With cryptocurrency on the rise, new lenders, such as SALT Lending and Nexo, are entering the market and extending loans to clients for which the borrowers’ cryptocurrency is serving as collateral. However, these lenders are requiring that the borrower transfer the digital currency to a custodian that provides multisignature wallets to “hold” the currency during the life of the loan.
This is in contrast to other lending backed by assets such as real property, general intangibles, furniture, fixture, equipment, receivables, accounts, and other type of personal property, for which the lender can take a security interest while still allowing the borrower to possess and use the collateral. The reason for the difference lies in the difficulties lenders face due to the fact that the Uniform Commercial Code, which governs secured transactions and has been adopted by most states, is not currently equipped to address security interests in cryptocurrency.
Typically, Article 9 of the UCC governs security interests in personal property, while Article 8 governs security interests in securities, such as stocks and investment contracts. To date, there is no uniform consensus as to whether cryptocurrency should be characterized as money, a general intangible or a security, as those definitions are set forth in Articles 8 and 9. The characterization of cryptocurrency into one of these categories is key because creation and perfection of a security interest varies greatly depending on what category of collateral the lender accepts from the borrower. For example, the only way to perfect a security interest in money is by taking possession of it. In contrast, perfection of a general intangible can be done through the filing of a financing statement with the appropriate state agency. In Maryland, this is accomplished by filing a UCC-1 financing statement with the Maryland State Department of Assessments and Taxation.
It seems unlikely that cryptocurrency will be considered money for purposes of UCC application since §1-201 of the UCC defines money as “a medium of exchange currently authorized or adopted by a domestic or foreign government.” Until and unless cryptocurrency is adopted by a sovereign government, this definition would exclude cryptocurrency. As a result, cryptocurrency is most properly characterized as a general intangible or a security.
If cryptocurrency is considered to be a general intangible, then any buyer or transferee of the encumbered cryptocurrency will take the cryptocurrency subject to the lender’s perfected lien, even if that purchaser or transferee is a buyer in the ordinary course of business. This is because §9-102(44) of the UCC specifically excludes general intangibles in the list of property that can be sold free of security interests, if the buyer is qualified as a buyer in the ordinary course of business and purchases the property for value. Such a result would significantly hamper the ability for parties to buy and sell cryptocurrency in the free market, since no buyer of property could be sure that it was taking the property free and clear of all liens of prior lenders.
If, on the other hand, cryptocurrency is characterized as a security subject to Article 8 of the UCC, it most certainly would be considered an uncertificated security because no cryptocurrency is currently represented by an instrument; instead, cryptocurrency is registered on the issuer’s books. If deemed to be an uncertificated security, a lender could create its security interest in the cryptocurrency through a security agreement or possession. The lender could then perfect its lien pursuant to a control or pledge agreement with the borrower or through delivery of the property to the lender. For the same reasons above, this kind of physical possession or restriction of the negotiation of the cryptocurrency would serve to decrease the value of the property by making it difficult or impossible for the borrower to freely transfer it.
As a result, the lenders who are currently accepting cryptocurrency are requiring that the borrower deliver it to a custodian who has control over the property, or otherwise are starting to consider the use of smart contracts. Smart contracts are best described as a type of “digital vending machine,” for which the contract between lender and borrower is converted to computer code, stored and then replicated on the network of computers that run the blockchain. Building the lender’s contract right into the platform enables the borrower to freely transfer the property, subject to the limitations set by the lender, without the use of a custodian or intermediary.
While smart contracts seem like a perfect solution to many of the problems lenders currently face, they are not regulated and require sophisticated programming that must be compatible with both the lender’s and the borrower’s existing technology and processes. Thus, smart contracts are not a viable option for many lenders.
As a result, there is much uncertainty as to how lenders can properly create and perfect security interests in cryptocurrency, resulting in higher interest rates to the borrower and a tightening of credit to those borrowers who cannot park their investments with a lender’s custodian because they do not intend to hold their cryptocurrency for a long period of time. Statements by the SEC in June support the argument that cryptocurrency is not a security, but there remain no judicial opinions supporting this position. As this market continues to emerge, lenders and borrowers alike will be seeking updates to current law governing these issues.