Virtual Collateral 101: How To Take And Enforce Security Over Cryptocurrencies, Crypto-Assets And Central Bank Digital Currencies

• Jurisdiction: United States,Federal
• Law Firm: Aird & Berlis LLP
• Subject Matter: Finance and Banking, Technology, Financial Services, Fin Tech
• Author: Mr Sam Babe, Angela Oh and Tamie Dolny
• Published date: 25 April 2023

In recent years, there has been a proliferation of lending secured by crypto-assets through online decentralized platforms. It is estimated that, during one month in 2021, more than US$122 billion in transaction volume occurred through such platforms.¹ This level of activity demands a close look at legal issues that arise when borrowing against cryptocurrencies and other virtual assets. Virtual collateral is not explicitly addressed in the personal property security law of Canadian common law provinces, as primarily set out in theirPersonal Property Securities Acts(collectively, the "PPSA").² Lenders and insolvency practitioners therefore face open questions when dealing with loans backed by cryptocurrencies or other virtual assets - most importantly, how should secured parties best protect their interest in this online collateral?

Further complexity has been added by the recent adoption of bitcoin as legal tender in El Salvador and the Central African Republic and the introduction of central bank digital currencies ("CBDCs") in other jurisdictions, which likely will split virtual currencies into multiplePPSAasset classes. Additional nuances arise in the case of other types of potential crypto-collateral, such as non-fungible tokens ("NFTs"), which have the potential to fall under yet another third asset class.

In the United States, lenders should soon gain more clarity as extensive relevant amendments to theUniform Commercial Code(the "UCC")³ were adopted and recommended for enactment by the Uniform Law Commission in July 2022 (the "2022UCCAmendments").⁴ New Article 12 will introduce rules for transactions involving a new category of assets called "controllable electronic records" ("CERs") which will include cryptocurrencies and NFTs. Concurrent amendments to the definitions inUCCArticle 1 and to thePPSA's older cousin,UCCArticle 9, will create rules concerning security interests in CERs as well as in CBDCs. At the time of writing, the 2022UCCAmendments have been enacted only in two states, although bills in respect of the amendments have been introduced in 23 other state legislatures. Unfortunately, no similar amendments to thePPSAare pending.

This article aims to break down these issues of categorization to propose answers to the questions of how security over cryptocurrencies, other crypto-assets and CBDCs can best be attached, perfected, protected and enforced, from both a legal and practical perspective. A common theme throughout this article is the value for a lender of taking possession or control of any crypto-asset that is pledged as collateral. Depending on thePPSAandUCCcollateral class that a crypto-asset falls into, possession or control by a lender may lead to attachment and/or perfection of a security interest in such crypto-asset. But even where possession or control does not further a lender's legal rights, it still gives practical protection that may, in the end, be far more valuable than actionable legal rights.

Cryptocurrencies in Lending: A General Overview

Blockchain, which constitutes a decentralized, peer-to-peer network of computers, underpins the majority of existing cryptocurrencies.⁵ Digital signatures verify transactions in ledgers, which can be public or private, and users hold cryptocurrencies in secure hot or cold personal addresses that are commonly termed "wallets." More specifically, hot wallets are wallets that are linked online (e.g., web-based or desktop), while cold wallets are immune to hacking, as they are not continuously connected to the internet (e.g., through physically separated USB devices).⁶

There are also various generations of cryptocurrencies which range from completely public (bitcoin) to private (Monero), among others. Privacy coins are cryptocurrencies that allow entities to transact in a decentralized manner without revealing owner, buyer or seller information.⁷ As an example, Monero, which holds the largest capitalization of privacy cryptocurrencies, protects sender anonymity by using ring signatures, which create groups of users and aggregate their transactions; each transaction can thus only be linked to the group as a whole. This protects both sender and receiver anonymity.⁸ In comparison, all addresses where bitcoin is sent to are publicly available on the blockchain.

Regardless of their privacy status, cryptocurrencies were designed to solve the issue of "intermediaries" in the world of financing, due to the transactional confidence created by blockchain. In a 2020 article, Xavier Foccroulle Menard aptly explains how cryptocurrency fixes what he terms the "double-spending problem" in digital finance, without the need for a bank intermediary:

". . . physical cash can only be spent once, as once you hand it over in a transaction, you no longer possess it...