On-chain Law Series Part 1: Why Blockchain Networks are New Legal Systems
On-chain Law Series Part 1: Why Blockchain Networks are New Legal Systems
As blockchain technology continues to advance, a new type of legal system known as ‘on-chain law’ has emerged. On-chain law is based on the open-source code of blockchain networks, which is an environment for smart contracts, token protocols, DAOs and other on-chain entities/vehicles. But what makes on-chain law different from traditional legal systems? Does on-chain law have the potential to replace these traditional systems? In this article we explore the unique characteristics of on-chain law and the challenges it faces in being recognized as a viable alternative to traditional legal systems. We also discuss why legal wrappers, which are unique legal structures that bridge the gap between on-chain and off-chain worlds, are still going to be needed for on-chain entities in the next five to ten years, as we see a more widespread adoption of the blockchain technology.
Before we dive into the topic, this is a polite reminder that this article is not to be construed or treated as legal advice or legal opinion. It’s for informational purposes only. Now, let’s get started.
What different types of legal systems exist?
A legal system comprises a set of rules of conduct that have their own hierarchy depending on the source of their origin and, as a result, the hierarchy of their power. Depending on who or what is considered as the source of law (a parliament, a monarch, a church, local customs, or the spirit of law and justice) and how authoritative this law is in society, the following legal systems can be discerned:
- common law, where the main source of law are judicial precedents and the spirit of justice. Countries with common law systems include the US, the UK, and Singapore;
- civil law, where the main source of law are codified laws adopted by parliament. Countries with civil law systems include Germany, France, and Switzerland; and
- religious law, where the main source of law are religious dogmas, such as Canon Law in the Vatican or the Sharia system in Arab countries.
Transformation of national legal systems
In terms of IT terminology, a legal system is a white label of rules that govern the behavior of people in society. Each state chooses a system and then customizes it for its own needs, often reflecting its own customs and culture within the system. Finally, these rules are then published on official websites in the form of laws. The role of the state itself in this process is in ensuring the compliance with the laws and rules with the help of law enforcement and judicial bodies. In other words, the state is an intermediary (guarantor) between the legal system and society, whose members are obliged to comply with such a law.
However, we can say that with the emergence of blockchain technology, a new legal system of on-chain law has appeared, with distinct characteristics:
- the source of law is the open-source code of blockchain networks (Ethereum, NEAR, Cardano);
- the open-source code determines the rules of operation of blockchain networks, where hundreds of thousands of autonomous on-chain entities / DAOs "live and work" today; and
- there is no requirement for any intermediaries/guarantors to comply with on-chain law, as–thanks to smart contracts and the principles of decentralized consensus algorithms– these systems are completely autonomous and self-regulated.
If this is really so, what is the likelihood that on-chain law will replace traditional (off-chain) laws, either now or in the future?
Let us explore the possibilities below.
On-chain law as a new legal system
With the development of blockchain technology, the rules of operation of large blockchain networks such as Ethereum, NEAR, and Cosmos have become a new legal system, "on-chain law". Tens of thousands of projects with tokens and protocols are working on them today and each of them is supported by hundreds thousands of stakeholders (tokenholders), multi-million dollar treasuries, and on-chain governance systems.
The following criteria differentiates on-chain law (the rules of operation of the blockchain network) from off-chain law systems (which include a collection of laws, judicial precedents, or religious doctrines as detailed above).
- On-chain law is self-regulatory
In layer 1 blockchain networks, the rules of conduct for participants are not regulated by the legal system, which is built on real-world (off-chain) sources of law (court precedents, laws, religious books, etc.) but rather on the open-source code that is in the basis of blockchain networks and which govern the rules of its operation.
- On-chain law is decentralized
The deployment and operation of the open-source code is autonomous and self-regulated, as it is supported by blockchain nodes in a decentralized manner. This way, the validators and oracles ensure the operation of a decentralized consensus algorithm between system participants, which is built on mathematical rules and encryption.
- On-chain law is autonomous
Thus, layer 1 blockchain networks are completely autonomous and do not need any intermediaries or guarantors to ensure their own functioning. This is in contrast to off-chain law, where states with police and court systems act as guarantors.
How ‘legal entities’ fit in a legal system and why they are essential to businesses
Rarely can an entrepreneur start a business without incorporating a legal entity. The reason is that without a legal entity, which by its very nature is a legal fiction and exists in the form of a virtual entry in the register of public bodies, a business will not be able to:
- open a bank account and, as a result, accept payments from clients and pay salaries to employees;
- formalize and, in the future, protect the right of shareholders to a share in the business. This is needed to receive dividends and distribute profits from the sale of the business in the future; and
- authorize people to sign documents on behalf of the business to form management bodies and appoint people there who will act on behalf of the company.
All in all, any business project without a registered (off-chain) legal entity cannot today have a fiat treasury, protected stakeholders, and a working management (governance) model. And the very registration of a legal entity and the rules of its work must correspond to the law of the country in which it is registered.
How do ‘on-chain entities’ fit in on-chain legal systems and do they need a registered legal entity to operate?
At the same time, each on-chain project (DEX, DeFi, play-to-earn game, etc.) is based on the same three pillars as an off-chain business: stakeholding, treasury and governance. However, there are a number of significant differences between on-chain and legal (off-chain) entities, namely:
- in legal (off-chain) entities, stakeholding is structured by issuing shares, while in on-chain business, stakeholding is affirmed by tokens;
- in order for an off-chain business to form and start accumulating treasury, it needs to at least open a bank account. On-chain entities need a crypto-wallet, the opening of which does not require any intermediaries; and
- when a decision needs to be made in an off-chain business, it needs authorized persons (directors, officers), whose right to act on behalf of the company is regulated by the company's statutory documents such Articles of Association, and Bylaws, for example. In on-chain entities, stakeholders (tokenholders) vote with their tokens, after which their decisions are automatically executed by smart contracts.
To sum up, the term ‘on-chain entity’ can be understood as a token protocol, which lays down the rules for issuing and distributing tokens (tokenomics). It also provides the rules for the system of smart contracts with the token treasury, which ensure the ‘self-regulation’ of the on-chain entity, as well as regulate on-chain voting (governance).
Based on this, it’s pertinent to ask whether on-chain projects even need a legal fiction such as a ‘legal entity’. The answer consists of two parts:
- in the short term, yes.
- in the long term, probably not.
Why in the short term on-chain entities will still be unable to function without legal entities
To date, the total valuation of the on-chain world floats around 1 trillion US dollars. This is about 1% of the size of the world economy if calculated as the sum of the GDP of all the countries of the world. In light of this fact, business projects created as on-chain entities, such as token protocols with issued tokens and decentralized apps sold by on-chain entities as their own services, cannot be completely independent from the traditional (off-chain) world. This is because these on-chain entities:
- cannot accept payments from customers in cryptocurrency or tokens only: some customers, especially those coming from the real (off-chain) world, are only willing to pay in fiat;
- cannot pay employees and contractors, as well as pay taxes purely in cryptocurrency or tokens: not all contractors/employees are happy to accept cryptocurrency payment, while states do not accept cryptocurrencies as payment of taxes as well; and
- cannot attract investments only in cryptocurrency, as many funds today invest only in fiat.
Until there is enough liquidity in the on-chain world, all on-chain projects will need a bridge to the off-chain world, which will help on-chain entities to be able to accept payments from customers in fiat, settle with contractors and employees, and attract investments from traditional markets.
Today, these ‘bridges’ between the on-chain and off-chain worlds are called legal wrappers for on-chain entities. They are created and structured as legal entities. These legal wrappers allow on-chain entities to work with fiat payments and sign traditional (legal) contracts. Simultaneously, they help attract more liquidity to the crypto world by converting fiat into cryptocurrencies and tokens.
Due to the fact that today there is no jurisdiction in the world equally favorable to the issuance of tokens and launching a DAO, hiring team members, and accommodating the founders’ lifestyle, it will not, unfortunately, be possible to create a legal wrapper for an on-chain entity with the help of one off-chain legal entity. Perhaps, this blockchain heaven will see the light of day some time but it simply does not exist yet. Therefore, most legal wrappers are created as a group of companies, where each legal entity is responsible for its own function, and, accordingly, is registered in the most favorable jurisdiction for this.
Long-term prospects for on-chain entities and the transformation of off-chain law into on-chain law
Analysts predict that in the next five to 10 years, a critical mass of liquidity will flow from the real (off-chain) world to the on-chain world, helping the latter to grow 10-fold and reach a total value of 10 trillion US dollars. This moment can tentatively be considered as the “product-market fit” for on-chain law, as it is highly likely to trigger a cascade effect where on-chain entities will no longer need to work with fiat to pay employees or accept investments. At the same time, the above-described legal wrappers for on-chain entities will lose their relevance too, since there will no longer be a need to build bridges between the on-chain and real (off-chain) worlds.
At this point in the development of the blockchain ecosystem, multiple new questions will arise as to whether on-chain projects should register legal entities if:
- their treasuries are now fully on-chain and all clients, employees, and investors are ready to settle exclusively in tokens and cryptocurrency;
- their stakeholders are tokenholders of such on-chain entities; and
- their governance comprises smart contracts that independently execute decisions according to the results of on-chain voting by the tokenholders.
This, in turn, will cause the loss of relevance of the traditional (off-chain) legal systems (laws on government websites), according to which legal entities are registered, as the former will lose its applied (practical) meaning. They will be replaced by on-chain law in the form of blockchain networks (Ethereum, NEAR, Cardano), which will have their own rules, according to which on-chain entities will be formed and will function.
What role will on-chain entity legal wrappers have during the transition period between traditional (off-chain) law to on-chain law systems?
As mentioned above, attracting liquidity from the off-chain world to the on-chain world requires bridges between these worlds. These bridges today are described as legal wrappers, which are created around on-chain entities in the form of a number of legal entities. However, it is important to emphasize that legal structures for on-chain projects differ significantly from traditional corporate structures for the off-chain world in terms of their architecture.
In the case of legal structures for off-chain entities, it is customary to create vertical (hierarchical) structures: a holding company with founders and investors is placed at top with subsidiary and/or operating companies below it. This model allows the business to work in different markets or launch separate business endeavors, as well as hire people from different regions. In contrast, horizontal (holacratic) structures are chosen for legally structuring on-chain entities. There, legal entities are not connected to each other with subordinate corporate relations, but rather each of them works autonomously and is responsible for its own function. For example, the DevCo develops dApps, the Token Distribution Co is in charge of issuance and distribution of tokens, while the Foundation is responsible for treasury management. The images below illustrate these differing models with further detail.
Why on-chain entities are more sustainable than legal (off-chain) entities
At this point I would like to emphasize that the key difference between traditional (off-chain) entities and innovative on-chain entities lies in the approaches taken for structuring ownership. It can be argued that the structuring of ownership in on-chain entities is substantially more sustainable than the model for structuring ownership in off-chain entities.
Ownership in on-chain entities is structured with the ownership of ecosystem tokens and not with the ownership of holding company’s shares as found in traditional off-chain entities. Due to the fact that these tokens are owned not only by founders and investors, but also by team members, partners, clients, validators, and oracles, for example , the level of alignment between the participants of such on-chain entities in achieving common goals is much higher, as all tokenholders are interested in one thing only: to increase the value of the token.
As a result, all participants (tokenholders) of these on-chain entities are collectively interested in the overarching success of the on-chain entity. In other words, they are all equally incentivized by tokens and, as a result, motivated to make maximum contributions to the ecosystem. In addition, as tokens often have not only a corporate utility within the on-chain entity (governance, staking, etc.), but also a commercial one (discounts, access to exclusive functionality, community membership, etc.), it assures a significantly better interaction between tokenholders. This, in turn, solves the problem that is the downfall of most centralized corporations, where there is a huge gap between shareholders and users in the form of complex corporate structures. This, as a result, worsens the communication between the two, and, consequently can result in users refusing services, as their owners stop listening to their consumers.
Thus, the revolutionary nature of on-chain entities is that all their participants—not only founders and investors—but also team members, clients, partners, validators, etc., are incentivized by tokens. In turn, this model makes an entity much more sustainable and, ultimately, more successful.
This concludes part 1 of Legal Nodes’ series on on-chain law. In this article, we explored blockchain networks as new systems of law and discussed why this new type of legal system could replace traditional legal systems in the coming years. These changes shall not be abrupt, and the transition period from traditional legal systems (off-chain) to on-chain legal systems will require the help of legal wrappers to bridge the gap between the two worlds in the foreseeable future.
Check out Part 2 of Legal Nodes’ series on on-chain law, where we will uncover answers to the following questions:
- what are the legal wrappers for on-chain entities?
- why do blockchain networks such as Ethereum, NEAR, Cardano need standardized legal wrappers for on-chain entities that are launched there today and how will this increase the mass adoption of blockchain networks themselves?
- how developing open-source on-chain entity legal wrappers for various blockchain networks lowers barriers for a faster transformation of off-chain law into on-chain law.
Disclaimer: the information in this guide is provided for informational purposes only. You should not construe any such information as legal, tax, investment, trading, financial, or other advice. Any mention of any of assets or third party services or products in this article is not an endorsement to purchase them.