Crypto-assets are subject to sharp volatility. Last Friday, 13 May 2022, Bitcoin (BTC) devalued by more than 50% from the historic highs of November 2021, when 1 BTC was worth more than 67,000 $USD. In the history of its price in $USD, three devaluations of more than 80% have occurred: April 2013, January 2016 and December 2018, always related to specific events, including a tweet by Elon Musk. To date, the aforementioned depreciations have always been overcome, and have boosted the cryptocurrency to successive highs in terms of value.
Notwithstanding such sharp devaluations, BTC is usually recognised as the safest investment in terms of volatility. It is therefore fair to say that anyone who acquires any crypto-assets, whatever their purpose, faces the very serious risk of market variations in value. Positive variations create the new multimillionaires; negative variations can destroy life savings.
It is in this scenario that stablecoins appear. These are designed to ensure a certain parity with the value of legal tender currencies (for example, 1 token = 1 $USD), and thus provide their “owners” with a safe harbor against variations in value. The best known are the collateralised stablecoins, of which Tether (USDT) is the most representative, with a market capitalisation of $USD 75.68Bn. The stabilisation of the value of these coins occurs because they are backed by reserves that secure this value. The holder of 1 Tether can redeem this token, being given 1$USD that it represents.
Although Terra (UST) was also a stablecoin, it was not collateralised. Rather, it was an algorithmic stablecoin, in which its value was secured by a smart contract linking UST to another crypto-asset, Luna. The protocol always ensured the possibility of converting UST for the 1$USD worth of Luna, and vice versa. The conversion would simultaneously imply the redemption, destruction, of the token sold and the creation, minting, of the token purchased. This mechanism consisted of an incentive to arbitrage, designed to place the value of Terra at parity with the US dollar. Situated below $USD, UST holders would buy Luna, to make a capital gain corresponding to the difference in value to the $USD. Simultaneously they would cause a reduction in the supply of UST, increasing its value. Whenever above 1$USD, the Lunatics would buy Terra, to benefit from the difference with respect to the dollar and, increasing the quantity of Terra in circulation, they would lower its value. None of this functioned under extreme market conditions, in which the investors wanted neither Terra nor Luna, but rather to abandon the protocol. On 13 May, Terra was worth $USD 0.0520 and was suspended from several exchanges.
Smart contracts and litigation on crypto-assets
It is frequently said that smart contracts are self-executing and that, by eliminating the risk of non-performance, they will disintermediate lawyers and courts. Nothing could be less accurate. A legally binding contract always implies an agreement for the creation of legal relationships which, expressly or tacitly, is executed in natural language, i.e., understandable by human beings. Blockchain programming can translate, in a better or worse way, the automatic execution of that agreement. If it does not translate well, the automatic execution is not performance, but breach of contract or unjustified enrichment. All remedies under the Law shall be applicable and litigation is inevitable. Code is Law, but the Law comes first.
From the hacking of the DAO, in 2016, the misappropriation of NFTs that recently gave rise to the recognition of NFTs as property by the UK High Court of Justice, to the failure to obtain the promised stabilising effect, and the uncertainty as to the destination in the use of BTC reserves, in this Terra-Luna case, it is more than clear that the execution of smart contracts, irrespectively of the Code, may amount to breach of contract, with legal consequences. In exactly the same way that a vending machine programmed not to deliver “coke” after receiving the currency from the customer implies breach of contract between seller and buyer, even if it is programmed to do so. Litigation with crypto-assets is only in the beginning, and lawyers and Courts with dspecialized skills are increasingly necessary. In fact, very important issues are raised from the outset, from the jurisdiction of the Court, the importance of gathering evidence, a careful preparation of the litigation that will certainly be determinant for the final outcome and a thorough and specialized knowledge of the applicable legislation that will certainly make a difference. All this becomes especially relevant when we are dealing with a new type of litigation, fairly unknown to the Courts.
What seems certain is that this type of litigation starts to be won even before the judicial process is initiated, which is why a correct preparation of it is decisive.
Regulation and gray areas
The promise of future conversion of Terra and Luna, at the pre-fixed value of 1 $USD, underlying the protocol, seems to rely on a derivation technique similar to other derivatives that are financial instruments. The question is: does execution by a smart contract change the nature of that derivative? The SEC has already announced supervisory and sanctionary measures against Do Kwon, founder and CEO of Terraform Labs, as it believes that the promise to stabilise the value of the Earth may constitute a security for the purposes of US securities legislation.
The classification of crypto-assets is one of the most complex issues in the analysis of blockchain related projects, and such classification, form a legal perspective, is of a fundamental importance, as it triggers the legislation that will be applicable and, often, the responsibility or irresponsibility of the project promoters.
A careful regulatory legal analysis should be by design and by default a key component of the project. Also here, if this fundamental steps are not taken, litigation involving crypto-assts, also in Portugal, will only be a matter of time.
Taxation of crypto-capital gains
Speaking of panic: the Portuguese government announced the taxation of capital gains from investments in crypto-assts. Due to a loophole in tax legislation, Portugal benefited from an involuntary marketing effect that had the extraordinary consequence of bringing countless international entrepreneurs to our country. These are not speculative activities: they are people who bring capital, technological resources and knowledge – in areas as diverse as e-commerce, gaming, digital art, philanthropy, digital identity, etc. – which have allowed Portugal to be at the forefront, in global terms, in projects using blockchain.
The panic that besets us is not about taxation per se, but about the tendency that sometimes exists of wanting to cook the goose that lays the golden eggs. As Diogo Mónica, president of Anchorage, said the other day: 50% of nothing is nothing.
