Analysis: Court Ordered Code – The Implications of a Forced Fork

The cryptocurrency space and the blockchain technology underlying it is constantly evolving. National authorities, central banks, regulators, and lawyers are constantly trying to keep up the pace. There are very few occasions where blockchain technology presents one with the opportunity to formulate legal arguments and an even broader legal strategy.

The Bitgrail / Nano / XRB saga, however, presents us with such an opportunity.

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The saga involves a cryptocurrency called XRB, which comes from a blockchain called Nano. Nano developers are based in the US. The white paper for XRB was published in late 2014. According to sources and reports, most of the XRB issued was exchanged and traded on Bitgrail, an Italy-based cryptocurrency exchange.

In February 2018, $170 million worth of XRB tokens were stolen from BitGrail. BitGrail and Nano have been publicly blaming each other for the hack, as can be seen in the social media accounts of both Nano developers and Francesco “the bomber” Firano, the operator of Bitgrail.

The latest twist in the saga is highly interesting. One of the account holders of the stolen XRB decided to take legal action in the form of submitting a class action suit against Nano. The plaintiff is asking the court to order a ‘rescue fork’ in Nano’s blockchain. Such a step would allow the issuance of new XRB tokens, which would then be distributed to all account holders as a substitute to the stolen XRB tokens.

When does a fork occur?

A fork occurs when a single blockchain is split in two for one of two reasons:

1) A split in consensus or – since bitcoin is a distributed and decentralized network – a fork occurs when miners discover a block at the same time, resulting in two split chains. However, this is only a temporary fork, as the chain that finds the next block first becomes the longest chain and automatically becomes the ‘true’ chain. Therefore, the shorter chain will be abandoned by the network.

2) A change in the underlying rules of the protocol. This represents a conscious change of the underlying codes by developers and is permanent. The reason for changing the code base can be due to either adding new features to enhance the network’s functionalities or by changing a core rule, such as increasing the block size.

A change in the underlying rules of the protocol can be classified as either a soft fork or a hard fork. A soft fork is a software upgrade that is backwards compatible with older versions. This means that participants who did not upgrade to the new software will still be able to participate in validating and verifying transactions.

A hard fork refers to a software upgrade which is not compatible with older versions. That means that all participants will need to upgrade to the new software if they want to continue to participate in validating and verifying transactions. Otherwise, they will be separated from the network. This creates a divergence in the blockchain.

The plaintiff in the XRB case argues that ‘forking’ is the best legal relief available. Needless to say, this legal claim is a novelty in the crypto space. While we await the court’s ruling, let us share some thoughts on the matter.

The need for regulation

We cannot escape the thought that all responsibility is put on the account of Nano while evading the discussion about the exchange’s responsibility. The fact the exchange is based outside of the US (Italy) must have played a role as to whom to sue. In this case, it also highlights the urgent need for regulations to be applied on crypto exchanges.

The focus on ICOs and the analysis of whether tokens are securities or not have taken us away from the fact that most crypto exchanges, including some of the major players in the crypto space, are unregulated.

The underlying rationale behind the rescue forking relief is that it is the relatively easiest thing to do. We can assume that in regards to direct costs, changing the underlying rules of the Nano protocol is likely to be cheaper than reimbursing $170 million worth of XRB tokens. But we need to consider the broader picture.

As a start, XRB holders who were not affected by the Bitgrail hack may argue that a fork may have a negative impact on them, especially because the class action suit does not state which kind of fork will be sought – soft or hard. In case of a soft fork, non-affected holders of XRB may argue that if they are to remain in the original, non-upgraded version of Nano, their functionality is likely to be affected as this is typically the case in a soft fork.

For that reason, it is likely that the forking to be sought will be a hard fork, either in the form of a contentious hard fork or in the form of spin-off coins (as was the case with Litecoin).

Another important point is the applicability of securities laws. One of the cornerstone arguments in the class action suit is that XRB tokens are investment contracts which should have been registered as securities. Let us set aside the legal analysis of the Howey test as presented in the claim, which is far from being exemplary; the mere involvement of the securities laws and potentially the SEC is likely to have a major impact and more of a revolving sword.

It is likely that the SEC will examine whether XRB tokens are securities. Should the SEC conclude that this was the case, Nano will be facing potential federal charges. On top of that, if XRB tokens are securities, what is the likelihood of the new tokens to be issued after the rescue fork not being securities? That means the fork is likely to result in a lengthy and expensive securities registration and offering process.

The plaintiff may have been better arguing other civil claims without involving securities. Time will tell if that should have been their initial strategy.