Canada: Virtual Collateral 101: How To Take And Enforce Security Over Cryptocurrencies, Crypto-Assets And Central Bank Digital Currencies

In recent years, there has been a proliferation of lending secured by crypto-assets through online decentralized platforms. It is estimated that, during one month in 2021, more than US$122 billion in transaction volume occurred through such platforms.¹ This level of activity demands a close look at legal issues that arise when borrowing against cryptocurrencies and other virtual assets. Virtual collateral is not explicitly addressed in the personal property security law of Canadian common law provinces, as primarily set out in theirPersonal Property Securities Acts(collectively, the "PPSA").² Lenders and insolvency practitioners therefore face open questions when dealing with loans backed by cryptocurrencies or other virtual assets - most importantly, how should secured parties best protect their interest in this online collateral?

Further complexity has been added by the recent adoption of bitcoin as legal tender in El Salvador and the Central African Republic and the introduction of central bank digital currencies ("CBDCs") in other jurisdictions, which likely will split virtual currencies into multiplePPSAasset classes. Additional nuances arise in the case of other types of potential crypto-collateral, such as non-fungible tokens ("NFTs"), which have the potential to fall under yet another third asset class.

In the United States, lenders should soon gain more clarity as extensive relevant amendments to theUniform Commercial Code(the "UCC")³ were adopted and recommended for enactment by the Uniform Law Commission in July 2022 (the "2022UCCAmendments").⁴ New Article 12 will introduce rules for transactions involving a new category of assets called "controllable electronic records" ("CERs") which will include cryptocurrencies and NFTs. Concurrent amendments to the definitions inUCCArticle 1 and to thePPSA's older cousin,UCCArticle 9, will create rules concerning security interests in CERs as well as in CBDCs. At the time of writing, the 2022UCCAmendments have been enacted only in two states, although bills in respect of the amendments have been introduced in 23 other state legislatures. Unfortunately, no similar amendments to thePPSAare pending.

This article aims to break down these issues of categorization to propose answers to the questions of how security over cryptocurrencies, other crypto-assets and CBDCs can best be attached, perfected, protected and enforced, from both a legal and practical perspective. A common theme throughout this article is the value for a lender of taking possession or control of any crypto-asset that is pledged as collateral. Depending on thePPSAandUCCcollateral class that a crypto-asset falls into, possession or control by a lender may lead to attachment and/or perfection of a security interest in such crypto-asset. But even where possession or control does not further a lender's legal rights, it still gives practical protection that may, in the end, be far more valuable than actionable legal rights.

Cryptocurrencies in Lending: A General Overview

Blockchain, which constitutes a decentralized, peer-to-peer network of computers, underpins the majority of existing cryptocurrencies.⁵ Digital signatures verify transactions in ledgers, which can be public or private, and users hold cryptocurrencies in secure hot or cold personal addresses that are commonly termed "wallets." More specifically, hot wallets are wallets that are linked online (e.g., web-based or desktop), while cold wallets are immune to hacking, as they are not continuously connected to the internet (e.g., through physically separated USB devices).⁶

There are also various generations of cryptocurrencies which range from completely public (bitcoin) to private (Monero), among others. Privacy coins are cryptocurrencies that allow entities to transact in a decentralized manner without revealing owner, buyer or seller information.⁷ As an example, Monero, which holds the largest capitalization of privacy cryptocurrencies, protects sender anonymity by using ring signatures, which create groups of users and aggregate their transactions; each transaction can thus only be linked to the group as a whole. This protects both sender and receiver anonymity.⁸ In comparison, all addresses where bitcoin is sent to are publicly available on the blockchain.

Regardless of their privacy status, cryptocurrencies were designed to solve the issue of "intermediaries" in the world of financing, due to the transactional confidence created by blockchain. In a 2020 article, Xavier Foccroulle Menard aptly explains how cryptocurrency fixes what he terms the "double-spending problem" in digital finance, without the need for a bank intermediary:

". . . physical cash can only be spent once, as once you hand it over in a transaction, you no longer possess it; on the contrary, digital files can be duplicated and falsified. Until the apparition of bitcoin, central trusted third parties like banks would verify whether the digital money, which constitutes most of the money circulating in the economy, has been spent twice. Commercial parties could trust each other because of the intervention of this trusted intermediary. With bitcoins, the intermediary is not needed for the establishment of trust between parties."⁹

The elimination of banking intermediaries from cryptocurrency transactions allows funds to be transferred far more quickly, at a lower or non-existent cost, and often without significant regulatory oversight. These features of blockchain technologies, and the confidence that such technologies instil, allow cryptocurrency to be used with relatively little regard for government action, be it legislative or executive. In the secured lending space, these practices, which prioritize exploiting the immediacy and directness of blockchain technologies over adherence to the common and statutory law regarding lending and personal property security, often reign supreme. As will be discussed further in this article, secured online lending models tend not to observePPSArequirements for attachment, perfection and enforcement of security. Commentators have suggested that, instead of adapting to existing, government-imposed personal property security regimes, notice of security over cryptocurrency should just be reflected in the blockchain itself.¹⁰

This same inclination toward independence and self-regulation, as well as a lack of judicial resources and inefficiency of the existing asset recovery system, has triggered the creation of new recovery mechanisms for crypto-assets that sidestep traditional legal systems. As an example, alternative options to legal enforcement mechanisms have flourished for crypto-recovery initiatives. In September of 2021, hackers allegedly stole approximately US$275 million from the exchange KuCoin in one of the largest online crimes to hit a cryptocurrency asset provider,¹¹ with the North Korean hacker collective, "Lazarus Group," accused of carrying out the heist in question.¹² Following the alleged hack, Kucoin was able to recover 84 per cent of the stolen funds in question, not through legal processes, but largely through an alternative "freezing" offered by both: (i) other crypto-exchanges; and (ii) operators of the stablecoin Tether ("USDT").¹³ The most interesting aspect of the KuCoin hack is that the majority of these other crypto-projects and asset providers were able to "freeze" hackers' funds without any approval from courts or criminal investigative entities.¹⁴

In January of 2022, Tether froze an additional $150 million USDT in three accounts which may have been blacklisted due to cyberattacks and enforcement investigations.¹⁵ The total blacklist of addresses by Tether had reached 563 since November 28 of 2017.¹⁶ While Tether has commented that funds are regularly frozen upon "request[s] from law enforcement,"¹⁷ they also have the ability (as seen in the KuCoin hack) to freeze funds upon requests from private entities. There is no current clarity into which law enforcement agencies regularly sends requests to Tether for freezes, or which request correlates to which address.

The crypto community's impulse to self-regulation has also resulted in at least one instance of what could be described as mob justice. In March 2022, angry token holders of Juno voted to strip tokens from a fellow investor who they felt had cheated the community by gaming the system when developers were issuing free promotional tokens.¹⁸

The crypto community does, however, regularly find its insular space pierced by formal insolvency proceedings where self-help remedies are not as viable. As an example, from 2017 to 2021, there were at least 19 global crypto-related insolvency proceedings ranging from jurisdictions including South Korea to Turkey.¹⁹ The pace of such insolvencies has, if anything, only accelerated since. One of the most common catalysts for crypto insolvencies are hacks and fraud.²⁰ In court-supervised insolvency or restructuring proceedings, rights will generally not be recognized if they are not legal rights.²¹ In light of the growth of these global crypto-related insolvency proceedings, it is thus always recommended that appropriate legal security be taken against crypto-assets to partly mitigate such risks.

Cryptocurrency As Money

There is no mention of cryptocurrency in thePPSA. In order to determine if and how security over crypto-collateral can attach and be perfected, it therefore is necessary to find a fit under existingPPSAasset categories. The obvious first category to examine is "money," which thePPSArecognizes as a securable class of personal property.²² ThePPSAdefines "money" as "a medium of exchange authorized or adopted by the Parliament of Canada as part of the currency of Canada or by a foreign government as part of its currency."²³ While this definition was once considered sufficient to exclude all cryptocurrencies,²⁴ that is no longer the case as the government of El Salvador adopted bitcoin as part of its currency, effective September 7, 2021, and the Central African Republic followed suit on April 22, 2022.²⁵ On a plain reading, bitcoin is now caught by thePPSA's definition of money and, as a result, is explicitly excluded from thePPSA's definition of "intangibles" which, as discussed further below, is the only category into which bitcoin would otherwise fit.²⁶

While we await enactment of the 2022UCCAmendments, there also remains no mention of cryptocurrency in theUCC. Like thePPSA, theUCCrecognizes money as a securable class of personal property²⁷ and the Article 1 definition of "money," which applies throughout theUCC, requires adoption by a government.²⁸ Pending enactment of the 2022UCCAmendments, bitcoin, as legal tender in two countries, is money and as a result is excluded from the definition of "general intangibles."²⁹ Bitcoin's current status as money is confirmed in the Uniform Law Commission's summary of the 2022UCCAmendments.³⁰

This situation is set to change in the United States as the 2022UCCAmendments will amend the definition of "money" inUCCArticle 1 to add the following sentence:

"The term does not include an electronic record that is a medium of exchange recorded and transferable in a system that existed and operated for the medium of exchange before the medium of exchange was authorized or adopted by the government."

In short, theUCCwill exclude from the definition of "money" any pre-existing cryptocurrency that is adopted as legal tender by a government. This amendment will therefore neutralize the effect of the adoption of bitcoin by El Salvador and the Central African Republic. Since bitcoin will no longer be money, it will not be excluded as such from the Article 9 definition of "general intangibles," which definition will also be amended to explicitly include CERs.³¹

It had been argued that cryptocurrency did not fall under the oldUCCdefinition of "money," even if it were adopted by a national government.³² Although this question will soon be moot for purposes of theUCC, it is still relevant for the purpose of thePPSA. Professor Jeanne L. Schroeder reasons that the oldUCCdefinition of "money" does not (explicitly) include deposit accounts, which are the most common form of money. Schroeder reasons, therefore, that the oldUCCdefinition of "money" was intended to be limited to what she calls "hand-to-hand" currency, or physical cash, and she concludes that since bitcoin is not physical, it cannot fall under the definition of "money."³³ In response, it should be pointed out that, for reasons we expand on below, a cryptocurrency such as bitcoin does not fall under the definition of "deposit account," and thus the exclusion of deposit accounts from "money" does not entail the exclusion of cryptocurrency as well.

We are also required to employ the modern theory of statutory interpretation, whereby the provisions of a statute are to be read in their entire context and in their grammatical and ordinary sense, harmoniously with the scheme and purpose of the statute, and the intention of the legislating body.³⁴ This principle subsumes the older "plain meaning rule," whereby the word of a statute were to be taken in their ordinary and grammatical meaning so long as it did not lead to an absurd result, but also requires a court to look beyond the language to its context. In Ontario, we also have to follow theLegislation Act, which requires us to interpret thePPSAas being remedial and thus to give it "such fair, large and liberal interpretation as best ensures the attainment of its object."³⁵ Whether we take their plain meanings, or give them a more liberal and contextual interpretation, thePPSA's definitions of "money" (like the oldUCCdefinition) allows a place for bitcoin, now that it has been adopted by national governments, as long as no absurdity results.

Professor Schroeder's second argument is that such an absurdity (or, in her words, a "perverse effect") does result if the oldUCCdefinition of "money" is interpreted to include a cryptocurrency that has been adopted as legal tender by a government.³⁶ She reasons that, since a security interest in money can only be perfected by physical possession and since bitcoin cannot be physically possessed, then, if bitcoin is money, security over it could never be perfected. Both of her premises are, however, false, at least in aPPSAcontext. As we discuss below, a security interest in money can, under thePPSA, be perfected either by possession or by registration. In addition, we will argue that cryptocurrency can be physically possessed - especially under a fair, large and liberal interpretation - through physical possession of a cold wallet.

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Footnotes

1 Alexander Osipovich, "Upstart Peer-to-Peer Crypto Exchanges Take Aim at Coinbase" (24 May 2021), online:The Wall Street Journalwww.wsj.com/articles/upstart-peer-to-peer-crypto-exchanges-take-aim-at-coinbase-11621848601.

2 In this article all references to thePPSAwill be to the OntarioPersonal Property Security Act, RSO 1990, c P.10.

3 Online: www.uniformlaws.org/acts/ucc.

4 Uniform Commercial Code Amendments (2022), www.uniformlaws.org/viewdocument/final-act-164?CommunityKey=1457c422-ddb7-40b0-8c76-39a1991651ac&tab=librarydocuments.

5 Certain cryptocurrencies are not blockchain-based, such as IOTA or Nano. These later-generation cryptocurrencies are based on directed acyclic graphs ("DAGs"), which eliminate mining fees and speed up transactions. However, for the sake of this article, the authors will largely analyze and study blockchain-based cryptocurrencies for the purposes of secured lending requirements.

6 Cryptopedia Staff, "Hot Wallets vs. Cold Wallets" (10 March 2022), online:Crytopediawww.gemini.com/cryptopedia/crypto-wallets-hot-cold.

7 Tamie Dolny, "Finding Needles in Haystacks: Statutory Reform Recommendations for Quasi-Criminal Insolvencies Involving Online Money Laundering" (2021), 19^thAnnual Rev of Insolvency L(CanLII).[Dolny]

8 Wai Wu,Limitations of Privacy Guarantees in Cryptocurrency(EAS 499 Senior Capstone Thesis, University of Pennsylvania School of Engineering and Applied Science, 2015) at 6, online (pdf): www.cis.upenn.edu/~fbrett/assets/theses/wai_wu.pdf[Wu].

9 See Xavier Foccroulle Menard, "Cryptocurrency: Collateral for Secured Transactions?"Banking & Finance Law Review,34:3 347 at 350, online: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3548126. [Menard]It should be noted that the double spending problem can still arise, and has arisen in the case of smaller cryptocurrencies, where bad actors can come to control more than half of the mining power on a blockchain: see "The 51% Attack: Crypto's Double-Spending Achilles Heel" (3 January 2022), online:Pyments.comwww.pymnts.com/cryptocurrency/2022/51-percent-attack-crypto-double-spending-achilles-heel/.

10 Barnett, Graig S., "Cyber-Lending: Perfecting Security Interests in the New Frontier of Cryptocurrency-Backed Loans" (11 July 2018), online:Blockchain Magazineblockchainmagazine.net/cyber-lending-perfecting-security-interests-in-the-new-frontier-of-cryptocurrency-backed-loans/.

11 Chainalaysis Team, "The KuCoin Hack: What We Know So Far and How the Hackers are Using DeFi Protocols to Launder Stolen Funds" (28 September 2020), online:Chainalaysisblog.chainalysis.com/reports/kucoin-hack-2020-defi-uniswap/.

12 Thomas Brewster, "North Korean Hackers Accused of 'Biggest Cryptocurrency Theft of 2020' - Their Heists Are Now Worth $1.75 Billion" (19 February 2021), online:Forbeswww.forbes.com/sites/thomasbrewster/2021/02/09/north-korean-hackers-accused-of-biggest-cryptocurrency-theft-of-2020-their-heists-are-now-worth-175-billion/?sh=30974f515b0b.

13 Terence Zimwara, "Kucoin Boss on Strategy After Hack: 'We Chose to Act'" (12 August 2021), online:Bitcoin.comnews.bitcoin.com/kucoin-boss-on-strategy-after-hack-we-chose-to-act/. A stable coin is a cryptocurrency whose value is pegged to a fiat currency such as USD or, in some cases, to the price of a precious metal or industrial metal.

14 Keegan Francis, "KuCoin Faces $150 Million Hack, then Freezes Funds on Blockchain" (14 October 2020), online:Cryptovantage.comwww.cryptovantage.com/news/kucoin-faces-150-million-hack-then-freezes-funds-on-blockchain/.

15 Brian Newar, "Tether freezes $150 million in USDT" (14 January 2022), online:Cointelegraph.comcointelegraph.com/news/tether-freezes-150-million-in-usdt.

16 Ibid.

17 Helene Braun, "Tether Freezes $160M of USDT Stablecoin on Ethereum Blockchain" (13 January 2022), online:Coindesk.comwww.coindesk.com/markets/2022/01/13/tether-freezes-160m-of-usdt-stablecoin-on-ethereum-blockchain/.

18 Liam J. Kelly, "How The Juno Network DAO Voted to Revoke a Whale's Tokens" (19 March 2022), online:Decrypto.codecrypt.co/95435/juno-network-dao-proposal-16-voted-to-revoke-tokens-from-whale. In contrast, the victims of the MakerDAO Black Thursday $0 auction sales (discussed later in this article), lost a vote to be compensated, an thus had to pursue their claims through the traditional legal route of a class action lawsuit: Jamie Redman, "Makerdao Vote to Not Compensate Black Thursday Victims Receives Harsh Criticism" (24 September 2020), online:news.bitcoin.comnews.bitcoin.com/makerdao-vote-to-not-compensate-black-thursday-victims-receives-harsh-criticism/.

19 For a detailed listing of proceedings, see: Dolny,supranote 7, at Table 1.

20 In contrast to the self-help response to the KuCoin hack, there has been recent success in recovering hacked cryptocurrency in the cross-border insolvency of the U.K. company, Dooga Ltd., which ran the Cubits crypto-asset exchange platform. See: Tamie Dolny and Simon Dugas, "How to Find Stolen Cryptocurrency: Litigation Tools Used by Insolvency Professionals inDooga,"Banking & Finance Law Review(December 2022),39B.F.L.R. 135.

21 One of the foundational principles of Canadian insolvency and restructuring law is equitable distribution, or ratable distribution within creditor classes. This leaves little room for equitable (as opposed to legal) arguments that would give one creditor a preference over other creditors of the same class.

22 PPSA,supranote 2, s 22(1)(e) andUCC,supranote 3, § 9-312(b)(3) and § 9-313(b).

23 PPSA,supranote 2, s 1(1).

24 See: Menard,supranote 9, at 357, and Sandra Appel, "Can you take a security interest in Bitcoin?" (7 May 2014), online: www.lexology.com/library/detail.aspx?g=08578e82-5bc0-4151-bf5c-d0be3ad213c3. [Appel]

25 Tim Fries, "El Salvador has adopted Bitcoin as official legal tender - but will other countries follow?" (30 September 2021), online: www.weforum.org/agenda/2021/09/el-salvador-officially-adopts-bitcoin-as-legal-tender-but-will-other-countries-follow/;

26 PPSA,supranote 2, s 1(1).

27 UCC,supranote 3, § 9-312(b)(3) and § 9-313(b).

28 UCC,supranote 3, § 1-201(b)(24).

29 UCC,supranote 3, § 9-102(a)(42).

30 Uniform Law Commission, "A Summary of the 2022 Amendments to the Uniform Commercial Code," at page 6, online: www.uniformlaws.org/HigherLogic/System/DownloadDocumentFile.ashx?DocumentFileKey=2a18c952-5db5-ca16-2274-8c7531990903&forceDialog=1.

31 2022UCCAmendments,supranote 4, § 9-102(a)(42).

32 Jeanne L. Schroeder, "Bitcoin and the Uniform Commercial Code," 24 U. Miami Bus. L. Rev. 1 (2016), online: repository.law.miami.edu/umblr/vol24/iss3/3/.[Schroeder]

33 Ibid, at p. 20.

34 See:Rizzo & Rizzo Shoes Ltd. (Re), [1998] 1 SCR 27, at para 21; andAtlas (Brampton) Limited Partnership v. Canada Grace Park Ltd., 2021 ONCA 221 at para 66.

35 Legislation Act, 2006, SO 2006, c 21, Sch F, at s. 64.

36 Schroeder,supranote 32, at p. 20.

37 Government of Canada, "El Salvador" (November 2022), online: www.international.gc.ca/country-pays/assets/pdfs/fact_sheet-fiche_documentaire/el_salvador-salvador-en.pdf.