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Blockchain and Distributed Ledger Technology (DLT): Overview, Practical Law Practice...

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Blockchain and Distributed Ledger Technology (DLT):Overviewby Practical Law*

Practice notes | Maintained | United States

A Practice Note providing an overview of blockchain and distributed ledger technology (DLT), including blockchainbasics, details on blockchain mechanics, and types of blockchains, as well as an introduction to cryptocurrency andsmart contracts.

Blockchain technology is a means of recordkeeping using a digital ledger that is often described as being:

• Encrypted.

• Decentralized.

• Distributed.

• Self-proving.

Blockchain technology is most commonly known as the foundation for the virtual currency Bitcoin. However, ithas rapidly and broadly permeated many industries worldwide and, therefore, has wide-ranging and profoundimplications in almost every area of the law. For details on how blockchain may be impacting your practice area, seePractical Law's Blockchain Toolkit and Update Tracker.

This Note provides an overview of blockchain and distributed ledger technology (DLT), including blockchain basics,details on blockchain mechanics, and types of blockchains, as well as an introduction to cryptocurrency and smartcontracts.

Blockchain Technology Defined

Blockchains are digital online ledgers that typically:

• Are implemented in a distributed fashion – that is, the ledger is distributed, or shared, across multipleindependent nodes of a network.

• Allow users to record transactions in a shared ledger.

• Follow established policies but lack a central authority or data repository.

According to the National Institute of Standards and Technology (NIST),blockchain technology:

• Groups cryptographically signed transactions into blocks of code that make up a digital ledger.

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Isabelle Chamberlain

This article belongs to Thompson Reuters and is reproduced with their permission. February 2021.



• Makes the ledger tamper-resistant and tamper-evident by cryptographically linking each block to theprevious entry after validation.

• Resolves conflicts automatically and instantaneously using established rules.

• Replicates the ledger so that it is copied across a network of independent nodes.

(Executive Summary, NISTIR 8202, Blockchain Technology Overview, NIST.)

Blockchain Basics

Blockchain is a real-time ledger system which is decentralized among multiple computers and multiple networks(each referred to as a node) allowing different parties to have a live copy of the ledger. Having a live copy of aledger means that it is updated automatically as transactions take place, and allows the tracking and recording oftransactions and assets without the use of an intermediary.

DLT is the foundation of blockchain. DLT offers a consensus validation mechanism by using a network of computers(nodes) that facilitates peer-to-peer transactions without the need for an intermediary or a centralized authorityto update and maintain the information generated by the transactions. Each transaction is validated by multiplenodes and is then added as a new "block" to an already existing chain of transactions, giving rise to the name"blockchain." Once a transaction has been added to the chain, it generally cannot be altered or removed (see Box,A Visual Representation of Blockchain).

Blockchain technology provides certain key transactional advantages and raises important considerations,including:

• Real-time records. Distributed ledgers are updated in real time as transactions and other events occur,with software automating the process. These features ensure that each network participant has its own up-to-the-moment record of transactions, which reduces opportunities for fraud. The automated process andlack of a centralized record keeper also increase efficiencies and generates cost savings.

• Immutable records. Blockchain technology enables entities to create permanent transaction records.Because these records are replicated across the entire network, for all practical purposes, they areimmutable. This ability offers an obvious commercial benefit, but it can also raise regulatory risk for someparties.

• Anonymity. Blockchain technology makes it easier for network users to be pseudonymous. This hasramifications for operators of networks subject to anti-money laundering (AML) and know-your-customer(KYC) regulations.

Blockchain Core Concepts and Applications

The core ideas behind blockchain technology emerged in the late 1980s and early 1990s. Software developerscombined the blockchain idea with other technologies and computing concepts in 2008 to create moderncryptocurrency, culminating in the launch of Bitcoin in 2009.

Cryptocurrency is the most widely recognized application of blockchain technology. However, many industries arealso exploring blockchain-technology-based solutions to enhance efficiency, streamline business processes, and

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develop trust between parties with little or no knowledge of each other. For example, blockchain technology cansupport:

• Smart contracts.

• Identity management systems.

• Supply chain solutions.

• Public records, such as property registers.

• Other applications, especially those that require sharing verified data among multiple geographicallydistributed parties.

• Improvements and enhanced efficiencies in securities, finance, financial services, and payment systems.

Blockchain presents an opportunity to reduce, streamline, and in some cases even eliminate the role of certainintermediaries and therefore reduce transaction costs. For example, at present money cannot be sent electronicallydirectly to a family member on a peer-to-peer basis. Peer-to-peer means from one person to another without afinancial intermediary like Western Union, PayPal, or Venmo. Financial intermediaries add time and, often, expenseto internet-based transactions. With blockchain, this time and expense can be eliminated without the loss of trust,security, and accountability that these intermediaries are designed to provide.

To support clients in assessing risks and making sound implementation decisions, counsel should understandseveral core blockchain technology concepts. Specifically:

• The distinction between public and private blockchains (see Public/Private and Permissionless/Permissioned Blockchains).

• Key blockchain technology characteristics, including:

• ledger distribution (see Overview of Distributed Ledger Systems);

• security measures (see Blockchain Security Measures); and

• consensus mechanisms (see Blockchain Consensus Mechanisms).

Overview of Distributed Ledger Systems

A distributed ledger is a system that enables independent participants (the nodes of the network) to reach consensuson the validity of a set of shared data in the absence of a central coordinator. Distributed ledgers are auditable,real-time digital listings of transactions or data that are made available or distributed to network participants. Theproduct of this consensus is a shared, append-only "ledger" (resembling a computer log file) that is constantlyupdated to reflect the addition of new data. Distributed ledgers can either be public or private, depending on whichparticipants are permitted to execute and validate transactions on the ledger.

While the terms blockchain and DLT are often used synonymously, a blockchain is actually a particular type ofdistributed ledger in which data (typically transactions) are grouped into blocks and then chained together inchronological order using a cryptographic mechanism known as a hash function. The process of chaining one block

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to the next across the entire distributed ledger creates a virtually irreversible record of all transactions that can bereferenced in the future to prevent users from double-spending their digital assets.

This technology:

• Gathers new transactions or other data into blocks.

• Validates them using a consensus mechanism, usually requiring:

• the participant adding the block to perform some form of work; or

• approval from the other participants; or

• both

(See Blockchain Consensus Mechanisms.)• Connects, or "chains," the new validated block to the blockchain using a cryptographic hash function.

• Updates the ledger.

Blockchain participants that maintain a copy of the ledger are generally known as nodes. Each node maintains oneor more current copies of the ledger on its system. Each node receives an identical copy of the updated ledger asparticipants add validated data.

Counsel should consider the potential legal implications, including the laws and regulations that may apply,according to how a particular ledger is geographically distributed. For example, the data localization and dataprotection laws and regulations in certain jurisdictions may limit whether and where organizations store certainkinds of transaction data.

How Blockchain Works

Like a spreadsheet that consists of data-filled rows and columns, a blockchain consists of blocks of data residing in adigital ledger on a network that is publicly or privately distributed to the network participants' computer systems (seePublic/Private and Permissionless/Permissioned Blockchains). Each network participant in the blockchain holds acopy of the complete ledger and its transactional history.

When a transaction in the blockchain or other change to the distributed network takes place, it is broadcast to allnetwork participants. The transaction is then validated and grouped into a proposed block that must be selected bythe blockchain network using its consensus mechanism (see Blockchain Consensus Mechanisms).

After this validation process takes place, the transaction is permanently added to the blockchain.

A Visual Representation of Blockchain




Public/Private and Permissionless/Permissioned Blockchains

While the original and most common vision of blockchain is of a fully public, decentralized, permissionless network,there are a wide variety of blockchain solutions, many of which are, in fact, either fully or partly private or requirepermission to join, or both.

The distinction between public and private refers to which members can access the blockchain in any capacity:

• Public blockchains are open to all (see Public/Open/Permissionless Blockchains).

• Private blockchains are open only to pre-approved members (see Private/Closed/PermissionedBlockchains).

The distinction between permissioned and permissionless refers to which members can add data (commonly in theform of submitting transactions and executing smart contracts) to the blockchain:

• Permissionless blockchains allow all members to add data (see Public/Open/Permissionless Blockchains).

• Permissioned blockchains restrict this right to approved members (see Private/Closed/PermissionedBlockchains).

Participants in public blockchains typically can only control their own nodes' locations. However, organizationsconsidering private blockchain projects may:

• Have some influence over most or all of the nodes.

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• Wish to build location requirements into the application's administrative governance structure.

Public/Open/Permissionless Blockchains

In a classic implementation of blockchain, copies of a complete ledger (the distributed database), which includesboth the current state of a network and its entire history, are distributed among many or all the nodes and updatedsimultaneously. Each node that elects to be a "full node" by maintaining a full copy of the blockchain has access tothe blockchain's entire database and complete history. No single party controls it.

Participants in this type of blockchain are pseudonymous. The blockchain associates unique identifiers withparticipants. However, additional information from outside the blockchain is generally needed to discernparticipants' actual identities. Security researchers, law enforcement, and others have had varying results inidentifying actual public blockchain participants.

Each time a user submits a transaction (a proposed change to the ledger), the data for that transaction is broadcastto the network and wait in a pool of unconfirmed transactions to be validated by validator nodes on the network(these validator nodes on the Bitcoin network are referred to as "miners" and validation is referred to as "mining").

Validator nodes must first independently check unconfirmed transactions against the blockchain's history to verifylegitimacy, using computational methods hard-coded into the network. Once transactions are verified, each validatornode groups them into a proposed block. For a block generated by a given validator node to be added to theblockchain (so that all nodes' ledgers are updated to include it), it must be selected by the blockchain networkusing its consensus mechanism. In the Bitcoin network, this is called proof-of-work and requires a miner to solvea complex computational challenge before all other miners can solve it for that miner's proposed block to be addedto the blockchain.

Once a block is selected using the consensus mechanism and verified by the network (see Blockchain ConsensusMechanisms), it is added to the blockchain, logically and inextricably linked to the chain of all of the verifiedblocks that preceded it and then distributed to all of the nodes on the network (see Box, A Visual Representation ofBlockchain). In doing so, the transactions embodied in the new block are etched across the network as the verified"truth" and the network's "chain" is extended. In this way, all of the full nodes have a complete copy of every validatedtransaction ever conducted through that network.

Once a new block is added to the chain, it cannot be modified without network consensus due to the cryptographiclinking of each block and its contents to all of the blocks that came before it. This fundamental feature of blockchainis often called immutability. Unlike centralized databases, a blockchain can be updated with a new transactionsubmitted by any node on the network (assuming it passes verification by the network), and each node's copy of thatupdated blockchain is identical to all other nodes'. Private/Closed/Permissioned Blockchains

For many reasons, including the ability of each node in a public or permissionless blockchain to view all data on theblockchain, purely public blockchains are unlikely to be adopted by enterprises. However, certain elements of publicblockchains are still likely to be found in enterprise applications.

Instead, companies have been creating private, closed, or permissioned blockchains which, while retaining theconcept of an immutable distributed ledger, are characterized by some different features, including that:



• The right to participate in the network is restricted to participants granted permission by the company orinstitutions authorized to transact on the network.

• Participants are likely directly identifiable, rather than indirectly identifiable or pseudonymous, becauseprivate blockchains typically use clear, vetted identities.

• Outside of the blockchain itself, participants may be parties to written agreements relating to their use of andinteractions with the blockchain. These agreements may include commitments covering:

• responsibility for maintaining the blockchain;

• remedies in case of technology failure or error; and

• governance matters.

• Different nodes may be allocated different permissions and powers, such as the ability to:

• decrypt and read only certain types or silos of data, rather than all data;

• modify the blockchain or its governance rules;

• participate as a transaction validator; and

• submit transactions to the network or, alternatively, be limited to read-only access.

• There may be some degree of centralization, with a primary organization or organizations managing,running, or maintaining the blockchain in some respects.

Public and private blockchains are not mutually exclusive. Hybrid blockchains combining attributes of both can beestablished.

Blockchain Consensus Mechanisms

Consensus mechanisms typically require a majority or other prescribed number of nodes to agree on whether:

• A new data block is valid and appropriate for inclusion in the shared ledger.

• The ledger and its entire history is currently correct according to the network's rules.

These functions mean that a properly implemented consensus mechanism provides a continuous check on theintegrity of both:

• New data blocks.

• Past ledger transactions.

Public blockchains typically use consensus mechanisms, such as:



• Proof-of-work, which uses a system of rewards to induce users to compete for the right to publish the nextblock by solving computationally intensive puzzles. For example, cryptocurrency miners invest in extensivedata centers and computing resources to:

• solve these puzzles;

• gain or "mine" rights; and

• earn rewards for their efforts, such as fees paid in cryptocurrency.

• Proof-of-stake, in which users' rights to publish new blocks is based on their current investment in theblockchain application.

Private blockchains generally use less complicated or computationally intensive consensus mechanisms, such as:

• Proof-of-authority, which verifies a node's identity.

• Simple delegation of authority for approving new blocks to certain trusted nodes.

• Allowing participating nodes to publish new blocks at will or on a rotating basis, subject to verification.

Each blockchain application establishes rules for creating new data blocks in the ledger (see Ledger Distribution).These rules:

• Establish procedures for validating the integrity of new data blocks before they can be added to the ledger.

• Apply across all nodes that participate in the blockchain, collectively known as the blockchain's network.

• Provide mechanisms, which are validation procedures that allow participants to agree on new data blocks.This agreement, or consensus, takes place in code using algorithms that implement the particular blockchainapplication's governance structure.

Blockchain Security Measures

For a variety of reasons, blockchain networks have proven to be targets for hackers. During the past couple years,blockchains have proven vulnerable to "majority" or "51%" attacks, as detailed in this Proskauer blog post.

Other blockchain security incidents have ranged from mundane service disruptions to more serious thefts ofsensitive data and valuable cryptocurrencies. Although the decentralized structure of blockchain networks makesthem more resilient against network-wide attacks or tampering, the enterprises and technology relating to certainblockchains have also been hacked or manipulated.

Blockchain security measures vary according to each individual application, but typically include:

• Public-private key encryption to manage participant access.

• Transaction data integrity protection within blocks using cryptographic hashes. The security technology alsorecords each block by tying it chronologically to the previous block and the following block. This measure:


https://www.blockchainandthelaw.com/2020/02/blockchain-51-attacks-lessons-learned-for-developers-and-trading-platform-operators/



• prevents data tampering within a block because any attempt to alter the data changes the hash values,which other participants can rapidly detect; and

• provides the immutability widely touted for blockchain-recorded transactions.

Specific blockchain applications may use different security measures that affect risk levels. Potential users shouldinvestigate and understand the security measures used by a particular blockchain application to avoid unexpectedvulnerabilities. Private blockchains require heightened security because they often have a less robust network ofusers, which is essential for policing attempts to mistakenly or intentionally introduce erroneous data into a publicblockchain.

Digital Assets and Virtual Assets on the Blockchain

There are a myriad of potential title and ownership interests that may be represented and transferred digitally usingblockchain – from intellectual property rights in music, art, and intangibles to ownership interests in real property,automobiles, and other vehicles. These are real-world assets the ownership of which is represented digitally on ablockchain. Title to these assets may be recorded and transferred on the blockchain.

However, at present, the primary assets based entirely on the blockchain are:

• Virtual currency and cryptocurrency (see Virtual Currency and Cryptocurrency).

• Digital tokens (see Digital Tokens).

Virtual Currency and Cryptocurrency

The terms virtual currency and cryptocurrency are often used synonymously. However, technically, cryptocurrencyis a subset of virtual currency. The term cryptocurrency implies the use of encryption to provide the required securityfor the currency. As a semantic matter, virtual currency may or may not be encrypted. However, as a functionalmatter, most digital currency usually involves some sort of encryption.

Virtual currencies and cryptocurrencies are digital representations of value that do not have a central issuing orregulating authority like a central bank, but instead use a decentralized system to record transactions and managethe issuance of new units. Many virtual currencies, including Bitcoin, the most well-known and commonly usedvirtual currency, are based on blockchain technology.

Virtual currencies and cryptocurrencies typically:

• Function as a medium of exchange between natural and legal persons that can be transferred, stored, andtraded electronically.

• Are issued and controlled by their developers.

• Are used and accepted among members of a specific virtual community.

• Exist in the form of digital tokens or coins.



• Lack legal tender status, unlike fiat currency, which is issued and recognized as legal tender by agovernment.

• Have a value that fluctuates, often wildly, like precious metals.

• Are encrypted for greater security. However, the blockchains supporting virtual currencies and, morecommonly, the exchanges that sell, trade, and hold these currencies, are increasingly being hacked.

Virtual currencies and cryptocurrencies have benefits, including:

• User identity masking. Most cryptocurrencies are likely pseudonymous and not truly anonymous becauseparticipants, although often not directly identifiable, may be discernible using additional information.

• Growing acceptance for a wide variety of financial transactions worldwide.

• Political independence, as they are not tied to a single government.

• Unlike other kinds of electronic payments such as credit cards:

• are transmitted instantaneously; and

• have lower transaction fees.

Although virtual currencies and cryptocurrencies have many useful features, because they lack uniform regulationand can facilitate hard-to-trace transactions, they are favored by criminals engaged in illicit activities, including:

• Tax evasion.

• The sale of counterfeit goods.

• Human and drug trafficking.

• Money laundering.

• Cybercrime.

Virtual currencies and cryptocurrencies are usually acquired either:

• Through an exchange for fiat currency (in other words, by purchase), which can be done in person orthrough an online exchange such as Coinbase.

• By undertaking activities, such as mining, completing online surveys, or responding to a promotion. Asnoted above, mining is a process of solving cryptographic strings in order to verify network transactions.Miners are rewarded with a certain amount of digital currency for each block of transactions that areverified.

Virtual currencies and cryptocurrencies are intended to be used anonymously, though transactions may be trackedby IP address and other data. For Bitcoin, every transaction is publicly shared and stored forever on a publicblockchain ledger, which is maintained on unidentified computer networks and available for inspection by anyone.



For updated tables tracking regulatory developments affecting virtual currency, cryptocurrency, and other digitalassets among applicable US and global regulators, including a state-by-state regulatory tracker, see Virtual Currencyand Digital Asset Regulatory Tracker. For details on the SEC's approach to regulating digital assets, see PracticeNote, Understanding the SEC's Digital Asset Framework and Approach to Digital Asset Regulation.

StablecoinsStablecoins are a type of cryptocurrency that is tied to the value of an underlying asset, most often a fiat currency likethe US dollar. While the value of many cryptocurrencies may be volatile, stablecoins are designed to limit volatilityby maintaining a fixed relationship (that is, a "peg") between a specified quantity of the stablecoin and a specifiedquantity of the underlying asset.

For example, a stablecoin might be pegged to the dollar in a 1:1 relationship. The peg is maintained by collateralizingthe stablecoin with reserves of the underlying asset. Stablecoins combine the benefits of cryptocurrency, includingtransparency, instantaneous transaction processing, low fees, and privacy, with the stability and trustworthiness offiat currency.

Stablecoins may be backed by:

• Fiat currencies. These are the most common type of stablecoin, which are fully backed by a fiat currency ata specified ratio. In September 2018, the New York State Department of Financial Services authorized theissuance of stablecoins by Gemini Trust Company and Paxos Trust Company, both of which are pegged 1:1 tothe US dollar (see Legal Update, NYDFS Authorizes Two Stablecoins). The issuer of a fiat-backed stablecoinmust maintain a reserve of the fiat currency, usually on deposit with a bank or other third-party custodian,equivalent to 100% of the amount of stablecoin in circulation.

• Commodities. These are backed by commodities, most commonly gold. The physical commodity backing thestablecoin is typically stored in a third-party vault.

• Cryptocurrencies. These stablecoins are collateralized by a mix of cryptocurrencies to minimize risk andvolatility and are often overcollateralized to further buffer against price volatility.

• A mix of fiat currencies, commodities, and cryptocurrencies. Issuers of these stablecoins aim to minimizerisk and volatility by diversifying the collateral pool that backs the stablecoin.

For further details on stablecoins, see Blockchain Cash Issuer Q&A with R3 Legal Center of Excellence. Digital Tokens

As blockchain technology has developed and proliferated, so have blockchain-based digital tokens. Digital tokensare typically not intended for use as currency or a means of payment, but rather as a means of access to, participationin, and investment in blockchain enterprises.

Digital tokens primarily take the form of:

• Utility tokens.

• Security tokens.









There is often overlap between these.

Utility TokensA utility token – also referred to as a digital token or, simply, a token – is a digital representation of value or rightsthat is offered and sold for the purpose of:

• Facilitating access to, participation in, or development of a distributed ledger, blockchain, or other digitaldata structure; and/or

• Raising capital for the development of the network or platform.

Utility tokens typically provide holders with the ability to access, via encrypted key, a particular blockchain ornetwork for purposes of:

• Accessing certain benefits or functionality on that blockchain or platform.

• Participating in or developing that blockchain or network, or an associated application, enhancement,related functionality, or related product.

Security TokensLike virtual currency or cryptocurrency, tokens may be issued by blockchain developers in an initial coin offering(ICO) or similar offering. These tokens may have value, and that value may rise or fall as the result of the efforts ofother parties. In many cases, therefore, utility tokens may have characteristics of securities. If so, they may be subjectto the US securities laws (see Practice Note, Understanding the SEC's Digital Asset Framework and Approach toDigital Asset Regulation).

Smart Contracts

Certain distributed ledgers also allow users to embed scripts of computer code into the ledger that executeautomatically if the conditions specified in the script are satisfied. These scripts are known as smart contracts.

Smart contracts can be run on blockchain platforms that are programmed to support them, and they automaticallyself-execute, verify, and enforce the performance of the agreed-on transaction. By using smart contracts, blockchainscan automate settlement of business transactions without human intervention and with limited counterparty risk.

Smart contracts may be:

• Entirely written in code.

• Incorporate some or all of a written natural language contract.

• Written in natural language with an encoded payment mechanism.

The Chamber of Digital Commerce, the world's largest trade association representing the digital asset and blockchainindustry, defines a smart contract as:






"[c]omputer code that, upon the occurrence of a specified condition or conditions, is capable of runningautomatically according to prespecified functions. The code can be stored and processed on a distributed ledger andwould write any resulting change into the distributed ledger."(Smart Contracts: Is the Law Ready?, Chamber of Digital Commerce, Sept. 2018.)

After a smart contract has been deployed by the creator, other users may interact with it to achieve a desired outcome.For example, a basic multi-signature smart contract would allow a transfer from one individual to another only if arequisite number of participants sign and approve the transaction.

Other basic examples may include smart contracts that only allow transfers:

• Up to a spending cap.

• Within certain time periods.

• To pre-approved persons, such as accredited or institutional investor accounts.

When smart contracts are based on a blockchain, they are typically:

• Irrevocable.

• Difficult to hack.

Benefits to using blockchain smart contracts include:

• Reducing counterparty risk.

• Reducing risk of error resulting from manual data entry.

• Increasing efficiencies.

• Reducing costs.

• Eliminating go-betweens like banks and insurance companies in common financial transactions.

• Increasing data security and privacy.

Smart contracts also carry risks, including:

• If entirely code-based, it may be difficult for courts applying traditional contract law principles to interpret acontract or determine whether a contract has been formed or breached.

• Although smart contracts can be difficult to hack, the risk of hacking is not entirely eliminated.

For a practical explanation of how blockchain smart contracts work and an examination of issues presented by theapplication of traditional contract principles to smart contracts, see Practice Note, Smart Contracts: Best Practices.

*This Note is based in part on material contributed by David J. Kappos, D. Scott Bennett, and Michael E. Mariani,Cravath, Swaine & Moore LLP; Jeffrey M. Amico, Fluidity; Vincent Molinari, Christopher Pallotta, AnnemarieTierney, and Peter Chiaro, Templum Inc.; Michael J.W. Rennock, Alan Cohn, and Jared R. Butcher, Steptoe &Johnson LLP; Claire M. Blakey, Paul Hastings LLP; and Adam Greetis, Seyfarth Shaw LLP.

https://digitalchamber.org/smart-contracts-paper-press/




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