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Market Making in Crypto — A Secured Lending Lawyer’s Learnings

Notwithstanding recent pricing dips, crypto trading volume is reportedly, but unverifiably, high — folks are seeking liquidity but markets remain opaque. Why? We still lack clear rules and best practices around fostering transparent, safe markets where participants can accurately price risk, and this is true in the US as it is globally — just last month the NY AG released its Virtual Markets Integrity Initiative Report delving into same; meanwhile, back in March, we saw BTC tumble on news of regulatory hurdles in Japan. In this post I will try to clarify how crypto assets are characterized for secured lending purposes and what level of security that affords lending counterparties — like BlockFi (which raised $52.5M from Novogratz’s Galaxy this summer), SALT Lending, Lendingblock, Coinloan, ETHLend, Bitbond, Depository Network and Unchained Capital.

I covered, at a very high level, the state of legal thinking around token origination and securities concerns in my last post whereas I now want to focus on the secondary markets and how folks can get liquid — specifically, I’ll share my learnings around how capital providers can effectively secure their interests in crypto collateral to the extent they are lending against the asset class, directly or via a marketplace. This might involve borrowers leveraging crypto they already hold or effectively mortgaging or ‘purchase money financing’ crypto assets they are purchasing with borrowed fiat, which collateral assets might be cryptocurrencies or [security] tokens. But first, a refresher on the broader legal landscape before we narrow in to look at secured transactions.

Again, this is not legal advice and these views are mine alone.

Legal frameworks overview: outside the securities regulatory environment referenced in my last post, legal frameworks are diverse and sometimes overlapping (inter- and intra-state) but here’s a quick summary of the major relevant U.S. frameworks or regulators, as applicable:

• SEC: its mandate is to regulate and foster open and transparent securities markets, so it is focused on investment assets — assets into which folks funnel fiat in hopes they will realize an appreciation in value. In June, William Hinman, Director of the Corporate Finance Division, remarked at the Yahoo Finance All Markets Summit: Crypto, that applying federal securities laws to trades in bitcoin or ether “would seem to add little value”, prompting spikes in the prices of both digital assets. In so doing, he added however that tokens for companies built on Ethereum can be securities for purposes of the federal securities laws and thus subject to liability should folks fail to comply with federal disclosure regimes. This is consistent with Chairman Clayton’s December 2017 guidance, drawing a line between (a) ICOs (noting they largely implicate federal securities laws) and (b) cryptocurrencies, which, to the extent they function like stores of value, provide many of the same functions as long-established fiat currencies and do not rise to the level of a ‘security’.
• CFTC: unlike securities, commodities fall within the realm of the CFTC, which regulates commodity (i) derivatives (like futures, options, any other swaps) (7 U.S.C. 2(a)(1)(A)) and (ii) spot and forward transactions, but only to the extent of any fraud or market manipulation (see 7 U.S.C. 9(1)), unless they are among retail investors in which case the CFTC has exclusive jurisdiction (7 U.S.C. 2(c)(2)(D)). The CFTC clarified as early as 2015 in the Coinflip ruling that BTC and other cryptocurrencies are commodities and fall within its jurisdiction (Coinflip operated a marketplace for BTC options); by this year, a federal judge agreed in the McDonnell/CabbageTech ruling (see also Oct 2017 CFTC Primer on Virtual Currencies). There are however, limits to the CFTC’s jurisdiction — the ‘actual delivery’ exception for contracts of sale (vs. leveraged transactions), whereby a commodity delivery if actually effected within 28 days will fall outside the CFTC’s purview, as will commodity transactions among sophisticated parties like ‘eligible contract participants’ or banks. These exceptions are basically not helpful for purposes of affording non-bank lenders with an exception from CFTC requirements as to financing crypto purchases or related leveraged transactions. (As for the ‘actual delivery’ exception, the CFTC’s Bitfinex settlement order shed light on same — finding that Bitfinex, in operating a platform that “permitted users… that did not meet the definition of an eligible contract participant … to borrow funds from other users on the platform in order to trade bitcoins on a leveraged, margined, or financed basis” without registering with the CFTC or actually delivering BTC and instead holding the purchased coins in wallets that Bitfinex owned and controlled, amounted to “illegal, off-exchange commodity transactions”).
• FinCEN and money transmitter laws: The Financial Crimes Enforcement Network (FinCEN) within the United States Department of the Treasury is focused on fighting money laundering, terrorist financing, and other financial crimes. As early as March 2013, FinCEN clarified that it would treat virtual currencies like fiat for purposes of money transmission laws and 5 years later clarified that virtual currency exchangers and administrators have been subject to the Bank Secrecy Act since 2011, requiring them to register with FinCEN, prepare AML written compliance programs and comply with same as well as OFAC requirements.
• IRS: As early as 2014, the IRS issued guidance that it would treat virtual currency as property, meaning crypto holdings must be reported and “the character of gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer”.
• UCC: The Uniform Commercial Code is a model code that governs commercial transactions, which has been adopted by, thereby rendering it effective in, all 50 states, DC, Puerto Rico and the U.S. Virgin Islands. It promulgates rules for various types of transactions, including commercial lending and in so doing, governs security interests in personal property — meaning it tells us how to effectively collateralize a loan and have legal recourse to the pledged property in bankruptcy.

So with volume up, we see exchanges and other platforms developing to help ‘hodlers’ leverage their digital holdings and to help lenders capture the collateralized value of crypto — to the extent you are pledging or taking crypto as collateral, Revised Article 9 of the UCC (“UCC9”) dictates how that pledge can be legally effective against the pledgor and any of its other creditors.

UCC As Applied to Crypto: Legally effective collateral transfers depend on the type of collateral pledged and experienced legal practitioners do not all agree on how digital assets should be categorized — here is what I gathered, in part from the American Bar Association meeting a few weeks ago discussing crypto. By way of background, categorization of pledged assets drives so called ‘perfection’ steps that a lender must take to have a legally effective security interest (read: ability to realize on collateral pledged by a bankrupt debtor) — most asset types can only be perfected by filing what’s called a ‘financing statement’ (which just tells the world and any other creditors that the lender has a security interest in the covered collateral — see NY UCC 9–312 for more), whereas some collateral types can be perfected by taking possession (for possessory collateral like money or instruments — see NY UCC 9–313 for more) or by taking ‘control’ (where a third party custodian or indirect holder is involved — see NY UCC 9–314 for more), or some but not all of these 3 methods in limited circumstances. Generally, ‘control’ offers a higher form of protection for the lender (vs filing) but affords no actual or contractual control over the asset; it’s also only available for select collateral types, including, in relevant part, ‘investment property’. Any asset can only qualify as a single collateral type at any one time, though it might change as it makes its way through the chain of commerce (for instance ‘inventory’ once sold becomes ‘accounts’ under UCC9).

Collateral types under the UCC can initially be divided into tangible and intangible assets and crypto is clearly intangible so I’ll focus on same here — possible sub-categories include: money, accounts, deposit accounts, instruments, investment property (which includes ‘securities’, whether certificated or uncertificated, ‘security entitlements’, ‘securities accounts’, ‘commodity contracts’, or ‘commodity accounts’) or general intangibles (which is the catchall category).

1. Money: Nearly everyone agrees that non-sovereign issued cryptocurrencies like BTC are not ‘money’ under UCC9 because “money” for UCC9 purposes must be authorized or adopted by a domestic or foreign government (NY UCC 1–204(b)(24)).
2. Accounts: Similarly, cryptocurrencies or tokens are generally not thought of as “accounts” under UCC9 since that term encompasses receivables and similar rights to payment of monetary obligations “for property that has been or is to be sold, leased, licensed, assigned, or otherwise disposed of” (see NY UCC 9–102(a)(2)). This collateral type excludes ‘investment property’ and rights to payment for money or funds advanced or sold (other than credit card receivables), so if a digital asset qualifies as ‘investment property’, it won’t be an ‘account’ hereunder. Likely more compelling is the assessment that delivery of digital assets or the obligation to exchange them into fiat isn’t really a monetary obligation for property sold — holders of digital assets advanced money in the first place to acquire crypto or tokens so the right to fiat in the reverse exchange immediately takes us out of the ‘accounts’ definition, and the right to receive a token isn’t a right to payment of the borrower or pledgor from the relevant exchange or token issuer, lender or custodian (for the narrow purposes of this definition).
3. Deposit Accounts: these are limited to ‘demand, time, savings, passbook, or similar account[s] maintained with a bank’ and also exclude investment property or accounts. No blockchain qualifies as a bank under NY UCC9 so digital assets are carved out of this collateral type (notwithstanding (i) NY’s Bitlicense framework, which permits virtual currency transactions but does not grant them a bank charter or (ii) the OCC’s recent acceptance of applications for special purpose charters from fintech companies).
4. Instruments: Digital assets won’t qualify as ‘instruments’ either because this category is essentially limited to physically possessory rights to payment of monetary obligations represented by a negotiable instrument or by a writing — like promissory notes, checks, negotiable certificates of deposit and drafts (see NY UCC 9–102(a)(47) and NY UCC 3–104; NY UCC 3–202 then defines negotiation as a transfer whereby transferee becomes a ‘holder’ and NY UCC 9–313 then limits perfection mechanisms to physical possession).
5. Investment Property: this asset class includes any ‘security, whether certificated or uncertificated, security entitlement, securities account, commodity contract, or commodity account” (NY UCC 9–102(49)). Some folks think that digital assets could qualify as ‘financial assets’ if custodied in a securities account, thereby affording lenders superior perfection via control. Here’s a closer look at each of these sub-categories and their challenges:

First, the basic building blocks so we can level-set:

• “Financial asset” means “(i) a security; (ii) an obligation of a person or a share, participation, or other interest in a person or in property or an enterprise of a person, which is, or is of a type, dealt in or traded on financial markets, or which is recognized in any area in which it is issued or dealt in as a medium for investment; or (iii) any property that is held by a securities intermediary for another person in a securities account if the securities intermediary has expressly agreed with the other person that the property is to be treated as a financial asset under this Article. As context requires, the term means either the interest itself or the means by which a person’s claim to it is evidenced, including a certificated or uncertificated security, a security certificate, or a security entitlement.” (NY UCC 8–102(9))
• A ‘security’ means an “obligation of an issuer or a share, participation, or other interest in an issuer or in property or an enterprise of an issuer: (i) which is represented by a security certificate in bearer or registered form, or the transfer of which may be registered upon books maintained for that purpose by or on behalf of the issuer; (ii) which is one of a class or series or by its terms is divisible into a class or series of shares, participations, interests, or obligations; and (iii) which (A) is, or is of a type, dealt in or traded on securities exchanges or securities markets; or (B) is a medium for investment and by its terms expressly provides that it is a security governed by [UCC Article 8]”. (NY UCC 8–102(15))
• “Securities intermediary” means “(i) a clearing corporation; or (ii) a person, including a bank or broker, that in the ordinary course of its business maintains securities accounts for others and is acting in that capacity.” (NY UCC 8–102(14))
• “Security entitlement” means “the rights and property interest of an entitlement holder with respect to a financial asset specified in Part 5” [of UCC Article 8, which deals with securities interests in securities entitlements, which are essentially interests in investments that are recorded in what’s referred to as the ‘indirect holding system’, which just means that beneficiaries are identified not by possession of physical certificates but rather by a securities intermediary noting their interests on its books]. (NY UCC 8–102(17))
• “Entitlement holder” means “a person identified in the records of a securities intermediary as the person having a security entitlement against the securities intermediary.” (NY UCC 8–102(7))

With building blocks behind us, where do digital assets fit in?

1. Are digital assets ‘securities’ for UCC9 purposes? Most practitioners take the position that cryptocurrencies are not obligations of an issuer (i.e., the chain does not issue the asset but rather just records the coin’s or token’s pseudonymous ownership) and even if they are, the relevant chain does not exist solely to maintain ownership records of the relevant cryptocurrency. I’m not so convinced that a chain, especially as new blocks are mined, cannot be thought of as an issuer but I think for cryptocurrencies, the analysis falls apart at prong (iii) (dealt in securities markets) unless the chain at inception somehow opts into UCC8. As for security tokens though, I think it’s easier to satisfy these ‘security’ prongs and for the token issuer network to qualify as an issuer, rendering the tokens (or SAFTs) as obligations of that network / issuer. I agree it’s murky though and don’t think this is a very compelling position.
2. Are digital assets ‘financial assets’? I think there’s a more colorable argument that security tokens qualify under prongs (i) or (ii) as they are obligations of a person or property (the relevant network), dealt in financial markets for purposes of investing (especially after the SEC’s position that tokens are generally securities for purposes of federal disclosure rules). As for cryptocurrencies, I think there’s as colorable an argument that they can qualify under prong (iii) so long as custodied with a true securities intermediary subject to an effective control agreement whereby all parties agree to deem the custodied crypto a “financial asset” under UCC8. The securities financing presentation at this month’s ABA meeting suggests that some margin lenders have opted for this approach.
3. To the extent cryptocurrencies or tokens cannot neatly fit into any of the above sub-categories, they will be ‘general intangibles’, an asset class in which secured parties can only perfect interests by filing, so for purposes of legally enforceable collateral, the assets remain outside of lender control. Most legal practitioners think this is the right outcome under UCC9.

This is all to say that for purposes of having a legally enforceable claim to a borrower’s cryptoassets under the US bankruptcy regime, which some secured lenders will need depending on their risk appetite, filing a UCC financing statement might be the only way. This is not to say that for practical purposes, lenders won’t want to also take control of private keys or set up multisig arrangements prohibiting the borrower-pledgor from further transferring or encumbering pledged cryptoassets; Columbia professor and UCC expert Ronald Mann in his draft paper for the September ABA crypto meeting, despite characterizing digital assets as general intangibles, nonetheless argues for what he calls ‘quasi-control’ as a practical mitigant against fraudulent conveyances — essentially saying that lenders should transfer pledged assets to the secured party’s public key and possibly rely on smart liens to unencumber the assets once obligations are satisfied. Notably, as mentioned above in re: Bitfinex, control is helpful for practical purposes but bad for tripping CFTC retail commodity restrictions.

Outside of legally effective collateral claims, there are a myriad of other legal and practical concerns worth considering that I have not addressed here — see, for instance, Alex Grishman’s very helpful presentation on Bitcoin financing from this April (e.g., margin lending restrictions; beneficial ownership reporting requirements; Regulation U margin limits; concentration limits; lender liability to the extent in control or custody of private keys; valuation mechanics and dispute resolution; adjustment events like forks and related effects; foreclosure considerations — is there a recognized market notwithstanding digital assets not being fungible? was adequate notice given or fair price discovered?).

Hopefully distilling the secured lending framework here and highlighting related lender concerns will help both market making lenders and borrowers create more robust crypto trading platforms. Would love to connect with you if you are thinking through these issues or perhaps seeing you at the next conference — I’ll be at Blockchain SF + CESC next week and hope to see you there! Find me on twitter @irinamarinescu

Thank you Alex Grishman, Brittany Laughlin, Gary Basin, Joseph Kelly, Kishan Shah and Meredith Morgan for previewing and kindly sharing your thoughts.