving as the transformed version of the original information. It plays a crucial role in blockchain technology as it is highly challenging to reconstruct the input data solely from the hash value. Additionally, hashing connects blocks in a chronological manner, linking them together. Consequently, each block is identified by its number, title, timestamp, creation details, and creator, all stored as a digital fingerprint, often represented by a cryptographic hash or hash value. This enables the observation of all past transactions while making it arduous to reverse engineer the process.

As previously mentioned, each block in a blockchain network contains a summary of the information from the previous block due to its structure. Therefore, if one wants to modify the content of a specific block, they must also modify all subsequent blocks. If an error occurs in a block within the blockchain network, a new transaction is necessary to rectify the mistake. For instance, even if a block is tampered with by a hacker, any changes made will be immediately and permanently visible. However, in a scenario where a group of miners controlling more than 50% of the computing power in a blockchain network conducts a 51% attack, they can prevent the confirmation of new transactions and halt transactions between certain or all users.

In the past few years, certain players in the blockchain market, like Accenture, have developed blockchains that are editable, rewritable, or removable by utilizing “chameleon hash” functions. While these designs may help the blockchain adhere to the GDPR and KVKK regarding personal data protection, the ability for a blockchain to be edited implies that it could become a disruptive technology, contradicting its original purpose as a decentralized, immutable system and potentially rendering it meaningless.

Article 17 of the GDPR states that organizations must delete personal data once they have fulfilled the original purpose of collecting it. This means they must be able to remove personal data from their own and third-party databases if the individual withdraws their consent and there is no other legal reason to keep the data.

However, this requirement contradicts one of the main principles of blockchain technology, which is that data recorded on the blockchain ledger is permanent and cannot be tampered with. Removing data from the blockchain would go against the principle of irreversibility and immutability.

In a blockchain system, each block is connected to the previous block through cryptographic hash functions. This means that any attempt to alter the data in a block would affect the entire blockchain. Therefore, if a company using blockchain technology complies with requests to delete data, it could compromise the consistency of the blockchain, leading to a loss of reliability and customer trust.

Transparency of Blockchain

Certain elements of blockchain technology don’t align with the privacy requirements outlined in Article 25 of the GDPR. The GDPR necessitates that data processing systems be designed and developed with privacy in mind, but the nature of blockchain technology contradicts this requirement.

The characteristic of tamper-proofness or immutability is one of the key features of a blockchain database. It is currently not possible to remove data from the blockchain ledger without disrupting the integrity of the entire chain.

The fundamental nature of blockchain goes against the concept of being able to be forgotten. Integrating a feature that allows for forgetting contradicts the original design of the technology. Blockchain keeps a record of the origin of items it tracks, and removing oneself from this record would disrupt the chain of custody. This contradicts the main value of blockchain technology.

The blockchain’s transparent and tamper-proof nature allows for every transaction to be recorded and verified by anyone with access to the system. This raises concerns from a data protection perspective, as personal data must be stored securely and only accessible to authorized individuals. Companies can use techniques like pseudonymization and encryption to comply with these requirements.

The visibility of personal data on the public blockchain ledger contradicts the principle of availability because it can be accessed by unauthorized parties. Additionally, if someone can identify users from the transactional data stored on the blockchain, it goes against the principle of confidentiality. One study shows that it is still possible to trace blockchain users by their pseudonymized addresses and transactional data, linking them to their IP addresses. This contradicts the privacy-by-design requirement as the transparent nature of blockchain ledgers poses privacy concerns.

The Common Ground of GDPR and Blockchain Technology

The conflicts between GDPR and blockchain can be resolved by finding common ground, reinterpreting the regulations, and adjusting the blockchain technology to comply with data protection laws. It is not a situation where one side wins at the expense of the other, but rather a need for compromise and balance between the two.

Both blockchain and the GDPR follow data privacy principles. Instead of focusing on their differences, it is better to focus on what they both aim to achieve. This will help in finding a way to accommodate the technology and the GDPR.

Both blockchain technology and the GDPR aim to enhance data privacy and security, but they have different approaches to achieving this goal. While they share some fundamental principles such as transparency, individual control over data, data minimization, and encryption, they differ in their methods. To reconcile the differences, it is important to focus on their shared objectives rather than debating the specifics of how they are achieved.

Highlighting commonalities between the blockchain database and the right to be forgotten would provide further insight. While the immutability of the blockchain may conflict with the right to be forgotten, it aligns with the “privacy by design” principle of GDPR. The decentralized and immutable nature of the blockchain ensures the integrity and accuracy of stored records, reducing the risk of unauthorized modifications. This aligns with the considerations outlined in Article 25 of GDPR regarding the design and development of technology.

The blockchain technology allows users to have control over their personal data stored on the blockchain database. They are able to decide whether or not to share their data and can limit the amount shared to only what is necessary for a specific transaction. However, once data is entered into the blockchain, it cannot be removed or forgotten due to the architectural rules of the digital environment.

In conclusion, the blockchain database stores information in a way that is anonymous and transparent. Users can only see each other’s personal data if they are given a special private key. However, the transactions without personal data are visible to all users, which removes the need for a trusted intermediary. Both blockchain and the GDPR use anonymization and transparency to ensure data privacy and security.

Types of Data Stored on the Blockchain

Blocks are what contain transaction data. The data here can be the number of blocks, the block header that indicated the digital signatures, and when and by whom the block was created. The blocks will also contain transactional information. This transactional information may be encrypted or written in plain text. The blockchain can also contain a digital wallet and private or public keys.

The main question that arises when evaluating data on the blockchain from a legislative perspective is, if the data stored on the blockchain is, or can be, classified as personal data. For example, Personal Data Protection Law No 6698 states that all information that is on or about an identified or identifiable person is accepted as personal data. Therefore, the content of the block is important in this evaluation, is there an identified or identifiable data subject?

For instance, block headers cannot be considered personal data. However, the content of the block, depending on whether connections or identifications can be made, may be considered personal data processing.

The discussion surrounding whether data stored on the blockchain should be considered personal data is important, especially when it comes to transaction data and public keys. To ensure compliance with the GDPR and the KVKK, the definitions of transaction data and public key concepts are explained below.

Transaction Data

Transaction data is information that is obtained directly from specific transactions and it includes details such as the time, location, price, payment methods, discounts, and quantities involved in the transaction.

Encryption methods allow for data to be accessed with the appropriate keys, making it not truly anonymous. This means that encryption is considered a pseudonym under EU data protection laws. Therefore, data stored on the network using encryption is considered pseudonymous data, as individuals can still be identified, making it personal data.

While the KVKK does not specifically mention pseudonymous data, it is likely that it could be considered personal data based on EU regulations. However, the lack of clear guidance on this concept in KVKK may create uncertainty when applying it to blockchain technology.

The EU’s GDPR considers pseudonymous data and data that has been subjected to cryptographic hashing as personal data. However, the process of cryptographic hashing is not seen as anonymization, but rather as pseudonymization, as it still allows for the possibility of linking the data to the individual.

According to Article 29 of the Directive, the Article 29 Working Party clarifies that the cryptographic hashing method is not true anonymization but rather a technique known as pseudonymization, as it still allows for the identification of the data subject.

Anonymous data, where the connection between the information and a particular person is removed, is not considered personal data according to Directive 95/46/EC of the European Union. Anonymization makes it impossible to identify a person, which goes against the transparency and immutability principles of blockchain technology, causing a conflict with privacy.

Transactional data is recognized as personal data when it is connected, either directly or indirectly, to an identifiable person. Since distributed ledgers frequently track assets like an accounting tool, it’s important to note the stance of the United Kingdom’s Data Protection Authority. They suggest that financial data is especially attractive to attackers, implying a higher level of motivation for potential intruders, as seen in their ‘motivated intruder test.’ Therefore, it’s clear that transactional data can indeed be classified as personal data.

Public Key

Public keys are alphanumeric sequences that can be used to identify an individual or organization for transaction or communication purposes. These keys are considered pseudonymous, not anonymous, because they contain address and name information. Research suggests that public keys can be traced back to IP addresses, potentially revealing the identity of the person associated with the key. Under the GDPR, pseudonymous data that can be linked to a real person when combined with other data is considered personal data. Similarly, dynamically assigned and changeable IP addresses are also considered personal data. However, there is no definitive stance on this issue due to the absence of explicit definitions and a lack of consensus from relevant authorities.

In summary, public keys are considered personnel data and cannot be stored outside of the blockchain. They are essential for verifying transactions and finding legal solutions for public keys is more difficult than for transactional data.

The French Data Protection Authority has emphasized that public keys are likely to be considered personal data according to GDPR. This view is also supported by a report from the European Union’s Blockchain Observatory and Forum, highlighting the risk of linking data. While each situation requires a detailed individual assessment, it’s clear from these observations that public keys connected, directly or indirectly, to an identifiable individual are recognized as personal data within the EU framework.

Reversibly Encrypted Data

Reversible encryption is a method of scrambling data so that it can be understood, but only the person with the encryption key can decrypt it. There are different types of reversible encryption, such as symmetric and asymmetric encryption.

Although strong encryption methods can be used to protect personal data, it cannot be said that these methods completely make the data anonymous. Instead, they only transform the personal data into pseudonymous data, which can still be reversed using the key. Therefore, general keys, transaction data, and reversibly encrypted data are often classified as personal data and should be handled in accordance with the regulations outlined in the KVKK and GDPR if utilized in a blockchain network.

The CCPA

The California Consumer Privacy Act of 2018 (CCPA) went into effect on January 1st, 2020, was a push in the United States for privacy protection laws to be strengthened and broadened. Although there hasn’t been a federal law passed for statewide privacy legislation, many expect the United States Congress to enact a comprehensive privacy and data security regulation.

The CCPA defines personal information in a broad sense as to include any information that directly or indirectly identifies, describes, or can reasonably link to a particular California resident consumer, or household. The CCPA mainly applies to businesses that collect or control consumer personal information. For a business to be responsible in this aspect, they must either; have an annual gross revenue exceeding 25 million dollars, or annually buy, receive, share, or sell alone or in combination the personal information of more than 50.000 consumers/households for commercial purposes; or derive 50% or more of annual revenue from selling consumer personal information.

According to the CCPA, entities that qualify as “businesses” must provide or report certain data. These entities must perform abbreviated disclosure on the personal information collected from or about covered consumers as well as other disclosures. They are expected to also disclose the sale or disclosure of personal information for a business purpose.

These entities are also expected to provide the ability to opt-out from the sale of personal information as well as opt-in requirements before selling minors’ personal information. Lastly, there is also the requirement to provide the ability for such covered consumers to access and/or delete personal information that has been collected on them. These business entities must also provide measures that prevent discrimination against consumers exercising CCPA rights.

Complying with the CCPA can be challenging for many blockchains. The CCPA’s regulation of personal information is distinct in that it creates a category that not only identifies users, but, broadly, also includes information that relates to, describes, can be associated with, or reasonably linked, directly or indirectly with a particular consumer or household. Therefore, personal information can also be unique personal or online identifiers.

The CCPA identifies a consumer as a natural person who is a California resident, as defined in Section 17014 of Title 18 of the California Code of Regulations, as that section read on September 1, 2017, however identified, including by any unique identifier. This definition, with the use of “any unique identifier” results in most businesses likely storing consumer personal information.

The business purpose is important in the context of the CCPA. Business purpose is the use of personal information for the businesses or a service provider’s operational purpose, or notified purposes, provided that the use of personal information shall be reasonably necessary and proportionate to achieve the operational purpose for which the personal information was collected or processed. The use of personal information can be a business purpose also if it is used for other operational purposes that are compatible with the context in which the personal information was collected.

Section 1798.140(d) of the CCPA is important in evaluating business purposes. This Section pertains to the examination of interactions with consumers and transactions, encompassing activities such as tallying ad impressions for unique visitors, confirming the positioning and quality of ad impressions, and auditing adherence to specified standards and other criteria. The CCPA addresses the identification of security incidents, safeguarding against malicious, deceptive, fraudulent, or illegal activities, and pursuing legal action against those responsible.

The carrying out of services on behalf of the business or service provider, including acts such as account maintenance, customer service provision, order and transaction processing, customer information verification, financing provision, payment processing, advertising and marketing services, analytic services… etc. that is carried on behalf of a business or service provider. There is also a focus on activities aimed to verify or ensure the quality or safety of a service or device, owned, manufactured, or controlled by the business or service provider can also be seen in the scope of business purpose.

Consumers Right to Opt-Out and The Business’ Right of Non-Compliance

The CCPA regulates a consumer’s right to opt out as well as the consumer’s right to request that a business delete any personal information about the consumer that the business has collected. The consumer has the right to, at any time, direct a business that sells personal information about the consumer to third parties not to sell the consumer’s personal information.

There are circumstances where a business is not required to comply with a consumer’s request to delete their personal information. This can occur if it is necessary for the business or service provider to maintain the customer’s personal information. This necessity can be if the information is needed for the completion of a transaction, to provide a good or service that the consumer requested, or if the need for the personal information is anticipated reasonably within the context of the ongoing relationship between the consumer and the business. This can also be the case if the information is necessary to perform a contract between the consumer and the business.

If the data is required for the detection of security breaches, the protection against malicious, deceptive, fraudulent, or illegal activity, and to prosecute those responsible for such activity, then the business is not required to comply with consumer requests. If the business is using such personal information to identify and repair errors that impair existing functionality, the business isn’t required to comply with opt-out requests.

If the consumer’s request constitutes free speech and ensures the right of another consumer to exercise free speech of rights provided by the law, then businesses can reject consumer requests to delete information. If the business engages in public or peer-reviewed scientific, historical, or statistical research in the public interest that adheres to all other applicable ethics and privacy laws and the deletion of information is likely to render impossible or seriously impair the achievement of such research, if the consumer has provided informed consent, then the business isn’t required to comply with consumer requests.

Finally, if the information is used to comply with legal obligations or used internally, in a lawful manner that is compatible with the context in which the consumer provided the information, the business can also deny the consumer’s request for deletion.

Responsibility Under The CCPA

The CCPA is clear in that businesses are responsible for the processing of personal information. However, the issue in the context of blockchain is whether the blockchain organization is a business. On the other hand, developers will not have a responsibility to comply with CCPA rules. The right to action is put on the consumer’s shoulders, as they have the responsibility to request deletion or the correction of personal information. If they qualify as a business and meet requirements set out by the CCPA, miners, and nodes can be required to comply with CCPA rules.

For permissioned businesses that exercise control or ownership over blockchain networks, they should adopt technology that adheres to the CCPA. They have the option to regulate access to personal information through permission controls. Meeting CCPA requirements for permissionless, decentralized blockchains poses a challenge, as it may not always be evident whether a business exists, let alone anyone with the capacity to modify the immutable data on the ledger.

If a business develops and deploys a permissionless, public, decentralized blockchain that stores and transmits consumers’ personal information, it is likely obligated to comply with the CCPA. However, especially in terms of deleting consumer personal information, this isn’t attainable.

The Issue of Applicable Law

In the context of the application of the CCPA, it applies to certain entities conducting business in California that collect consumer personal information. However, there are various forms of blockchain organizations that can affect the liabilities of enforcing the CCPA. There is also the fact that some blockchain organizations may qualify as a business but are not permissionless. Ultimately, in the case where certain blockchain organizations are not permissionless, do not make up a legal entity, and don’t have a responsible party, enforcing the CCPA would be difficult.

Based on the explanations given above, it is clear that in blockchain technology, personal data is not only recorded by a single center or group of centers, but by all participants in the system. The main objective of this system is to distribute the established rules and the record chain generated by these rules to everyone involved, without the need for the parties to know each other. In open and Permissionless Blockchain Networks, the main function nodes (master nodes) that hold copies of all data can be located anywhere in the world. Therefore, it is challenging to determine the exact location of these fully functional nodes and which country’s laws they fall under. It is important to note that neither the GDPR nor the KVKK can be freely contracted; instead, the provisions of these regulations will be directly applied to any situation falling within their scope.

Furthermore, as explained earlier, a broad understanding of the geographical reach of the GDPR, particularly in the context of open Blockchain Networks, is expected to lead to the enforcement of the regulation across almost the entire network. Consequently, it is anticipated that all parties involved will be required to comply with all the obligations specified in the GDPR.

However, because the relevant regulations are directly applied, particularly in open and Permissionless Blockchain Networks where data controllers and data processors can be situated globally, there might be a requirement to adhere to multiple data protection regulations at the same time.

In fact, due to the cross-border nature of business activities of data controllers like cryptocurrency exchanges, wallet providers, and other blockchain service providers, the broad interpretation of the regional scope of the GDPR suggests that all of them will be impacted by this regulation. As a result, multinational companies from outside the EU might choose to prevent individuals within the EU from accessing their services in order to avoid GDPR compliance, or they might even go as far as completely stopping their operations in the EU.

Complying with the GDPR can present a substantial economic obstacle for smaller data-focused businesses in the EU, potentially jeopardizing their survival. Recent events demonstrate this, as Coinbase, the leading cryptocurrency exchange in the US, has already introduced distinct privacy policies for its users in the US and the EU. Concurrently, CoinTouch, a P2P exchange based in London, declared its closure entirely because it could not afford to meet the expenses associated with GDPR compliance.

In conclusion, when blockchain technology is implemented, there may be concerns about how the KVKK and the GDPR apply in terms of scope and regional coverage. This is especially important for smaller businesses in the EU, as complying with the GDPR can significantly affect their economic stability. Recent instances, like Coinbase and CoinTouch, demonstrate the difficulties businesses encounter when adjusting to data protection regulations in various jurisdictions.

Personal Rights of Data Subjects and General Obstacles

First of all, it is important to note what kinds of rights data subjects (relevant individuals) have with respect to their personal data. According to KVKK and very similarly to GDPR and CCPA, everyone has the right to apply to the data controller and inquire about the following regarding their personal data:

a) to find out whether their personal data is being processed,

b) If their personal data has been processed, to request information regarding this,

c) To learn the purpose of processing their personal data and whether it is used in accordance with its purpose,

d) To know the third parties to whom their personal data has been transferred, either domestically or abroad,

e) To request the correction of their personal data if it is incomplete or processed inaccurately,

f) To request the deletion or destruction of their personal data within the framework of the conditions

g) To request notification of the processes carried out according to clauses (d) and (e) to the third parties to whom personal data has been transferred,

h) To object to any outcome against the individual resulting from the analysis of the processed data exclusively through automated systems,

ğ) To request compensation for damages in case of loss due to the unlawful processing of personal data,

As stated above, data subjects have the right to request deletion of their personal data. This stems from the fundamental right to privacy of individuals. Data subjects may also request the complete eradication of their personal data as well as editing or updating inaccurate information. Such rights of data subjects have been demonstrated above.

Due to the technical structure of blockchain technology, deletion or altering of information is not possible. Data on the blockchain cannot be erased therefore this yields a serious point of contention between data privacy laws and the technology.

The data stored on the blockchain cannot be updated either. Privacy laws underline the importance of data being up-to-date and accurate, therefore this also draws a point of contention.

Reconciling Blockchain Technology and Data Privacy Laws

Data protection laws such as the GDPR, the KVKK, or the CCPA do not outlaw the use of blockchain technology. However, it is also true that these laws are not as compatible with the technology as they could be. Yet, companies utilizing blockchain technology in their business or service providers using this technology may still be required to comply with these laws.

The most sensible approach a blockchain organization can take in order to avoid violating privacy laws is to refrain from processing and storing personal data and information. However, this can be easier said than done. Another approach could be storing data off-chain instead of within the blockchain itself. Ultimately no new mechanisms for providing protected data processing within the blockchain have been created.

Quick Takeaways

In this part, we would like to address some direct questions readers may have. However, before reading this part or acting solely upon the information we provide in this part, we strongly recommend everyone to read the whole paper and consult with local experts in this area.

What types of data are generally stored on blockchain networks, and how are they classified legally?

The data stored on the blockchain can be categorized as transaction data and public keys. Since it is detailedly explained above, personal data can be broadly defined as any information of all and any kind which in fact makes an individual identifiable.

Transaction data mostly consist of senders’ and receivers’ addresses, the amount transferred, timestamps, cryptographic hash, and various other data depending on the nature of the transaction and blockchain. As long as the information is eligible to be considered as pertaining to an identified or identifiable individual, then, all this information regardless of what it is, will be considered as personal data and relevant pieces of legislation will be applicable to the case depending on relevant individual and nature of the dispute.

What existing legal frameworks govern the storage of data on blockchains?

It is worthwhile to note that almost every country has its own legislation on data privacy and security. However, it is safe to say that the idea behind all is actually quite similar and the rules that come with them generally tend to align with each other.

However, there are also some legislations such as GDPR that burst into prominence. So, while determining what jurisdiction and regulation you are subject to, you shall consider the nature of your data processing, whom personal data is being collected and processed, where you process this personal data, with whom you share this data, etc.

How do jurisdictional issues affect the legal matter regarding data stored on a decentralized network?

Decentralized networks frequently span several nations, making it difficult to ascertain which legal system is in effect. Due to its worldwide distribution, there may be inconsistencies between national laws, particularly in regard to data protection, cyber security, and financial restrictions.

The data in a classic centralized system is stored in distinct, recognizable locations, which facilitates the identification of the relevant legal jurisdiction. Decentralized networks, on the other hand, disperse data over a large number of nodes, maybe in several jurisdictions, making it more difficult to identify which rules apply to the management and transfer of the data.

Therefore, it is actually not possible to directly answer this question at first sight. It is even possible for a decentralized network to be subject to one jurisdiction on a particular matter and one other jurisdiction for some other issue. For example, if the issue is regarding an individual who resides in Türkiye and of Turkish citizenship, then, the KVKK will be most probably applicable. However, in another scenario, if the legal matters are about an EU citizen, then, it is possible for the blockchain to be subject to GDPR regardless of where they process personal data.

Furthermore, it is even possible and probable for a blockchain to be subject to more than one legislation at once, for example, if the blockchain is somewhat located in Türkiye, or somehow connected to Türkiye via its managers, and the personal data being processed is pertaining to an EU citizen, then, that blockchain will be most probably obligated to comply with both KVKK and GDPR.

The first and main thing to do is to determine what type of personal data is being processed, whom personal data is processed, and how. After that, applicable legislation will be easier to find.

Are there instances where data stored on blockchain networks has been subpoenaed or involved in legal proceedings?

As far as we are aware, there are no cases where a case has gone public and attracted attention. However, we are confident and first-hand witness to cases where courts or prosecution offices request information from blockchain networks or crypto asset service providers regarding legal matters they examine.

One of the main cases where these authorities request information is about fraud, AML, and KYC. Many jurisdictions such as Türkiye are concerned with the anonymous nature of transactions conducted on the blockchain. Furthermore, they closely examine suspicious transactions whether they are for financing of terrorism or not. Moreover, unfortunately, blockchain transactions are commonly perceived by many authorities as a means of tax evasion. Therefore, governmental bodies often ask for information from blockchain networks or crypto asset service providers. In Türkiye, since crypto asset service providers are included in MASAK (Financial Crimes Investigation Board) obligators, crypto asset service providers have to comply with KYC and AML procedures, which in fact naturally results in the collection of personal data that will be shared with MASAK and other relevant authorities upon request.

LEGAL DISCLAIMER

THE INFORMATION PROVIDED IN THIS PAPER PROVIDES GENERAL INFORMATION AS TO THE POSSIBILITIES IN MULTIPLE JURISDICTIONS. PLEASE KEEP IN MIND THAT LAWS THAT APPLY TO THE SUBJECT HEREIN MAY DIFFER IN EACH JURISDICTION. THUS, NOTHING CONTAINED HEREIN CONSTITUTES ANY LEGAL OPINION OR SUGGESTION OF ANY KIND. PLEASE CONSULT TO LOCAL EXPERTS IN RELEVANT AREAS BEFORE TAKING ANY ACTION BASED ON ANY INFORMATION CONTAINED HEREIN.

TLDR

Coins and fiat currencies often draw comparisons, with the latter operating on closed, government-controlled ledgers, leading to non-transparency and potential misuse. In contrast, cryptocurrencies use open, people-governed ledgers, preventing monopolization and offering transparency. Many crypto assets are designed with limitations to curb inflation, contrasting with the overproduction of fiat currencies.

Blockchain technology can be used to exchange ownership or possession of many assets, from money to movable property, from a motor vehicle to any intellectual and artistic work. The concepts of “Coin” and “Token” are frequently encountered in these transactions. Although these two concepts and tools have different meanings and functions, they are used in a close sense that is difficult to distinguish from each other, especially in initial coin offerings (“ICO”), and sometimes intersect in terms of meaning and function.

One other type of classification mainly depends on the nativity of the underlying blockchain technology of a crypto asset. Layer 1 blockchains like Bitcoin, Ethereum, and Cardano are examples of foundational blockchains. A Layer-1 blockchain uses cryptocurrencies to cover transaction fees and validates and supports its own network without the aid of another network. The main crypto assets of L1 blockchains, such as Bitcoin and Ethereum, are coins, and the derivative and secondary crypto assets are regarded as tokens.

On the other hand, their conceptual characteristics include technical, legal, and operational differences. The type of token, the rights, and authorizations it provides change and affect the rules of law to which the ICO will be subject and the regulatory and supervisory authority under whose supervision it will be considered.

Comparison Between Coins and Fiat Currencies

Coins and fiat currencies like the Dollar and Euro are often compared. Public frustration exists regarding central banks’ practices, sometimes leading to monetary inflation.

Closed Ledgers of Fiat Currencies

Fiat currencies operate on closed ledgers controlled by governmental institutions such as the U.S. government and the EU, making transactions and additional printing non-transparent and inaccessible for ordinary people to track and oversee.

Open Ledgers of Cryptocurrencies

In contrast, cryptocurrencies like Bitcoin, Ethereum, and Cardano operate on open ledgers, enabling transparency and participation. Unlike fiat currencies, these ledgers are people-governed and aren’t monopolized by a single entity.

Government Control and Misuse

Governments can exploit their control over financial systems, leading to inflation and impacting the public negatively. They possess the unilateral right to print money, often resulting in overproduction.

Limitation of Crypto Assets

Many cryptocurrencies are technologically designed with a cap to prevent inflation due to excess printing, in stark contrast to fiat currencies.

Types of Coin and Possibly Adhered Regulations

a. Bitcoin

Bitcoin is the first cryptographic coin and the first crypto asset. For the last decade, it has been the most talked about concept and asset in banking and finance technologies, both because it is the first cryptocurrency created with cryptography and because it is a payment system. Bitcoin’s decentralized nature is the main reason for this interest. The main function and feature of Bitcoin is its usage as a means of payment, which brings it closer to the Banking Law and other relevant applicable laws.

b. Altcoin

Altcoin, as the name suggests, is a generic name for alternative coins that were launched after the success of Bitcoin. These crypto assets generally present themselves as a better alternative to Bitcoin. Altcoins are coin projects that aim to replicate and follow the success of Bitcoin as a peer-to-peer (P2P) cryptocurrency. Most Altcoins aim to circumvent or avoid technical or legal restrictions. Thus, new alternatives to Bitcoin are emerging. As a term, “Altcoin” is used for all crypto assets that are not Bitcoin.

In April 2011, the first Altcoin appeared with NameCoin, followed by the launch of numerous crypto-asset exchanges to broker the trading of BitCoin and Altcoins. Today, these exchanges function as platforms where Bitcoin and other altcoins can be traded, allowing the price of Bitcoin to be determined in the free market. Thus, today, the price of Bitcoin is at least theoretically determined by the free market. Supply and demand create the price. Bitcoin trading platforms, namely crypto asset service providers, match buyers and sellers.

The platforms are independent of each other, not interrelated. Cross-platform transactions are also possible, and cross-platform transactions ensure that the market price is in line with each other. Differences in value between platforms, or more accurately, between crypto asset service providers for the same crypto assets, may lead to arbitrage and transactions focused on this. As a matter of fact, the legal institutionalization of crypto assets requires a governance principle and system that will ensure that value differences are kept to a minimum. The impact and appropriateness of such a principle and system on the interest in the crypto asset market or the nature of this market is open to further discussion.

As a conclusion, possibly adhered regulations regarding Altcoins shall be closely examined and determined according to its functions and nature. The more they are close to becoming a means of exchange, the possibility of being subject to the Banking Law respectively increases. On the other hand, if an Altcoin has some features that are eligible to fall into the scope of capital market instruments and rules, then, it is more likely for them to be subject to Capital Markets Laws.

Sad Fact:

The creation of a value transfer system based on cryptography allows parties to transact directly with each other without the need for a reliable third party, which can result in a significant reduction in transfer fees. According to the World Bank’s data, the transaction fee spent for money transfers was $575 billion in 2016, $548 billion in 2019, and $540 billion in 2020. For comparison, according to the World Bank’s data, the Gross Domestic Product (GDP) of the Republic of Turkey was $869 billion in 2016. As can be seen, the fee paid to intermediary financial institutions for money transfers corresponds to 66% of the GDP of the Republic of Turkey in 2016 alone.

Financial institutions place a huge burden on the shoulders of the ordinary people for simple monetary transactions. Therefore, many people naturally ask the rightful question of which side the regulators are really on when it comes to adversely regulating the crypto asset ecosystem.

c. Stablecoin

Stablecoin is a type of coin whose value is indexed to a precious asset such as gold or a stable currency such as the Dollar, Euro, Pound, where the underlying asset is held by the issuer for the value attributed to the issued coin. The opposite of this type of coin is the unstable coin, which is a coin with a floating value. The value of unstable coins varies depending on the form and quantity of their supply, whether they are centralized or not, their mining structure, and the projects in which they will be used.

It would be appropriate to consider the legal nature of Stablecoins and the legal framework they will be subject to according to the underlying asset. This is because the legal regime to which the underlying asset is subject is generally suitable to be applied to the Stablecoin in an instrument-independent manner according to asset-backed securitization regulations.

Possibly Adhered Regulations

a. Security Token

In Turkish law, the concept of securities is regulated by the Capital Markets Law (“CML”). One of the most significant effects of crypto assets is the introduction of a payment instrument outside of banking law with its money feature, and the other feature is the creation of an alternative and unregulated market and product to capital market instruments.

As mentioned below, crypto assets, which have the characteristics of investment instruments or securities in the Markets in Financial Instruments Directive (“MIFID”) and Markets in Crypto Asset Regulation (“MiCA”) axis, tend to be considered as financial products or instruments, leaving aside the technology or instrument in their issuance.

In the US, the Howey Test attempts to shed light on this issue. Thus, it is concluded that if a token meets the characteristics in the definitions of securities or other capital market instruments, this crypto asset will be accepted as a security. In this case, it is concluded that transactions such as the issuance, offering and custody of the Token in question will be subject to the CML and such crypto assets will be accepted as securities tokens.

Ultimately, Security Tokens, as mentioned above, should not be the first choice for launching a token due to its nature and strict worldwide regulations that are subject to legal risks related to it.

Furthermore, it is essential to state that the possibility of defining a coin as a security, consequently, may result in consideration of accepting every token developed on the same blockchain as the main coin as a security. Since the tokens are the derivative products of the blockchain and the main coin, its success may directly affect the value which may inevitably result in considering said tokens as securities.

b. Payment Token

A Payment Token is a type of token that is used for payment transactions and has a dominant role as a means of payment. Tokens in this category are the closest in type to Coins. Deciding whether a coin or token can be used as a payment instrument in a particular country or region, such as the EU, is generally the prerogative of the bodies of that country or region that have the authority to regulate it.

The general tendency is not to accept the use of crypto assets for payment purposes. Although such assets have the effect of improving and developing the existing financial system, the fact that the legal regime to which they will be subjected has not been established and their relationship with existing financial instruments has not been defined leads to a prejudiced view of their positioning as payment instruments.

c. Utility Token

These tokens, referred to as Utility or Service Tokens, offer their holders the right and opportunity to benefit from a particular product or service. They are not securities, capital markets or payment instruments. They can be used within the ecosystem in which they are issued, enabling a product, service, or privilege to be utilized in the usage areas listed in this limited network. This includes those that are used for crowdfunding purposes, such as DAO Tokens, which give the right to benefit from and purchase products that will be produced with this funding.

Characteristic examples of this group are Fan Tokens issued by sports clubs that provide the right to participate in decision-making processes regarding their team’s anthems, uniforms, regular and substitute players, and transfers. Compared to other token types, they are currently the most distant from the binding, mandatory terms and rules of banking and capital market law.

The general characteristic of Utility Tokens is that they are generated, issued, and used for non-financial purposes. MICA’s distinction classifies this type of token as a utility crypto asset, pointing out that they are assets that have no financial purpose and are not used for that purpose, and that the issuance or treatment of such assets does not require any special authorization provided that the offered utility exists or is in operation during its offering to the public.

The issuance of such assets may also be in the form of an ICO, as they are generally produced, offered, and used for the purpose of providing benefits and privileges to their owners, such as utilizing a certain service or having an advantage.

d. NFT (Non Fungible Token)

NFTs are perhaps the newest, but no less popular, of crypto assets. Legally, there is no widely accepted definition. Given its characteristic structure, an NFT can be described as a unique cryptographic asset. NFT differs from other assets produced by blockchain cryptography in that it has no duplicate. While other cryptographic entities can be substituted for each other, NFTs are unique and singular. Therefore, one cannot replace the other. NFTs are produced in conjunction with or integrated into intellectual products such as games, paintings, photographs, etc.

NFTs are commonly perceived only in relation to intellectual property. However, any entity can be expressed in NFT form. Since uniqueness and originality are the characteristics, most needed by intellectual and artistic works, producers of intellectual property products are much more interested in NFTs. This is expected to increase further. This is because NFTs ensure and protect the authenticity of a work with the blockchain. In this case, the work-as-creation character of the NFT itself and the effect of the NFT registration in proving authorship are other noteworthy legal effects.

e. Asset-Based Token

An asset-backed token is the token version of Stablecoin. As a type of crypto asset, it is issued based on either another crypto asset or a physical asset. They usually refer to a legal tender, a currency, one or several commodities, one or several other crypto assets, with the aim of maintaining a fixed value. However, they may later be used as a means of payment or a medium of exchange for the purchase of goods or services.

In the MICA classification, such assets are characterized by the function of storing a fixed value, and a whitepaper is required to explain the underlying asset and its functions in issuance and offering transactions.

Examples include the need for the underlying assets to be available and maintained by the issuer, equity coverage, and a certain provisioning requirement. Unlike utility-based crypto-assets, in MICA the supervision and oversight of such assets are assigned to the European Securities and Market Authority, in cooperation with the European Banking Authority.

Understanding the SEC’s Perspective on Crypto Asset Qualification

The SEC, governing securities transactions, scrutinizes tokens based on the Howey test, a criterion originating from a dispute over real estate contracts for citrus groves. This test classifies an ‘investment contract’ as an investment of money in a common enterprise, with profits solely from others’ efforts. Though comprehensive, Bitcoin exemplifies its limitations, fulfilling the investment aspect but lacking a ‘common enterprise’ and deriving value from speculation, not managerial efforts. Consequently, Bitcoin isn’t considered a security.

Despite covering various assets, the Howey test leaves over half of the crypto market outside SEC jurisdiction. It applies to tokens sold with expected returns and might extend to secondary sales, but a token’s qualification can change with decentralization, as seen with Ether. The SEC faces criticism for relying on a 1946 case to regulate a market born in 2008, providing unclear guidance, and seemingly favoring early tokens, raising questions about its adaptability to technological advancements.

The DAO and SEC Examination

The US SEC scrutinized The DAO, Slock.it UG, its founders, and intermediaries for potential federal securities law violations. Created by Slock.it for profit-making, The DAO aimed to fund projects through selling DAO Tokens, which were investigated to determine if they were securities under U.S. law. The Commission concluded that they were, requiring registration or exemption adherence.

Launched in April 2016 on the Ethereum Blockchain, The DAO was promoted through various platforms, emphasizing its secure, audited code and participatory features. The Commission, recognizing the growing use of distributed ledger technology for capital, stressed the applicability of U.S. securities laws regardless of organizational form or technology.

The laws prohibit unregistered securities offers or sales and encompass “investment contracts,” adaptable definitions focusing on transactional economic reality. In conclusion, compliance with federal securities laws is mandatory for all securities transactions, regardless of currency, form, or issuer type, emphasizing investor protection and informed decision-making. Additionally, entities facilitating securities exchanges must register or qualify for exemption.

SEC Allegations Against Coinbase

The SEC filed a complaint against Coinbase Inc. and Coinbase Global Inc., accusing them of violating the Securities Act of 1933 and the Exchange Act of 1934 by operating their crypto asset trading platform.

The SEC alleged that Coinbase acted as an unregistered exchange, broker, and clearing agency, thereby breaching various sections of the Exchange Act. Additionally, the complaint highlighted Coinbase Global Inc.’s role as the controlling entity, participating in the alleged violations. A significant point of contention was the SEC’s lack of a clear definition of coins, raising questions about its consumer protection intentions. Lastly, Coinbase was accused of violating Sections 5(a) and 5(c) of the Securities Act through the offer and sale of the Coinbase Staking Program without proper registration.

SEC Files Comprehensive Complaint Against Binance

On June 5, 2023, the SEC filed a comprehensive complaint involving 13 claims for relief against Binance Holding Ltd and its U.S. subsidiary, BAM Trading Services Inc., operating Binance.com and Binance.US respectively, and their founder, Changpeng Zhao. The SEC accused both entities of operating as unregistered exchanges, broker-dealers, and clearing agencies, alleging intentional avoidance of registration to sidestep regulation. Binance was further accused of violating Sections 5(a) and 5(c) of the Securities Act by offering and selling BNB, BUSD, Simple Earn, and BNB Vault without proper registration. Additionally, BAM Management and BAM Trading were charged with making false statements, engaging in fraudulent practices, and violating the Securities Act and the Exchange Act by not registering the offer and sale of its staking program.”

SEC v RIPPLE: Overview of Legal Action

In December 2020, the SEC filed action against Ripple Labs, its executives Bradley Garlinghouse and Christian A. Larsen, alleging that they raised over $1.3 billion through an unregistered digital asset securities offering, violating Sections 5(a) and 5(c) of the Securities Act. In early 2023, both parties filed for summary judgment.

The court examined four categories of XRP transactions to determine if they constituted investment contract security according to the Howey Test and evaluated the defendants’ claim of “fair notice”. The categories included Institutional Sales, Programmatic Sales, Other Distributions, and sales by Larsen and Garlinghouse.

The court found that Institutional Sales satisfied the Howey Test elements, with Ripple’s actions creating a reasonable expectation of profits for investors based on Ripple’s efforts. However, for the other XRP sales categories, the court did not find sufficient evidence to satisfy the Howey Test elements. The court also rejected the fair notice claim, asserting that existing Howey case law provided clear standards and sufficient notice for compliance.

Stance of Commodity Futures Trading Commission

The Commodity Exchange Act (CEA) defines a commodity as any basic good, raw material, or other entities in which contracts for future delivery are dealt with. This broad definition encompasses various products, including new technologies like crypto assets. The CFTC, responsible for regulating commodities, gained jurisdiction over crypto assets through key cases like CoinFlip (2015) and My Big Coin (MBC).

In the My Big Coin case, developers were charged with defrauding users by falsely claiming the virtual currency was backed by gold. The main issue was whether the CFTC had authority over MBC under the CEA, despite it not being a subject of futures trading. The defendants argued that MBC was not a commodity as futures trading was necessary for the classification under the CEA.

In 2018, the court ruled in favor of the CFTC, establishing that virtual currencies are considered commodities even without futures contracts. The decision broadened the definition of commodities and affirmed the CFTC’s authority over virtual currencies, paving the way for future regulation and enforcement against deceptive acts involving digital assets. This case was a turning point, clarifying the CFTC’s power and how traditional commodity rules apply to emerging financial technologies.

CTFC v. Ooki DAO

In the case of CFTC v. Ooki DAO, the CFTC accused bZeroX of developing and marketing a blockchain protocol functioning like a trading platform, which facilitated margin and leveraged retail commodity transactions from June 2019 to August 2021. Ooki DAO faced three counts of violations: first, for engaging in illegal over-the-counter leveraged transactions; second, for conducting activities requiring registration as a futures commission merchant; and third, for failing to implement customer information, KYC, and Anti-Money Laundering programs. After Ooki DAO missed the response deadline in January 2023, US District Judge William H. Orrick ruled in favor of the CFTC in June, ordering a shutdown of Ooki DAO and imposing a $643,542 fine. This case established a precedent, affirming CFTC’s jurisdiction to regulate DAOs and their activities.

What Regulations Should Be Adhered Relating Each Crypto Asset?

As mentioned above, the main distinction amongst crypto assets is as Tokens and Coins. Accordingly, Coins are split into categories as Bitcoin, Altcoins and Stablecoins. On the other hand, Tokens are classified amongst each other as Security Tokens, Payment Tokens, Utility Tokens, NFTs and Asset-Based Tokens.

Coins in General

As a matter of fact, Bitcoin and other coins that followed it are mainly designed to be a substitutive of fiat money and instruments of the classic financial system. Their main feature and aim are to be a means of exchange for transactions of economic value. When it comes to deciding which regulation will be applicable to a particular type of coin, the features and nature of the coin is determinant.

Since the main objective of coins to be a substitutive of fiat money, relevant laws on banking, finance and payments systems will be most probably applicable to coins. For example, in terms of Türkiye, crypto assets which constitute a monetary feature are considered by the Central Bank of Türkiye. Accordingly, the Central Bank issued a regulation with which it prohibited the usage of crypto assets as a means of exchange and further bans the development and usage of direct or indirect payment systems of any kind that uses crypto assets. As a conclusion, Coins that mainly function as a means of exchange will most probably be subject to laws relating to banking and finance law.

Tokens in General

When it comes to Tokens, determining which regulation to be adhered to may be quite tricky due to the variety of the tokens. Therefore, feature and nature of each token shall be closely examined and adhered regulation shall be determined accordingly.

Security Tokens

Digital or cryptographic tokens known as security tokens reflect ownership in tangible assets like stocks, real estate, or even fine art. They get their name from the fact that they are regulated as securities and are related to “securities” as that term is used in conventional finance. Also, the governance tokens that are commonly used by Decentralized Autonomous Organizations fall into the category of security tokens.

Security tokens shall be specifically created to comply with security laws, which makes them stand out from other token kinds like utility tokens or payment tokens. This may involve clauses requiring investor identification, trading limitations, and other legal obligations. Because traditional securities rules and cutting-edge blockchain technology are combined, the legal environment around security tokens is complicated.

Tokens are not entirely equivalent to securities. The categorization is determined by the token’s characteristics and intended use. For instance, to evaluate whether a transaction qualifies as a “investment contract” and, thus, a security, the Securities and Exchange Commission (SEC) in the U.S. utilizes the Howey Test, a test drawn from a 1946 U.S. Supreme Court case.

Payment Tokens

Payment tokens are a subset of tokens that are primarily used as a means of exchange or as a store of value. They are also frequently referred to as crypto assets. Since Payment Tokens are closest to the coins, they mainly fall into the scope of regulations relating to banking and finance law. However, it is worthwhile to note that adhered regulation may vary depending on the jurisdiction, but it is safe to say that Payment Tokens generally fall into the scope of either securities law or banking law. With, relevant Know Your Customer, and Anti-Money Laundering laws and regulations shall be carefully considered.

Utility Tokens

Utility tokens generally serve as a means of gaining access to a certain good or service on a platform or in a specific blockchain-based project. Utility tokens give consumers access to a future good or service, as opposed to security tokens that represent an ownership interest or investment return or payment tokens that serve as a means of exchange.

Utility tokens are primarily intended for consumption, although they can occasionally resemble securities, particularly when offered in an Initial Coin Offering (ICO) with the hope of making money afterwards. To classify a token, regulators in different countries look at its nature, intended use, marketing, and selling environment.

As the Utility Tokens’ nature and features get closer to the general features of securities, the possibility of being subject to the securities law dramatically increases accordingly. Despite all that, Utility Tokens are currently considered the safest bet for the crypto ecosystem.

NFTs

The blockchain and digital art communities are very interested in NFTs, or Non-Fungible Tokens. They stand for a separate digital asset that can only be confirmed through blockchain technology, making sure that each NFT has a unique value and cannot be exchanged for another one exactly, unlike fungible crypto assets like Bitcoin or Ethereum.

Since the originality, uniqueness and singularity is mostly valued and needed in terms of intellectual and industrial property, the main legal discussion evolves in this area.

When purchasing an NFT, the customer often only receives ownership of the one-of-a-kind token and not the rights to the actual digital product or artwork. Confusion can result from this distinction. For instance, unless expressly indicated, holding an NFT of a digital artwork does not automatically provide the owner the right to duplicate, distribute, or profit from the artwork.

While it is doubtful that the majority of NFTs will be categorized as securities, there may be circumstances in which an NFT’s structure and the claims attached to it cause it to fall within the scope of the securities laws.

As a conclusion, NFTs are evaluated mainly in terms of intellectual and industrial property law. Unauthorized tokenization of an asset may result in copyright infringement. On the other hand, in the event of tokenization of a security as a NFT may be subject and in fact in violation of securities law. The adhered regulation shall be determined in accordance with the nature and feature of each NFT in accordance with the underlying tokenized asset.

How Do You Share The Tokens and Legal Implications

ICOs, or Initial Coin Offerings, are a means for new projects to raise funds by selling tokens or coins, resembling IPOs but offering crypto assets instead of stocks. The classification of these offerings as securities, assessed through tests like the Howey Test in the U.S., influences the applicable regulations. Countries differ in definitions and regulations, and understanding the nature of the token is essential to determine its security status.

AirDrops involve sending crypto assets to multiple wallet addresses, often for free, for promotional purposes or to reward loyalty. Despite their seemingly gratuitous nature, airdrops have legal implications. Regulatory bodies may classify airdropped coins as securities, subjecting them to strict laws, and recipients might incur taxes based on the asset’s value at the time of receipt, as indicated by agencies like the IRS in the United States.

TLDR

ICOs raise funds by selling crypto assets, and their classification as securities determines their regulation, varying by country. Airdrops, while often free, can have legal ramifications, potentially being classified as securities and incurring taxes based on value upon receipt.

Staking and Its Legal Implication

Within Turkish law there are a few regulations to consider when determining staking and its legal implications. First, the regulation on Non-Use of Crypto Assets in Payments, defines crypto assets as assets that are created virtually using distributed ledger technology or a similar technology and distributed over digital networks. Thus, crypto assets are not characterized as fiat money, dematerialized money, electronic money, payment instruments, securities, or other capital market instruments. Ultimately, this Regulation does not prohibit crypto assets in principle but aims to prevent their use in payments.

Likewise, Law №1567 on the Protection of the Value of Turkish Currency and Decree №32 on the Protection of the Value of Turkish Currency do not prohibit the creation of a crypto asset account. Law №1567 and Decree №32 have a list of prohibited transactions in foreign currencies. However, it is not legally possible to include crypto assets within “prohibited transactions in foreign currency” as these provisions are numerus clausus.

In addition, the activity of creating a foreign currency/foreign currency deposit account, which we can liken to staking activity, is not prohibited under Law №1567 and the Decree №32. Therefore, it should be concluded that the staking of crypto assets is not prohibited by the legislation. In private law, anything that is not expressly prohibited is permitted. Therefore, all crypto assets, from stable crypto assets to crypto assets denominated in foreign currency or gold, can be subject to staking today.

Using Token as a Payment Method

With the introduction of blockchain technology and decentralized platforms, the practice of using tokens as a means of trade inside a particular platform has grown in popularity. In this situation, tokens serve as in-house crypto currencies that help with transactions or provide access to particular platform features or services.

The rules and laws for crypto assets vary greatly between countries, and even within different areas. This can make it very difficult for crypto asset users to understand and comply with the legal system. Governments and central banks are primarily worried about crypto assets being used for transactions between any global accounts, regardless of whether they are anonymous or not.

Regulations like know-your-customer (KYC) and anti-money laundering (AML) procedures have been implemented by centralized authorities to address the barriers hindering the broader acceptance of crypto assets. Countries are quickly adopting regulations to benefit from the expansion and potential of crypto assets.

Here are some countries and their positions on crypto assets in general.

El Salvador has become one of the first countries in the world to accept Bitcoin as a legitimate form of currency. The country’s Congress, under President Bukele, passed a bill in 2021 that declared crypto assets as a legal means of exchanging value and allowed citizens to use it for buying products and services.

The Central African Republic is one of only two countries in the world that consider Bitcoin to be a legitimate form of currency. It officially recognized Bitcoin as legal tender during the second quarter of 2022.

In the US, people and companies that store, or trade Bitcoin are considered money services businesses and are regulated by the Bank Secrecy Act. The Treasury has classified Bitcoin as a currency that can be exchanged and used as a substitute for real money. There are specific regulations for investigating illegal activities or financial misconduct related to certain crypto assets, but regular people and businesses can still use crypto assets for making payments.

The European Union considers tokens to be a type of asset and does not view their usage as illegal. The European Union has a varied approach towards crypto assets, with several member countries implementing laws to facilitate their usage.The European Banking Authority has expressed concerns about the dangers of crypto assets and does not have authority over crypto asset activities. The European Union has introduced a proposed law for regulating crypto assets in 2022.

In Canada, crypto assets are treated as commodities for tax purposes and exchanges are categorized as money service businesses. In Canada, there are laws and regulations in place to prevent money laundering and terrorist financing when it comes to using crypto assets. As long as individuals comply with these rules, they are allowed to use and trade crypto assets in the country.

Israel is a country that accepts and utilizes crypto assets, such as Bitcoin, with numerous crypto ATMs and merchants accepting them as payment. Although Bitcoin is not classified as a currency, security, or asset by Israeli tax authorities, sellers are required to pay a 25% capital gains tax when selling Bitcoin.

Australia, like Canada, views crypto assets as taxable digital assets. If an individual engages in activities such as buying, selling, gifting, or converting crypto assets into regular currency for spending purposes, they will incur a taxable event in terms of capital gains. However, if they typically hold onto their crypto asset to profit from its increasing value, they will generally not be required to pay taxes. The individuals must maintain records of their transactions, although this task is often automated by wallets and exchanges.

Several countries have permitted the use of crypto assets in financial transactions and are developing regulations to integrate them into their financial systems.

India’s position on crypto assets is multi-faceted and has changed over time. The Finance Minister has expressed a commitment to combat the illegal use of Bitcoin and other virtual currencies in India, but also recognizes the potential of blockchain technology in payment systems. The Reserve Bank of India initially prohibited entities under its regulation from buying and selling crypto assets, but this ban was later lifted.

In Japan, Bitcoin is allowed to be used but it is seen as a type of asset held in a digital form, rather than a recognized currency. In 2014, the Japanese government declared that Bitcoin is not considered as money or a bond, which meant that banks and securities firms were prohibited from engaging in crypto asset transactions. This ruling highlighted that there are no specific laws prohibiting individuals or organizations from accepting crypto assets as payment for their products or services. However, businesses involved in crypto asset exchanges must be registered and comply with certain regulations since April 2018.

In Mexico, Bitcoin has been authorized since 2017 and the country intends to regulate it as a virtual asset under the FinTech Law.

The regulatory authorities in Singapore have said that businesses can decide whether or not to accept crypto assets, but they have also cautioned users about the risks of using Bitcoin.

Saudi Arabia has issued a warning to financial institutions about the risks associated with using Bitcoin, stating that the government does not provide protection or rights to companies involved with it. While it is deemed legal, there is a banking ban on it.

In the United Arab Emirates, the Dubai Financial Services Authority within the Dubai International Financial Centre initiated the regulation of investment tokens in September 2021, and has been implementing substantial modifications to its regulatory structure for acknowledged cryptocurrency tokens starting from November of 2022.

There are several other countries where crypto assets are considered legal, including Angola, Costa Rica, Ecuador, Lebanon, Türkiye, Iran, Argentina, Brazil, Pakistan, Chile, South Korea, Malaysia, the Philippines, Thailand, Vietnam, New Zealand, and many others.

The following countries have implemented complete bans on crypto assets: China, Qatar, Egypt, Algeria, Morocco, Nepal, Bangladesh, and Tunisia.

Finally, in Türkiye, crypto assets which constitute a monetary feature are considered by the Central Bank of Türkiye. Accordingly, the Central Bank issued a regulation with which it prohibited the usage of crypto assets as a means of exchange and further bans the development and usage of direct or indirect payment systems of any kind that uses crypto assets.

Governance Tokens and Their Legal Implications

Governance Tokens generally either fall into the scope of Security Tokens or Utility Tokens. In practice, the common practice is to name the Governance Tokens as a Utility Token. However, the mere act of naming a token as a Utility Token actually does not mean that much. Especially in the USA example, SEC and other relevant governmental authorities do not really care what the name of the token is. Governmental authorities prefer to examine the token or the coin by themselves rather than the way the coin or token is stipulated by its issuer.

Governance Tokens may in fact have some features such as voting rights that may result in the token being subject to capital markets law or commercial law. Therefore, it is crucial for the issuer to carefully consider the legal implications arising from the specific features of a token. For example, if a governance token provides its holder to have a voting right in a company or ordinary partnership or entitles its holder to have a profit from the revenue generated by the relevant project of the token, then, it is quite possible or even inevitable for the token to be subject to capital markets or commercial law.

In the event of considering a governance token as a security, the issuers will most probably be in violation of relevant legislation. For example, in Türkiye and the USA and generally all around the world, issuance of securities is strictly regulated and subject to permission from relevant authorities. It is important to eliminate or reconstruct a project in a way that does not intersect with the regulations of capital markets or commercial law. In conclusion, it is vital to consult with an experienced lawyer before even starting a relevant project.

LEGAL DISCLAIMER

THE INFORMATION PROVIDED IN THIS PAPER PROVIDES GENERAL INFORMATION AS TO THE POSSIBILITIES IN MULTIPLE JURISDICTIONS. PLEASE KEEP IN MIND THAT LAWS THAT APPLY TO THE SUBJECT HEREIN MAY DIFFER IN EACH JURISDICTION. THUS, NOTHING CONTAINED HEREIN CONSTITUTES ANY LEGAL OPINION OR SUGGESTION OF ANY KIND. PLEASE CONSULT TO LOCAL EXPERTS IN RELEVANT AREAS BEFORE TAKING ANY ACTION BASED ON ANY INFORMATION CONTAINED HEREIN.

Our Rapid Growth into the Metaverse

Human beings and their needs are at the heart of the changes and developments of our world. In meeting the needs of people, almost all hope is focused on technology. The widespread and continuous use of technology in meeting the needs of humanity continuously develops technology, and the development of technology affects and changes the whole life of human beings; this change transforms the rules of life.

Technology, today, has transformed people’s daily lives, what they consume, what they produce, what they think, what they do not think, their relations with each other and with authorities, and the products and services they receive from the financial and entertainment sectors. Furthermore, these changes and transformations continue steadfastly, garnering what can be called a revolutionary change in information technologies and communication.

Giving life to technology, the internet has also expanded and brought out data science. Digital processing models of data, their multiplicity, and their ability to become meaningful have pushed humans to discover and create a new universe beyond what we have known, the metaverse!

Naturally, debates in the legal realm of matters have been highlighted with the internet and with the blockchain being integral parts of conversation around the metaverse. Posing a chain of possibilities beyond our experiences of social matters such as consumption, religion, and democracy, the metaverse proposes philosophical and ideological debates, in and of itself as well as within legal interpretation and regulation.

Defining the Metaverse

The idea of the metaverse was first introduced as a concept in Neal Stephenson’s 1992 novel Snow Crash. While there are similarities and differences between the novel’s metaverse and our current modern concept, it can be characterized as a virtual environment that combines the physical and digital worlds, taking into account advancements in areas like the internet, computer science, and augmented reality.

It is also important to talk about Facebook in what can be called the resurgence of the metaverse beyond a fictional concept. The metaverse gained traction once Facebook rebranded as ‘Meta’ and Meta’s investments in the metaverse, blockchain technology, and creating a virtual world. Yet, humans have often had an interest in virtual reality and augmented reality technology, components of the metaverse.

Legal Implications of the Metaverse

The metaverse is not one and the same nor is it singular. With Web 3.0, big data, virtual reality, augmented reality technologies, and the software and hardware that embody them, many independent metaverses can be created. Bridges and connections can be made between them.

However, just as the emergence of the internet and the World Wide Web brought with it a plethora of new legal issues, the resurgence of the metaverse in our understanding of it today as a virtual reality will bring legal issues. The primary of which being the underlying data. Since privacy has been the most popular legal issue of the last 20 years, it is clear that it will remain so in the metaverse. It will come as no surprise that privacy will be the subject of new regulations in the Metaverse.

Regulation is a customizable mechanism of jurisdictions, being adapted to specific industries such as marketing, healthcare, finance … etc. Discussions on ownership, copyrights, ownership, and usurpation of the software and hardware components of virtual reality and augmented reality, the two underlying technologies of the Metaverse, are also potential legal issues. It would not be surprising to observe that as the Metaverse becomes more integrated with artificial intelligence, and as artificial intelligence is fed data and evolves, traditional legal criteria such as the average consumer, general impression, and likelihood of confusion may change or diversify.

Although the metaverse is currently generally evaluated on the axis of entertainment and commerce, its area of application in the social and legal context will diversify as technological possibilities increase. Ultimately, it is unlikely that the metaverse will be limited in terms of products or sectors. Thereby making necessary a more complex legal analysis.

Property Rights

While the metaverse and virtual worlds in general bring forth new legal issues or theories, concepts such as domain names as well as assets existing within a virtual world are not completely unfamiliar. For example, digital objects such as swords and shields can be “owned” by a character in a computer game, and objects such as houses, cars and lands in virtual worlds such as the metaverse can lead to a debate on ownership.

The legal status of these digital assets in the context of property law can be controversial. Our understanding of property law may need to be reinterpreted in the context of this new field. The value of virtual land sales and other similar commodity exchange transactions, which have already begun to be seen in the metaverse, can be worth millions of dollars. Therefore, the notion of ownership cannot be thrown out the window.

When the economic value and financial aspect of virtual reality-related ownership is taken into account, a sense of urgency develops. The law’s indifference to the issues regarding the ownership of the rights of these virtual assets and leaving this to those who determine the rules of these virtual environments, even indirectly, will bring serious drawbacks when the investments made in these assets and the economic value of these assets are taken into consideration. Therefore, it is inevitable to review and reinterpret traditional approaches to the ownership of virtual assets.

Particularly, NFTs, crypto assets, and artificial intelligence are technological tools with extremely high potential for adaptation to the metaverse, and each of these developing technologies is unregulated by law, at least on an international/global scale.

Users in the Metaverse

The metaverse is interactive, therefore in these virtual worlds, users can interact with each other visually and audibly through their avatars. Users communicate with each other in the Metaverse, for example, directly or indirectly, play games, shop, participate in training, and trade. It is inevitable that a virtual or physical environment in which its members/users can interact with each other and conduct business or transactions that have legal consequences will bring legal and economic conflicts of interest. Consequently, it is foreseeable that the legal relationship between the users and Metaverse, as well as the problems and conflicts between the users themselves, will be in need of legal analysis and regulation.

Platform neutrality is the emphasis on products or services that act as platforms, not unfairly favoring or discriminating against complementary products or services. If platform neutrality or net neutrality is applied to metaverse platforms, the legal conflicts between the users themselves may come to the fore in a more practical way. Therefore, in Metaverse structures that adopt net neutrality or non-interference in content, the area of legal responsibility of these structures will automatically narrow.

It is also possible for users to commit unlawful acts or transactions against each other or the public, actions that may bring up the violation of personal rights and intellectual property rights in the metaverse. In such cases, it is important to consider how and to what extent concrete legal norms can be applied to acts performed in virtual worlds.

It should be emphasized that the unlawful performance of an act or transaction in the metaverse cannot be ignored solely on the grounds that it was performed within virtual reality. Here, there is no legal difference between the internet and the metaverse. In other words, just as unlawful acts can be performed on the internet, so can they be committed in the metaverse. Although it may seem like pointing out the obvious, this aspect should still be noted. Even if there is possible offline access to the metaverse or intranet, the situation will not change. If the actions and transactions in question are unlawful, they will be subject to legal and criminal sanctions.

Another aspect to consider would be impersonation or false identity presented by users. However, this can be combated through the application of blockchain-based identity systems or KYC-type user identification systems.

Here, the major issue in question in case of a clear criminal or legal violation is jurisdiction and applicable law. In virtual environments, national borders disappear, and users from two different countries can commit such acts against each other in a virtual environment created by a company based in a completely different, third country.

The most common method used in such cases today is to sanction the users who commit such acts based on the “General Terms of Service” and “User Agreements” of the service provider. However, the law of the metaverse being one that is supranational, self-contained, and harmonized in the rules it sets may become a necessity in the future.

Contract Enforcement

A combination of traditional legal structures, smart contracts, and potentially innovative governance mechanisms specific to virtual content is necessary for the enforcement of contracts in the metaverse. Several strategies, other than the application of legal frameworks directly, can be used to ensure effective contract enforcement. Examples can be listed as digital signatures, Decentralized Autonomous Organisations (DAOs), blockchain-based identity systems, oracles, community governance, alternative dispute resolution…etc.

Smart contracts can be defined as programmable contracts that are executed on their own once predefined conditions are met. These contracts facilitate the automatic enforcement of contractual terms and are supported on blockchain platforms. For more information on smart contracts and their legal analysis, please see here. On the other hand, oracles are what connect the blockchain and external data sources. They enable the smart contract to keep up and react to real-world events, making them useful for contracts that rely on external information. This way contributing and making them accurate and responsive.

An integration of blockchain-based identity systems would ensure security in the metaverse. This identity system can verify user identity, and ensure that the parties of a contract are real and accounted for. Digital signatures can be created and used for confirmation as well. Establishing legal frameworks that clearly apply to virtual contracts would also strengthen security by ensuring the validity of metaverse contracts.

It is important to include decentralized dispute resolution methods in order to improve the overall reliability of contractual agreements. Whether it is through decentralized arbitration or community-driven governance systems, having efficient processes to settle disputes is crucial for virtual contracts to be effective and trustworthy.

DAOs operate transparently and are controlled by their members, therefore can also play a significant role in governing and enforcing contracts. They provide a decentralized framework for managing and executing contracts based on predefined rules. For more information on DAOs, please see our paper here.

The metaverse is constantly changing, and as technology and governance models evolve, the way contracts are enforced will also change. Legal and regulatory factors will play a significant role in shaping these enforcement methods. Encouraging community involvement in platform governance and contract enforcement is important for building trust and collective responsibility. This approach fits well with the decentralized nature of virtual environments, allowing the metaverse community to contribute to decision-making and ensure fair contract execution. Including insurance or collateral in contracts can help reduce risks from breaches or unexpected events, making contracts stronger and more resilient.

Ultimately contract enforcement in the metaverse will require a multifaceted approach, combining various strategies, both legal and technological. Consequently, this creates a quite complicated field wherein aspects of several technological tools and legal frameworks should be comprehensively utilized.

Data Protection

Metaverse and similar technologies rely heavily on data and data protection is crucial for their operation. These applications process data even at their inception. Once operational, these data processing activities continue to increase rather than decrease. It is not possible to envision this technology and new formation independent from data and therefore data protection. Moreover, with the developing technology, the economic value of data has increased and the data obtained from users has become vital for global companies.

Users share personal data such as biometric information with these platforms, and it is the responsibility of the metaverse platform to ensure the security of sensitive information. The platform must ensure the security of such shared data and other data and make and/or obtain the necessary permissions and notifications regarding the processing of such data before and/or when necessary. In this context, like most institutions and organizations that actively process data today and are subject to national and international regulations on the protection of personal data, the metaverse platform is obliged to protect the security and confidentiality of users’ personal and other information.

In addition to personal data, protection of trade secrets and confidential information is important in commercial activities within Metaverse. Just as the confidential information and data we keep on our desks, in our diaries, in our documents, etc. are legally protected, our virtual identities, personal data, and trade secrets in the virtual world should be able to benefit from similar protections.

The responsibility for the safe collection and storage of the data collected in accordance with the legal periods and requirements, making the necessary notifications to the relevant persons during the collection and processing period and obtaining the necessary approvals from the relevant persons if necessary, transferring to third parties in accordance with the law, ensuring information security against cyber attacks is the responsibility of the owners of the relevant metaverse.

Despite the need to collect large amounts of data, the metaverse can implement measures to limit data collection and ensure data security through encryption methods. The concept of metadata, data produced within the metaverse, may introduce new challenges for data protection law. Overall, data protection is an ongoing concern in the development of Metaverse and similar technologies.

Intellectual Property Rights

Perhaps, along with the data aspect, the intellectual and industrial property aspect is the most important facet of the metaverse. One of the most important aspects of the metaverse that attracts attention in the field of intellectual and industrial property law is that its users are not only consumers but also producers in the creation and continuation of the metaverse.

Users not only consume the content offered to them within the metaverse but also play an active role in the intellectual production process of such content. In fact, at the level of development that the metaverse really wants to reach, it is thought and even realized that people will start to engage in artistic activities and produce content, inventions, and designs, rather than just having fun per se. These creations can be subject to copyright law and protection in the same way to the extent that they meet the conditions. For example, the avatars that users create even before they start their activities in the virtual world can be considered as works of art.

Some argue that the limitations of the metaverse restrict the creativity and uniqueness of these intellectual products, but it cannot be denied that some creations in the metaverse are unique and can be subject to intellectual property rights.

The limitations in the creation process should not be used as a reason to deny people their rights to their intellectual work in the metaverse. Users should be protected if their intellectual products fall into the categories of works. However, there may be conflicts between the metaverse and its users regarding ownership of intellectual creations.

The user is indeed making use of the technical possibilities of the metaverse in the creation of the intellectual product, and at some point cannot go beyond the rules and technical capacity of this system. From this point of view, it can even be argued that the intellectual product does not have any particularity, that the way it is created is a result of technical possibilities, and therefore the impact of creative intelligence and talent here is limited.

However, it can neither be said that no intellectual product realized in the metaverse is or will be unique or that it cannot be technically created in any other way and therefore cannot be subject to intellectual or industrial property. The existence of technical limitations in the processes of intellectual creation cannot constitute a justification for depriving people of their rights to their intellectual labor.

Another issue is that of who will benefit from the intellectual property rights in question. Although the metaverse bases its development in terms of content on the intellectual products of its users and even encourages and promises this, the metaverse can also own the intellectual creations of its users and the rights arising from them based on the general terms of service and user agreements. It is inevitable that a conflict of interest will arise between the metaverse platform, which encourages and enables its users to produce intellectual products and the users who themselves produce the intellectual products in question.

Further, there isn’t a singular metaverse, meaning users can switch between different metaverses with different owners. Here, people can bring their IP rights along with them when moving from one universe to the next. An example could be the user’s avatars, however, it may be difficult for users to claim intellectual property rights for their avatars.

The Metaverse may try to protect itself from intellectual property infringement through non-liability statements. Regulations regarding exhibition priorities may need to be developed for national or international exhibitions in the Metaverse.

Payment Systems and Tax Law

Monetary and payment systems laws in the Metaverse are governed by currency and central banking laws. Currency laws define legal tender and restrict the use of other currencies, while central banking laws regulate payments. Different countries have varying approaches to cryptocurrencies, with some restricting their use within their jurisdiction. The rise of cryptocurrencies threatens the effectiveness of central banks as they are issued and circulated outside of the central bank’s control.

The taxation of crypto assets has also been evaluated extensively. The taxation of crypto assets was brought under the radar of G20 countries and the Crypto Asset Reporting Framework was introduced. The metaverse itself, if yields taxable properties will not likely be exempt from taxation. Further suitable frameworks for taxing products and services deriving from the metaverse might be developed in the future. For more information on the taxation of crypto assets please see here.

Legal Frameworks on the Metaverse

The integration of the physical and virtual worlds is becoming increasingly important, with neither being meaningful without the other. However, advancements in technology are favoring the virtual world and causing dissatisfaction with the current reality. The law must adapt to this new virtual world introduced by the metaverse, addressing issues such as property rights, contracts, privacy, and personal data protection, which have been outlined above.

Some legal problems in the metaverse are similar to real-life issues, while others are unique to the virtual world. The law in the metaverse consists of both traditional legal principles and new approaches that align with the virtual world’s realities. It is important to establish rules and educate legal professionals to handle the legal challenges posed by the rapid integration of virtual technologies.

Different Jurisdictions and Their Approach

Regulating the metaverse can very likely fall under existing legal frameworks that cover areas such as intellectual property, privacy, consumer protection, and financial transactions. Countries can also have their own laws that can be applied to various aspects of the metaverse, introduce frameworks that are specific to the metaverse, or have their own approaches as well.

Türkiye

There is no effort by lawmakers to create special legal regulations for the metaverse on a global scale, including Turkey. Since Turkey has not yet regulated the law applicable to crypto assets specifically either, how the existing legal rules will be applied to disputes arising from the metaverse should be evaluated. As mentioned above, the metaverse is already technically and by default subject to legal frameworks such as privacy and data protection, consumer law, intellectual property law, tax law, and other legislation applicable to the internet.

According to data from Social Network Map, 87.7 percent of the Turkish population have internet access and 89.9 percent have smartphones in October 2021. This interest in digital media has also been reflected in the metaverses even at their early stages. So much so that a famous website called sahibinden.com which is used for property sales and rentals, had advertisements for the purchase and sale of land in a metaverse.

The United States

Regulation of the metaverse is currently limited and is only likely to increase if social and economic issues arise. Regulation regarding blockchain or crypto asset technologies can however be a reference point not only in the case of the US but also in other jurisdictions. Large investments, if made, in the metaverse may challenge regulation if it affects potential profits.

Although there is no clarification on how existing laws will be applied to the metaverse in the US, the Federal Trade Commission, which is in charge of enforcing competition on the internet, is the regulatory body overlooking the metaverse. However, the main form of regulation of metaverse activity has been through the enforcement of terms of service contracts entered into by the users and the metaverse platform.

While the Federal Trade Commission overviews competition and marketing on the internet, the Securities and Exchange Commission overviews securities, and in the use of blockchain and crypto assets in a metaverse, the Securities and Exchange Commission can perform as a regulatory body.

The European Union

The European Union aims to lead in the regulation of most technological advancements, as evident from the General Data Protection Regulation and with the soon-to-be fully adopted Markets in Crypto Assets Act.

With the appearance of Meta Platforms, the EU is most likely to delve much deeper into the regulation of metaverses. Evidently, the European Commission adopted a strategy on Web 4.0 and virtual worlds, with a stated aim to ensure an open, secure, trustworthy, fair, and inclusive digital environment for EU citizens, businesses, and public administrations.

In February of 2023, the European Commission released an extended study titled “Extended Reality: Opportunities, Success Stories and Challenges (Health, Education)”. The study found that 98% of professionals believe that Extended Reality (XR) technologies will have a significant impact on their industries in the next five years. Sectors such as healthcare, education, art and design, and logistics can benefit from these technologies. However, there are also challenges to consider, such as the need for awareness, access to reliable information, digital skills, and user trust. The European Digital Rights and Principles aim to promote a human-centered approach to virtual worlds, aligning with EU values and fundamental rights.

The European Commission has established the Virtual and Augmented Reality Industrial coalition to bring together industry and policymakers. They also conducted a citizen’s panel to gather recommendations on how virtual worlds can be fair, safe, and beneficial in the future. These recommendations will guide the new strategy on Web 4.0 and virtual worlds. Web 4.0 is the next generation of the internet that will enable better integration between the physical and virtual worlds. The strategy is focused on empowering people, supporting businesses, improving government services, and promoting openness and global governance.

European Commissioner of the Internal Market Thierry Breton states that the European way to foster the virtual worlds is threefold: people, technologies, and infrastructure. He states that with the Digital Services Act (DSA) and Digital Markets Act (DMA), Europe now has strong and future-proof regulatory tools for the digital space. According to Breton, the EU’s ability to shape the metaverse will depend on the ability to master and develop cutting-edge technologies in Europe and build a sustainable ecosystem, and the Commission has been laying the groundwork to structure this ecosystem.

Breton also launched the Virtual and Augmented Reality Industrial Coalition, bringing together stakeholders from key metaverse technologies and developing a roadmap endorsed by over 40 EU organizations active in this space, from large organizations to SMEs, and universities.

The Policy Department for Citizens’ Rights and Constitutional Affairs Directorate-General for Internal Policies of the European Parliament released an extensive study in June of 2023 on the metaverse, authored by Mariusz MACIEJEWSKI. The study stated that commercial, industrial, and military applications of the metaverse bring both opportunities as well as significant concerns for everyday life, health, work, and security. Legislative initiatives promoting fundamental principles of law, and legislative and judicial oversight, applied comprehensively across a broad range of policies, are necessary to make sure that the metaverse will play a positive role.

The study evaluated challenges of the metaverse including metaverse-related health concerns in adults and minors, inappropriate conduct and content, personal data protection and privacy concerns, digital twins, doppelgangers, industrial, and military metaverse as products of the metaverse being a power-shifting technology. Tax avoidance, cryptocurrencies, gambling, and lottery laws were also evaluated.

Dubai

Sheikh Hamdan bin Mohammed bin Rashid Al Maktoum, the Crown Prince of Dubai and Chairman of Dubai’s Higher Committee of Future Technology Development and Digital Economy, has approved the Dubai Metaverse Strategy. Officially launched in July of 2022, the Dubai Metaverse Strategy aims to strengthen the digital economy and prepare for the future integration of the metaverse and other advanced technologies.

The Dubai Metaverse Strategy seeks to foster innovation, enhance the metaverse’s economic contributions through R&D collaborations, and promote advanced ecosystems utilizing accelerators and incubators that attract companies and projects to Dubai, foster talent and invest in future capabilities by providing the necessary support in metaverse education aimed at developers, content creators and users of digital platforms in the metaverse community and to develop Web3 technology and its applications to create new governmental work models and development in vital sectors, including tourism, education, retail, remote work, healthcare and the legal sector.

The strategy also aims to develop global standards in building safe and secure platforms for users and develop metaverse infrastructure and regulations to accelerate the adoption of these technologies. The strategy’s key pillars focus on extended reality, augmented reality, virtual reality, mixed reality and digital twins, which is a virtual representation of an object or system.

The Dubai Metaverse Strategy is built in part on Dubai’s success in attracting blockchain and metaverse businesses and supports the development of Web3 technology and its applications. This will of course, in turn, result in growth in sectors of tourism and education as well.

Colombia and Court Proceedings in the Metaverse

Colombia is listed as the first country to hold actual court hearings in the metaverse with its participants using VR headsets and their avatars to interact in Colombia. This, of course, garnered a reaction from many. The Administrative Court of Magdalena had the hearing in Meta’s Horizon Workrooms. The participants were directed to configure their avatars.

Supporters of using artificial intelligence and the Metaverse in legal proceedings believe that Colombian law Ley 2213 allows for the use of advanced technology. However, there are concerns among scholars about the impact of virtual proceedings on access to justice. Some viewers praised the video on a Colombian judicial system YouTube channel as innovative, while others criticized it as foolish and a misuse of public funds. The magistrate ended the hearing by stating that they hope Colombia will make investments in technology to enhance the efficiency of legal proceedings.

Barbados

In the latter half of 2021, the Cabinet of the Government of Barbados approved the establishment of the Metaverse Embassy. Although the government of Barbados will continue to lay out and keep up with actual consulates, there has been a move to involve the metaverse as a chance to spearhead the advancement of worldwide strategy past the actual world.

Barbados aims to strengthen international relations by their adaptation of technologies to governmental mechanisms. The Ambassador of Barbados to the United Arab Emirates is also a pioneer in the field of central bank digital currency and blockchain technology and has supported the creation of the Metaverse Embassy. Ultimately, there has been a push for the involvement of the virtual world in the mechanisms of governance, providing digital solutions for the people.

Abiding Laws in the Metaverse

Abiding laws in the metaverse currently occur as users and platforms take precautions and make sure they are not violating already existing laws and regulations. For example, according to one view, property law in the sense of civil laws cannot necessarily be applied to the metaverse as there is no tangible property in place, therefore intellectual property laws become more relevant.

The Metaverse is a digital social ecosystem that includes communication and information. It requires its own set of laws to govern social relations within it and between the physical world. While projecting physical laws onto the Metaverse may not be effective, developing international electronic legislation can be important for keeping up with modernization.

E-jurisdiction and e-justice become relevant. These forms of governance are important for managing public relations in the metaverse. Building on traditional justice systems while adapting to the unique challenges of online social interactions can be the steps to take toward a concept of e-justice mechanisms.

It is also necessary to establish legal mechanisms to regulate public relations in the metaverse, which will help resolve conflicts between different jurisdictions. National legislation should be updated to ensure compatibility with the metaverse and provide a structured framework for online social interactions.

The development of global electronic legislation in the metaverse is likely to drive the modernization of national laws. Key objectives in the metaverse’s electronic jurisdiction include establishing trust and reputation through blockchain technology, ensuring the integrity of identification data, protecting intellectual property rights, and maintaining information security. This model of e-jurisdiction will address important issues related to virtual reality technologies and provide a foundation for regulating public relations in the Metaverse.

Examples of Real World Disputes Arising from the Metaverse

The Hermes Case

Emerging as quite a high-profile case, the Hermes case is between Hermes, a luxury fashion brand, and Mason Rothschild. The lore behind the Hermes Birkin Bag is that it is very exclusive, expensive and not attainable by the average person, thereby garnering a major marketing and identity of the brand itself.

Digital artist Mason Rothschild created what was called his MetaBirkin NFT collection which gave rise to the legal dispute. The issue was about ownership and intellectual property protection of virtual assets. Mason Rothschild’s collection included 100 NFTs that were inspired by the famous Birkin bag without any connection to the luxury brand itself. The NFTs went for sale on OpenSea for millions of dollars.

This, of course, gained much attention, and Hermes, filing a claim in the Southern District of New York claimed that their trademark rights were thus violated and “Birkin” was their registered trademark and the MetaBirkins were a clear violation of their intellectual property rights.

The jury in the trial found that Hermes’ trademark rights were in fact infringed upon by Mason Rothschild’s MetaBirkins, wherein he made a profit from the NFTs based solely on the real-life Birkin bags. Rothschild had also claimed free speech as a defense, however the jury found that the First Amendment Rights were not applicable here as the similarities between the Birkin and MetaBirkins.

Democracy, Digital Dictatorship, and Monitoring in The Metaverse

It is expected that the metaverse will yield an important shift in our world and daily life. Due to its initial introduction with Meta Platforms being quite explosive, it might seem like the concept of such an all-consuming daily life type of virtual reality sizzled out. However, new platforms and services in this area are being introduced as well as different jurisdictions adopting mechanisms around the metaverse.

Albeit no concrete legislation has come forward on the metaverse itself, the legal system will most likely be challenged by the new technology. Not only a challenge in creative aspects of law such as intellectual property or aspects of data but also in our understanding of decentralization and cyberdemocracy.

With the introduction of electronic voting systems, especially after the Covid-19 reality of remote systems hit, political decision-making and voting through digital means have emerged. Especially considering a blockchain-based e-voting system, democratic means in elections will be strengthened.

A rise in civilian distrust of politicians and legal systems can help strengthen the trust and continuation of state democracy. Further, voting can be a huge inconvenience where people need to take time off their work in order to stand in line and vote or even register to vote. A metaverse democracy allowing people the ability to register and vote can be a viable option that does not take up so much of people’s day and is more accessible.

Digital dictatorship appears as a concern when discussing digital technologies and the metaverse. Technology can very well be used to repress political dissent. For example, Facebook and the Cambridge Analytica scandal come to mind as well as the service of pro-specific political party content being exclusively promoted for some users.

Allowing any government, the power to track user activity, and the ability to store and process data and private information through surveillance surely can do more harm than good in the context of state democracy. A metaverse controlled or provided in partnership with a government can give rise to major data processing. Thus, actions to eradicate the risks of digital dictatorship should be evaluated especially in the context of the metaverse, considering different countries are adapting and introducing concepts of metaverse-based governmental mechanisms. Further, if an e-voting mechanism in proprietorship with the government body is introduced, many identity verification systems must be adapted and thus sensitive data would be processed.

There are however ways in order to avoid the creation of a digital dictatorship. Examples can be; internet access being a fundamental right, the regulation of fundamental rights on the internet and the metaverse, tailored data protection regulation, transparency, an emphasis on constitutional rights of people in the metaverse, and legislation in place combating excessive surveillance by any intelligence agency.

The use of artificial intelligence in creating several profiles is also a point of concern. This area is that of a merge of privacy laws, criminal laws, intellectual property laws, and human rights laws. For example, the damages incurred by people who were defrauded by someone in the metaverse who has stolen another person’s identity, artwork, and information would be subject to several aspects of legal penalty. Here, AI can make the creation of such profiles pretty accessible. Therefore, this sector needs to be monitored.

Perhaps each person being limited to creating a single personal profile can combat this issue or certain information must always be kept out of digital profiles, such as address, and place of birth. Another form of combatting this is through several prongs being fulfilled in the creation of a profile wherein the user’s identity is fully confirmed. This would in turn necessitate up-to-date and accurate private data protection.

It can however be expected that once the metaverse becomes more immersive in our daily lives, new forms of cybercrime are likely to increase.

Louis Rosenberg, Ph.D. states that “Unless regulated, the metaverse could become the most dangerous place of persuasion ever created“. Rosenberg also states; that the infrastructure required to enable immersive worlds will give powerful corporations the ability to monitor and mediate intimate aspects of our lives, from what products, services, and information consumers are exposed to, to what experiences they have throughout their day and who they are having those experiences with”. This has been referred to as the three M’s; monitor, manipulate, and monetize.

Forms of combatting this, however, according to Rosenberg are not only regulatory. For example, he states that steering from ad-based gains and into subscription models will likely decrease platform providers from targeted ad placement and therefore processing of sensitive data. Rosenberg also suggests restricted user monitoring activities, restricting emotional analysis for targeted advertisements, regulating virtual product placements and making sure real users can be distinguishable from non-human users.

Conclusion

Companies and states alike are making huge investments in the development of metaverse applications both research-wise and in practice. The only reason for this interest in the Metaverse and virtual worlds is not only the investments made by global companies, but also the rapid developments in the fields of augmented reality, virtual reality, big data, informatics, and the internet have started to enable the formation of virtual worlds that are desired to be realized.

It has become inevitable that this increasing interest in virtual worlds and a period in which human beings digitize every aspect of their lives brings with it a number of legal problems and requires the reinterpretation of existing legal concepts. Albeit many positive attributes can be found in the world of immersive metaverses such as accessibility, transparency …etc., there is also an impending expectation of a rise in cyber crimes.

We are currently evaluating the insurgence of metaverse and augmented realities and AI systems in their primary stage. At this point, there is an emphasis and entertainment with legal fields of intellectual property and data privacy being prominent. It may be necessary to re-evaluate the ownership of rights to objects that are controversial in terms of the applicable law in the context of the traditional concepts of property law.

The ability of users to interact with each other visually, audibly, or otherwise through the metaverse has brought legal debates and problems. Most of which are almost always interlinked with real-life consequences. This raises the question of whether will there be consequences that are solely digital. Some of these problems are problems encountered in “real” life, while others are problems specific to the virtual world. To these problems, the application of the applicable law directly or to the extent appropriate to the virtual world becomes relevant and ultimately some actions may be subject to criminal sanctions, others may be subject to civil sanctions.

Although some may argue otherwise, it is seen that the intellectual products that people create within the metaverse should benefit from work protection to the extent that they meet the general conditions stipulated by intellectual property law. It is determined that the direct transfer of users’ intellectual creations to the metaverse itself is incompatible with the nature, philosophy, and formation process of the metaverse. This is because the metaverse itself encourages its users to contribute to the creation of the virtual world and to produce content. Furthermore, the general terms of service and user agreements between the platforms or institutions and organizations that create the Metaverse and the users play a critical role in the ownership and transfer of rights to the intellectual creations in the Metaverse.

On the other hand, the fact that the Metaverse and the technology it brings with it are data-dependent and continuously process data raises important issues in the field of personal data protection, data security, and privacy. Institutions behind the metaverse will most likely be the ones held accountable for the safe processing of data. While this can be enabled through existing data privacy laws, there might also be unprecedented and unregulated forms of data collection put in place in the future. This can also be said in the context of intellectual property rights. For example, Non-Fungible Tokens also created a new form of application of intellectual property rights that was not necessarily accounted for in the creation of IP regulation.

Ultimately, and especially in tow of developments in the EU regulatory landscape, new legal frameworks that merge existing laws as well as create a new legal basis for the regulation of the metaverse and augmented reality platforms can likely be on the horizon.

LEGAL DISCLAIMER

THE INFORMATION PROVIDED IN THIS PAPER PROVIDES GENERAL INFORMATION AS TO THE POSSIBILITIES IN MULTIPLE JURISDICTIONS. PLEASE KEEP IN MIND THAT LAWS THAT APPLY TO THE SUBJECT HEREIN MAY DIFFER IN EACH JURISDICTION. THUS, NOTHING CONTAINED HEREIN CONSTITUTES ANY LEGAL OPINION OR SUGGESTION OF ANY KIND. PLEASE CONSULT TO LOCAL EXPERTS IN RELEVANT AREAS BEFORE TAKING ANY ACTION BASED ON ANY INFORMATION CONTAINED HEREIN.

Crowdfunding 101

Entrepreneurs often require additional funding to bring their creative ideas to life. However, due to lack of sufficient capital, they turn towards crowdfunding. This is particularly common among individuals who are passionate about entrepreneurship but don’t have enough financial resources. To cater to such needs, lawmakers have legally recognized and regulated crowdfunding. Crowdfunding is a way to keep up with the rapidly developing technology and financial advancements by funding deserving ideas.

The main idea is that while entities or people with great or even small capital become a part of a very profitable project, entrepreneurs acquire the financial resources they desperately need. Furthermore, crowdfunding is a process where many people with low capital get together to raise great capital. Therefore, crowdfunding is a quite effective way to increase people’s participation in the financial system, even with an insignificant amount of capital.

Initial Coin Offering(s) (“ICO”) is the term used for the process of introducing crypto assets to the public or participants. These assets can be offered in different stages, including during the project phase, development, or after completion. Once launched, these assets can be bought, sold, and stored on crypto asset transaction platforms.

ICOs represent a significant evolution in crowdfunding, marrying technology with finance and offering an alternative to traditional financial systems.

The popularity of ICOs can be attributed to several factors. These include the convenience, reliability, and cost-effectiveness of using technology to generate, store, transfer, or invest in digital currencies or assets. Additionally, the economic crises and lack of trust in institutions have driven people to seek solutions through technology. ICOs are evolving into a more convenient, faster, and cost-effective crowdfunding tool than traditional financial services.

Crowdfunding activities can be classified under four main categories: based on rewards, donations, equity, and debt. In each crowdfunding activity, the relationship and structure between the parties change.

Types of Crowdfunding

Crowdfunding can be conducted through various procedures and methods, and it is divided into different classes based on what they promise in return for the funds provided by investors. It can be examined under four classes: donation, reward, lending, and equity models. In the first two types of crowdfunding, there is no partnership or debt relationship between the people providing the funds and those being funded. In crowdfunding activities, providing shares or debt instruments to the funders is not mandatory, and sometimes, these crowdfunding activities may also be related to social responsibility projects.

Donation and Reward-Based Crowdfunding

In donation-based crowdfunding, the fund providers receive nothing in return and donate to the project. In reward-based crowdfunding, investors are given a reward in return, which may have financial value or not and can be material or sentimental. In both types of crowdfunding, there is no establishment of a partnership or creditor relationship between the parties.

Debt and Equity-Based Crowdfunding

Fund providers act as investors in debt or equity-based crowdfunding and are generally interested in financial gain. They become either partners in or creditors to, the venture companies or funded projects in exchange for the capital they provide.

In debt-based crowdfunding, the funds collected from investors are considered a debt. This debt is repaid by the funded entrepreneurs to the investors, along with predetermined interest, upon maturity. Investors in this type of crowdfunding act somewhat like creditors, aiming to make a profit by getting back the funds they provided along with interest. It is quite similar to government bonds.

Considering the debt relationship between the investor and the funded company/project, and that the fundamental aspect of this relationship is the investor’s aim to make a profit, it can be said that the bond between the investors and the funded company/project is weaker compared to equity-based crowdfunding.

In equity-based crowdfunding, instead of seeking debt capital for the funded company/project, partners are sought for the company. In this type of crowdfunding, the capital provider becomes a partner of the company. Investors who provide funds and become partners of the company through equity-based crowdfunding can earn a share of the profits from the partnership according to the terms of the agreement between the parties.

Parties Involved in Crowdfunding Activities

Crowdfunding activities, regardless of their type, almost always exhibit a three-pronged structure. Firstly, entrepreneurs who lack sufficient capital for their ideas enter a search for funding to realize these ideas and projects. These entrepreneurs in need of funds form the first leg of the crowdfunding activity.

These entrepreneurs, seeking funds for their ideas and projects, generally apply to a crowdfunding platform instead of raising the funds themselves. Through these crowdfunding platforms, investors who want to use their capital to finance ideas and projects lacking sufficient financial resources become aware of these ideas and projects, providing financial support through the platforms. Crowdfunding platforms emerge as a kind of intermediary agency in this activity.

The final and arguably most important leg of crowdfunding is formed by investors who want to finance the entrepreneurs’ ideas and projects. These investors, who bring the crucial element of funding, may become partners in the funded company, creditors to the company, or sometimes act merely as donors and supporters without any financial motive. The position of the investors varies depending on the type of crowdfunding activity, as detailed above. In equity-based crowdfunding, investors become partners in the funded company, while in debt-based crowdfunding, they become creditors to the company. Additionally, in cases often involving social responsibility projects, investors may finance projects without seeking any financial gain.

To summarize the parties involved in crowdfunding activities, there is an idea or project in need of funding, platforms that facilitate the funding of these projects by investors or supporters/donors, and through these platforms, investors or supporters/donors who want to provide funds to these financially needy projects for financial motives and/or other reasons. The legal relationships between the crowdfunding platforms facilitating the funding, the individuals seeking funds for their projects through these platforms, and the fund providers should be carefully noted as they are subject to general legal provisions.

Crowdfunding in Türkiye

In Türkiye, crowdfunding is mainly governed by the strict rules set forth by capital markets law provisions. Crowdfunding can only be done through intermediaries who are duly licensed by the Capital Markets Board of Türkiye. Licensing procedures regarding these intermediaries, also known as crowdfunding platforms, are quite challenging and demanding. Crowdfunding platforms must register with the Capital Markets Board and subsequently form investment boards.

Furthermore, strict capital markets law provisions necessitate additional requirements for the establishment of such crowdfunding platforms, such as minimum capital, who can be a shareholder, qualifications of shareholders, minimum educational or professional experience for members of the board of managers and investment, etc.

It is strictly forbidden and subject to serious legal and criminal penalties to conduct unauthorized crowdfunding. The act of conducting crowdfunding without necessary authorisation from Capital Markets Board in fact regarded as unauthorized/licensed capital markets activities. The penalty for such action ranges from 2 to 5 years in prison in addition to serious monetary fines.

Moreover, it is worthwhile to note that the fact that the crowdfunding activity takes place outside of Türkiye does not necessarily mean that provision of Türkiye is not applicable. According to the Article 13 of Crowdfunding Communique issued by Capital Markets Board, if a crowdfunding activity is promoted, advertised or enabled for Turkish citizens or legal entities, then, the crowdfunding itself and persons who manage such crowdfunding in fact may be held responsible to comply with Turkish law in this matter. Therefore, it is crucial for managers of a crowdfunding company to be very careful about how to advertise and promote their activities.

Introduction to ICOs

For the sake of fluidity in the narrative of this paper, tokens and coins are commonly used interchangeably, rendering almost no substantial effect to the meaning of the text, unless it is explicitly stated.

New ways of raising funds have emerged recently with the use of blockchain technology. One such method is an ICO, where blockchain-based tokens or coins are sold in exchange for crypto assets or traditional money. These tokens can serve different purposes, such as accessing a product or service, representing assets, or representing ownership in a project. Additionally, many buyers of these tokens are interested in profiting from selling them on a secondary market.

The first token sale took place in July 2013 by Mastercoin, marking the beginning of what would become a multi-billion dollar phenomenon.

The first token sale took place in July 2013 by Mastercoin, followed by Ethereum and a few others in 2014. The popularity of ICOs grew with TheDAO’s token sale in May 2016, which raised around $150 million. However, it was in 2017 that significant amounts of money were raised through ICOs. By the end of 2018, ICOs had collectively raised approximately $24 billion through over 5,000 token sales. Despite regulatory challenges, the number and size of these offerings continued to increase until March 2018, when around $1.8 billion was raised in that month alone.

In the face of economic crises, ICOs have evolved into a more convenient, faster, and cost-effective crowdfunding tool compared to traditional financial services.

Definition of ICOs, Benefits and Risks

ICOs are a way for businesses to raise capital by exchanging fiat or virtual currency for digital assets called tokens or coins. These tokens allow investors to access the business, participate in its returns, and potentially sell the tokens for a profit on the secondary market. For example, an amusement park may sell tokens to investors in order to fund its construction, and those tokens can then be used to access the park or traded for profit.

Businesses create tokens and sell them to investors after registering them on the blockchain. Unlike traditional banking systems, where money is sent to a central server, the blockchain is a decentralized ledger that records transactions across a network of computers. This allows for the transfer of crypto assets between digital wallets, providing a new method for issuing and trading these assets.

The record, known as the blockchain, enables anyone on the network to confirm and monitor the movement of assets across different networks. When a computer joins the network, it receives a copy of the blockchain, which includes records of all past transactions. Each connected computer is referred to as a node. Once a transaction is made public, it cannot be altered.

The popularity of ICOs grew with TheDAO’s token sale in May 2016, which raised around $150 million, showcasing the massive potential of this new form of crowdfunding.

Benefits

The significant increase in ICOs can be attributed to the advantages they offer to both investors and issuers. One major appeal for investors is the potential for significant returns. ICOs allow for investment in the early stages of a project without a minimum investment requirement, making it possible for everyday investors to invest small amounts and earn large profits.

Unlike traditional investment avenues that are only available to a select few, ICOs are accessible to the average person. Typically, an average investor would have to pay a premium at an initial public offering (“IPO”) , after the venture capitalists have already absorbed most of the company’s/project’s true value. However, with ICOs, all information about the company is generally available to the general public, giving every investor, regardless of their size, equal access to investment opportunities from the very beginning.

ICOs offer various advantages for companies, including the ability for founders to keep all the money raised, unlike venture capitalism. Additionally, ICO issuers are not burdened with expensive paperwork, allowing a wider range of companies to participate. ICOs are generally not subject to government control, commissions, or taxes. Moreover, ICOs provide opportunities for funding projects that may not appeal to venture capitalists.

Moreover, due to the global and border denying nature of the blockchain, investors from all around the world may in fact join these crowdfunding activities through blockchain and crypto assets. Furthermore, the secure record keeping nature of blockchain provides a more trustworthy environment for the investors in terms of auditing and following the transactions regarding the funded project.

Last but not least, ICOs provide comparably more easy infrastructure when it comes to crowdfunding. In many jurisdictions, crowdfunding is strictly regulated. In order to crowdfund a project, authorisation of many governmental bodies is required. Furthermore, many jurisdictions foresee an intermediary which collects the funds and then transfers it to funded projects. Blockchain technology and crypto assets make intermediaries unnecessary and make global crowdfunding easy, accessible and safe. Any individual across the world with an internet connection may smoothly access crowdfunding through crypto assets.

Risks

Although this technology has the potential to revolutionize fundraising, it currently has many significant flaws. There are numerous stories of people gaining unexpected wealth through crypto asset investments, which scammers and promoters of risky investments take advantage of. These predators attract investors by offering high returns and the chance to be part of this innovative field.

Market manipulation, specifically through a ‘pump and dump’ scheme, is a frequently employed tactic by fraudsters. They deceive investors by spreading false information through different channels to artificially increase the value of an investment. Once the value rises, the fraudsters sell their portion of the investment, making a profit. They then cease promoting the investment, causing its value to decline and resulting in financial losses for investors.

In addition, if someone who invests in tokens is scammed or has their funds stolen, it is challenging to recover the money. The decentralized nature of ICOs makes it hard for law enforcement to pursue the perpetrators and track the movement of funds.

When exchanges happen overseas or are operated unlawfully without the investors’ knowledge, the risk becomes even greater. For example, foreign issuers can sell tokens in the United States, allowing them to receive funds outside the control of US regulators. This makes it difficult for the SEC to address any misconduct by the issuer. Even if the asset is found, law enforcement may struggle to freeze or secure the virtual asset due to encryption of virtual wallets. Due to many unfortunate events arising out or in connection to ICO, many jurisdictions started to closely examine and even try to regulate these ICOs.

Moreover, ICOs themselves may in fact pose various legal risks. Many jurisdictions tend to regulate some of the ICOs in terms of capital markets law. For instance, the Securities and Exchange Commission of the United States closely examines ICOs and generally applies the Howey Test to determine whether the offered crypto asset is a security or not. If the offered crypto asset is deemed to be a security, then, the ICO itself is subject to capital markets law of the United States which requires prior strict approval and authorisation processes. Conducting an ICO without prior approval and authorisation of SEC may in fact be considered as unauthorized securities offering which raise the risk of both criminal and legal liability.

Legal Status of ICOs

In terms of regulation, traditional crowdfunding is subject to various regulations that depend on the platform and jurisdiction, while ICOs are seeing an emergence of regulatory frameworks

The analysis of the legal status of ICOs can differ based on the specific type, characteristics, and purpose of the crypto asset being examined. When evaluating the purpose of an ICO, the initial factor to consider is the type of crypto asset being provided. The main emphasis should be on legal qualification of the offered crypto asset. Additionally, the significance of the White Paper, which outlines the ICO’s purpose, along with the characteristics and potential applications of the crypto asset being offered, cannot be underestimated.

Another important feature of an ICO is its online nature, where crypto assets are transferred to virtual wallets without any physical ties to a specific location or country. This quality underscores the global reach of ICOs, allowing it to take place anywhere in the world. As a result, individuals from any part of the globe can partake in any ICO. This introduces an element of unfamiliarity to legal relationships, which may lead to conflicts of laws and significant difficulties in resolving disputes in ICOs involving parties from diverse jurisdictions.

The characteristics of the crypto asset provided, along with the statements and explanations found in the White Paper regarding its integration, functions, and use cases, can sometimes result in the ICO being classified as Initial Coin Offering (ICO), Initial Exchange Offering (IEO), Security Token Offering (STO), Equity Token Offering (ETO), or occasionally as Fan Token Offering. As a result, it is important to internally analyze and classify the features of the relevant crypto asset, particularly in regards to its initial offering, before assigning a legal characterization.

The tokens provided to participants in each ICO can possess various characteristics. The legal regime and principles governing the ICO may differ based on the type and extent of rights and powers granted by the token. Matters such as whether participants are categorized as consumers or investors, the application order and extent of legal rules, and the authority of institutions in terms of regulation and enforcement may become topics of discussion.

Comparison with Traditional Crowdfunding Methods

Unlike traditional investment avenues that are only available to a select few, ICOs are accessible to the average person, democratizing investment opportunities

Traditional crowdfunding has distinctive characteristics when compared to ICOs or crowdfunding activities performed by crypto asset service providers. However, both are usually commenced for similar reasons. Crowdfunding is used by entrepreneurs that may lack sufficient funds and capital for their projects.

As aforementioned, there are four main forms or types of crowdfunding that can be utilized; reward-based crowdfunding, equity-based crowdfunding, debt-based crowdfunding and donation-based crowdfunding. ICOs mainly occur as a combination of crowdfunding or equity-based crowdfunding with digital/crypto assets.

In traditional forms of crowdfunding, funders contribute their funds in exchange for products, services or rewards, typically without receiving equity or ownership within the project or company in return for the funding. In comparison, an ICO will usually have funders receive crypto assets, representing a stake or gain access to more services or potential profits, in exchange for their contribution. In terms of regulation, traditional crowdfunding is subject to various regulations that depend on the platform and jurisdiction the crowdfunding project is subject to. On the other hand, ICOs are seeing an emergence of regulatory frameworks. However, in both traditional and new forms of crowdfunding, there is a focus on protecting backers and an insurance of transparency in activity.

Traditional crowdfunding appeals to a much broader audience of consumers and individuals, while ICO crowdfunding attracts a more specialized audience, usually with an interest in blockchain technology. Another difference is that often, traditional crowdfunding is utilized for creative projects or inventions and small businesses. ICOs however have been primarily associated with blockchain-based projects and crypto asset service providers’ projects.

Typically, funds can be accessed directly in the form of currency or fiat money and are managed by the platform conducting the crowdfunding. For ICOs, the funds are raised in the form of crypto assets. This distinction is where ICOs or non-traditional forms of crowdfunding brought by the utilization of crypto assets grants funders to participate globally, without being bound to currency conversion.

Yet, a factor that shall be considered is that crypto assets have a volatility that fiat currencies do not. The value of the crypto assets issued in an ICO can be extremely volatile. In contrast to traditional crowdfunding, the value of these assets is frequently determined by speculative market feelings surrounding the blockchain project rather than by real assets or a tested business plan.

ICOs frequently function in a murky regulatory environment. Significant risk is increased by unclear regulations or the possibility of future regulatory crackdowns. Investors can encounter legal issues or the chance of the ICO being closed down by regulators. On the other hand, since traditional crowdfunding is generally strictly regulated by governmental authorities, legal risks are comparably more foreseeable.

Last but not least with comparison to traditional crowdfunding, ICOs present some serious technical risks. Participants of an ICO must be aware of technical requirements such as wallets, smart contracts and blockchain technology.

Furthermore, ICO itself may in fact constitute serious technical liabilities. For example, a technical error in the smart contract of a very famous ICO also known as the DAO resulted in unlawful gain for some ill-intended persons.

The DAO’s smart contract code had a weakness that the hacker(s) took advantage of. More specifically, the reentrancy attack was made possible by a recursive call fault in the code. Because of the attack’s recursive nature, the hacker was able to continuously withdraw Ether from the DAO and deposit it into a duplicate DAO with the identical structure — before the original DAO’s balance was updated. This procedure was carried out repeatedly in order to deplete the DAO’s Ether reserves. The hacker was able to divert over 3.6 million Ether, which was valued at around $50 million at the time.

Legal Frameworks Governing Crowdfunding and ICOs

The decentralized nature of ICOs makes it hard for law enforcement to pursue the perpetrators and track the movement of funds.

The unique risks associated with crowdfunding and its role as an alternative to traditional banking and finance raise important considerations for lawmakers when creating regulations.

Several countries are exploring different ways to regulate crowdfunding. Two main approaches have emerged: regulating through laws or other normative acts, and regulating based on basic principles. There are also different approaches to regulating financial crowdfunding and social crowdfunding. Some countries advocate for special regulation for financial crowdfunding, while others prefer traditional regulation. Also some jurisdictions tend to include ICO into established capital markets laws and mainly crowdfunding provisions.

Investment restrictions on casual investors are widely used, such as setting limits on investment amounts for specific projects or periods. Some countries exclude crowdfunding platforms from the regulations that govern professional stock market participants and banks. There are also requirements for disclosing information about the risks of companies raising funds through crowdfunding platforms. Additionally, there is a licensing process for crowdfunding platforms that attract funds on a repayable basis.

Prominent Jurisdictions to Consider

United States

The US was the first country to establish regulations for crowdfunding with the adoption of the JOBS Act in 2012. This act aimed to make it easier and cheaper for new and small companies to attract capital. Title III of the act sets rules for stock issuance, investors, and platforms. In 2015, the US SEC implemented rules for Title III, including criteria for exemption from registration requirements and allowable investment amounts. Platforms were also given certain requirements, such as not providing investment advice to users.

The United States has taken a more regulated and scrutinized approach to initial coin offerings, or ICOs. Because initial coin offerings (ICOs) are frequently viewed by investors as unregulated transactions, the U.S. Securities and Exchange Commission (SEC) has become more involved in looking into and enforcing regulations surrounding them.

The SEC has made it clear that initial coin offerings (ICOs) may be deemed securities offerings and thus be subject to federal securities laws based on their particular characteristics. Thus, a large number of initial coin offerings (ICOs) will probably have to register with the SEC or be eligible for an exemption from registration. The SEC highlights that a token does not automatically become less of a security just because it is structured to have some utility or is branded as a “utility” token.

On the other hand, the Commodities Futures Trading Commission (CFTC) has expanded the scope of its regulatory authority to possibly encompass some Initial Coin Offerings (ICOs). ICOs are seen by the CFTC as falling under its purview, particularly when they involve utility tokens that are not securities. This position is a result of the CFTC’s extensive enforcement jurisdiction over commodity transactions, which encompasses “virtual currencies.”

When implementing federal commodities laws and regulations, the CFTC and the SEC take a similar approach to initial coin offerings (ICOs), concentrating on the intent and nature of the activity. Although ICOs that fall under the CFTC’s purview are closely monitored, the commission has not said that ICOs are inherently bad or that enforcement action will inevitably follow. ICOs that are legally compliant, have the right structure, and have made the necessary disclosures can move forward. The CFTC focuses on issues such as virtual currency fraud and manipulation, even in cash-market exchanges and transactions that don’t involve financing, margin, or leverage.

SEC’s Regulatory Approach

The SEC has pointed out the unique risks associated with investing in crypto assets. Unlike traditional securities and bank accounts, crypto asset investments are not insured, leaving investors vulnerable to potential losses from fraud, technical issues, or hacking. Additionally, the crypto asset market is relatively new and lacks a proven track record of credibility. The market also experiences extreme volatility, with investments able to rapidly increase or decrease in value. Overall, investing in crypto assets is considered to be a high-risk endeavor.

On the SECs official website a list of things to know about ICOs and information for investors is presented. ICOs can be securities offerings based on specific facts and may fall under the SEC’s jurisdiction of enforcing federal securities laws. Hence, they may need to be registered with the SEC. Also, tokens sold in ICOs can be called many things; the SEC here states that ICOs, or more specifically tokens can be called a variety of names, but merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security. It is further stated that ICOs may pose substantial risks as many may be frauds.

The SEC v. Telegram Group Inc. and TON Issuer Inc.

On October 11th of 2019, the SEC announced its filing of an emergency action and its obtaining of a temporary restraining order against two offshore entities that were claimed to be conducting unregistered, ongoing digital token offering in the U.S. and overseas. These offerings had raised more than 1.7 billion dollars in investor funds. The SEC filed, stating that Telegram Group Inc. and its wholly owned subsidiary TON Issuer Inc. started raising capital in January of 2018 to finance company business as well as develop their own blockchain called the “Telegram Open Network” or “TON Blockchain”.

Important accusations and revelations from the SEC’s Telegram case consist of:

Unregistered Offering and Sale of Securities: According to the SEC, Telegram violated federal securities laws by selling Grams through an unregistered offering of securities. They contend that because investors purchased Grams expecting to profit from Telegram’s efforts to develop the TON Blockchain and raise Gram’s value, Grams are securities.

Absence of Required Disclosures: Telegram failed to give investors the information that is normally required in securities offerings, which left them without the knowledge they needed to make wise investment choices.

Telegram’s Marketing Initiatives: The Securities and Exchange Commission (SEC) notes that Telegram actively marketed Grams as an investment, highlighting the anticipated rise in their value and the possibility of financial gain.

Integration of Grams with Telegram’s User Base: As part of its strategy, Telegram positioned its messaging platform as the main factor driving Grams’ uptake and value, taking advantage of its sizable user base to boost demand for Grams.

Expectation of Profits from Telegram’s Efforts: Telegram’s development efforts, as well as the company’s successful launch and integration of the TON Blockchain, were key factors influencing investors’ expectations of profits.

Absence of a Functional Ecosystem for Grams: At the time of the offering, Grams could not be used for any goods or services, meaning that their value was speculative and contingent on Telegram’s future developments.

Plans for Quick Distribution and Market Development: In order to establish a liquid market for the tokens, Telegram intended to quickly distribute Grams to a large user base.

The SEC pleaded for the following relief:

• Telegram faces long-term injunctions for breaking securities regulations.

• orders to repay all unjustified profits, including interest earned prior to judgment.

• Penalties for civil money.

• prohibitions against taking part in offerings of digital asset securities in the future.

Regarding their unregistered offering of “Grams” digital tokens, Telegram Group Inc. and TON Issuer Inc. reached a settlement with the SEC in June 2020. Telegram consented to pay a $18.5 million civil fine in addition to returning more than $1.2 billion to investors. Prior to this, the court had granted Telegram a preliminary injunction, reiterating the SEC’s argument that the Grams offering was not registered in accordance with federal securities laws. In addition to requiring Telegram to notify the SEC prior to any future digital asset offerings, the settlement also includes an injunction.

The DAO Incident and SEC’s Report

The DAO case involved an unincorporated organization that used blockchain technology to operate as a “decentralized autonomous organization.” It raised funds through an Initial Coin Offering (ICO) by issuing DAO Tokens in exchange for Ethereum. However, The DAO was hacked, leading to a significant loss of Ethereum. The SEC investigated and concluded that DAO Tokens were securities, thus subject to federal securities laws. This case set a precedent for the application of securities laws to ICOs and similar digital asset transactions.

The SEC report provides a detailed analysis of The DAO’s Initial Coin Offering (ICO). It underscores that ICOs, where digital tokens are offered in exchange for assets like crypto assets, are often subject to federal securities laws. This classification depends on the economic realities underlying the transaction, including factors like the expectation of profits and the role of a third party in driving those profits. The report is critical for understanding the regulatory landscape for ICOs, highlighting the importance of compliance with securities laws to ensure investor protection and fair market practices.

SEC v. Kik Interactive Inc.

In the lawsuit against Kik Interactive Inc., the SEC claims that Kik violated Sections 5(a) and © of the Securities Act in 2017 by selling Kin tokens through an unregistered offering of securities. From mid-July to September 2017, Kik sold Kin tokens to both wealthy investors and the general public, raising about $100 million.

The SEC’s main accusations are as follows:

• Federal securities laws required Kik to register the offering and give investors the required disclosures before selling Kin tokens.

• Kik was able to raise roughly $50.5 million from the general public in addition to $49.5 million from sales to wealthy investors.

• Kik made no distinction between money received from different investors or via different channels.

• Kik emphasized its own role in guaranteeing the success and raising the value of Kin when presenting the Kin tokens as an investment opportunity.

• Kik didn’t take any action to find out if investors were purchasing Kin to invest in them or to resell and distribute them right away.

The following final ruling is sought by the SEC:

• an injunction prohibiting Kik Interactive Inc. from breaking securities laws for all time.

• All profits or unjust enrichment obtained from the activities must be disgorged, along with any prejudiced interest.

• payment of civil fines in accordance with Securities Act Section 20(d).

This case underscores the significance of disclosures and registration in initial coin offerings (ICOs) and underscores the SEC’s focus on ensuring compliance with securities laws in digital asset offerings.

The SEC obtained a final judgment against the company in October 2020. The court determined that Kik had failed to register its token sales, which were considered sales of securities. As a result, Kik was ordered to notify the SEC prior to any future transactions involving digital assets and was permanently barred from breaking the Securities Act’s registration requirements. Kik was also mandated to pay a $5 million fine.

European Union and MiCA

The European Union (EU) began to regulate crowdfunding around 2015–2016. By May 2016, seven out of 28 EU Member states had implemented national laws regarding equity-based crowdfunding. However, charity crowdfunding remained under existing legislation, with some specific provisions. G. Gabison analyzed the regulations introduced by European states and identified various requirements such as platform licensing, limitations on funds raised, investment restrictions for non-qualified investors, and requirements for attracting funds from professional investors. Most EU Member states did not require registration for crowdfunding platforms that solely operated for charitable or repayment purposes, as long as they did not provide payment services.

The European Commission and European Parliament are consistently interested in crowdfunding and believe it is important to have ongoing communication with member states, regulatory authorities, and individuals involved in the crowdfunding industry. In March 2018, the European Commission proposed regulations for crowdfunding service providers as part of their FinTech Action Plan. These regulations would allow platforms to apply for an EU passport based on a standardized set of rules, making it easier for them to offer services throughout the European Union. The Commission’s regulations only apply to crowdfunding services that involve financial repayment to investors.

The EU Council has released a compromise proposal for the regulation of crowdfunding platforms in the EU. This follows the European Parliament’s position on the project, which aimed to increase investor protection. The proposal focuses on assisting cross-border crowdfunding platforms, implementing adaptive rules for different types of financing, and establishing uniform authorization and supervision rules for national authorities.

ESMA released a report on July 12, 2019 regarding the licensing regulations for FinTech companies in the EU. The report identified that issues arise when the activities of FinTech companies fall outside of current rules, such as those involving crypto asset, blockchain, and ICOs. ESMA stated that certain tokens are considered financial instruments and should be regulated. It is important to note that crowdfunding instruments are not classified as ‘financial instruments’ according to the MiFID II.

Some countries have implemented laws to define and regulate different types of crowdfunding. For example, Finland has the Crowdfunding Act, which defines loan crowdfunding and investment crowdfunding. In Lithuania, the Law of Crowdfunding regulates the terms and requirements for crowdfunding platforms. Australia has introduced a special regulation for public capital funding called Crowd-Sourced Funding (CSF). These laws do not apply to charity or donations, as they are covered by separate legislation.

In the EU, there is no unified regulatory framework for ICOs yet. Instead, each member state applied existing financial regulations to ICOs on a case-by-case basis.

The European Securities and Markets Authority (ESMA) has issued warnings to investors and companies about the potential risks involved in Initial Coin Offerings (ICOs). They stressed the importance of adhering to the current securities laws in the European Union.

Several EU member states have implemented regulations and guidelines for ICOs. Malta and Switzerland have positioned themselves as blockchain-friendly countries and have established regulatory frameworks for digital assets, including ICOs.

AML and CFT regulations were enforced on ICOs to prevent illegal activities, often necessitating the implementation of KYC procedures by issuers. In certain situations, Initial Coin Offerings (ICOs) may be required to comply with the prospectus regulation, which mandates issuers to release a prospectus unless they qualify for an exemption.

Token classification varies depending on the jurisdiction, with some tokens being classified as securities and others as utility tokens. The EBA and ECB have both stated the importance of having a unified regulatory approach for crypto assets due to their international nature.

Markets in Crypto-Assets Regulation

A thorough regulatory framework for crypto assets, including those sold through initial coin offerings (ICOs), is known as “Markets in Crypto-Assets Regulation” (MiCA). It attempts to provide investors and issuers with clarity and legal certainty by standardizing the regulation of crypto assets throughout the European Union.

MiCA outlines the rules for the issuance and trading of different kinds of crypto-assets. This covers tokens with particular regulatory requirements, such as utility tokens, asset-referenced tokens, and e-money tokens.

The framework sets tight guidelines for organizations that use initial coin offerings (ICOs) to issue crypto assets. This includes having to release a white paper that outlines the project’s objectives, finances, risks, and token holders’ rights and responsibilities. The white paper must contain accurate, lucid, and non-misleading information and be approved by the appropriate authorities.

MiCA prioritizes investor protection by putting a strong emphasis on issuers’ integrity, equity, and professionalism. It requires the creation of complaint handling protocols, the management of conflicts of interest, and clear communication.

The main goals of the regulation are to protect ICOs’ transparency and integrity of the market. Issuers are required to give comprehensive details about their financial status, governance, and token technical specifications. To keep the confidence of the market, regular reporting and auditing are also necessary.

Issuers must uphold strong governance, risk control, and sufficient capital to cover any losses in order to maintain operational resilience. This guarantees their operations’ dependability and continuity.

MiCA requires issuers and service providers to perform due diligence on their customers and report suspicious activities in line with current AML and CTF regulations. Furthermore, the rule gives issuers and service providers passporting rights, facilitating cross-border operations within the EU. This unites the markets in all EU member states for crypto-assets.

MiCA makes sure that issuers follow the rules by outlining the consequences for non-compliance. Administrative sanctions and fines are included in this. In addition to market regulation, MiCA seeks to foster competition and innovation in the EU’s crypto asset market. It offers both new and established businesses a controlled and secure environment in which to develop new financial services and products.

In conclusion, MiCA is a big step toward the European Union’s standardization of regulation for initial coin offerings (ICOs) and digital assets. It creates a thorough legal framework for the issuance and administration of crypto-assets while striking a balance between the demands of investor protection, market integrity, and innovation support.

China

In September 2017, the People’s Bank of China (PBOC) and several other Chinese regulatory bodies issued an outright ban on Initial Coin Offerings (ICOs). Given China’s role as a major market for digital assets, this ban was a significant development in the global crypto asset landscape. The following are the key aspects of this ban:

Comprehensive Prohibition of Initial Coin Offerings (ICOs): The esteemed People’s Bank of China has pronounced the categorical illegality of all forms of ICOs. It has unequivocally asserted that ICOs function as unsanctioned means of soliciting funds, posing threats of financial deceit, unlawful issuance of securities, illicit fundraising practices, financial dupery, or even schemes of an exploitative nature.

Ceasing of ICO Platforms: Moreover, in compliance with the prohibition, it became imperative to terminate any and all platforms associated with ICO fundraising. This encompassed platforms facilitating seamless exchanges between conventional currencies and digital assets.

Refund Obligations: In order to safeguard the financial well-being of investors and effectively address potential risks, it was imperative for organizations and individuals who had previously undertaken Initial Coin Offerings (ICOs) to honor their commitment of refunding investors.

Reasoning for the Prohibition: The PBOC has invoked the imperative of safeguarding the equilibrium of the financial market and the well-being of investors. Furthermore, apprehensions have been expressed regarding the possibility of ICOs being exploited for illicit purposes, such as the facilitation of money laundering and perpetration of fraudulent activities.

The prohibition swiftly and considerably influenced the worldwide crypto asset markets, resulting in a substantial decline in the values of prominent digital currencies.

The ban on ICOs in China aligns with a wider framework of robust regulation surrounding cryptocurrencies and their associated activities. The Chinese government has adopted a prudent approach towards digital currencies, prioritizing financial stability and acknowledging the impact they may have on conventional financial regulatory systems.

Singapore

In Singapore, business owners who cannot secure funding from traditional sources like banks may turn to crowdfunding platforms. This involves issuing shares or debt instruments to potential funders in exchange for their investments. This can also include peer-to-peer lending.

Equity-based and debt-based arrangements can be considered securities-based arrangements because they involve the issuance of securities to funders. The definition of securities includes shares, units in a business trust, debentures, and other prescribed products. However, it does not include collective investment scheme units, bills of exchange, certificates of deposit, or other prescribed products. Equity-based arrangements typically fall under the definition of securities in limb (1), while debt-based arrangements typically fall under limb (2). Previously, promissory notes were excluded from the definition of securities, but this led to issuers classifying their debt as promissory notes to avoid securities laws issues. The Monetary Authority of Singapore (MAS) has stated that promissory notes should be subject to regulation to provide investors with the same protections as other debentures. As a result, MAS has amended the Securities and Futures Act (SFA) to remove the exclusion for promissory notes.

Despite some challenges with certain exemptions that platform operators may rely on, the growth of the alternative finance market is largely due to increased regulatory certainty and confidence. Unlike traditional debt and equity markets, crowdfunding investors have not had clear regulations and enforceable accountability until recently. The MAS has also shown a willingness to ease certain requirements for securities-based arrangements. If crowdfunding platform operators adhere to the regulatory parameters set by the MAS, there is potential for further growth and development of the alternative finance market in Singapore.

For instance, MAS stated on June 28, 2019, that it plans to grant up to two licenses for digital full banks and three licenses for digital wholesale banks. These new digital banks would be separate from any digital banks already established by Singapore banking groups under MAS’ current internet banking framework.

Importance of Qualification of Offered Crypto Asset

For more detailed information, please see our paper on Crypto Conundrum: Navigating the Maze of Assets & Regulations Across Borders

There are three primary digital tokens in the crypto asset family:

• Currency tokens, such as Bitcoin, are digital forms of money that can be used to make purchases similar to how physical money is used. These tokens are created by blockchain platforms, like Bitcoin, and are meant to represent money for commercial transactions between the purchaser and any party willing to accept the platform’s currency. Unlike security tokens, currency tokens do not have a value tied to physical assets, but rather their value is determined by the platform that issued them. Crypto assets that may be regarded as currencies generally tend to fall into the scope of banking law. Therefore, it is important to closely examine and comply with strict regulations of banking law.

• Utility tokens, such as Ethereum’s ERC20, are created by the issuer to function like coupons that can be used in the future to purchase goods or services at a reduced price. These tokens are often sold by the issuer to raise funds for their business. Utility tokens are generally accepted as the safest option with regards to legal uncertainty. As long as issuers of the utility token are careful to not provide utilities that may make the token subject to securities law, it is right now the safest option for crypto assets.

• Security tokens are tokens that are created by the issuer to represent the funder’s investment. They can be equivalent to a certain percentage of ownership in an asset, such as a house. These tokens are backed by assets, similar to how gold backs a fiat currency. They offer liquidity and can be easily bought or sold in the market. Due to their stability and attractiveness as an investment, they are regulated as securities and provide a larger pool of investors for filmmakers. If the token is considered a security or an investment contract, then, securities law will most probably be applicable which is in fact not preferable. Also, if the token is accepted as security, then, offering of such a token is required to be authorized by relevant governmental authority.

Associated Rights to an Offered Crypto Asset

In general, ICO tokens can be categorized into four main types of rights: usage rights, participation rights, profit rights, and ownership rights. These rights are not mutually exclusive, meaning that a token can provide the holder with the ability to use a specific blockchain system, participate in its governance, and potentially receive future dividends.

We offer one example for each of the four categories listed below.

1. The right of usage refers to the ability of token holders to use various decentralized networks for different purposes. Examples of this include Filecoin for decentralized cloud storage, Golem Network for accessing a decentralized supercomputer, Ether for deploying computer code on the Ethereum blockchain, and bitcoins for using the Bitcoin network as a decentralized payment system.

2. The right of participation is given to token holders in DAOstack and MakerDAO. In DAOstack, token holders can vote on content and governance proposals, with voting power based on the number of tokens they have. In MakerDAO, token holders can vote on risk management and business logic decisions for the MakerDAO system.

3. Polybius digital bank created a token called Polybius Dividend Tokens (PLBT) to reward its investors. Each year, 20% of the bank’s profit is distributed to PLBT holders based on certain conditions. Similarly, TheDAO tokens allowed holders to collect a portion of profits from a decentralized investment fund. It is important to mention that TheDAO tokens also provided other rights, including participation and usage rights.

4. The right of ownership is demonstrated through various tokens. For example, DGX tokens from Digix can be redeemed for gold, stable tokens like Tether, USD Coin, and Paxos are supposedly backed by an equivalent amount of dollars, and Cryptokitties are non-fungible tokens associated with digital kittens that are owned by the token holders.

If the Offered Crypto Asset is a Security Token

A Security Token is a structure that can be created during an ICO, and it does not have to be in the form of a company. However, there is nothing stopping the establishment of a company at the start of the ICO to manage it. Additionally, it is also feasible to create tools or assets, like platforms, websites, or service providers, for trading the developed crypto asset without the requirement of establishing a company before or after the ICO phases.

If the token defined in an ICO gives participants ownership rights in the current or future company, offers or directly provides ownership in the ecosystem components where the crypto asset will be incorporated, or incorporates an instrument that can be exchanged optionally, such as a convertible bond, then in those instances, the token in question may be regarded as a security token. The issuance of this token could be categorized as an equity token offering or a security token offering.

Determining and accepting Tokens and their ICOs as securities, particularly in the United States, involves meeting the requirements of the Howey Test set by the U.S. Securities and Exchange Commission (SEC). The Howey Test states that if a Token possesses certain elements, it is considered a security and falls under the category of a capital market instrument. These elements include the expectation of profit from an investment made in an ICO, the investment being held within a common enterprise managed by others, and the profits being derived from the efforts of those individuals. If these criteria are met, the Tokens can be classified as Security Tokens. In this case, the team conducting the ICO must register with the SEC, regardless of whether it is done on the blockchain or with a crypto asset. Additionally, individuals who facilitate the buying and selling of such Tokens are also required to hold an SEC license.

European Union’s Approach: The Case of Estonia’s Proposed ‘Estcoin’

In 2017, Estonia was in the process of creating their own digital asset called Estcoin. The idea was introduced by Kaspar Korjus, who runs Estonia’s e-Residency program. The e-Residency program lets people from other countries start and run businesses in Estonia online, and according to initial plans, having a national Estcoin would make the program even better.

Key points of Estocoin’s proposal were that it introduced a token for e-Residency program. The main idea being the use of Estcoin as a token within the e-Residency program and here, digital currencies are used to facilitate transactions and provide additional services to e-residents. Secondly, there was a highlight to community involvement with a proposition to involve the global community in the development of Estocoin. One of the proposals was the creation of a community-driven venture fund where Estcoin holders could vote on projects and receive funding.

There was also consideration of an ICO where, initially, discussions were had on the possibility of conducting an ICO to fund the development of Estcoin and related projects. However, this aspect of the proposal faced criticism and regulatory challenges. Ultimately, there were concerns from the European Central Bank. The proposal faced skepticism from the European Central Bank (ECB), which expressed concerns about the potential impact a national digital currency would have on the eurozone. The ECB made it clear that no member state of the euro area can introduce its own currency. Despite talks and proposals, Estonia has yet to go ahead with its Estcoin plans, however, blockchain technology and digital initiatives are still at the forefront within the country.

Conclusion

In conclusion, crowdfunding emerges as a pivotal and dynamic instrument in the financial landscape, catering to the needs of modern entrepreneurs and investors alike. This essay has delved into the various facets of crowdfunding, from its fundamental necessity for entrepreneurs lacking capital to its intricate legal and structural frameworks. The advent of Initial Coin Offerings (ICOs) represents a significant evolution in crowdfunding, marrying technology with finance and offering an alternative to traditional financial systems.

Crowdfunding is not a monolith; it is a spectrum comprising donation-based, reward-based, equity-based, and debt-based models. Each model presents unique dynamics and legal considerations, highlighting the importance of understanding these differences for both entrepreneurs and investors. The essay underscores the transformative role of crowdfunding in empowering individuals with limited capital to participate in financial ventures, thus democratizing access to capital.

However, this landscape is not without challenges. The legal and relational intricacies of crowdfunding necessitate careful navigation to ensure mutual benefits for all parties involved. Crowdfunding platforms play a critical role as intermediaries, connecting ideas needing funding with potential investors. This relationship, while beneficial, requires a keen awareness of legal and ethical considerations to maintain trust and efficacy.

Looking forward, crowdfunding stands as a testament to the innovative spirit of financial markets, adapting to technological advancements and evolving investor needs. As this landscape continues to evolve, it will be essential to monitor and adapt to the changing legal and technological frameworks. Crowdfunding not only fuels entrepreneurial endeavors but also reflects a broader shift towards more inclusive and accessible financial systems. The future of crowdfunding, particularly in the realm of digital assets and technologies, holds promising potential for further democratizing finance and empowering a new generation of entrepreneurs and investors.

Furthermore, this essay has explored the intricate world of Initial Coin Offerings (ICOs), a modern and increasingly popular method of crowdfunding using blockchain technology. ICOs represent a significant shift from traditional fundraising methods, offering unique benefits and challenges to both investors and entrepreneurs.

ICOs provide an accessible platform for diverse investors to participate in early-stage projects, potentially yielding significant returns. This democratization of investment opportunities is a stark contrast to traditional avenues like IPOs, which often favor larger, institutional investors. Furthermore, the global reach and decentralized nature of blockchain technology enable widespread participation, transcending geographical boundaries.

However, this innovation is not without its risks. The volatile nature of crypto assets, coupled with regulatory uncertainties and potential technical vulnerabilities, presents significant challenges. Investors must navigate a landscape rife with potential for market manipulation, fraud, and technical failures, as exemplified by incidents like the DAO attack.

As the legal and regulatory frameworks around ICOs continue to evolve, it is crucial for all stakeholders to remain vigilant and informed. The intersection of technology and finance through ICOs is reshaping the landscape of crowdfunding, offering new possibilities while also demanding a careful assessment of risks and rewards.

In sum, ICOs stand as a testament to the innovative potential of combining finance with blockchain technology. They offer a glimpse into a future where investment is more inclusive and global, yet also remind us of the need for robust legal and technical safeguards to protect all parties involved.

The exploration of the legal frameworks governing crowdfunding and Initial Coin Offerings (ICOs) reveals a complex and evolving landscape. Countries worldwide are grappling with the challenges of regulating these innovative financial mechanisms, balancing the need for investor protection with the promotion of technological advancement and market growth.

In the United States, the JOBS Act and subsequent SEC regulations reflect a cautious yet enabling approach, emphasizing investor protection while recognizing the potential of crowdfunding and ICOs. The SEC’s stringent stance on ICOs, particularly concerning registration and disclosure requirements, underscores the need for compliance with federal securities laws. This regulatory rigor aims to mitigate risks associated with crypto asset investments, such as fraud and market volatility, as illustrated by cases like SEC v. Telegram Group Inc. and SEC v. Kik Interactive Inc.

In the European Union, efforts to standardize regulations are evident in initiatives like the Markets in Crypto-Assets Regulation (MiCA). MiCA seeks to harmonize the legal framework across member states, focusing on transparency, investor protection, and market integrity. It establishes clear guidelines for crypto asset issuers and service providers, promoting a secure and competitive market.

Contrastingly, China’s outright ban on ICOs reflects a more conservative approach, prioritizing financial stability and protection against potential misuse of digital currencies. Singapore’s regulatory framework, on the other hand, illustrates a nuanced approach, accommodating the growth of alternative finance while ensuring investor protection through amendments to the Securities and Futures Act.

These diverse regulatory approaches underscore the complexities inherent in governing emerging financial technologies like crowdfunding and ICOs. As the global financial landscape continues to evolve, it becomes increasingly important for regulators to adapt and respond to these changes, ensuring a balance between innovation, market integrity, and investor protection.

Moreover, this essay has examined the complexities surrounding the classification and qualification of crypto assets, underscoring the varied nature of digital tokens and their implications in the realm of Initial Coin Offerings (ICOs). The distinction between currency tokens, utility tokens, and security tokens is crucial in understanding the legal and regulatory frameworks that apply to each. Currency tokens like Bitcoin represent digital forms of money and tend to fall under banking law, while utility tokens such as Ethereum’s ERC20 offer a safer legal ground by avoiding securities law as long as they are structured appropriately. Security tokens, representing investment in an asset, are subject to securities law and require careful handling to ensure compliance.

The rights associated with these crypto assets — usage, participation, profit, and ownership — further complicate their classification and regulatory implications. From Filecoin’s decentralized cloud storage to Polybius’s dividend tokens, each token category exemplifies the diverse functionalities and legal considerations within the ICO landscape.

A critical aspect of this discussion is the legal status of these tokens, especially in jurisdictions like the United States, where the Howey Test plays a pivotal role in determining whether a token is classified as a security. Compliance with SEC regulations is imperative for security tokens, involving registration and adherence to strict securities laws.

In conclusion, the qualification of crypto assets and the legal implications of ICOs represent a dynamic and evolving field. Navigating this landscape requires a nuanced understanding of the different types of tokens, their associated rights, and the regulatory environments in which they operate. As the digital asset space continues to grow, regulatory clarity and compliance will be key to fostering innovation while ensuring investor protection and market integrity.

LEGAL DISCLAIMER

THE INFORMATION PROVIDED IN THIS PAPER PROVIDES GENERAL INFORMATION AS TO THE POSSIBILITIES IN MULTIPLE JURISDICTIONS. PLEASE KEEP IN MIND THAT LAWS THAT APPLY TO THE SUBJECT HEREIN MAY DIFFER IN EACH JURISDICTION. THUS, NOTHING CONTAINED HEREIN CONSTITUTES ANY LEGAL OPINION OR SUGGESTION OF ANY KIND. PLEASE CONSULT TO LOCAL EXPERTS IN RELEVANT AREAS BEFORE TAKING ANY ACTION BASED ON ANY INFORMATION CONTAINED HEREIN.

I. Introduction

NFT's are a sophisticated and compelling concept that can be seen as a certificate of ownership of digital or physical assets on a secure, blockchain-based marketplace. Essentially, blockchain technology is a decentralized database that tracks transactions, and NFT's are cryptographic assets that employ unique codes and metadata to distinguish one from the other. Since they are non-interchangeable, they cannot be replaced by identical copies, and this makes them a powerful tool for establishing ownership of digital creations. These unique digital tokens can be traded on digital platforms, enabling artists worldwide to sell their creations while retaining control over their copyrights.

In this paper, we will first examine what NFTs are and then focus on their real-world applications. We will establish the legal status of NFTs, if necessary. After establishing the legal status of NFTs, we will continue our research by examining the importance of metadata for NFTs. After outlining the basics of NFTs and their implications, we will cross-examine LFF’s Action NFTs with other NFTs. Eventually, we will investigate whether NFTs can be used as a digital notary in this paper.

II. Overview of Non-Fungible Tokens (NFTs)

NFTs are a relatively new addition to the crypto asset ecosystem. However, they seem to be attracting even more attention than their predecessors. Like many other types of crypto assets, NFTs generally lack a legal definition. This causes some hesitation within the ecosystem. Although there is no uniform legal definition of NFTs, here are some prominent features that may be used to tell what NFTs really stand for.

A. The Definition and Characteristics of NFTs

Non-Fungible Tokens (NFTs) are unique, indivisible, and non-interchangeable digital assets that exist on a blockchain. They may be used as useful tools to represent ownership of a particular digital or physical asset, such as artwork, music, videos, collectibles, virtual goods, or real estate. The main characteristics of NFTs include their uniqueness, provable scarcity, and ability to be transferred and traded on various platforms.

NFTs, as the name suggests, differ significantly from classic tokens due to their lack of fungibility. But what exactly does “fungibility” mean? Fungibility refers to the characteristic of an asset or good that allows it to be exchanged for another unit of the same asset or good without any loss in value. Fungible assets or goods are essentially indistinguishable from each other. For instance, fiat currencies are generally considered fungible - a single U.S. dollar bill can be swapped with any other U.S. dollar bill without resulting in a loss of value.

Bitcoin is another example from the world of crypto assets and is generally considered fungible - one Bitcoin has a similar value and utility as any other Bitcoin and can be exchanged without any loss of value.

The primary difference between NFTs and these other assets is that NFTs are each unique and non-interchangeable. Since each NFT represents a distinct and different asset with its own inherent value or utility, they cannot be exchanged for one another at all or at least without some form of change in value.

B. Underlying Technology of NFTs: BlockChain

Like other crypto assets, NFTs are considered secure, transparent, and immutable. To ensure these features, NFTs are built on decentralized blockchains that record transactions across multiple databases such as computers. This makes it almost impossible to alter or tamper with the data. Most popular NFTs are built on Ethereum blockchain which utilizes ERC-721 or ERC-1155 tokenization standards. However, Ethereum isn’t the only blockchain that enables the minting of NFTs, other blockchains such Binance Smart Chain and Cardano also support the minting of NFTs.

As NFTs are promoted based on their authenticity and originality, the use of blockchain technology is essential. The prominent features of blockchain ensure that NFTs have a verifiable origin, which allows ecosystem members to trace the ownership history of a digital asset and examine its originality.

C. Real World Applications of NFTs

Although there is no uniform approach to defining NFTs, they are increasingly being used in various industries and platforms. Below are some real-world examples of how NFTs are being applied:

i. Art NFTs

With digitalization of every aspect of our daily lives, it seemed like NFTs were the last piece of puzzle needed to complete the transformation of art. Since NFTs paved a new way for artists and collectors to buy, sell and trade their art, Art NFTs have drawn enormous amounts of attention. Art NFTs aim to offer a solution to monetizing problems that artists face in the digital era.

Artists now may tokenize their either physical or digital work. Tokenization of a work plays an important role in determining the uniqueness of a work. They primarily provide the ensurement of authenticity. Artists sometimes have a hard time getting the royalties they are actually entitled to. It is possible to set up a royalty system integrated into the NFT that enables the artists to earn a royalty due to the transactions of their work in the secondary market.

While it is impossible to list every application of Art NFTs; CryptoPunks, BoredApe NFT, Beeble may be shown as popular examples.

ii. Collectible NFTs

NFTs can be used to represent digital collectibles such as trading cards, virtual pets, and limited-edition items. These one-of-a-kind digital artifacts range in rarity and worth. CryptoKitties, NBA Top Shot, and CryptoPunks are some prominent examples. These collectibles are frequently exchanged on specialized marketplaces and have the potential to increase in value over time.

iii. Gaming NFTs

NFTs in gaming enable the ownership and trading of in-game assets such as skins, weapons, and characters. This gives users full ownership of their digital things, allowing them to trade or sell them in secondary markets. Axie Infinity, The Sandbox, and Decentraland are three prominent blockchain-based games that use NFTs.

iv. Utility NFTs

Utility NFTs main feature is that they provide their holders with some rights; such as accessing certain products and services. Contrary to Collectible NFTs and Art NFTs, Utility NFTs aim to offer their holders some practical use. The certain practical use depends on the utility that the NFT has to offer. For example, some Utility NFTs enable their holder to have access to some exclusive content. Some Utility NFTs may be considered as symbol membership to certain clubs or platforms. Additionally, in DAOs, it is possible to benefit Utility NFTs to grant governance and voting rights to specific members of a DAO. Furthermore, there have been cases where these Utility NFTs are being used as authentic tickets to certain organizations or events.

v. Payment NFTs

In comparison with other types of NFTs, Payment NFTs are a relatively new concept. NFTs’ nonfungible feature may seem challenging for it to be used as a means of exchange. However, the nonfungible feature of NFTs may be useful in providing customized digital currencies which can be essentially used in loyalty or reward programs.

These Payment NFTs may be used by companies or foundations to incentivize the members of their ecosystems. Companies and foundations may use Payment NFTs to build and strengthen loyalty and engagement.

III. Legal Status of NFTs

It is common to see the law struggle to keep up with the ever-evolving technology. Lawmakers must first understand new technologies and their products in order to properly regulate them. If humans cannot comprehend something, they cannot regulate it effectively. Additionally, poorly calculated regulations have the potential to hinder the development and usage of a technology. Relevant regulations for crypto-assets and blockchain technology are still forthcoming.

A. Current Legal Landscape

As NFTs are still a relatively new concept and product, it is safe to say that legal frameworks regarding them have not yet been fully developed. Although there is serious legislation in progress concerning crypto-assets and blockchain technology in different jurisdictions, currently no legislation exists or in the preparation process that exclusively targets NFTs. However, this does not mean that there is no applicable legislation to NFTs. Before delving into any legal examination of specific issues related to NFTs, it is important to emphasize that relevant laws and regulations may be applicable to NFTs, even if they do not explicitly mention them. Intellectual property law, consumer law, contract law, tax law, securities law, and CFT and AML regulation may be found applicable to NFTs and transactions involving them. In conclusion, it is crucial to thoroughly examine each NFTs in this regard.

B. Intellectual Property and Copyright Aspect of NFTs

The application of civil law ownership rules to NFTs remains unresolved. As per the legal systems with Roman law tradition, ownership is defined as possession of a physical object that can be perceived and located. However, this definition is not applicable to digital tokens like NFTs. Consequently, there is no uniformity in the definition of NFT ownership across various national regimes due to the absence of harmonized property laws in the EU.

NFTs are not to be considered as artworks, as they serve the purpose of recording the creation and ownership of an asset that may, in fact, be an artwork. Rather, NFTs are a tool of cryptography, governed by a smart contract- a concise software program that controls the operation of the NFT. Utilizing blockchain technology, this contract verifies the documents the existence and ownership of both digital and three-dimensional assets.

As an NFT buyer, you gain full control over the smart contract that governs the functions of the NFT. This contract registers your ownership on the blockchain, providing indisputable evidence of your possession of the asset associated with the NFT, whether it’s a stunning artwork or a valuable piece of property. It is important to note that while owning an NFT doesn’t grant you copyright or control over the artwork automatically, it’s still a powerful investment in today’s NFT industry and crypto community.

There exists a notable distinction between the act of purchasing a tangible piece of artwork and acquiring a digital artwork tokenized for ownership.

Copyright safeguards "the work," but it is not synonymous with the creation or expression conceived by the author. This distinction is vital in understanding why NFTs do not inherently confer copyright. It is worth noting that the copyright is an autonomous property distinct from the work it protects.

i. Copyright ownership of NFTs

It is widely accepted by the United States and the world at large that, from a legal standpoint, copyright is a distinct form of property from the object or file which contains the protected work. This is because a copyright entails several individual rights that can be exercised or even sold separately. It is crucial to note that the object containing the work can be sold independently from all the copyright rights.

Not only is it a well-established principle that the physical or digital copy of a work can be sold separately from the copyright, but current copyright law also presumes that the buyer of such copy does not acquire the copyright unless it is deliberately licensed or transferred. This serves to protect the rights of copyright holders and ensures that their creative works are properly safeguarded.

When purchasing digital art, it is important to note that unless the copyright is transferred to the buyer, they cannot make copies or derivative works of the original. Additionally, they cannot prevent others from making copies, whether authorized or not. However, owning an NFT linked to the artwork still designates the buyer as the registered owner of the original copy. Obtaining the copyright to the artwork can provide the buyer with several attractive rights, such as the right to copy, sell, and distribute the work. This is especially important if the art is to be used in future projects or activities that require copies to be made. By owning the copyright, the buyer can have a say in preventing unauthorized copying of both digital and physical art.

A complete transfer of copyright ownership to the buyer is referred to as an assignment, and it must be executed in writing rather than verbally or through actions. On the other hand, when only a portion of the copyright is transferred, it is commonly known as a licensing agreement.

ii. Licensing agreements for NFTs

There are two primary types of licenses: exclusive and nonexclusive. An exclusive license grants the licensee sole access and use of the licensed rights, without the possibility of the copyright owner granting the same rights to another party. To transfer exclusive rights of any economic value, a written agreement is essential. Conversely, a nonexclusive license allows the licensee to use the rights, but the copyright owner has the liberty to grant the same rights to multiple parties. The transfer of nonexclusive rights can be carried out orally or through the parties' conduct, without the need for a written agreement.

There exist diverse methods to effectively communicate license terms for a portion of the copyright intellectual property of an artwork. We have listed them in order of their probable recognition as a legally valid license:

• A mutually negotiated agreement between the seller and purchaser prior to purchase

The option of a mutual agreement presents an exquisite solution as it enables the seller and buyer to engage in fruitful communication, reach a consensus and mutually agree on the terms of the sale. They can then formalize their agreement by signing a written document, which can be conveniently done electronically, specifying the rights conveyed. Essentially, this creates a contractual agreement that grants the purchaser the license or even the complete copyright to the artwork.

• License terms embedded within the smart contract of the NFT

Incorporating the terms of a license into the smart contract of the NFT that is being sold is a highly effective way to ensure legal compliance. The written terms in the code and the ability to access and control the smart contract are integral parts of the NFT purchase. Smart contracts commonly contain license terms within their code, making this option a practical solution. By including the license terms or a link to them in the metadata of the smart contract, each owner of the NFT will have notice of those terms as they will be transferred with the smart contract.

• Pop-up clickwrap license terms presented at the point of purchase

This option offers the benefit of requiring a clear and affirmative action of acceptance, such as clicking a button to agree to the terms of use at the point of purchase. This type of "clickwrap" license is generally favored by the law over "browse wrap" licenses, which rely on implied consent. While implied consent is not insignificant, the act of clicking to agree is a stronger indication of assent, similar to signing a contract. However, it's important to note that both types of licenses are only effective for the initial buyer of the NFT.

• License terms outlined in the NFT sales platform's listing and item description

If you are a creator, when selling an NFT on a sales platform, you hold the power to craft a captivating and informative description of your masterpiece within the listing. You can even include the license terms or a link to the license, thereby ensuring that the purchaser has access to all pertinent information prior to making their purchase. This exemplifies a level of transparency that reinforces the purchaser's understanding of the terms and conditions associated with their acquisition.

• License terms displayed on the website of the NFT creator

One of the most popular ways to disclose licenselicence terms is through the creator's website. It is a convenient and effortless option, especially for creators who may want to adjust the terms as their project progresses. However, it lacks an actual or implied agreement from the buyer of the NFT, which may not be ideal for those looking for easy enforcement of the terms. Nonetheless, it is still better than having no terms disclosed at all.

When crafting a license agreement, there are numerous possibilities to explore. However, it is crucial to take into account the following rights while designing the terms of the license:

1. the right to display

2. the right to copy for specific incidental purposes

3. the right to create derivative works, the right to commercially exploit the artwork

4. the option to share everything through the use of Creative Commons licenses

5. the possibility of selling everything by assigning the copyright to the purchaser.

By thoughtfully considering these rights, the drafter can create an elegant and persuasive license agreement that meets the needs of all parties involved.

iii. Resale Royalties

NFTs represent a groundbreaking technological advancement, particularly in the realm of art, as they provide a means for artists to receive resale royalties. By incorporating a royalty payment system directly into the NFT's underlying "smart contract," artists can rest assured that they will receive a ten-to-twenty percent cut of any future resales. This automated process eliminates the need for purchasers to comply with individual royalty agreements and ensures that payments are promptly delivered to the artist's digital wallet. Overall, NFTs offer an elegant and persuasive solution for promoting fair compensation within the art industry.

In addition, artists have the right to receive a royalty based on the total amount received from the resale of their NFTs, which is commonly referred to as "Droit De Suite". With the integration of smart contracts, the management of this right no longer requires the involvement of collecting societies, providing artists with greater control and balance of power. It is worth noting that the miner of the NFT receives the resale price, but if the author is the initial owner of the NFT, they can benefit from the resale royalty.

C. Jurisdictional Differences

As it is repeatedly stated through this paper, there is no uniform approach regarding NFTs. As a matter of fact, crypto assets generally lack legislation. Therefore, legal qualifications of NFTs and crypto assets in general, may differ substantially. Each country has a unique approach to NFTs and crypto assets. The variation on approaches closely affects the rights and obligations of NFT creators, purchasers, and sellers.

Even though it is not possible to clearly define the legal qualification of NFTs in each jurisdiction, some of them are as follows.

i. USA

In the United States, there are no specific laws regulating NFTs. However, this doesn’t mean that there is no applicable law to cases regarding NFTs. Existing laws such as intellectual property, contract, tax and securities law may be applicable to NFTs depending on the specific case. If a NFT is eligible to be considered as a work, then, intellectual property law regulations may be applicable. On the other hand, digital assets such as NFTs and other crypto assets may be accepted as property by the Internal Revenue Service. As a result, NFTs may be subjected to taxation such as capital gains tax.

When determining whether something is a security or not, the criteria stipulated in the Howey Test are used. It is unlikely but if a NFT is deemed a security, then, securities law may be applicable.

Furthermore, similar to other crypto assets and ecosystems, Financial Crimes Enforcement Network may require NFT marketplaces to comply with the relevant Anti-Money Laundering (AML) and Know Your Customer (KYC) regulations.

ii. European Union

The main legislation in the European Union is the Markets in Crypto Assets (MiCA) Regulation. Even though MiCA offers a great clarity and foreseeability to crypto asset ecosystems, this regulation clearly states that it excludes crypto assets that are unique and non-fungible with other crypto assets. As a result, it is safe to say that as a rule, MiCA will not be applicable to NFTs.

The fact that MiCA is not applicable to NFTs in principle does not mean that there is no applicable law to NFTs in the EU. There are important regulations such as GDPR and 5th and 6th AML Directives that have to be followed. If a NFT involves personal data, then, GDPR can be applicable. Moreover, if necessary, KYC and AML regulations can extend to the NFTs.

In terms of intellectual property law, the EU, in general, recognizes copyright of digital assets. NFTs that have a copyrightable matter, may be subject to intellectual property laws of relevant jurisdiction, which in fact vary.

iii. Türkiye

It has been known for a long time that Türkiye has been working on introducing a new legislation regarding crypto assets. However, as of May 2023, there is still no specific legislation that exclusively targets NFTs or other crypto assets. Nevertheless, general rules and principles of law and relevant legislations are applicable to NFTs.

Just as classic works, digital versions of works are copyrightable in Türkiye. If a NFT involves a copyrightable work, then, Turkish intellectual property law rules will be applied.

Since there is no clear legal qualification on crypto assets, taxation aspects of crypto assets and NFTs are debatable. Taxation of NFTs varies depending on the nature of the transaction conducted with them. If the event resulting from the NFT is eligible to be considered as a taxable event, then, NFTs may be subjected to income tax, capital gains tax, etc.

Furthermore, NFTs may be subject to securities law depending on their nature. If a NFT is eligible to be deemed as a financial instrument or even a security, then, relevant securities law may be applicable. The approaches of Capital Markets Boards and Banking Regulation and Supervision Agency on crypto assets and more specifically on NFTs are crucial in determining the applicable laws to NFTs.

Additionally, if the criteria on accepting a transaction as a consumer transaction is met, then, NFTs may be also subject to consumer protection law.

V. Metadata and its Role in NFT Transactions

Metadata is commonly defined as data that offers insights into other data. Its primary purpose is to differentiate between the actual data, such as an object or dataset, and the accompanying information that describes and defines it, known as metadata. This information can come in various forms, including descriptive, structural, and administrative metadata, all of which can facilitate numerous tasks, from identifying and discovering resources to organizing collections. Overall, metadata plays a crucial role in supporting various information-related activities.

NFT content can include physical or digital items such as tweets, music videos, images, documents, artworks, and even immovable property. These items can be tokenized as NFT, and the multimedia file within can have various extensions like .png, .jpg, .mp3, .pdf, .mp4.

NFTs can represent existing assets or digital artworks, allowing for legal transactions on the blockchain. The metadata in NFTs is crucial and defines and describes the NFT, and JSON is the most commonly used format for this metadata. Essentially, when an NFT is acquired, it is the metadata that is being acquired.

NFT metadata should include the name, description, and content of the NFT. Storing the entire multimedia file on the blockchain makes NFTs more valuable and secure, but it is expensive. Many NFTs have a link to access the multimedia instead. The location of the multimedia is important, and using IPFS is more secure as it offers permanent storage.

IPFS assigns a unique Hash to each file and distributes them across multiple nodes instead of on a single server. This system is similar to blockchain and the two technologies can work together. However, storing large amounts of data on a blockchain can be expensive so only the IPFS Hash for the file is stored in the blockchain. This allows for the combination of these decentralized systems.

The common method of utilizing IPFS in NFT applications involves saving NFT metadata in IPFS. This can be easily done using applications like "Pinata" to upload and manage files. The resulting hash of the file saved in IPFS is included in the NFT contract along with a URL address associated with the corresponding token ID. This IPFS-based URL address points directly to the data, making it more secure and permanent compared to traditional centralized website extensions. Therefore, storing NFT content in IPFS may be a good idea if it needs to be stored outside the blockchain.

The intricacies of metadata within the realm of NFTs can be quite intricate and encompass a variety of legal domains such as intellectual property, contract, and data protection laws. It is imperative to take note of the following legal factors when dealing with metadata.

A. IP Rights, Licensing and Authenticity

The preservation of intellectual property rights is of the utmost importance in the digital age. Metadata serves as a valuable tool in identifying the creator of a digital asset and any pertinent copyright or trademark information. It is imperative that the metadata accurately reflects these rights in order to prevent any potential conflicts or infringement matters from arising.

Metadata holds valuable information on licensing and usage rights granted to NFT purchasers. Such information dictates the permissible ways of using, displaying, and reselling the digital asset. Comprehending the licensing terms and conditions outlined in the metadata is crucial for both parties to adhere to legal requirements and prevent any conflicts.

The use of metadata can elegantly establish the provenance and authenticity of a digital asset, which is crucial from a legal standpoint. This is particularly relevant in scenarios where disputes arise regarding the original creator or chain of ownership of a digital art piece. Consequently, safeguarding the precision and reliability of metadata is paramount in upholding transparency and trust within the NFT market.

B. Agreements and Validity

Metadata within NFT transactions may include contractual agreements or terms between parties. This can be exemplified by the specification of agreed-upon terms and conditions upon the purchase of an NFT. The enforceability of these agreements is subject to a variety of factors, such as jurisdiction, the clarity of the terms, and the mutual understanding and consent of the parties involved.

In Turkish law and with slight differences in many jurisdictions that follow Roman Law, agreements are formed via offer, acceptance, consideration, and intention of the parties. Parties who have the legal capacity to do so can enter into agreements when their declaration of intent is met. Unless it is explicitly stated by law that an agreement on a specific subject has to be in formal written form, agreements may be formed verbally. Additionally, it is not mandatory to form an agreement on a piece of paper. Agreements can also be formed online, even on blockchain.

Assuming that a NFT has an agreement embedded on its metadata, is this agreement valid? Explanations provided in previous paragraphs are valid in terms of NFTs. If the intention of the parties is duly met and their intention to enter into such agreement is clear, and if the said agreement is valid in terms of other criteria, then, the agreement embedded in metadata of the NFT is deemed to be valid.

C. Data Privacy

The inclusion of personal information within metadata pertaining to NFTs necessitates adherence to data protection and privacy laws, such as the GDPR in the European Union. Those handling such data must ensure compliance with applicable regulations, including obtaining consent, providing notice, and implementing proper security measures.

Furthermore, data protection regulations generally require data controllers to obtain explicit consent from persons prior to collecting persons’ personal data. Since metadata of an NFT may contain some personal data, the relevant consents shall be obtained. In this regard, individuals who are subject to data processing, shall be informed about the collection and processing of their data as well as the purpose of data processing.

Moreover, data controllers have the tendency to collect as much information as possible. Data protection regulations such as EU’s GDPR and Türkiye’s KVKK aim to minimize the amount of collected personal data. Data controller shall collect only the data that are necessary to achieve the purpose of their collection. As a result, when forming the metadata, one shall act on utmost care about the personal data involving metadata.

Additionally, obligations of data controllers extend to protection of personal data. Data controllers have to provide the necessary protection to personal data they process. Security measures to be taken in this regard shall provide appropriate security from unauthorized access, disclosure or alteration. Since metadata and NFTs are built on blockchain, these innovative technologies can be used as a tool for protection of personal data.

In conclusion, the content of the metadata of a NFT has significant effects and consequences in terms of data protection regulations. General rules and principles stipulated in relevant data protection regulations are applicable to the metadata of NFTs.

D. Liability

The accuracy of metadata is of utmost importance as any inaccuracy or false information can result in legal disputes and potential liability for all parties involved. For instance, relying on incorrect metadata about the creator or licensing rights can cause NFT buyers to face legal issues related to copyright infringement and suffer damages. The individuals responsible for providing or maintaining the metadata may be held accountable for such consequences. Therefore, it is crucial to ensure the accuracy and authenticity of metadata to avoid any legal implications.

To summarize, metadata is a crucial component of NFT transactions, and its legal implications span across multiple areas of law, including intellectual property, contract, and data protection laws. It is imperative for both NFT creators and buyers to understand the legal ramifications related to metadata and implement necessary measures to guarantee its precision, reliability, and adherence to relevant laws and regulations.

VI. NFTs as Digital Notary

The role of a notary is much more than simply validating a signature and confirming transactions. It encompasses a vast array of responsibilities, including assessing the signer's capacity and ensuring the legality of the transaction. The notary assumes full responsibility for drafting the document, guaranteeing its legality, and confirming that all parties involved comprehended its contents. Moreover, the notary also provides impartial advice, takes measures to prevent money laundering, and notifies the relevant public administration bodies of the transaction. In short, the notary is an indispensable resource for those seeking legal and ethical guidance in their dealings.

Blockchain technology has the ability to provide permanent document storage and enables the automation of agreements, which minimizes the need for intermediaries and simplifies procedures. The documents can be signed by all parties involved and are recognized as official. In this way, blockchain technology serves much similarly to notaries.

While it is true that blockchain technology can verify the authenticity and ownership of goods on a public network, it is incapable of performing the full range of functions that notaries offer in legal terms. Unlike notaries, for now, blockchain cannot draft legal documents, verify the grantor's capacity or comprehension, or guarantee the legality of the transaction.

Furthermore, the notaries are worldwide acknowledged entities, meaning that even if the blockchain technology is suitable for becoming a digital notary, it must be recognized legally in order to perform as such. This is a topic in discussion internally, but no actions nor regulations have been taken or proposed in any part of the world for now regarding acceptance and recognizing the blockchain technology as a digital notary.

VII. LFF Action NFTs

lLittlefish Foundation’s Action NFTs offer a new method of doing business. lLittlefish Foundation provides the necessary ecosystem for people to gather around a purpose and the Colony. As Colonies work to achieve their goals, they produce valuable content and conduct activities. Colonies are expected to tokenize their activities and mint NFTs regarding their activities and content. NFTs minted in this process are called Action NFTs. Thanks to these Action NFTs, activities and content of the Colonies are properly recorded indefinitely in the blockchain.

Next step is about creating and distributing the value. To incentivize the valuable contributions of the Colonies, lLittlefish Foundation sells the Action NFTs. These Action NFTs can be bought by the members of the lLittlefish Foundation or by third parties. The value created in this process is distributed amongst lLittlefish Foundation and the relevant Colony, in accordance with the agreements between each.

Depending on their metadata, these Action NFTs may be considered as Art NFTs, Collectibles or Payment NFTs. Regardless of how they are artificially considered, relevant data protection, intellectual property, agreement, and tax laws may be applicable.

Most of the evaluations given on the Section IV. Metadata and its Role in NFT are still valid for Action NFTs. Here is how:

First of all, since Colonies transform their content and actions into Action NFTs, these Action NFTs may contain copyrightable works. As stated before, purchasing just the NFT does not mean that the purchaser also gained the intellectual property rights relating to the underlying work of NFT. Unless otherwise is explicitly stated, intellectual property rights of the work remain with the seller. In conclusion, it is strongly recommended for both seller and buyer to regulate the intellectual property rights relating to underlying work of the Action NFT.

Secondly, it is important to take into account the tax consequences of selling and purchasing an Action NFT. Depending on the nature and parties of the transaction, the seller may be subject to income tax, and capital gains tax. In terms of Turkish Law, if the seller is a business, then, the income generated from such sale may be considered as business income which is taxable. On the other hand, if the seller is an individual, then, the income generated may be regarded as self-employment income. The situation of the buyer is somewhat different. If the buyer resells the said Action NFT at a higher price than the price they paid, then, the realizedrealised profit from such transaction is taxable as capital gains tax.

With regards to the USA, the IRS recognizes NFTs as property alongside with other crypto assets. Basically, if you sell the Action NFT at a higher price than the price you bought, then, the gain resulting from such a transaction is subject to capital gains tax. However, if you are the creator of the Action NFT, then, the gains arising from your first sale of the Action NFT are accepted as ordinary income and taxed accordingly.

Thirdly, these Action NFT transactions may be executed through various sale methods such as direct sale or auction. The sale method of Action NFTs doesn’t really change much. The key components of selling and purchasing a NFT stipulated in this article are mostly applicable for different sale methods. It is strongly recommended that both buyers and sellers shall be well aware of the accurate information about the transaction they enter into such as intellectual property law.

LEGAL DISCLAIMER

THE INFORMATION PROVIDED IN THIS PAPER PROVIDES GENERAL INFORMATION AS TO THE POSSIBILITIES IN MULTIPLE JURISDICTIONS. PLEASE KEEP IN MIND THAT LAWS THAT APPLY TO THE SUBJECT HEREIN MAY DIFFER IN EACH JURISDICTION. THUS, NOTHING CONTAINED HEREIN CONSTITUTES ANY LEGAL OPINION OR SUGGESTION OF ANY KIND. PLEASE CONSULT TO LOCAL EXPERTS IN RELEVANT AREAS BEFORE TAKING ANY ACTION BASED ON ANY INFORMATION CONTAINED HEREIN.

DAOs are the new and prominent actors of digitalized corporations. With their unique and revolutionary features such as being decentralized and autonomous, they promise outstanding solutions to challenges faced due to the distances between people and unnecessary bureaucratic procedures. The way they function prevents the tyrannical system of classic corporations and partnerships. With the emergence of DAOs, a new, more democratic and decentralized version of corporations and partnerships come to life. Thanks to the wonders of blockchain technology, via the smart contracts DAOs are now able to function with the minimum amount of human intervention. Voting processes and execution of taken decisions are more trustworthy and safer from the potentially corrupt hands more than ever.

Despite all its perks, DAOs currently face a new challenge in the field of Law. The everlasting need of foreseeability and therefore legal norms, raises the question of how to legally categorize and give Decentralized Autonomous Organizations a legal entity. Even though there is no uniform approach on the topic, there are some applicable legislations in different jurisdictions. Namely, in Vermont and Wyoming, new and specific legislations are issued for the DAOs, integrating them mostly to the provisions of LLCs. On the other hand, countries such as Türkiye and Switzerland adopt a different approach. In Türkiye and Switzerland, current legal norms are found to be applicable to the DAOs. For example, according to Turkish Law, it is possible to regulate DAOs as an ordinary partnership.

There are various questions and concerns that shall be addressed by the members of a DAO before deciding to establish a legal entity for a DAO. These questions and concerns range from legal relations a DAO aims to conclude, to the liability of the members of a DAO depending on the amount of debts and obligations a DAO plans to undertake. One of the most crucial thing to keep in mind is the fact that as the debts and obligations a DAO plans to undertake increase, the risk and amount of liability of the members of a DAO increase to the point that the personal properties and financial assets of a member of a DAO may be subjected to a liquidation.

With having a legal entity, DAOs will be able to be a part of legal transactions, own property and assets, sue and be sued, employ and conduct business with legal entities. The liability of the founders and the participants, the rights and obligations of the DAOs will be clearer and more foreseeable.

What is a DAO?

It should be noted that following explanations are made with respect to the general principles and applications of the DAOs. Due to their unique and flexible nature, rights and obligations of the members of the DAO or even how the DAOs work, their voting procedures etc. may dramatically vary from one another.

To be precise, DAO stands for decentralized autonomous organization. DAOs are sort of organizations or entities based on smart contracts written on the blockchain. These smart contracts are made according to DAO’s purpose, functioning, distribution and structure. Main difference between the classic organization and DAOs is the fact that DAOs’ governance relies mostly on its codes and smart contracts instead of typical and sometimes even tyrannical leaderships.

Although a DAO can be multifunctional or it may focus on a specific area of business, with the help of blockchain technology and therefore smart contracts, DAOs are mostly collectively owned organizations that bring people together throughout the world to pursue one common mission. In this common mission, people generally purchase or earn DAO’s tokens and become a member of and in some cases shareholder of the said DAO.

After becoming a part of the DAO’s ecosystem, members of the DAO can participate in decision making procedures in respect to the amount of token they possess. In the event of DAO making profit, members of the DAO may be entitled to have a share of this profit.

Even though it is challenging to strictly define and identify the main features of each unique DAO, it is safe to say that most DAOs are built on three principles: being decentralized, autonomous and organizational.

Some Prominent Features of the DAOs

In this section, we are providing information regarding DAOs’ features. In order to understand the structure of DAOs one must know these features. DAO is decentralized, autonomous and an organization. DAO is decentralized since it is governed with codes and the governance is mostly distributed amongst its members, is autonomous since it can function with the codes without a need of interfering DAOs are said to be autonomous. Last but not least, DAOs are a type of an organization which are gathering people across the world.

First and main feature of the DAOs is being decentralized. As stated above, current DAOs are mostly operated on blockchain. The way blockchain works and the fact that blockchain technology made the possibility of smart contracts a reality, makes DAOs decentralized. After the establishment of a DAO, the founders are not the complete shotcallers in that DAO. Codes and underlying smart contracts take over and DAO is governed in accordance with the codes. Unlike classic corporations and companies, DAOs lack a governing body and its governance is automated thanks to their underlying blockchain technology and smart contracts.

Thanks to the wonders of blockchain and tokenization, DAOs now can function without the necessity to have a governing centralized body. Governance and other aspects of a DAO can be distributed more easily.

Second feature of DAOs is being autonomous. Even though DAOs don't have a governing body in principle, they have to be able to operate and function somehow. The governing principles and functions of the DAOs are generally imprinted on the smart contracts. After its establishment a DAO can operate and function without needing the approval or initiation of its founders. This autonomous body can exercise its duties and functions independently. Therefore, it becomes an entity which is independent of its founders and automatically functions in accordance with its underlying codes. Since rules of the DAO are embedded in the codes, no administrator is needed, thus it eliminates the barriers of bureaucracy and hierarchy.

With the development of smart contracts, the decisions taken by the DAOs can be executed autonomously with the minimum human intervention. This autonomous feature provides a significant amount of foreseeability by eliminating the risk that comes with human intervention.

DAOs third and perhaps most meaningful feature is being an organization. Even though DAOs are built on codes and smart contracts, they are more than just a few lines of codes or software. DAOs are the entities that people join together to fulfill a purpose. Its ability to unite people across the globe in something that people want to work on together is simply fascinating. That’s why in our opinion DAOs are not just an organization that is built on smart contracts but rather an exceptional and innovative international organization that extinguishes the distance between people.

The emergence of DAOs is perhaps the last missing piece of a true globalization. With its innovative and revolutionary nature, people all across the globe can truly come together to pursue one common goal under an organization.

How to establish a DAO and how does it work?

DAOs mostly function via smart contracts. These codes that lay out the working and governance principles of a DAO are essential in its formation. Codes that are integrated into the smart contracts are generally open-source and recorded on blockchain. Therefore, these sets of rules and principles that are set forth by the DAO can be viewed by the members of the DAO.

The fact that DAOs mainly function according to their underlying smart contract and therefore codes doesn’t mean that they are such organizations that lack people. On the contrary, the very codes and smart contracts that form the DAO itself are programmed by people. In these smart contracts founders lay out the fundamental principles and rules of the DAO, the voting procedures and field of activity etc. Unlike hierarchical structures, each member of the DAO can control the operating protocol at some level, and it is in the interest of individuals that all rules benefit the entire DAO. These rules, which will form the protocol of the DAO are recorded in the blockchain. This protocol also includes DAO’s operation and finance model.

After its establishment, generally DAOs funding process starts. In this period, people all across the globe who wish to participate in the DAO, purchase the tokens of the said DAO. Sometimes these tokens are called governance tokens because they enable its holders to participate in voting procedures of the DAO and therefore have a say in its governance. Also, it is quite common for these tokens to entitle their holders to have a share of profit generated by the DAO.

To sum it all up, in DAOs, the rules agreed by the community are applied via smart contracts, voting is done and the codes containing all these rules and operations are made publicly available. Without intermediaries and unnecessary hierarchy and bureaucracy, a group of people possibly with different backgrounds gathers around a decentralized autonomous organization and works on various projects, some of them with financial goals or some with other purposes. If the DAO generates an income and makes a profit, then this profit is shared in accordance with their DAO Token holdings amongst the members of the DAO without avoidable intermediaries and bureaucracy.

After forming its smart contracts and therefore the governing rules and principles of a DAO, tokens of the said DAO are generally offered. With the token offerings people become a member of the DAO which mainly gives its holder the right to vote and to be entitled to profit generated by the DAO. The wonders of blockchain technology and smart contracts also eliminate the unwanted intervention of intermediaries and unnecessary bureaucracy.

Advantages of DAOs

There are many advantages of DAOs. A DAO can function worldwide, you just need to be online. DAOs’ rules are predefined and public so you will know what you are getting into. Plus, you can see any action or decision that is taken within the DAO, it is always recorded mostly in blockchain. You can gain much by contributing small amounts. Even if you lack the financial resources, you can always put your trust and finances to a DAO, as long as it fits you. In DAOs, you have a saying! Your opinion matters and will affect the decisions of the DAO. You are a customer of a DAO and at the same time, you are an owner. So, you will know what benefits you and your organization better.

DAOs offer to solve and overcome many problems regarding classic corporations and the financial system. Ranging from enabling a system without classic intermediaries to democratic decision making, it brings forth an innovative approach to organizations.

First of all, due to its digital and technological nature, DAOs generally cut across the limitations set by geographical difficulties. People all across the world who don’t know and trust each other may come together under an organization that serves a common goal. In that sense, individuals become a member of a DAO and work with one another or invest in a project.

Even though getting rid of the limitations that are set forth by the borders is sometimes perceived favorable, it is not always the case. In the classical system, it is hard for individuals to invest in overseas projects or companies. It is quite scary and challenging for a person to defend its right in a foreign jurisdiction and law system. However, with the underlying technology of the DAOs, individuals who decide to become a part of a DAO know the procedures and consequences of each action. Another advantage of DAO is that rules are predefined, transparent, verifiable and distributed. Since the rules are always clearly verifiable, the member will join the DAO by accepting the rules of the DAO. More importantly, these actions and consequences are generally executed automatically and autonomously by the DAO itself. That’s how the DAOs offer to solve trust problems of its members.

Many people are concerned when it comes to putting your finances and hours of your time to a foreign investment of any kind. With the foreign projects or organizations, comes the element of surprise, a different law system and a jurisdiction! Since the governing principles and rules of a DAO are predefined and mostly transparent, members of a DAO generally don’t have to fear uncertainty.

One other feature that makes DAOs attractive is its ability to create a more trustworthy environment when it comes to company governance. Unfortunately, there are more than countable cases where corrupt managers or founders of a company fraud its investors or embezzle the assets of its company. Due to its transparent nature, codes of the smart contract are generally open for public display. Everything is recorded in its blockchain. Moreover, a DAO's rules and transactions are always recorded on the blockchain, ensuring full transparency and accountability of every financial decision and action. While central organizations may keep opaque records, DAOs' records are always public. With its technological features, DAOs offer quite reliable protection regarding corrupt managers.

Embezzlement, fraud and corrupt managers and founders are an ever-lasting problem when it comes to trusting classic corporations and organizations. Thanks to the underlying technology of DAOs, namely blockchain, the transactions and accounting of DAOs generally recorded in its blockchain which enable the members of a DAO to audit and follow the transactions of the DAO.

Sad but true, it is always cheaper to think of something rather than doing it. In business life, and in almost every aspect of life, it is the same. People with ideas generally lack the necessary capital to realize their project. With DAOs even the individuals with relatively small capitals are incentivized to invest in these projects. It is possible and therefore fascinating to raise a great amount of capital out of small put many capitals within a minute.

Decentralized decision making has two major advantages. For starters, it can help to alleviate agency issues. Second, it allows for greater engagement with an organization's stakeholders, such as employees and customers, which can strengthen the organization's sense of identity and belonging while also improving information flow.

When we hire a financial advisor to manage our investments, we want the advisor to allocate funds in a way that maximizes our wealth; however, the advisor may have an incentive to invest in high-fee products that earn a lower return. Similarly, agency issues are prevalent in public companies, ranging from labor negotiations to CEO compensation, merger decisions, and capital investments. These types of issues could be greatly reduced when all owners are directly involved in decision making, as in a DAO.

Shareholders of a company are frequently users of its services and products. They have firsthand knowledge of the quality, strengths, and weaknesses of the company's offerings and can provide valuable feedback. This is usually invaluable to the organization's success. Additionally, when customers are also owners, they develop a sense of belonging and identity, which promotes loyalty, coordination, and incentive alignment. This is a feature shared by credit unions, cooperatives, and DAOs. When organizational structures are centralized, users are not directly in control of the company and may not feel as empowered to contribute to information dissemination and optimal governance. While most organizations in the world are managed and controlled by central parties, DAOs entrust the management of the organization to members who have invested in them. In theory and in practice, every investor has the opportunity to assist in the management of the DAO.

If you think about classic corporations, you can see that control of the company is generally left to the central parties. On the other hand, DAOs enable and moreover incentivize their members to be a part of the governance of the DAO.

Disadvantages of DAOs

It is best to make a pros and cons list for DAOs. Anyone can become a member. But this means that people who lack knowledge or information of the DAO will become a member too. If one doesn’t have a clue of the function or the purpose of a DAO, they may take actions and these actions can have outcomes that are not in favor of the DAO. For a decision to be passed, it shall be voted by the members in the DAO. So, decision making will, probably, take time to settle. Digital world comes with downsides, such as cyber-attacks. If a hacker gains access to the system, they can steal funds or your data.

In DAOs, there are some disadvantages. For instance, lack of confidentiality, potentially higher organizational expenses, expertise problems and lack of fast decision making.

Decision-making is not a free process. It takes time and effort to learn about all of the options and weigh the benefits and drawbacks of each. Since it is inefficient, this is why businesses centralize decision-making by hiring managers who have extensive experience. Decentralized owners or group members are less likely to be informed and understand the consequences of their decisions than a CEO and expert team.

Many corporate decisions are meant to be kept private and unknown to current or prospective competitors or even to its shareholders. This advantage allows businesses to stay ahead of the competition by keeping their data and strategic plans hidden. In contrast, a decentralized decision-making process allows information to be widely accessible, making it more difficult to keep information confidential. To ensure confidentiality to some extent, DAOs may prefer to use private blockchains that prevent unauthorized access. Usage of private blockchain may provide some confidentiality against outsiders but as a rule, the information regarding the decisions that are taken and executed by a DAO through smart contracts and blockchain will still be widely accessible to its members. This situation may be undesirable for a DAO, because sometimes there is such information which is meant to be kept hidden even from the members of a DAO.

Organizations sometimes have to make quick decisions. Decentralized organizations must put proposals to a vote and give all governance token holders time to understand and vote on potential courses of action. In contrast, centralized organizations are often better able to make quick decisions because only a few people are required to be involved in the process.

Contrary to decentralized organizations, centralized and classical organizations sometimes have the opportunity to make decisions faster. Due to their centralized nature, classic organizations can react quicker when needed.

Almost every technological innovation comes with a downside. Inevitably, as the digitalization continues more it is possible to face new cybersecurity challenges. DAOs may be more susceptible to fraud and hacking than traditional organizations. Since their very existence and function is based upon smart contracts and codes, they are more vulnerable to cyber-attacks. Because DAOs are decentralized, no central authority is responsible for its security. If hackers can gain access to the organization's computer systems, they can steal funds or user data.

As it is stated thoroughly throughout this paper, DAOs are built upon new technologies and almost fully digitalized. Despite the strong and reliable safety blockchain technology has to offer, DAOs are more vulnerable to cybersecurity problems.

DAOs may be less adaptable to shifting conditions than regular organizations. A DAO lacks a centralized authority to adapt swiftly to changing conditions since it is decentralized. This might make it difficult for the business to adapt to new problems and opportunities.

Finally, the lack of a defined regulatory structure is the primary worry with DAOs. The majority of countries throughout the globe have not properly stated their legal position on DAOs. This may impede organizations' quick development. Their worldwide character and international membership make this scenario much more difficult. Uniform or almost identical legislation throughout the world would hasten the emergence of DAOs.

Why Do People Prefer DAOs?

People need, want and long for many things. Despite its search for independence, a huge part of being human is being dependent on each other. If not for the cooperation and the ability of humankind to work together, many wonderful features of our civilization would have not been established. Throughout the history of humankind, peoples that manage to form an effective, practical and relatively fair organization thrive and prosper.

Many things and concepts that were revolutionary and innovative for their times eventually bit the dust and became old-fashioned. Our current understanding of corporations and organizations struggle to address the needs of innovative projects and people and here is why:

As the corruption and bureaucratic formalities increase, the efficiency of the organization decreases. Legal and economic structure of the classic organization types started to be questioned long ago. Current legal structures for organizations such as partnerships and companies are wholly regulated. Rights and obligations of said organizations are strictly set forth by the governments. From managing the treasury to voting rules and procedures, almost all of the features and functions of an organization are decided in people’s stead. Applicable classic law lacks the appropriate solutions for new technologies. Almost everyone is complaining about the fact that judicial processes take so long. However, so far nothing seems to change. Sometimes judicial processes are carried so inefficiently to the point that solving the disputes and disagreements through judicial processes is even more expensive than the dispute itself.

Now, in the age of technology and digitalization, a new dawn for organization is seen on the horizon. Artificial boundaries set by the states are no longer withholding people from coming together.

Thanks to the developing technologies, people from different citizenships and geographies now have the opportunity to pursue a common goal.

To prosper and to have sustainable development, societies have to find a fair, organized and fair way. Current types of organizations lack the necessary features in the age of digitalization. In addition to their strictly regulated nature, the law itself struggles to address the question arising from new technologies. With the foreseeability, safety, and international nature they have to offer, DAOs emerge as a new type of organization.

Legal Structures for DAOs

If you want your DAO to be official, you should check out below for sure. It’s known that because DAOs are not governed, founders or members may be held accountable for their actions if something goes wrong. Since there are legal structures that provide a limited liability, you may want to consider legally establishing your DAO. This also applies to being able to enter into contracts with other companies, or even opening a bank account for a DAO if needed. We tried to sum up the options we have in the governed world that can be considered for a DAO.

DAOs as Partnerships

Because of its structure, a DAO can be seen as a partnership in many jurisdictions. If not legally acknowledged in another legal structure, we can say that a DAO is basically a partnership, as long as you formed that organization for profit.

To be more specific, if present worldwide legal frameworks apply to for-profit DAOs, its members would most certainly be called partners.

In general terms, partnership is a relationship established between persons who agree to share the profits and loss of a business which these persons come together to carry it out. Therefore, persons who wilfully enter into such a relationship are called Partners. Such a categorization may not appear noteworthy for DAOs created just for personal gain; yet, it poses a number of difficulties. To be more specific, if present worldwide legal frameworks mentioned below would apply to for-profit DAOs, its members would most certainly be eligible to be called partners.

Firstly, if a person or entity acquired or was granted tokens in the DAO, for instance, through an airdrop or as payment for supplying goods or services to the DAO, that person or entity may become a partner. Similarly, if a person sold all of their DAO tokens, they would no longer be a partner, and a new partnership would continue between the remaining token holders. Token holders, and therefore partners, might enter and depart on a daily basis, rendering partnership legislation impractical.

In the possibility of a DAO having more than one type of token, every token holder may not be qualified to be considered as a partner. In this context, the type and nature of the token is crucial. Tokens that enable its holders to have a say in the decision making process of the DAO or the tokens that entitle its holders to have a share of the profits and losses of the DAO would be eligible to qualify its holders as a member. On the other hand, tokens that do not give rights to its holders that partners generally have would not be eligible to qualify its holders as partners.

Additionally partnerships are often formed by persons who know and trust one another, and the partners have fiduciary obligations to one another and to the organization. Since partners are considered agents of each other and the organization, they have the power to bind their other partners and the organization. Since partnerships do not have separate legal bodies, they cannot own assets or conclude contracts, and other organizations may be hesitant to conclude contracts with the DAO due to its lack of legal authority. Such legal affairs shall be carried out via the partners of the partnership. More importantly, partners are jointly and severally accountable for the DAO's debts, obligations, and errors.

DAOs such as charities cannot be deemed as partnerships since they lack profit motive. People may be unaware that they have created a partnership when they participate in activities with others with the purpose of making a profit but do not formalize their legal structure. Therefore, regardless of whether DAO members consent to such enforcement, laws will apply to them. Since some DAO members may use anonymous identities, they make it more difficult to enforce the law against them. In actuality, DAO members who are identifiable carry significant risks since they might be sued for the DAO's debts or become targets of regulatory action. Some DAOs that claim to be non-profit may be deemed as for-profit and hence a partnership. For example, if the DAO contains transferable tokens and persons or businesses are ready to pay for them, the DAO may be considered and deemed as a for-profit DAO rather than a non-profit one. This is due to the fact that not-for-profit entities cannot issue shares, and most DAO tokens will function similarly to a share in a business if they represent a share of the DAO's equity.

It is recommended that DAOs be recognized as fitting within current legal frameworks, such as LLCs in the United States, and that such frameworks be modified as needed to accommodate the decentralized structure of decision-making within DAOs. For instance, it could be better for DAO developers to register as a LLC in a US state such as Wyoming, since the LLC would be recognized in New Zealand and Australia. Since there is no single type of DAO, developing sui generis legal organizational structures for multiple types of DAO at this juncture is not practical.

If no other applicable legislation is present, then, organizations that aim to profit are generally considered as partnerships. Tokens that grant their holders the power to govern the DAO to some extent, make their holders able to be considered as partners. With being considered as a partner, comes a great amount of power and responsibility. Each partner has the power to bind other partners and partnership. Each partner is responsible for and entitled to debts and obligations of the partnership, as well as its profits and rights. That much liability may result in the liquidation of the personal assets of a partner. Finally, the way that partners define themselves in such relations, doesn’t affect the eligibility of a DAO to be considered as a partnership. Be Careful!

DAO as Unincorporated Associations

If you are seeking a non-profit organization, becoming an unincorporated association may suit you in this journey. Similar to partnerships, if certain conditions are met, members of an unincorporated association may be held liable for the debts and obligations of the unincorporated association. Furthermore, due to the fact that unincorporated associations lack legal entities, legal affairs may be challenging to be carried out via unincorporated associations.

One can say that unincorporated societies are similar to partnerships in Australia, New Zealand and the United Kingdom. An unincorporated association is generally an organization that consists of at least two people of whom there is an agreement amongst. The key point of unincorporated association is the fact that they have to be established to pursue a common goal or fulfill a duty other than making a profit. These unincorporated associations lack legal personality.

As with partnerships, the absence of a legal identity and consequently, legal status poses issues. Because they are unincorporated, there is no legal entity against which to litigate, and jurisdictional concerns may emerge. Furthermore, because they lack legal personality, unincorporated associations are unable to enter into contracts. Because of their lack of legal standing, other persons and corporations may be unwilling or even prohibited from engaging with them.

Unincorporated associations cannot hold property. However, similar to partnerships, there is no practical requirement for a DAO to utilize others to store property such as tokens due to the DAO's capacity to manage assets housed on a blockchain. However, as with partnerships, some property, such as land, may be owned solely by legal bodies. As a result, a non-for-profit DAO cannot completely eliminate the risk of the DAO's assets being misappropriated by those who are supposed to keep them in trust for the DAO.

Further limitation of unincorporated association legislation for DAOs is that members of an unincorporated society may be held accountable for the association’s debts in certain circumstances. First, if the rules of the association state that they are liable, such as if they agree to personally indemnify the committee or the trustees for actions taken while transacting business on behalf of the association ; and second, members can be liable if they voted in favor of the action that incurred liability.

Limited Partnerships and Limited Liability Partnerships

Limited partnerships and limited liability partnerships are types of organizations that are recognized by most of the governments. Contrary to classic partnerships, at least one of the partners of a limited partnership has limited liability. In limited liability partnerships, liability of all partners is limited.

Many governments recognize limited partnerships (LPs) and limited liability partnerships (LLPs). Limited partnerships are again a type of a partnership however, in limited partnerships liability of at least one partner is limited. While in general partnerships every partner is personally liable of the debts and obligations of the partnership, in limited partnership there is at least one general partner that has unlimited liability. Limited Liability Partnerships on the other hand are also a type of partnership in which all of its partners have limited liability in contrast to Limited Partnerships. In comparison with Limited Partnerships, as a rule, every partner of the Limited Liability Partnerships has the right and possibility to be involved in the decision making procedure of the LLP while in Limited Partnerships generally only the general partner has the right to make decisions whereas the limited partner only makes a financial contribution.

Because they are meant to address the shortcomings of general partnerships, such as the absence of a legal body and the lack of restricted responsibility for partners, LPs and LLPs may be appropriate for for-profit DAOs.

Limited partners and general partners are the two sorts of LP partners. General partners have unlimited responsibility, but limited partners do not. Limited partners cannot participate in management in exchange for limited responsibility. A management decision would involve participating in a decision to approve or veto LP investments if the value of the investment is less than half the value of the limited partnership's assets prior to the investment. LPs, on the other hand, have limited utility for DAOs and are not an acceptable legal structure for the majority of DAOs. For instance, they are not suitable for not-for-profit DAOs.

LLPs are akin to LPs, in that they normally have just one type of partner, although all partners can participate in management if they agree. The capacity of all LLP partners, and hence DAO members, to participate in management appears to make the LLP structure more appealing for for-profit DAOs than LPs.

Since LLPs and LPs provide a limitation on the liability of its partners, they appear as an eligible candidate to address the shortcomings of partnerships. Additionally, the fact that they are a separate legal entity enables them to conduct legal affairs, such as owning property and signing contracts.

Foundations

Foundations are non-profit organizations regulated differently in various jurisdictions, notably within the US states where they are a prevalent legal structure. DAOs prefer foundations over limited partnerships or limited liability companies.

In addition to foundations, Switzerland recognizes Swiss Associations as an option to foundations. A Swiss legal company has developed a framework for decentralized autonomous associations (DAAs) in order to better match the Swiss Association with DAOs by eliminating centralization points. Instead of the Association's board of directors, which has the authority to administer the Association's business, every member of the DAA community has the power to suggest new initiatives and vote on whether they should be supported. Since the voting is done on-chain, it cannot be overturned. If a proposal is approved, the outcome of the vote is carried out automatically, without the need for human intervention.

While the power of members to propose proposals and vote on them, as well as employ on-chain voting, appears to satisfy most DAOs and be an appealing legal framework for DAOs, DAAs have strict limitations for DAOs. The key limits are that the association is restricted to one vote per member and that membership is difficult to obtain.

Another restriction would be that DAO tokens would not be freely transferable. A person must have Swiss residence or have visited Switzerland within the preceding three months to become a member of a DAA. Furthermore, the DAA requires one DAA delegate, a real person, to undertake activities mandated by Swiss legislation.

Business Trusts

Some states in the United States consider business trusts to be independent legal entities, allowing them to sue and to be sued. In contrast, business trusts, known as trade trusts in New Zealand and other jurisdictions, cannot be registered and are not legal organizations. The drawback of business trusts or trading trusts is that the individuals or businesses owning trustee tokens act as a centralized element.

A business trust's constraint is that people holding trustee tokens can transfer the DAO's property, which on the surface would violate the objective of a DAO because no single person should be able to transfer or otherwise dispose of the DAO's property. However, because there would be various trustee tokens, there would be multiple trustees rather than a single or a few trustees. Nonetheless, token holders are exposed to the trustee's activities. If a DAO used such a structure, it would also practice delegated democracy since token holders would delegate decision-making to the trustees. This may work for certain DAOs, but not all.

Furthermore, trustee token holders may face personal responsibility, and while they may have a right of indemnification against the DAO's assets, the DAO's assets may be inadequate.

Some jurisdictions treat business trust as a legal entity and some don't. If business trust structure is to be applied to DAOs, then, various problems arise. First of all, holders of the trustee tokens may exercise some right over the DAO’s assets. Additionally, trustee token holders can be held personally responsible for the DAO.

Limited Liability Corporations, LLCs

Since some DAOs have been registered as LLCs in the United States, this section concentrates on them. LLCs are controlled at the state level rather than the federal level, so law differs by state in the United States. As a result, there is no consistent handling of LLCs in the United States.

LLCs are a hybrid of a partnership and a corporation that sprang from partnership law and have become a popular legal form in the United States. While LLCs are not incorporated corporations, they are registered entities that provide their members with limited liability. They are not taxed individually, and the terms of each DAO may be customized, much like a partnership agreement. Thus, unless the applicable LLC Act or the LLC's operating agreement allows for such a power, members of an LLC will be unable to remove a member.

Due to its constraints, the LLC is not a great vehicle for DAOs. First, while DAO members are not individually accountable for the LLC's obligations, they may still be liable for their own torts, such as if a member designed a smart contract poorly. Second, even if a shareholders' agreement provides for the elimination of a board of directors, at least one shareholder must be a natural person, meaning an individual human being.

Third, registering a DAO as an LLC is not final since the registration can be withdrawn. For example, in Delaware, the Attorney General can commence procedures in a court to cancel an LLC's certificate for misuse or abuse of its limited liability company powers, existence or advantages. Fourth, unless the founders of a DAO engage the services of an organization that provides LLCas-a-service, the cost of developing an LLC operating agreement can be considerable since DAOs would be needed to draft their own LLC operating agreement. Finally, while the LLC may work for certain for-profit DAOs, it may not function as well for non-profit DAOs. Indeed, as we have seen, other DAOs have adopted other structures, such as foundations.

Despite their restrictions, LLCs are the most appropriate legal structure for for-profit DAOs of all the legal structures examined thus far.

Since LLCs are regulated differently by each state, there is no uniform set of rules regarding DAOs. However, regulations set forth by different states don’t significantly differ from one to another. Also, LLCs provide a substantial amount of limitation on the liability of DAOs’ members. On the other hand, they are subject to a wholly regulated structure which limits the flexibility of DAOs. Additionally, due to their profiting nature, LLCs are not an applicable legal structure for non-profit DAOs. Despite its downsides, LLCs appear as the most appropriate legal structure for for-profit DAOs.

Unincorporated Non-profit Associations (relevant to United States only)

If a state has adopted the Uniform Unincorporated Nonprofit Association Act, an unincorporated nonprofit association can own property, enter into contracts, sue and be sued. Accordingly, Wisconsin, Colorado, Delaware, the District of Columbia, Hawaii, Idaho, Texas, West Virginia have adopted the Uniform Unincorporated Nonprofit Association Act. For the states aforementioned, who adopted the Uniform Unincorporated Nonprofit Association Act, the unincorporated non-profit is treated as a legal entity.

An unincorporated non-profit is a separate legal organization under the Revised Uniform Unincorporated Nonprofit Association Act, which has been approved by various states. The ability to register unincorporated non-profit associations in US states avoids the issues that unincorporated societies face in Australia, New Zealand, and the United Kingdom, such as the inability to hold property, enter into contracts, sue and be sued, and the potential liability of members for the society's or association's debts and wrongs. As that being said, the formation of the DAO shall be non-profit in order to fall in this category.

Worldwide regulations regarding DAOs

1. Türkiye

In this section, applicable legislation in Turkish Law to the DAOs (if any) will be examined. Before getting started, it is necessary to underline that legal opinions set forth in this section are mostly based on the common features of the DAOs. For each specific DAO a new and specialized legal opinion shall be constructed.

In Turkish Corporate Law, companies are set forth in accordance with numerus clausus principle. There are two main branches of corporate law, namely equity/stock companies and partnership companies. Companies such as LLCs, incorporated companies and partnerships that fall into the scope of either equity companies or partnership companies are strictly regulated. Their procedure of establishment, governance and rights and obligations of its partners or shareholders are rigidly regulated. In order for an organization to be accepted as one of these companies, there shall be clear legislation that makes it possible. Unfortunately, since there is no regulation regarding the legal characteristics of DAOs, it is not possible to evaluate DAOs within these types of companies. However, this doesn’t mean that there is no applicable regulation in Turkish Law to DAOs.

In Turkish Corporate Law, companies are strictly regulated. Only the types of organizations that are foreseen and regulated under Turkish Law can be established in Türkiye. Their establishment, governance, rights and obligation of its partners and shareholders are decided by the law. Due to the lack of legislation, DAOs are not seen as a company under Turkish Law. Beware! This does not mean that there are no applicable regulations to DAOs.

In Turkish Law there is a type of organization called ordinary partnership which is also known as unlimited company or unincorporated association. According to the Turkish Code of Obligations article 620/2: If a partnership does not have the distinctive features of partnerships regulated by law, it is considered as an ordinary partnership subject to the provisions of this section.” Since the DAOs are not legally foreseen by the law, the only applicable piece of legislation regarding them in the manner of corporate law is the provisions that are set forth for the ordinary partnerships.

The Turkish law system accepts partnerships that do not fall into the scope of regulated ones as an ordinary partnership. Since DAOs can’t be regarded as regulated partnerships or corporations, rules and principles regarding ordinary partnerships will be applied to DAOs.

Formation of Ordinary Partnership and Evaluation of DAOs in This Manner.

Ordinary partnerships are based on an agreement which is to be concluded amongst its partners. There is no specific requirement for a partnership contract that shall govern the ordinary partnership. These ordinary partnership agreements may be both written or in any other format. So, even the actions that can be regarded as an acceptance of ordinary partnership may be enough for an organization to be possibly considered as ordinary partnership. Since there is no specific requirement for the formation of an ordinary partnership, DAOs and their way of bringing people together is quite eligible to be considered as partnership formation.

For ordinary partnerships, there is no written form requirement. Even the actions of people can be regarded as the formation of an ordinary partnership. Lack of written form requirement increases the possibility of DAOs being accepted as ordinary partnerships.

As a rule, these ordinary partnerships are formed with at least two people. Also, there is no limitation regarding the number of partners. In theory and sometimes in application, an ordinary partnership may have hundreds or even thousands of partners. As explained above, DAOs are the organizations where people across the whole world get together to accomplish something for some reason. In this way, DAOs again fall into the category of ordinary partnerships.

In terms of capital, partners of an ordinary partnership are obligated to provide a capital for the partnership to pursue its founding reason. Partners of the ordinary partnership may bring any thing that is of economic value. Even though ordinary partnerships do not have a legal personality, the capital generated from the input of partners are allocated for the activities of the ordinary partnership to accomplish its purpose. In exchange for providing the capital, the title of partner is given to providers. In the case of DAOs, DAOs’ governance tokens or assets that give out partnership rights and obligations to the holders are mostly purchased via the cryptocurrencies. Therefore, the transaction concluded to send cryptocurrencies to an address via smart contracts in exchange of DAO governance token may be eligible to be considered as an act of providing a capital.

In ordinary partnerships, there is no limitation on the number of partners possible. Since DAOs tend to have many members, ordinary partnerships are flexible and applicable in this manner. Also, partners of ordinary partnerships are obligated to provide a capital which can be anything that has an economic value. In the context of DAOs, tokens or assets that give out partnership rights have the strong possibility to result in the acceptance of holders as a partner.

In conclusion, according to Turkish Law, it is possible to consider the DAOs as ordinary partnerships. Since DAOs meet the criteria of at least two people gathering up for a common purpose via providing a capital or something that has economic value, the rules regarding the ordinary partnerships are applicable.

Applicable Specific Regulations Regarding Ordinary Partnerships for DAO

According to article 622 of the Turkish Code of Obligations, partners are obligated to share the earnings of the ordinary partnership between each other. Since most of the DAOs are established to make a profit or generate an income, the question of sharing the profit is essential. If the DAO makes profit, then, this profit or earnings shall be shared amongst the DAO governance token holders in accordance with the amount of token they hold.

According to article 624 and 625 of Turkish Code of Obligations, decisions that have to be taken to govern the ordinary partnership should be taken by the partners. The quorum needed to make these decisions may vary depending on the agreement between the partners of the ordinary partnership. Also, the governance of the ordinary partnership may be left to a specific group of people. In the perspective of DAOs, decisions are generally made according to the choices of the partners mostly in a democratic manner. So, provisions that are foreseen for the ordinary partnerships provide the necessary flexibility for the decision-making procedures of the DAOs.

B. Wyoming

In July 2021, Wyoming passed a law allowing the establishment of DAOs for the first time in the world and became the first state to recognize DAOs as limited liability corporations (LLCs) within the United States. Thus, in Wyoming, DAOs gained legal status as limited liability companies and were recognized by state authorities. In this context, although some additions are made to the law regulating limited companies in Wyoming, the rules applied to limited companies in the law can also be applied to DAOs unless otherwise stated. Such as articles of Association, members' rights, duties, relationships, voting rights, DAO activities and how they are carried out, ways to change articles or articles of association, distributions to members, transferability of membership interests, member contributions, liquidation and distributions to members after termination, changing, updating smart contracts or regulatory procedures. Most of the information needed to run the DAO will be available in the Whitepaper of the organization that created the DAO and announcing its benefits to potential members.

Wyoming, being the first state in the U.S. to recognize DAOs, allows DAOs to be established as a LLC. Therefore, relevant rules and principles regarding LLCs will be applicable to DAOs that are established as LLC.

According to the regulation, DAOs shall be recognized as a company, DAOs can own real-world assets, the rights of stakeholders and the functioning of the DAO shall be legally protected by contracts, DAOs shall carry out legal transactions between each other, employ workers, and have an account in a bank. DAOs shall be able to open a document, sign a document, that is, operate like a legal person.

DAOs that are established as LLC have a legal personality and therefore can own assets and be entitled to have legal affairs with one another on their own.

Apart from that, according to Wyo. Stat Ann article 17-31-109, DAOs can be "algorithmically managed" by the underlying smart contract without human intervention. The DAO is not required to disclose the operation of the smart contract or contracts used to run the DAO's business, but the law requires that the underlying smart contracts be "amended or otherwise editable". This requirement can pose a challenge for many DAOs because one of the main advantages of using blockchain and smart contracts is that the record is immutable. Given this situation, it is not possible to change contracts easily without a completely new contract to replace the previous version.

According to the Wyoming laws, DAOs’ don’t have to disclose their smart contract. However, the same law requires DAOs to have an editable smart contract, which to some extent is contrary to the philosophy of blockchain based smart contracts.

Another issue mentioned in the law is that the members should be aware that the law specifically hinders their right to examine the records. Since transactions made under the DAO are transparent on the blockchain, additional document transparency will not be required.

C. Vermont

The Vermont Limited Company Act provides that DAOs can be registered as Blockchain Based LLCs (BBLLC). A BBLLC is a DAO that has been incorporated in Vermont as a Limited Liability Company (LLC). This act allows a DAO to enter into legally binding contracts and protects its owners, managers, and blockchain participants from unwarranted liability. As a result, general LLC provisions apply to BBLLCs. The key development in this act is that company governance can be provided entirely or in part through blockchain technology. The act also recognizes the use of blockchain-based smart contracts for voting on BBLLC operations and activities.

D. Tennessee

Tennessee followed Wyoming's lead and enacted its own DAO law. The entity type in Tennessee's legislation, on the other hand, is referred to as a "decentralized organization," or "DO." DO LLCs are subject to Tennessee's ordinary LLC legislation as well. In many ways, Tennessee law is extremely similar to Wyoming law.

E. Marshall Islands

In February 2022, the Marshall Islands officially recognized DAOs. As a result of amendments to the non-Profit Entities Act, which came into force in 2021, DAOs can be established as non-profit limited companies and memberships can be registered on the blockchain. The first legal DAO on the island was registered as Admiralty LLC of Shipyard Software, a DeFi-focused infrastructure developer.

F. Australia

Currently, DAOs do not have legal personality in Australia. At Australian Blockchain Week on March 21, 2022, Senator Andrew Bragg spoke of the legislator's intention to draft regulation regarding DAOs. This regulation is expected to exclude algorithmic DAOs and is considered to be applied retroactively after a transition period. For now, a DAO can only benefit the relevant regulations by becoming a legal entity that would be recognized in Australia.

G. Switzerland

There is no specific legislation for DAOs in Switzerland at this time. Because there is no specific legislation adjusted to these new types of entities, we must rely on the existing laws to understand them in the legal order. DAOs as organizations should be acknowledged and qualified under private international law in order for their legal effects to be defined in Switzerland. The Swiss Private International Law Act (PILA) thus governs the recognition of foreign DAOs in Switzerland. The concern of a DAO being recognized as a validly formed company is the foundation of its presence as a subject of obligations and rights without which a DAO cannot perform legal acts or institute legal proceedings. According to Maltese and Vermont legislation, regulated DAOs are adequately structured under Art. 150 PILA to qualify as companies under private international law. As a result, if a regulated DAO is validly formed under the law under which it is organized, it can be recognized in the Swiss law order under Art. 154 par. 1 PILA.

SEC and Regulatory Uncertainty

The SEC considered how the DAO's tokens should be treated under securities laws. The SEC defines a "security" as "an investment contract," which is a monetary investment in a common enterprise with a reasonable expectation of profit from the efforts of others. Although buyers of The DAO tokens could vote on proposals presented to them, they were relying on the people who created the structure and the "directors" who chose which proposals to vote on. The SEC concluded that the voting rights granted to these ownership interests were similar to those of a corporate shareholder due to the wide dispersion of ownership of the DAO tokens and the anonymity of their owners. As a result, interests such as the DAO tokens are typically required to be registered under securities laws.

Should a DAO Seek a Legal Entity?

In terms of liability, becoming a legal entity may not be favorable for some members of a DAO. It depends on the choice of the legal structure and the favorable options of such legal structure shall be considered at the meantime. Please see our questions below and make an assessment whether you would prefer to become a legal entity. Also, there is a table below which shows the possible phases of a DAO. You may compare your DAO’s situation and decide whether you should establish a legal entity or not.

The question itself is somehow tricky. To answer this question, one shall examine why a DAO would want to have a legal entity. Also, how a DAO is able to seek a legal entity is one of the most crucial questions that members of a DAO shall ask before taking an action. With different types of corporations and partnerships come various liability regimes, rights and obligations.

For example, in case of having a legal entity due to be considered as ordinary partnership, partners of the ordinary partnership are personally and fully liable for the debts of the ordinary partnership. In a different example, if the DAO is regarded as an incorporated company, then, the shareholders of the DAO will be liable only for the amount of capital shares that he/she has committed. So, in terms of liability, creating a legal entity may not be always favorable for the members of a DAO.

One other thing that also has to be taken into account before taking an action is whether a DAO wishes to conduct legal matters that require a legal entity or not. For example, if a DAO wants to sue someone, then, as a rule, it needs to have a legal entity. Moreover, if a DAO wants to own property or employ an employee then, again as a rule, a legal entity is a necessity.

To summarize this section, here are some fundamental questions that members of a DAO should ask themselves:

• As a DAO, do you wish to enter into legal relations with other natural persons or legal entities?

• Do you want your DAO or yourselves as the side of possible legal relations?

• As a member of a DAO do you want to create a separate legal entity for your DAO that enables its members to have limited liability or do you want to risk the possibility of being considered as partnerships and therefore personally liable of the debts and obligations of the DAO?

• Do you want your DAO to own property, to have a bank account?

• Do you want your DAO to be eligible to pursue its rights before courts and other relevant legal and administrative authorities?

• Depending on the actions your DAO takes and debts and obligations that it undertakes, is the risk of being personally liable for the debts and obligations of your DAO affordable and foreseeable?

• Are you ready to afford, to undertake and to provide the legal and administrative infrastructure to conclude the bureaucratic, monetary and legal procedures of establishing a legal entity? Considering your actions, revenues and profits, is establishing a legal entity for your DAO affordable and worth it?

• In what jurisdiction do you wish to establish a legal entity for your DAO? Are you qualified to establish one according to that jurisdiction? Do you have the legal infrastructure and resources needed for such an action?

• To what extent the legal obligations, procedures and liabilities comply with the way your DAO wishes to operate?

• Does your DAO plan to develop and air an application of any kind? If yes, are you planning to do it via major intermediaries such as Google Store, Apple Store, or any kind of intermediary that functions as a marketplace for apps?

In the case of saying yes or giving relevant answers in favor of establishing a legal entity to the questions above, then, it is probably time to think of seeking a legal entity for your DAO.

First of all, explanations regarding this table shall be examined at utmost care. Every DAO has unique features, therefore, please do contact your legal advisor.

Even though we strongly urge DAOs to have legal entity, if your DAO falls into the scope of Level 0-2 and doesn’t own a considerable amount of assets, then, your DAO probably will be fine without having a legal entity. As a DAO progresses and evolves, the liability of their members increases. After becoming a Level 3 DAO, obligations and debts a DAO tends to undertake vastly increase. To avoid unexpected personal liability, establishing a separate legal entity for the DAO is strongly recommended.

Risks of Having and Not Having Legal Entity

As mentioned above, liability for members is a risk. One may want to put forward the entity instead of its members when it comes to being liable for DAOs’ actions. If an entity is not legally acknowledged, as a rule, it cannot be a party of a contract or own property. If a DAO wishes to participate in such businesses, it is best to seek a legal entity.

The idea of legal entities emerged with the industrial revolution and growing need of coming up with a method of creating great amounts of capital via small individual savings. With the legal entity idea, a new entity which is entitled with rights and obligation, assets and liabilities formed. This legal entity is independent from real persons and in theory acts on its behalf.

In case of a DAO not having any legal entity, it may easily result in holding the founders or even the participants of the DAO as solely and personally responsible. With the legal entity, this liability shifts from real persons to the entity itself and the real persons who participate in the entity are generally liable for the damages up to the amount that they committed. So, if a DAO does not have a legal entity, then, it is quite possible for it to be considered as an ordinary partnership and therefore a huge risk of liability for its founders and partners may emerge. Even though these said risks are sometimes hard to foresee and calculate, in the event of considering a DAO as an ordinary partnership, partners of the partnership are fully and personally liable for the debts and obligations of the DAO. To clarify, if the DAO fails to fulfill the debts and obligations it undertook, then, the partners are responsible to indemnify these debts and obligations. In this context even the personal and financial assets of a partner may be subject to liquidation. Depending on the amount of debt and obligations that a DAO undertakes, the risk may be roughly estimated. In conclusion, in the possibility that a DAO lacks a legal entity, as the amount of debt and obligation a DAO undertakes increases, the personal liability of the partners are increased accordingly. Depending on the said criterias, individual and specific examination shall be conducted for each DAO.

Furthermore, rights and obligations are generally entitled to those with legal personality. An organization that lacks a legal entity cannot pursue its rights and obligations via courts, or it cannot be part of legal relations. Moreover, it is not possible for an organization without a legal entity to be an owner of something.

To sum it all up, depending on how and under which name it gains legal entity, having a legal entity can be beneficial for the participants of a DAO for liability issues. With the legal entity established, the liability of the debts and other not preferable obligations shifts to the legal entity to some extent. Also, since the DAO with no legal entities cannot sue or be sued, the risk of not effectively pursuing or defending the rights of the DAO may emerge.

Main risk of having a legal entity for DAOs is the fact that with a legal entity comes a serious number of legal regulations and bureaucratic actions. For example, if a DAO is registered as an incorporation or limited liability corporation, almost every legal norm that is applicable to classic incorporations or limited liability corporations will be applicable to the DAO too. Also, the registration of a DAO as an LLC or something else is another bureaucratic and sometimes expensive procedure.

How to Create a Legal Entity for a DAO?

If you want your DAO to be part of legal relations such as being part of a contract, employing persons, owning assets, pursuing its rights in courts, then, you want your DAO to have a legal entity. With the DAO having a legal entity, it also means that founders and participants of the DAO will know the lengths of their liabilities. One other crucial perk that having a legal entity provides is the fact that the applicable law and regulations will be clear. There will be no room for discussion about the legal status of the DAO, which will provide serious clarity and predictability.

Depending on where you reside, challenges of creating a legal entity for a DAO may vary. There are two main pieces of legislation set forth in the U.S.A, namely Wyoming and Vermont. For example, in order to create a legal entity for the DAO in Wyoming, the DAO must be registered. In addition to the many other documents, statements and information for classic LLCs, information regarding the governance of the DAO via smart contract and a statement establishing how the DAO shall be managed by the members, including to what extent the management will be conducted algorithmically, must be issued. Also, to register a DAO in Wyoming, one must also have a Wyoming registered agent who meets the statutory requirements.

In conclusion, if you decide to create a legal personality for your DAO, you may establish your DAO as an LLC in Wyoming or Vermont. The requirements to establish a classic LLC in Wyoming and Vermont is the same for the establishment of a DAO as an LLC. Any person, even if they are not U.S. citizens, may establish a DAO LLC and start a business in the U.S.A.

Comparison Table for Possible Scenarios

LEGAL DISCLAIMER

THE INFORMATION PROVIDED IN THIS PAPER PROVIDES GENERAL INFORMATION AS TO THE POSSIBILITIES IN MULTIPLE JURISDICTIONS. PLEASE KEEP IN MIND THAT LAWS THAT APPLY TO THE SUBJECT HEREIN MAY DIFFER IN EACH JURISDICTION. THUS, NOTHING CONTAINED HEREIN CONSTITUTES ANY LEGAL OPINION OR SUGGESTION OF ANY KIND. PLEASE CONSULT TO LOCAL EXPERTS IN RELEVANT AREAS BEFORE TAKING ANY ACTION BASED ON ANY INFORMATION CONTAINED HEREIN.