Just weeks into 2018, cryptocurrencies continue to dominate the headlines while on their way to potentially becoming mainstream. The complexities of these digital financial instruments present significant risks that are little understood, including their potential effect on matrimonial and commercial litigation proceedings.
Although Bitcoin (BTC) has been around for almost a decade, it only recently became a household name. While Bitcoin and several other cryptocurrencies are gaining recognition, there remains a significant level of misunderstanding and misinformation about this new disruptive technology.
As with other disruptive technologies, it takes time for their full implications to be understood. Failing to recognize all the implications and associated risks can be financially disastrous.
To better appreciate the risks associated with cryptocurrencies, it is necessary to have a basic understanding of how the technology works. There are currently over a thousand different cryptocurrencies, but most of them function like Bitcoin. Bitcoin uses a network of individuals and groups that each keep a complete copy of the blockchain (transaction ledger) and securely add new transactions.
They are referred to as “miners” because they compete to uncover the solution to a complex math problem in order to add the next block on the blockchain. When they do, they are rewarded with newly created “bitcoins”; hence, they “mine” bitcoins. All of the miners are competing simultaneously to solve the problem and add the next block of transactions.
Only the first one to successfully solve the problem is rewarded. Each cryptocurrency network determines how much that reward is and how often blocks are mined.One risk that must be understood about cryptocurrencies is that they are developed and run by communities without governmental or corporate oversight. Even the original creator(s) of Bitcoin, known only by the pseudonym Satoshi Nakamoto, remains anonymous.
Sometimes the community decides to change the rules of the network, making it incompatible with the existing rules. This is called a “hard fork,” because anyone who does not update to the new rules can no longer participate in the network.
Sometimes, only part of the community agrees with a change and the community splits, with one faction adopting the new rules and the other faction maintaining the old rules (referred to as a “hard fork split”). When this happens, the network is duplicated and a new cryptocurrency is formed.
Recently, for example, a long dispute about the number of transactions to include in a bitcoin block resulted in a group updating the rules to include more transactions. Not everyone wanted the change, so the hard fork resulted in the first faction splitting off, thereby creating Bitcoin Cash (BCH).
Interestingly, individuals who owned bitcoins prior to the hard fork split were given an equal number of BCC after the split, because the entire blockchain was duplicated on the new network.
Owning a cryptocurrency does not give you a say in how that cryptocurrency is maintained. Theoretically, the community could decide to make drastic changes that are lucrative to one group, but adversely affect the cryptocurrency’s value.
This is especially true with newer, less mature cryptocurrencies.In addition to risks posed by adverse decisions made by the community, there are external security risks to cryptocurrency networks. In 2016 a hacker compromised a smart contract on the Ethereum (ETH) network and stole 3.6 million ether, worth more than $60 million at the time ($2.8 billion today).
Part of the community wanted to restore the ether to the rightful owners, but others did not want to violate a core tenet of cryptocurrencies, which is that transactions can never be reversed. This conflict ended in a hard fork split, with Ethereum Classic (ETC) absorbing the result of the fraud, and the original Ethereum network restoring the coins to their rightful owners.
In November 2017, a self-described Ethereum “newbie” named devops199 took control of more than 900,000 ether worth over $300 million. When he realized what had happened, he tried to reverse the transaction and, in the process, locked those coins, effectively destroying them.
Once again the question the community will need to answer is whether it should undo transactions that are meant by design to be irreversible. Think about the risk of some unknown individual unintentionally destroying $300,000,000 of your assets without any recourse!Unlike other investment vehicles, cryptocurrencies are accessed using encryption keys, called “private keys,” which only the owner knows.
Whoever has access to the private key has complete access to the funds in the account. Unlike in a traditional banking environment, where you can call your bank if you forget your password, no one else has the necessary keys. If the key is lost, the cryptocurrency is effectively destroyed.
People have lost significant numbers of bitcoins. Even Elon Musk tweeted that “A friend sent me part of a BTC a few years ago, but I don’t know where it is.” Recently Chainalysis estimated that between 2,780,000 and 3,790,000 bitcoins are lost and no longer in circulation.
While there are currently exchanges that will store and manage your private keys for you, so far no institutions such as Bank of America or Wells Fargo are providing this service. This leaves individuals with the choice of putting their trust in less well known (and unregulated and uninsured) organizations, or taking on the security risks of storing their keys themselves.
There is already malware that specifically attempts to steal cryptocurrency keys from infected computers. There are also fake online cryptocurrency wallets that steal deposited coins if you store your private keys on those websites.
A cryptocurrency exchange like Coinbase (http://www.coinbase.com) holds the assets of more than 11 million users, making it an extremely rich target for hackers. As we have seen in every industry, digital security is not a simple matter. If an exchange is hacked, it is possible that all of your cryptocurrency could be stolen without any means for recovery.
ValuationAs cryptocurrencies have become widely traded, a market value for the common cryptocurrencies can be easily determined. Although market value provides a relatively simple basis to establish a value for these assets in matrimonial and other litigation disputes, due to the extreme volatility of cryptocurrency values, the date of valuation can have a substantial impact.
Bitcoin was trading at $19,345 on Dec. 15, 2017, one week later it dropped by 38 percent to $12,034, two weeks later it rose by 41 percent to $16,935, and then 10 days later it dropped back again by 33 percent to $11,358—this is not for the faint of heart!Aside from this extreme volatility, at times of high volatility there are liquidity issues along with large spreads between bid and ask prices.
Cryptocurrency keys and the value they hold are managed with wallets, using either computer software or online via a website. It is a simple matter to transfer cryptocurrency between wallets, with those transfers allowing for a high level of precision.
As bitcoins can be transferred in 0.00000001 increments, this can facilitate settlement of matrimonial matters, as it is possible to transfer an almost exact portion of holdings. Since it is easy and free to create new wallets, it would be advisable to move cryptocurrency assets to new wallets for which only the receiving party would have the private key.
This avoids any risk that accidental disclosure of a private key by one party could expose the assets of the other party to theft.Barriers to GrowthAnother risk to consider with cryptocurrencies is the inherent barrier to growth. Not every network is able to scale to handle increased transactions. Bitcoin is continuing to struggle with its limited block size.
Only a few thousand transactions fit into a block, and it takes 10 minutes for a single block to be added. This is causing a backlog of transactions and slow processing.
Fees per transaction are rapidly increasing because of the demand, which makes the network less tenable for small transactions. Imagine trying to replace the Visa network with something that can only process 15,000 transactions an hour at a cost of several dollars per transaction.
Another result of the small block size is that with the massive network of miners all trying to solve the same block, each transaction on the bitcoin network is estimated to require almost as much electricity as an average house does in a month.
This is because the network is designed to increase the difficulty of the problem everyone is trying to solve as more people are mining, which is why, on average, a block is added every 10 minutes. Without changes, it seems obvious that the bitcoin network cannot grow much larger than it currently is.
Bitcoin and the current cryptocurrencies are the Model T of blockchain technology. Bitcoin, for example, performs one task, which is to securely store a pseudo-anonymous ledger of transactions. Ethereum, currently the second most valuable cryptocurrency, has the capability to run programs on its blockchain, but it is the first iteration of that technology and far from mature.
Now that cryptocurrencies and blockchain technologies are becoming mainstream, there will be a massive influx of talent focused on developing the technology.
Large corporations and governments will begin funding research, resulting in rapid improvement and new innovations using the technology. In the future, bitcoin will appear dated compared to new technologies (remember the rotary telephone?).
Cryptocurrency is a revolutionary technology and only part of what the underlying blockchain technology is capable of. We are at the beginning of what is sure to be a wild ride that will lead to incredible innovation. However, it is important to understand that for all of the benefits there are also risks.
Only by understanding the technology and the risks it presents can informed decisions be made.
Paul is a partner with Szaferman Lakind in Lawrenceville, specializing in financially complex divorce actions.
Hirschfeld is the managing partner of Marcum LLP’s New Jersey Advisory Group specializing in matrimonial and commercial litigation matters. Baker is a senior manager and head of the Digital Forensics Practice in Marcum’s Philadelphia office.
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Just weeks into 2018, cryptocurrencies continue to dominate the headlines while on their way to potentially becoming mainstream. The complexities of these digital financial instruments present significant risks that are little understood, including their potential effect on matrimonial and commercial litigation proceedings.
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