Virtual currency's new frontier: Cryptocollateral

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As cryptocurrency has gained popularity, one area of the financial markets where adoption has not occurred is the use of cryptocurrency as a credit enhancement for secured corporate debt facilities.

The number of corporate borrowers transacting in cryptocurrency is trending upward so this additional type of virtual secured corporate debt, called cryptocollateral, may be of greater interest to lenders seeking to expand their potential collateral.

Efforts to tailor existing commercial law to fit the cryptocollateral asset class are in the early stages. In 2019 alone, according to the Uniform Law Commission, only Rhode Island has adopted a model statute aimed at providing rules for perfecting security interests in cryptocollateral. And four other states — California, Oklahoma, Nevada and Hawaii — have seen this model statute introduced in their legislatures. A sixth state, Wyoming, recently enacted its own set of rules governing security interests in virtual currencies. Such evolution is helpful and necessary.

Until similar laws are adopted in more jurisdictions, lenders must look to existing rules. Most cryptocurrency today would qualify as a “general intangible” within the Uniform Commercial Code.

Perfection of a security interest in general intangibles requires filing a financing statement in the relevant state’s office. The financing statement must also contain the name of the debtor, the collateral (which description can be super generic) and the secured party. However, a financing statement is not ideal for perfecting security interests in cryptocollateral.

First, the information in a financing statement is irrelevant in the context of the pseudo anonymous system of cryptocurrency. Transactions on the blockchain are searchable by public key addresses, not by debtor name.

A financing statement that offered an option to fill in public key addresses would be more relevant. The goal of the public filing system is to put the world on notice of a debtor’s pre-existing liens. Unless a system is developed that permits potential creditors to tie a financing statement back to a blockchain address, the public filing system is not achieving its goal in the cryptocurrency context.

A second shortcoming is the lack of control over collateral. Filing a financing statement provides no effective mechanism for a lender to restrict a debtor from unauthorized transfers or enforce remedies in a default scenario.

In a decentralized peer-to-peer-based system designed without intermediary institutions in mind, the challenges any lender would face, in terms of tracing and clawing back proceeds, are infinitely more complex.

In place of reliance on financing statements, a more fitting alternative would be to assign priority to the secured creditor, who went through the trouble to achieve dominion over the cryptocollateral. Existing law already acknowledges that perfection through control is the strongest method available to any secured creditor when it comes to money, securities and other financial assets.

Cryptocollateral ought to be treated the same way. Control is the strongest method because the nature of the collateral is such that it can be transferred at the push of a button. It is this power of transfer, or the power to prohibit transfers, which is at the heart of the control concept.

Rhode Island’s model statute and the Wyoming statute both favor secured creditors who have availed themselves of some form of control over cryptocollateral. Until modernized rules are the law of the land, lenders have other options to effectively protect their interest in, and in effect, achieve a measure of control over cryptocollateral.

The sine qua non of control over cryptocollateral is control of private keys. Like having the bank account numbers plus authority to direct account balance transfers, only a creditor holding the private key has the power to unlock the cryptocollateral value.

There are several different methods for storing private keys, each with its costs, benefits and technical requirements. Cold storage, for example, is a method for keeping bitcoins offline to protect them from unauthorized access. Multi-signature online wallets, cold storage and even multi-signature technology incorporated into cold storage are stronger potential methods.

Best practices have developed for cold storage and the secured lender must familiarize itself with such practices and confirm that they are adhered to internally or by a third-party agent. Lenders may consider looking to experienced third parties to manage any cryptocollateral and related private keys. However, not all third-party custodians are created equally.

Experience with dealing and holding cryptocurrencies may vary widely. Custodians that are subject to any state or federal regulatory regime requiring regular audits, minimal risk management controls, capital requirements and regular examinations may provide additional comfort.

The ability to offer additional ancillary services such as valuation services may also help distinguish among third-party custodians. How the cryptocollateral is customized is as important as who is the custodian.

Whether the cryptocollateral is separately accounted or commingled is just one issue to consider. Also, the contractual arrangement between the lender and custodian should establish relative rights and duties.

As an accommodation to its customers, custodians may wish to offer form control agreements governing access, rights to direct transfers and exculpatory, and other custodian-protective provisions.

Lastly, lenders should consider additional modifications to their credit and collateral documentation. For example, tailored covenants or representations and warranties covering ownership and title of specifically identified cryptocurrency holdings, the location of the relevant wallet, as well as other specific provisions. This could enhance safeguards around the movement and monitoring of the cryptocollateral.

Although extending commercial credit with cryptocurrency value in mind is not widespread at present, it seems a logical extension for the cryptocurrency asset class. If the markets are to believe there is value in cryptocurrency, that value could be made available as collateral to providers of commercial credit.

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Cryptocurrencies Bitcoin Corporate finance Commercial lending CLOs CDOs Securities