CYBER-LENDING: Perfecting Security Interests in the New Frontier of Cryptocurrency-Backed Loans
Cryptocurrency – such as Bitcoin, Ethereum, and Ripple – may be the next generational game-changer – a decentralized, virtual monetary system that allows people and businesses to transfer value instantaneously to and from anywhere in the world without the need for any bank or financial intermediary to act as a middleman. As cryptocurrency gains wider acceptance in the marketplace, investors are faced with a new challenge – how to reap the benefits of the appreciating value of their cryptocurrency holdings without incurring the potential tax consequences of selling their tokens. One emerging option is to enable investors to borrow dollars or other government-backed currency, called fiat money, through loans secured by pledges of their cryptocurrency. While an innovative solution, lenders, and borrowers first must grapple with the issue of how to properly perfect these crypto-to-fiat loans in a recording system designed long before virtual currency became a reality.
Perfecting Security Interests in Cryptocurrency Under the Uniform Commercial Code
In a secured loan, a borrower obtains the loan proceeds by pledging collateral, something of value, to secure repayment of the loan. The lender may take possession of the collateral to hold while awaiting repayment; but more often, the borrower retains possession and control over the collateral, promising not to sell or otherwise dispose of it. To protect lenders, registries and recording systems have developed all over the world, so that lenders may provide notice of their interest in a borrower’s collateral to prospective buyers, transferees, and other potential creditors, and establish priority in the event that there are two or more competing claims against the same asset. The process of putting the world on notice of a creditor’s claim against a borrower’s collateral is called perfection. Anyone who seeks to claim an interest in collateral that is the subject of a perfected security interest is deemed to have constructive notice of the prior interest, and the later-acquired interest is considered subordinate.
In the United States, the perfection of security interests generally is a matter of state, not federal, law. Specific recording systems may vary from state to state, but a lender typically records its interest in real property, usually a mortgage, in a land registry maintained in the county in which the property is located. Perfecting security interests in personal property is governed by Article 9 of the Uniform Commercial Code (UCC), which has been adopted by all 50 states with a slight variation. The specific requirements for perfecting a security interest in personal property depends usually upon the nature of the property being pledged as collateral. For example, under UCC § 9-312(b)(3), a security interest in money may only be perfected by taking possession of it, while UCC § 9-314(a) provides that a security interest in a deposit account is perfected by taking control of the account. A security interest in “general intangibles” is perfected by recording a financing statement in the appropriate state registry in accordance with UCC §9-310(a).
The UCC does not address cryptocurrency. Although intended as a medium of exchange, cryptocurrency is not “money” within the definition of UCC § 1-201(24), which defines money as, “a medium of exchange currently authorized or adopted by a domestic or foreign government.” Because cryptocurrency is not backed by any government, it does not fall within the UCC definition. Similarly, cryptocurrency is not a “deposit account.” UCC § 9-102 defines a deposit account as one of a variety of “accounts maintained with a bank.” Cryptocurrency does not involve the use of a bank or similar centralized intermediary and, therefore, cannot be considered a deposit account. Under the current UCC framework, cryptocurrency is a “general intangible,” for which a security interest may be perfected by filing a financing statement in the registry where the debtor is located.
The Shortcomings of UCC Perfection in Cryptocurrency
The purpose of perfection under the UCC is to provide certainty in loan transactions – to ensure that a lender provides legally-sufficient notice of its claim against the borrower’s collateral and to establish priority between competing claims to the same collateral. A prospective creditor, purchaser or transferee is presumed to have looked in the state registries or recording systems to determine whether a lender or any third party claims a prior, adverse interest in the property. A lender who has complied with the requirements of the UCC is deemed to have given legally sufficient notice whether or not the third party has reviewed the registry. A prior, properly-perfected security interest is considered superior to interests that may arise later, as a matter of law.
The UCC provisions of the perfection of security interests in general intangibles are ill-suited to cryptocurrency. Cryptocurrency, after all, is intended to be a currency – transactions are fluid and immediate. They were never designed to be part of a public registry or recording system. For example, under the UCC, a restaurant who accepts Bitcoin for a dinner is deemed to be on constructive notice of any creditor’s claim against the patron’s cryptocurrency. Immediate searches in every crypto-transaction are not feasible. Even if immediate records searches were possible, searches of the nature required by the UCC require information about the location of the transferor. In many cases, however, the users are anonymous. Imagine that same restaurant, which accepts payment in Bitcoin, having to ask its patrons where they live, so that a proper and complete UCC search may be conducted. Without knowing where to look for a perfected security interest, it is practically impossible for prospective purchasers, transferees or creditors to be able to check to determine whether anyone else claims a superior right in the same tokens.
Possible Solutions for Perfection of Security Interests in Cryptocurrencies
A viable alternative to the UCC rules for perfection of security interests in general intangibles is necessary to bring certainty to the perfection of security interests in cryptocurrency pledged as collateral. Some of the solutions that are being explored currently include:
- Transfer of Possession – Although cryptocurrency is considered a general intangible within the definitions of the UCC, because tokens are more akin to money, some crypto-to-fiat lenders have “perfected” their loans by taking physical possession of the tokens, digitally, or, in some cases, by taking physical possession of a data stick, USB drive or other media containing the actual cryptocurrency. Under the UCC, however, possession is not the proper method for perfecting a security interest in general intangibles, nor is the standard by which priority of competing for security interests may be determined. Worse yet, perfection by possession offers little comfort to lender or borrower. The distributed ledger for the transferred tokens does not reflect that the lender merely holds them as security. The lender presumably is free to transfer or otherwise alienate the cryptocurrency as it sees fit and without restriction. At the same time, by taking possession of the cryptocurrency as security for its loan, a lender may be held to have assumed a legal duty of care to prevent the cryptocurrency from being irretrievably lost, destroyed or stolen. Making actual, physical possession of tokens the standard for a perfection of security interests is contrary to the promise of cryptocurrency in a global economy. Cryptocurrency facilitates transactions where centralized banks are inaccessible. This advantage will be lost if users, instead of trying to find banks, must now find trustworthy delivery companies or couriers to transport data sticks and USB drives all over the world.
- Cryptocurrency Custodians – As an alternative, third-party custodians have emerged to provide independent cryptocurrency storage solutions. Some of these custodians are associated with the various exchanges. These custodians could hold the collateral during the life of the loan, preventing either party from using them. The risk, however, remains that the tokens still could be lost, hacked, and/or stolen. If nothing else, the brief history of cryptocurrency is replete with instances in which exchanges were hacked and fortunes of virtual currency lost – from approximately 850,000 Bitcoin that was hacked from the Mt. Gox exchange dating back to 2011 until its suspension in 2014 to more than $32 million hacked South Korean exchanges in June 2018.
- Dual Private Keys – Solutions to the “perfection problem” may lie in ever-evolving cryptocurrency technology. One solution that is being explored is the feasibility of enabling lenders and borrowers to segregate the cryptocurrency that has been pledged as collateral within the borrower’s cyber-wallet. The segregated cryptocurrency then would be subject to a second private key controlled by the lender. Much like a safe deposit box that requires two keys to open, the cryptocurrency that is subject to dual private keys could not be transferred without both private keys, thereby preventing either lender or borrower from acting without the knowledge or consent of the other.
- Private Registrations on the Blockchain – Proponents of the blockchain technology underlying cryptocurrency tout its suitability as an alternative to traditional registries. Blockchain entries are themselves immutable and transparent. As such, many commentators see blockchain as the next logical step in the progression of title registries. In that light, it may be considered anathematic to suggest that perfection of security interests in cryptocurrency should follow a traditional government-based registration process, which may or may not provide the practical notice to users. Instead, to the extent that blockchain technology allows the lender and borrower to reflect the pledge of cryptocurrency as collateral on the blockchain, each cryptocurrency could become its own automated registry, a single place for lenders to provide notice to potential purchasers, transferees or creditors and the sole measuring stick for issues of priority.
True Solutions Require the Combined Efforts of the Legal Community and Tech World
With the growth of cryptocurrency, the legal community and tech world must come together to rewrite the system for perfecting security interests in this increasingly digital world. Lawyers and lawmakers must ensure that lender and borrowers are protected with respect to their various rights to digital collateral, while the tech world must continue to innovate in this emerging technology to provide new tools that provide the certainty in commercial transactions that the legal system requires.