All I want for Christmas is a CryptoKitty

What is crypto? What is blockchain? What is Bitcoin? As Wittgenstein might have put it, many of these terms are only familiar to those who are involved in this “language game”. Now, these arcane digital concepts are going mainstream. Why?! CryptoKitties.

CryptoKitties are digital cats. Each one has different attributes and users can breed, buy and sell these kitties on Ethereum. The most expensive kitten was Founder Cat 18, a bug-eyed orange animal with purple spots. This CryptoKitty was sold for $122,095 on December 6.

If you have developed an affinity for Ethereum, you could ask for ERC-721 tokens for Christmas to buy your CryptoKitty. Better still, ask for Bitcoin but it won’t come cheap.

So what do CryptoKitties show us?

1. Application of blockchain

CryptoKitties is the first mainstream recreational decentralised application (“Dapp”). If you don’t know what a Dapp is, it consists of: (1) a frontend, written in HTML; and (2) a backend (think of it as the ‘database’ for your frontend). The fact that the first mainstream Dapp is a game and is about cats shows that practical applications of the blockchain can extend well beyond Initial Coin Offerings (“ICOs”).

2. Cats, Digital Assets or Securities?

You will be delighted to hear that CryptoKitties are probably not securities. Just like Bitcoins or Ether, CryptoKitties are peer-to-peer tradeable, provably scarce digital items that are accounted for by an open blockchain network.

Rather than finance itself through an ICO), it is using its own revenue model: The CryptoKitties team releases a new “Gen 0” CryptoKitty every fifteen minutes (up until November 2018). The starting price of “Gen 0” CryptoKitties is determined by the average price of the last five CryptoKitties that were sold, plus 50%.

There are arguments as to whether some ICOs might be unregistered securities issuance. In the United States an offer and sale of “tokens” or “coins” may qualify as “securities” and be subject to the U.S. securities laws and the jurisdiction of the U.S. Securities and Exchange Commission (“SEC”). It all comes down to the “Howey” test. If an investment of money is made with an expectation of profits arising from a common enterprise that depends solely on the efforts of others (i.e. a promoter or third party) SEC v. W.J. Howey Co., 328 U.S. 293 (1946).

In a similar fashion, the Financial Conduct Authority (“FCA”) in the United Kingdom has issued a consumer warning about the risks of ICOs. It says “ICOs are very high-risk, speculative investments.” It adds that whether an ICO falls within the FCA’s regulatory boundaries or not can only be decided case by case and states: “Businesses involved in an ICO should carefully consider if their activities could mean they are arranging, dealing or advising on regulated financial investments.”

If we apply the Howey test, CryptoKitties are not being marketed as profit making investments, and ownership of a CryptoKitty doesn’t give you a right to dividends or revenue streams from the CryptoKitty team or anyone else for that matter.

Takeaway. I have had several clients asking us to review their ICO Whitepapers to determine, amongst other things, whether they would be likely to fail the “Howey” test. The utmost care should be taken when drafting documentation and promotional materials. If your offering is not a security then your materials should faithfully reflect that.

3. Capacity and labour pains

The interest CryptoKitties generated across the Ethereum network almost brought the network to a halt. At one point, its smart contracts accounted for up to 25% of the entire network’s transactions. As traffic increases, transactions become more expensive to execute quickly. CryptoKitties responded by issuing a tweet: Due to network congestion, we are increasing the birthing fee from 0.001 ETH to 0.002 ETH. This will ensure your kittens are born on time! The extra is needed to incentivize miners to add birthing txs to the chain. Long-term solution will be explored very soon!

Takeaway. This isn’t the first time the Etherum network has come under strain. CryptoKitties shows how scalability should be (and is) a top priority for the Ethereum development team. For blockchains to become fully mainstream, solutions will need to be found that can overcome the threat posed by digital cats. Ethereum is making progress on developments such as ‘Proof of Stake’, ‘sharding’, and second layer technologies that will support its ability to scale.

4. Cybersecurity and data protection

From a cybersecurity perspective, the immutability, encryption, and cryptographic elements inherent in cryptocurrency transactions on a blockchain lend themselves well to a secure environment.

Despite the added security benefits of cryptocurrencies’ underlying blockchain technology, it is not without risk. Notably the mechanism by which digital currencies are stored (e.g. in digital wallets) introduce penetration points that can be used to exploit the blockchain’s irreversibility, meaning that pilfered digital tokens and coins cannot be returned, and victims can be left without much recourse (unless issuers and users are properly insured or indemnified). Similarly, the use of private and public key authentication on a distributed network can create risk with respect to users’ private keys that, if lost or compromised, can result in serious losses. Further, many users are not actually holding their private keys (and therefore their Bitcoin) and instead entrust them to third parties.

No article nowadays would be without a discussion on data protection. The General Data Protection Regulation (GDPR) brings in a new data subject right, the “right to be forgotten/right to erasure”. This does not sit well with the decentralised and immutable components of blockchain technology which by its very nature does not enable the permanent deletion of data. Data subjects may however be less concerned if their data is pseudonymised. Regardless, further security features may need to be built on top of the existing framework to ensure compliance.

Takeaway. Issuers and users of cryptocurrencies should consider the need for adequate insurance solutions to account for these risks.

CryptoKitties may be as cool as cats but they are of the feral not the domesticated variety.

Please click here to email Simon Halberstam, Head of Technology Law, or call 020 3206 2781.