September/October 2018

The Cryptocurrency Conundrum — A Primer for Secured Lenders Entering the Cryptocurrency Space

Like personal computers, smartphones and the internet, cryptocurrencies are here to stay. For the secured lender, the blockchain technology that protects the privacy of the borrower can present an obstacle to securing collateral and receiving repayment. Alan Rosenberg provides a detailed explanation of the technology and a guide for lenders to protect themselves in cybercurrency transactions.



Alan Rosenberg Associate, Markowitz Ringel Trusty & Hartog

Alan Rosenberg
Associate, Markowitz Ringel Trusty & Hartog

Cryptocurrencies are not a passing fad. Open any major newspaper and you are likely to see a headline that mentions bitcoin, initial currency offerings or other cryptocurrency-related topics. Clearly the public is beginning to incorporate cryptocurrencies into their daily lives. But the masses are not just buying and trading cryptocurrencies; they are also engaging in cryptocurrency-based lending transactions (crypto lending). In this regard, however, innovation has progressed significantly faster than regulation. While some states have enacted cryptocurrency-based regulation, many would probably agree that crypto lending concerns are not adequately addressed therein. Accordingly, secured lenders entering the cryptocurrency space must educate themselves to ensure that their crypto lending transactions and associated collateral are secure.

Cryptocurrency Basics

Virtual currencies or cryptocurrencies are “digital assets used as a medium of exchange.”(1) These digital assets are described as cryptocurrencies because they use “cryptographic protocols to secure transactions.”(2) Cryptocurrencies “are stored electronically in digital wallets and exchanged over the internet through a direct peer-to-peer system.”(3) Digital wallets are then accessed by users through private keys, which are “a sophisticated form of cryptography that allows a user to access his or her cryptocurrency.”(4) However, if a user loses his or her private key, that user will no longer be able to access the digital wallet to spend, withdraw or transfer cryptocurrency.(5)

A hallmark feature of cryptocurrencies is their decentralization. Instead of being controlled by a central governing authority,(6) cryptocurrency transactions are processed, verified and recorded on a public ledger called the blockchain. More specifically:

The “blockchain” serves as a digital signature to verify the exchange. The public nature of the decentralized ledger allows people to recognize the transfer of virtual currency from one user to another without requiring any central intermediary in which both users need to trust. Some experts believe blockchain technology underlying virtual currencies will serve to enhance future economic efficiency and have a broad and lasting impact on global financial markets in payments, banking, securities settlement, title recording, cyber security and trade reporting and analysis.(7)

The individuals who maintain the blockchain are referred to as “miners” and typically receive transactions fees in the form of new cryptocurrency for their services.(8) Because the blockchain is public, cryptocurrency transactions can be reviewed by anyone at any time.(9)

What Type of Asset is Cryptocurrency?

A prudent lender will want to familiarize themselves with the collateral at issue before engaging in a secured lending transaction. Many would likely conclude cryptocurrencies are, as their name implies, a form of currency. And while cryptocurrencies share characteristics with their fiat currency counterparts, they differ in many key respects. Cryptocurrencies lack intrinsic value, regulatory oversight and institutional capital, which are important to secured lenders,(10) making cryptocurrency values extremely volatile.(11) These and other characteristics make cryptocurrency a difficult asset to classify — and tricky to collateralize. The Internal Revenue Service, Securities and Exchange Commission, Commodity Futures Trading Commission and the court system have all taken different approaches toward classifying cryptocurrency, adding to the confusion.

A Commodity or Not?

The IRS issued Notice 2014-21 which describes how existing general tax principles apply to transactions using virtual currency. The IRS describes cryptocurrencies as: “digital representation[s] of value that function as a medium of exchange, a unit of account, and/or a store of value. In some environments, [they] operate like ‘real’ currency — i.e., the coin and paper money of the U.S. or of any other country that is designated as legal tender, circulates, and is customarily used and accepted as a medium of exchange in the country of issuance — but [they] do not have legal tender status in any jurisdiction.(12)

For federal tax purposes, cryptocurrency is treated as property, and “[g]eneral tax principles applicable to property transactions apply to transactions using virtual currency.”(13)

The Commodity Futures Trading Commission (CFTC), on the other hand, believes that cryptocurrencies are commodities.(14) This classification has been accepted by at least some Federal courts(15) which believe cryptocurrencies:

“[A]re goods exchanged in a market for a uniform quality and value and thus, fall well-within the common definition of ‘commodity’ as well as the CEA’s definition of ‘commodities’ as all other goods and articles … in which contracts for future delivery are presently or in the future dealt in.”(16)

The SEC has not yet taken a position on whether cryptocurrencies are securities.(17) Given the parameters set forth by the U.S. Supreme Court in SEC v. W.J. Howey Co.,(18) it seems clear that cryptocurrencies, on their own, do not meet those requirements.(19) The SEC, however, has been involved in various cases and enforcement actions where particular cryptocurrency transactions were deemed securities transactions subject to securities laws.(20) These cases generally involve initial coin offerings — transactions which “involve the opportunity for individual investors to exchange currency such as U.S. dollars or cryptocurrencies in return for a digital asset labeled as a coin or token.”(21)

The court system has displayed little, if any, consistency with respect to the cryptocurrency classification. Some courts have found that cryptocurrencies — particularly within the context of the Federal money laundering and money transferring statutes — fall within the definition of “funds” and “monetary instruments.”(22) Other courts have determined that cryptocurrencies, such as bitcoins, are not the equivalent of money.(23)

Securing Crypto Lending Collateral

Given the lack of uniformity in the classification of cryptocurrencies, it is no surprise that §9 of the UCC, which governs security interests in most types of property, does not address cryptocurrency.(24) But even if it did, executing upon and/or taking possession of cryptocurrency-collateral has its own practical hurdles. After all, cryptocurrencies are designed to be safe, secure, anonymous and decentralized; characteristics that are excellent for borrowers and troubling for lenders. And without a private key, it is unlikely that a secured lender would be able to obtain possession of a defaulting debtor’s cryptocurrency. Accordingly, lenders engaging in crypto lending must employ a certain degree of creativity to ensure the security of their investments and their collateral.

Multi-Signature Cryptocurrency Wallets

One way to ensure the safety of cryptocurrency collateral is through the use of multi-signature cryptocurrency wallets. A multi-signature cryptocurrency wallet — or multisig — requires multiple private keys to process cryptocurrency transactions. Using a multisig platform, cryptocurrency cannot be transferred by one person without the consent of another person who holds an additional private key.(25) In the context of crypto lending, a lender taking a security interest in cryptocurrency may want to consider having the collateral placed in a separate, segregated multisig wallet. The lender can then hold an additional private key, thereby requiring the lender’s authorization before any cryptocurrency is transferred from the wallet. This should ensure that a borrower does not dissipate cryptocurrency collateral without the lender’s explicit consent.

Cryptocurrency Collateral Cold Storage

Cryptocurrency collateral can also be secured through cryptocurrency cold storage — “a non-internet-connected device and/or program which generates your [cryptocurrency] wallet within a reserve offline.”(26) Cold storage generally requires a user to either create a “paper wallet” or store their cryptocurrency on a USB drive or specialized cryptocurrency hardware wallet.(27) In the case of a paper wallet, a user will print public and private access keys on paper, which are required for the user to access the cryptocurrency. If the paper keys are lost or destroyed, however, the user will lose access to the subject cryptocurrency. A hardware wallet, on the other hand, is an actual device that stores the subject cryptocurrency. (28)

In a crypto lending transaction, a secured lender may request that the debtor place cryptocurrency collateral in cold storage. The cryptocurrency collateral — whether in paper or hardware form — can then be retained by the secured lender or independent escrow agent. Then, in the event of a default or other breach, the secured lender can be ensured that the collateral securing its investment is available to satisfy the debt.

"SALT — secured automated lending platform — is a cryptocurrencybased secured lender that engages in blockchain-backed loans. These are simply loans in which you hand over a blockchain asset, like bitcoin, as collateral in exchange for traditional currencies.

“SALT — secured automated lending platform — is a cryptocurrency based secured lender that engages in blockchain-backed loans. These are simply loans in which you hand over a blockchain asset, like bitcoin, as collateral in exchange for traditional currencies.”

What Are Other Cryptocurrency-Backed Lenders Doing?

Some lenders have already begun issuing cryptocurrency-backed loans. SALT — secured automated lending platform — is a cryptocurrency-based secured lender that engages in blockchain-backed loans. “These are simply loans in which you hand over a blockchain asset, like bitcoin, as collateral in exchange for traditional currencies.”(29) Utilizing a multisignature smart contract, borrowers deposit their cryptocurrency collateral, receive fiat currency loans directly into their bank accounts and then make regular payments on the loan. When the loan is repaid, the cryptocurrency is returned.(30) A caveat to SALT’s lending platform, however, is its strict adherence to loan to value ratio (LTV) requirements. If the LTV increases beyond the initial LTV — a likely outcome if the market value of the cryptocurrency sharply declines — the borrower is required to either provide more collateral or pay down the loan to lower the LTV. Given the general volatility of cryptocurrency values, it is likely that crypto lending LTV’s have the potential to drastically shift during the life of a loan. Secured lenders will want to keep this in mind when determining how to structure crypto lending transactions.

Given the increased popularity of cryptocurrency, it is likely that many secured lenders will begin to enter the crypto lending market.(31) At the very least, the general public — who will continue to purchase and accumulate cryptocurrency — will begin offering their cryptocurrency assets as collateral for loans. For those lenders who intend to participate in crypto lending, it is important to understand the nature and basic characteristics of cryptocurrency. While cryptocurrency may pose unique challenges as a form of collateral, it is not impossible to collateralize. With adequate planning, research and a bit of creativity, secured lenders should be able to wisely engage in crypto lending transactions.


 

1 Commodity Futures Trading Comm’n v. McDonnell. 287 F. Supp. 3d 213, 218 (E.D.N.Y. 2018)(citing Skadden’s Insights. Bitcoins and Blockchain: The CFTC Takes Notice of Virtual Currencies. Jan. 2016).
2 Id.
3 Id.
4 Definition of Private Key. Investopedia.
5 Id.
6 Some governments have attempted to create government-backed cryptocurrencies. Venezuela, for example, recently launched its own cryptocurrency — the Petro — to help “pull…the country out of an economic tailspin.” Venezuela Says Launch of “Petro” Cryptocurrency Raised $735 Million. Reuters.
7 Commodity Futures Trading
8 See Alexander v. BF Labs Inc. 2016 WL 5243412, n.3 (D. Kan. Sept. 22, 2016)(citing Morici v. Hashfast Techs LLC, 2015 WL 906005 at *2 (N.D. Ca. Feb. 27, 2015).
9 Websites such as Bitcoin Block Explorer are open source web tool[s] that allow you to view information about blocks, addresses and transactions on the Bitcoin blockchain.
10 Arthur Linuma. Why is the Cryptocurrency Market So Volatile: Expert Take. Cointelegraph. February 27, 2018.
11 Id.
12 IRS Notice 2014-21.
13 Id.
14 See U.S. Commodity Futures Trade Commission, Bitcoin Basics.
15 Commodity Futures Trading
16 Id.
17 See Alberts & Fry. Is Bitcoin A Security? 21 B.U.J. Sci. & Tech. L. 1, 2 (2015).
18 SEC v. W.J. Howey Co. 328 U.S. 293, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946).
19 The Howey test generally requires a court to determine “whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.” See S.E.C. v. Edwards, 540 U.S. 389, 393 (2004).
20 Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Exchange Act Release No. 81207, P.1 (July 25, 2017).
21 SEC Statement on Cryptocurrencies and Initial Coin Offerings. Clapton. Dec. 11, 2017 at P. 4.
22 U.S. v. Ulbricht, 31 F. Supp. 3d 540 (S.D.N.Y. 2014); U.S. v. Murgio, 209 F. Supp. 3d 698, 707 (S.D.N.Y. 2016).
23 State of Florida v. Michell Abner Espinoza, Case No. F14-2923.
24 Tu. Perfecting Bitcoin, 52 Ga. L. Rev. 505, 545 (2018).
25 Davenport. What Is Multi-Sig, and What Can It Do? Coincenter, January 1, 2015.
26 Oreso. Cryptocurrency Cold Storage: What is it and why should you adopt it? January 11, 2018.
27 Id.
28 Velu. How to Keep Your Cryptocurrency Safe: 7 Must Have Wallets. Blockgeeks.
29 Butchko. What Is SALT Lending? Beginner’s Guide. Coin Central. January 10, 2018.
30 Id.
31 Redman. Crypto-to-Cash Lending is Growing Quite Popular These Days. Bitcoin.com, May 4, 2018.