Mining bitcoin used to be less cool than submitting LOTR fan fiction to the libraryofmoria.com. When cryptocurrency first appeared in 2009 with the release of bitcoin, it was dismissed by critics as the pipe dream of cyber-utopians and disaffected nerds. The real-life utility of bitcoin was so untried that many questioned if 10,000 BTC was even worth a few slices of Domino’s pizza (it was — Lazslo Hanyecz lost $92,332,500 in that trade). But bitcoins’ disciples would not be daunted. Indeed, few currencies have been more fetishized or mythologized than bitcoin. (Perhaps gold tops the list, but it’s had 6,500 years to get ahead.)
Thanks to its shroud of anonymity, bitcoin became the symbol of choice for political anarchists and libertarians. Some crypto evangelists saw bitcoin as a chance for finance to finally break free from tyrannical governments and undermine the entire international monetary system.
Needless to say, these visions have yet to materialize. Crypto-inspired fan fiction, on the other hand, has really taken off. Our personal favorite is Unchained: A Story of Love, Loss, and Blockchain. As cryptocurrencies lost some of their early mystique and became more normalized, they attracted more government attention and legal discussion. Should bitcoin be treated as a legitimate currency or monopoly money? If it’s not a currency, what is it? A store of value? An investment? A poker chip? (Hint: for our purposes today, it’s a general intangible.) Beyond its classification as an asset class, bitcoin has also raised questions regarding its legal (and illegal) uses. If bitcoin is as anonymous as they claim, might this be a convenient way for me to hide money from my spouse? Could this be an easy place for me to stash all my cash when they try to divorce me? The answers are yes, and it might be time for your ex to hire a digital forensics expert. As the infosec experts say, don’t play down the risks of a $5 wrench attack.
Because it’s such a new phenomenon, many questions remain surrounding cryptocurrency’s usage and future classification. In this article, we will seek to answer just one small question: can you get a perfected lien on cryptocurrency? In other words, if we think about this question from the debtor’s perspective, we might ask: can you hide your crypto from the Repo Man? Before we can answer this, we’d like to get a few legal terms down first.
What Is a Lien?
A lien is the difference between a secured debt and an unsecured debt. A lien is the lender’s claim to collateral. Let’s say your father lends you 10,000 dollars. Unfortunately, the best thing about your financial profile is that you have no student loans. Beyond that, there’s not much to your name. You have nothing of value to serve as collateral. And so, he makes you an unsecured loan. If you fulfill his prophecy of vagrancy and personal ruin, he’ll never see another dollar. Let’s compare this to the new and improved you ten years later. Miraculously, you have pooled together enough savings to buy a house. You might look better on paper, but not many lenders are as generous as your father. They’ll lend you the money, but only if it’s secured by collateral. How can they do this? Through a specific type of lien: a mortgage.
Why Should I Care?
Secured debt is amazing for the lender. In almost every scenario, they’re getting paid. It transfers the majority of the risk from the lender to the debtor. As a consolation, secured debts typically have lower interest rates. Let’s say you enjoy the house for a few years. Then COVID-19 hits. You lose your job. You lose your savings. You start listening to The Eagles’ song “Desperado” on repeat and stop paying the mortgage. What happens? Theoretically, the lender seizes your house, sells it off, and collects their money.
And what happens to you? You increase your credit line (unsecured debt) and accept that you will spend the next few years renovating your parents’ basement.
A Lien Is One Thing, But What Is A Perfected Lien?
Perfection is the act of giving notice to the state. It announces to the world that you have a security interest in a specific item. Hello, my name is Affluent Alice, and if Bankrupt Bob forgets to pay me back, I will seize his second set of AirPods Pro (the first being stolen by his partner). Typically, you can notify the world about your claim by filing paperwork at a courthouse. Why do you have to do this? To save your spot in line. Let’s say Bankrupt Bob is a big spender and wants to get five different loans from five different people. However, he only has one piece of collateral: his second pair of AirPods Pro. Affluent Alice knows nothing about Bankrupt Bob’s dangerous spending habits or pending litigation. She sleeps well at night believing that, one day, the pair of AirPods Pro will be hers. But what if Bob has already promised his AirPods Pro as collateral to Creditor Clare? If Bob defaults on his loans, will Affluent Alice and Creditor Clare have to share the AirPods? How will they decide who gets to take the collateral? By priority. Whoever perfected the lien first — by filing the correct paperwork with the state — will have first priority in claiming the AirPods.
Cryptocurrency and The Uniform Commercial Code
Pivotally, the creation and perfection of a security interest depends on the type of collateral involved. In the Uniform Commercial Code — a very long legal document that governs business transactions — there are many different types of personal property, including goods, equipment, inventory, accounts, money, and intangibles. The main ways to perfect a lien are by filing a description of the collateral, taking possession of it, or taking control of it. For our purposes, we only care about Article 8 (securities) and Article 9 (personal property). The U.C.C. was written in the 1950s, long before Bitcoin Jesus was born, before he deserted his faithful for a confusingly named spinoff network, and before the Bitcoin Reformation was nailed to the internet’s front door. Unfortunately, this may be bad news for lenders exploring bitcoin, or any form of cryptocurrency, because it means that, according to the U.C.C., it doesn’t qualify as money. One of the many charms of money is that you don’t have to worry about someone else’s creditors showing up at your doorstep and demanding their dollar bill back. But in order to qualify as money, a government must adopt the currency as its medium of exchange. Even if bitcoin did qualify as money in the eyes of the U.C.C., the only way to perfect a security interest on money is by physical possession, an impossibility with virtual currencies. But what about bank accounts? Bitcoin also doesn’t qualify as a bank account because it’s stored on a decentralized ledger, the blockchain. There is no third-party involved, such as a bank, to cede or take control of the bitcoin. Instead, by process of elimination within Article 9, bitcoin falls under “general intangibles.” This may be the worst category of Article 9. Unlike money, which gets transferred free of any past security interests, general intangibles retain their past security interests by default. Since security interests attach and survive the transfer of assets, certainty of being the first lien creditor can be ambiguous. Beyond an initial lien search against the proposed borrower, it would be wise to conduct a lien search on each prior owner if the borrower had received the crypto from another party within the past five years. With bitcoin, that could be impractical or even impossible. Furthermore, if the debtor made a wrongful transfer of the collateral, the transaction would be irreversible from the debtor’s end and very difficult to chase down the lucky recipient thanks to crypto’s encryption. The lender could go to court and get a judgment, but the actual recovery of the collateral would prove very difficult.
A Loophole in Article 8… But At What Cost?
So, Article 9 is useless. But what about Article 8? Article 8 governs investment securities. If the bitcoin owner is willing to hold it through a financial intermediary, bitcoin should qualify as a financial asset. The lender could then perfect a security interest through a control agreement, which would prevent the borrower from making any peer-to-peer transfers of the bitcoin on the blockchain. Unfortunately, this approach also breaks one of the cardinal rules of bitcoin, i. e. no middleman. Hence the slogan, Not Your Keys, Not Your Bitcoin. The whole reason anyone got excited about bitcoin in the first place was because it was supposed to eliminate all the downsides of fiat currencies: namely, inflation, third-party intermediaries, and the need for a centralized authority.
Once an intermediary is introduced, the possibility of cyber attacks increases. We all remember when Mt. Gox — once the world’s largest bitcoin exchange — reported 850,000 stolen bitcoins. It’s no wonder that crypto lenders such as SALT hide their assets in deep cold storage (everything offline), and still require a debtor’s insurance policy.
Can I Borrow on Crypto Without a Middle-Man?
Collateralized lending on cryptocurrency is growing faster than the assets themselves. Genesis Capital alone issued over $4bn of crypto loans in 2019, and already originated another $2bn in Q1 2020. But can secured lending happen peer-to-peer? Perhaps, with smart contracts. We’ve seen the limitations of the U.C.C. and its classifications of bitcoin. You can either accept bitcoin’s cumbersome classification as a general intangible or sacrifice many advantages of the asset by bringing in a middleman. But other cryptocurrencies — namely, Ethereum — have worked their way around these problems with smart contracts. Ethereum is the second leading cryptocurrency network by market capitalization. Its main advantage over bitcoin is the ease of development of smart contracts. Smart contracts are computer-coded agreements that operate directly on the blockchain. If a bank wants to make a loan to a borrower using Ether as collateral, theoretically the smart contract could be coded to verify, monitor, and enforce the agreement without human intervention. If the borrower defaulted on the loan, they would have no chance to hide the collateral from the repo man because the smart contract would already have liquidated the assets. Lending and borrowing via smart contracts still remain a relative novelty. Interest rates are high (9%), volatility is a problem, and the potential for bugs in a smart contract remains a real possibility. Furthermore, the pesky Oracle problem may re-introduce the middle-man elsewhere in the stack. But if cryptocurrency continues to develop into an institutional asset class, we expect to see more borrowers. And, if even former bitcoin naysayer Jamie Dimon can come to see the error of his ways, we expect to many more believers.
(Note: Bitcoin since plunged to 3,000 USD in December 2018. It has recovered to 9,000 USD today).
About Colbeck: Colbeck is a strategic lender that partners with companies during periods of transition, providing creative capital solutions to meet their evolving needs. You can reach the team at email@example.com.