When cryptocurrency first materialized as an alternative, the only people who took currencies like Bitcoin seriously were those who had the imagination to envision a future where they would be accepted as a legitimate form of payment. Today, cryptocurrency has finally burst into the mainstream, making a big impact in the process.
As more investors decide to back or at least consider cryptocurrencies, questions regarding how cryptocurrency should be treated from a legal and regulatory standpoint are becoming increasingly common. One such topic is whether it is possible to get a perfected lien on cryptocurrency.
What Is a Perfected Lien?
First, consider what a perfected lien is and how it is designed to work using the following example. An entrepreneur wants to borrow capital to start a new business. They find a lender that agrees to loan the money, but only if the loan is secured with collateral. The new business owner happens to own a house that they can put up as collateral. As such, the lender would have a lien on the house; in the event that the debt is not repaid, the lender can take the house in exchange.
In contrast to a standard lien, a perfected lien is backed up by the government. Continuing the example, the lender may want a guarantee that the borrower will actually turn over their home in the event of a loan default. To do so, they obtain a perfected lien by filing the appropriate paperwork with the local government. In this case, if the borrower defaults, the government will help reinforce or ensure that the lender is able to collect the home as part of the agreed-upon lien.
Is Cryptocurrency a Valid Form of Collateral for a Perfected Lien?
For a perfected lien, lenders and borrowers need to designate a security interest as collateral. The Uniform Commercial Code (U.C.C.) is a legal document that governs what does and does not count as a security interest. In the U.C.C., six different categories of personal property can be used as a security interest: goods, equipment, inventory, accounts, money, and general intangibles.
The question is which of these categories cryptocurrency falls under, the answer is not straightforward. The U.C.C. was written in the 1950s and has not had many major updates since then. This means that the laws used to define how cryptocurrency is treated with regard to to perfected liens and security interests are outdated, having been written long before cryptocurrency existed. However, old laws are applied to modern circumstances all the time, and the U.C.C. is no different.
It may seem intuitive to treat cryptocurrency as money under the Uniform Commercial Code. However, for something to qualify as money under the U.C.C., the asset must be adopted by a government as a legitimate form of currency. Qualifying cryptocurrency as money under the U.C.C. would not be effective even if it obtained official currency status. According to a recent article by Colbeck Capital, the only way for a lender to perfect a security interest on money is for them to be in physical possession of that money. Since cryptocurrency has no physical form, this becomes impossible.
The next most logical U.C.C. category for cryptocurrency to fall under is accounts. This is the category used for savings accounts and stock accounts, so it would make sense that cryptocurrency, likewise an investment vehicle stored in a digital account, could fall under this designation. Despite the seemingly good fit, the U.C.C. accounts category does not work for cryptocurrency either. Since cryptocurrency is stored on a decentralized ledger known as the blockchain, no third party such as a bank can step in and cede control of the asset.
General intangibles is the last of the potential U.C.C. categories for cryptocurrency. This broad and purposefully vague category is applicable to a wide range of assets including cryptocurrency. But there are a few caveats.
First, assets that fit in the general intangibles category retain their past security interests. For example, assume a lender is able to get a perfected lien on $50,000 in Bitcoin. If the borrower is not able to repay the debt, the lender will prepare to collect their collateral. But they may be shocked to learn that the prior Bitcoin owner also used those exact assets as a security interest for a perfected lien before selling it to the current owner, the borrower. Since general intangible assets retain all past security interests, the lender who originally filed for a perfected lien on the $50,000 in Bitcoin is the only one with a legitimate claim to the asset. The current lender is left without viable collateral. Given the likelihood of a scenario such as this, most lenders are currently not eager to agree to a perfected lien on cryptocurrency.
NYC financial institution, Colbeck Capital, shared a couple of ways to work around this issue, but each has their own disadvantages. The first is to have the cryptocurrency held by a third-party financial intermediary, which would allow the lender to treat the cryptocurrency as a financial asset and obtain a control agreement to prevent the asset from being transferred. However, the entire attraction of cryptocurrency is that it eliminates the middleman. Allowing a third party to control cryptocurrency for the duration of a loan erases all the benefits of owning cryptocurrency in the first place.
Another option is to create a smart contract. These are computer-coded contracts that operate on the blockchain, allowing for the creation of ironclad agreements involving cryptocurrency without requiring the oversight of a third-party institution. The only drawback of smart contracts is that Ethereum is currently the only cryptocurrency that allows for the easy creation of smart contracts, making a perfected lien possible. For any other form of cryptocurrency, smart contracts are not an available option.
If cryptocurrency continues its current trajectory, we may see a future where the laws governing how cryptocurrency is treated as security interest become better defined. For now, getting a perfected lien on cryptocurrency, while possible under the right circumstances, is likely to be a challenge.