Ode on Digital Assets and DeFi’s Bankruptcy-Remoteness
Folks. The evening of July 13, 2022 was a cosmic gem. Some stars aligned, a Thunder Full Moon was in Capricorn, and the worlds of blockchain and decentralized finance (“DeFi”) tilted on their axes.
A little after 5pm (all times Eastern), the Uniform Law Commission voted to approve Uniform Commercial Code (“UCC”) amendments related to emerging technologies like blockchain-native digital assets, sending those amendments off to the states to (hopefully) make them law.
Then, starting at around 8pm, a bunch of Celsius Network entities (“Celsius”) filed Chapter 11 bankruptcy petitions.
Are these two events related? No, not in the “literal” or “dictionary” sense — that is, neither one had anything at all to do with the other. But were they related cosmically? Yes, for sure. These July 13 events marked the beginnings of two massive, parallel chapters in the stories of DeFi and blockchain more broadly. Read on.
So what in the world was Celsius doing?
Celsius’s story starts a few years ago, when Celsius started operating a bank-like business: customers deposit crypto with Celsius in exchange for a high-yield return, and Celsius turns around and puts those deposits to other uses, like lending and investment, in order to generate the depositors’ return and a little revenue for itself.
One thing Celsius did with those deposits was pledge them to DeFi lending protocols. Celsius would “lock” some amount of crypto (say, $100 worth of crypto 1) into a smart contract with these lending protocols, and, in exchange, Celsius would get (less of) some other crypto (say, $80 worth of crypto 2) — viz., overcollateralized secured lending against crypto.
Celsius did this with hundreds of millions of dollars worth of crypto, and then things eventually went poorly, as they do.
On June 12, 2022, Celsius froze withdrawals for its customers, meaning Celsius was most likely insolvent and didn’t have enough assets to pay its operating debts — DeFi or otherwise — and still give deposits (and their returns) back to the depositors.
Specifically regarding that DeFi debt, though, as of June 21, 2022 (so shortly after customer withdrawals were still frozen), Celsius reportedly had around $700 million in DeFi debt, with $1.5 billion worth of collateral tied up with lending protocols Aave, Compound, and Maker.
Between June 21 and the morning of July 13, 2022 (while customer withdrawals remained frozen), Celsius paid down all of that DeFi debt and received its crypto collateral back. And then, in the evening of July 13, 2022, Celsius filed for bankruptcy.
The fact that Celsius paid its DeFi debt first has been touted as proof of DeFi’s vitality, but, in the words of someone, kinda sorta: Reports that “DeFi worked great” are greatly exaggerated.
DeFi Coming Back Down to Earth?
Under bankruptcy law, Celsius’s pre-bankruptcy post-insolvency payments to creditors can be clawed back into Celsius’s bankruptcy estate — by Celsius as debtor-in-possession, by an appointed trustee, or maybe even by other creditors (we’ll assume a trustee).
Sure, the $700 million in crypto assets out (debt repayment) followed by the $1.5 billion in crypto assets back in (collateral release) is a net positive for the bankruptcy estate, but what if the trustee could get the $700 million back AND keep the $1.5 billion in released collateral? Maybe they can.
First, the trustee can claim that the DeFi payments were avoidable “preferences” (a bankruptcy term for pre-bankruptcy creditor payments like this), and, if that’s successful, the payments go back into the bankruptcy estate and the DeFi debt is restored.
Second, the trustee can assert that the DeFi creditors failed to properly secure the crypto as collateral for the debts, such that (i) the DeFi protocols’ outstanding debt is unsecured; (ii) that crypto collateral remains an asset of the Celsius bankruptcy estate; and (iii) the DeFi protocols should be repaid from the estate last (probably on the same terms that Celsius’s depositor customers get repaid).
This would be, as they say, a “bold strategy, Cotton.” Would it work, though? Maybe, first let’s digress a few hundred words into the UCC’s story.
UCC and Digital Assets
The UCC governs secured lending and mandates that, for a creditor to have enforceable rights in collateral, the creditor must “perfect” its security interest in that collateral. Different collateral types require different perfection methods, and, if you fail to perfect correctly, you may wind up as an unsecured creditor.
One such perfection method for digital assets is by “control.” Simply, the party that has the exclusive power to alter, benefit from, and transfer ownership of the digital asset is said to have control, and, therefore, a perfected interest in the digital collateral.
Importantly, the controller has the strongest claim to the asset. More importantly, a buyer who takes control of a digital asset gets that ownership free of any prior, unknown competing claims to the asset. Essentially, control makes the digital asset “negotiable,” in that parties can freely transfer control of the asset without any worry of some hidden challenge to their ownership.
Naturally, these ideas of control and negotiability vibe really nicely with the “no keys, no cheese” crypto ethos. Like, if a borrower gives the creditor control of their crypto — transfers it to the creditor’s wallet, custodies it with a third party, or locks it with a smart contract — it certainly feels like the creditor should be in a good position, since the creditor can easily liquidate the crypto if the borrower defaults.
Hold the phone, though. Perfection by control doesn’t apply to crypto. Not yet, anyway. On July 13, 2022, the ULC approved amendments to the UCC that will expand the concept of perfection by control to a host of digital asset types, including most crypto assets (more on that later), but it will likely take a few years for those amendments to be widely adopted across the United States.
Crypto Out of Control
In the meantime, crypto has to figure out how it fits into the existing UCC framework. And, y’all, it’s not like a glove. Crypto and crypto-adjacent assets (e.g., stablecoins) don’t fit into any specific collateral type in the UCC’s current form, so they, and blockchain-native assets more generally, mostly fall into the catchall category of “general intangible” assets, which is a problem.
Two problems, really. Problem one is that perfection of interests in general intangibles is through the filing of a “financing statement” — recording a document describing the collateral with the appropriate authority (often the secretary of state’s office) in the state where the borrower is located — not through control. And, if a creditor fails to file a satisfactory financing statement, the creditor’s security interest in the collateral is unperfected — meaning the creditor is essentially an unsecured creditor.
Problem two is that general intangibles are decidedly not “negotiable.” Buyers of crypto general intangibles basically take the asset subject to any prior perfected interest — and that interest can continue to run with the asset no matter how many times it’s transferred.
These two problems combine to severely undermine the crypto and blockchain worlds’ ideals of free, disintermediated, frictionless transferability, as digital asset selling and lending appear to require some real-world paperwork, along with a good bit of investigation into the buyer, the borrower, and the assets themselves.
Defining DeFi
So where does this leave Celsius and its DeFi creditors? Well, there are plenty of unanswered questions about the effect of Celsius’s pre-bankruptcy payments to DeFi lending protocols. Let’s ask two broad ones.
Are the payments to the DeFi protocols within the trustee’s reach?
Legally, most likely. Practically, maybe. The trustee has the power to avoid transfers by an insolvent debtor like Celsius made within 90 days of bankruptcy if those payments were made “to or for the benefit of a creditor.” Lending protocols, which really strain the standard debtor-creditor construct (DeFi has said its debts “are not loans”), present some fascinating obstacles for the trustee — like establishing who exactly are Celsius’s “creditors,” proving that they actually qualify as “creditors” under the bankruptcy code, getting jurisdiction over those entities, and tracking down the proceeds of Celsius’s payments. But getting an order from the court demanding repayment seems pretty plausible. Given the nature of DeFi and the lending protocols, the likelihood of successfully executing on such an order may be lower, but recent reports indicate that the blockchain world, and maybe the DeFi lenders themselves, aren’t as decentralized as we think. And a blockchain’s public, immutable transaction record should help, too.
Were the DeFi protocols properly perfected in Celsius’s crypto collateral?
Most likely those protocols had “control” of Celsius’s collateral — though that’s apparently up for debate if you ask, say, MakerDAO, which has said that borrowers retain “complete and independent control over their deposited collateral.” Anyway, under the UCC, control isn’t the standard to perfect. Instead, the UCC says the DeFi protocols needed to have filed appropriate financing statements against Celsius. And, along with the obvious question of, “Well, did they?”, the situation presents more unique issues — who is the appropriate creditor to file the financing statement, is that creditor an entity under the UCC that can actually file the statement, and were the assets appropriately described in the statement. This question maybe has less depth, but it’s got the same murk.
Ultimately, if DeFi protocols are found to be unsecured per UCC requirements, Celsius’s crypto collateral comes back into the estate, and the DeFi protocols get pro rata repayment out of the estate at the back of the creditor line.
Back to the Question of the Future
Celsius’s July 13 bankruptcy filings are prologue to an epic battle between the sexy mystique of DeFi and the unsexy plodding of codified bankruptcy. And how things shake out in the case will have a mondo impact on the futures of crypto, DeFi, and blockchain (and probably regulation thereof).
The ULC’s July 13 approval vote on the UCC amendments will have a similarly mondo impact on those spaces, but in a probably more subtle way. For years the Gazillion-Dollar-per-Year Finance Industry™ has been nibbling around the edges of blockchain without any large-scale adoption. One reason for that hesitation has to be that there really isn’t much for financial institutions to do in blockchain land, unless they want to buy crypto, borrow crypto against other crypto, or trade some NFTs.
For the big financial markets to move on chain, they need to be able to move their big assets there first — they need blockchain-native assets. But, recall, most blockchain-native assets are not controllable, are “non-negotiable,” and demand real-world paper perfection. There are a handful of existing financial assets that can, right now, be blockchain-native and controlled — primarily mortgages, auto loans, and securities — but, alas, for the rest of the financial world with assets that could be digital but can’t be controllable, the blockchain value proposition isn’t there.
Lo! Exciting news, though: the UCC amendments, which all the states are expected to approve over the next few years, expand the concept of control and negotiability to a much broader universe of digital assets, including new-era assets like cryptocurrency, stablecoins, NFTs, and digital money and old-school assets like loans of all types, receivables, accounts, health insurance reimbursements, payment and servicing rights — really, with these amendments, almost any existing financial asset can be digital and blockchain-native and transferred freely, without intermediaries, and with speed and finality.
So as the UCC amendments work their way through the statehouses, we should start to see more of the massive legacy asset markets take closer looks at the blockchains. Because, truly, the transformative promise of blockchain is undeniable — maybe we just need the law to catch up.
The Breadth of the DeFi Universe
July 13, 2022. Oh, what a night — DeFi is now facing off with bankruptcy in the first real test of its legal foundations, and the legal infrastructure for wholesale blockchain adoption by TradFi is ready for state adoption.
And the stakes are high: if DeFi financing of digital assets is found to be beyond the reach of a bankruptcy court — that is, if DeFi protocols are bankruptcy remote — and if every traditional financial asset can become a blockchain-native digital asset perfected by control in the DeFi space, then the blockchain universe may end up being bigger, deeper, and closer than we thought.
CHRIS KARLSSON
Attorney with Figure Technologies focused on digital lending strategy and the development of new blockchain-based assets and marketplaces. Former litigator and “cool” compliance guy. Not a right-clicker — don’t play.
