The concept of cryptocurrency has been with us since at least 2009. News about various cryptocurrency offerings, and exchanges, seems to be everywhere in news feeds today – sometimes not for the best reasons, such as the collapse of FTX, a so-called cryptocurrency exchange.
How could something that seems so volatile be worthy of consideration as loan collateral?
It’s a Digital and Decentralized Medium of Exchange
At its most basic, cryptocurrency is often defined as a digital, encrypted, and decentralized medium of exchange. There is no centralized authority that manages or maintains the value of cryptocurrency.
Cryptocurrency could, in one sense, be viewed as a measure of value determined solely by a distributed, worldwide electronic marketplace. The assets are creatures of the electronic universe. As such, these assets can be either mined or purchased on exchanges or through brokers.
Once created or purchased, these assets are “stored” in various ways, typically either left with the exchange, stored in an online account, or stored offline (usually on a USB drive or hard drive). They can be almost instantaneously moved anywhere on earth with almost no traceability.
In the Realm of Possible: Cryptocurrency as Loan Collateral
As cryptocurrencies and similar assets become more commonplace, pressure will continue increase on lenders to allow their use as collateral for loans. The loan underwriting process takes into many considerations, not the least of which is how to collateralize this obligation.
Typical forms of collateral vary based on the type of lending being undertaken. Both statutory and common law procedures are well-established, and provide ample guidance on the establishment and perfection of security interests and liens in all kinds of traditional forms of collateral.
While these traditional asset classes have well-defined procedures for their use as collateral, cryptocurrency collateral procedures are much less clear cut.
One reason for this is that it is not clear how cryptocurrencies, as an asset, are classified. Many proponents of these assets refer to them as non-fiat currency – in other words: money. Others refer to them as general intangibles.
The U.S. Securities and Exchange Commission (SEC) has so far refused to label cryptocurrency as a security (although recent comments by the SEC chairperson and legal action by the SEC seem to imply they feel many forms of cryptocurrency are securities). as issued limited guidance that cryptocurrencies will be treated like securities and not as currency for purposes of taxation.
Joseph M. Mella, U.W. 1991, is a shareholder with Ruder Ware in Wausau, where he has practiced with the firm’s business and transactions practice group for over 30 years.
What Is Lacking in Existing Law
Since the focus of this article is on perfecting security interests in cryptocurrency, a brief look at existing law is appropriate.
Wisconsin’s version of the Uniform Commercial Code (UCC), Wis. Stat. chapter 40, covers the process for creating and perfecting security interests in a broad range of tangible and intangible property.
However, the UCC does not currently define cryptocurrency. It is probably not “money” – defined as a “medium of exchange currently authorized or adopted by a domestic or foreign government” – nor currently is it “investment property” (which generally covers registered securities and similar items).
A few cryptocurrency offerors have taken steps to register their offerings as securities, and a few countries have begun to recognize the most common cryptocurrency of Bitcoin as a medium of exchange, but a universal classification is still lacking.
Reaching Perfection: Beware Ghosts
Without a more universal classification of this type of asset, one must conclude that cryptocurrency should fall under the category of “general intangibles” for security interest purposes.
The UCC specifies that the only permissible method to perfect a security interest in general intangibles is by filing a financing statement.1 The UCC does not allow for perfection of a security interest in general intangibles by taking possession or control of the asset. Perfection by possession is limited to tangible negotiable documents, goods, instruments, money, or tangible chattel paper.2 Perfection through control is limited to investment property, deposit accounts, letter-of-credit rights, electronic chattel paper, or electronic documents.3
So, the short answer of how to perfect a security interest in cryptocurrency would be to first create a security interest in the assets by agreement, make sure the interest has attached, and then perfect the security interest by an appropriate filing.
However, lenders who understand the nature of cryptocurrencies and the ease with which they can be transferred anywhere without almost any ability to track transactions (let alone the actual coin) will be less than satisfied knowing that they have a perfected security interest when they cannot find the assets. Further, security interests attached to a general intangible typically follow the intangible, as opposed to attaching to the proceeds of the sale of the intangible, resulting in possible ghost liens following cryptocurrency coins around in the untraceable ether.
Make It Physical? Here’s Three Possible Approaches
Additional approaches should be considered to address these concerns.
One possible approach is for lenders to also treat cryptocurrency as if it was money or a deposit account, and proceed with the lender’s standard collateralization procedures for these types of assets.
Treating cryptocurrency in this fashion would suggest the lender still seek to take possession or control of the asset as security for repayment. The procedure for how a lender chooses to take possession or control would presumably be set forth in the loan documents. The typical methods for taking control or possession of such an asset may include taking physical control of cryptocurrency, which is possible if the cryptocurrency is kept in a cold wallet on a flash drive. In this case the drive could be delivered to and held by the lender.
A second option would be akin to some variation of “quasi-possession,” which includes various permutations of virtual storage (i.e., a virtual wallet in either the name of the lender or the borrower, along with the designation of who controls the public and private keys to obtain the cryptocurrency). Obviously, the more control the lender has in this case, the better it would seem for the lender.
A third option is transferring the cryptocurrency to a third party to hold for the duration of the loan, as a trustee or custodian, with the corresponding surrender of the control keys to this party.
Accounting for Lender Risks
Obviously, any of these options would need to be negotiated, and the resulting possessory relationship managed by parties who have a sophisticated understanding the cryptocurrency assets and how to manage and transfer them.
The lack of a defined set of rules for handling these items creates uncertainty around duties and responsibilities on the part of the lender. One such risk may be the imposition of similar duties on lenders as those imposed by the UCC for creditors with possessory or controlling interests in collateral, such as requirements to insuring against loss from hacking and physical damage. Another consideration is the extent of requirements to respond to requests related to the collateral from the debtor, including for an accounting.
It Will Happen
At this time, there are several organizations that are proposing amendments to the UCC to specifically address transactions and security interests in cryptocurrencies. The status of these proposals is in the early stages of consideration.
While its market value fluctuates wildly, cryptocurrency has grown to become a world-recognized asset. Borrowers can be expected to propose its use as collateral as holdings of cryptocurrencies increase and become more mainstream.
Traditional methods of perfecting security interests in these general intangibles using the standard filing to perfect method may not give sufficient comfort to lenders who choose to allow these assets to be collateral.
While there are risks, treating cryptocurrency like an asset class that requires a possessory interest for perfection, such as actual money, does provide a path forward for lenders seeking greater comfort and security for these situations.
1 U.C.C. § 409.310(1).
2 U.C.C. § 409.313(1).
3 U.C.C. § 409.314(1).