Bitcoin as Collateral for a Commercial Loan: No Keys, No Cheese
25 May 2021
Not everyone agrees that bitcoin or cryptocurrency will someday replace fiat currency. But most tech-savvy people believe that (1) blockchain technology will have a huge impact on the securities and financial field, and (2) crypto assets will have value into the future.
We all know that lenders/borrowers will use anything with value as collateral. Accordingly, it should come as no surprise that one of the earliest applications for the blockchain has been at the crossroads of cryptocurrency, smart contracts and lending.
As futuristic as this all sounds, be cognizant that if you lend against bitcoin, you need a good old fashioned security interest, or else you are an unsecured creditor in a bankruptcy, and those bitcoins will be divided among creditors on a pro-rata basis, at best. Moreover, Article 9 of the Uniform Commercial Code is not well equipped for the world of cryptocurrency, from a practical point of view. So a lender must go even further than a valid security interest.
Let’s start with the basics: How do you perfect a security interest in cryptocurrency? Assuming that a valid security agreement is signed, the lender must perfect its interest. At this point in time, bitcoin appears to fall into the catch-all category of “general intangible.” However, circumstances may someday change that categorization. If a government begins honoring bitcoin as currency, then “money” may be the new categorization. If the legal consensus forms that cryptocurrency is a “security” (and some altcoins might be there already), then it would be “investment property.”
Assuming for a moment that cryptocurrency is a general intangible, you must file a UCC financing statement in the debtor’s state of residence to perfect the security interest.
However, perfection is only half the battle when it comes to bitcoin for practical reasons. First, once a bitcoin is sold on an exchange or elsewhere, a lender cannot simply track down that transferee (possibly foreign and pseudo-anonymous) and insist that the asset is subject to a lien. Even if you can determine the identity of a transferee, that person is likely to be outside the jurisdiction of the courts. Even if there was a valid judgment to assert a lender’s priority over the coins, you are never going to force a resident of China, for example, to turn over her wallet address and keys–so that the lender may take possession of (and ultimately, liquidate) the collateral. As they say in bitcoin, “no keys, no cheese.”
That means that, for practical reasons (not necessarily legal ones), a lender must have control over the borrower’s bitcoin, via a wallet for which only the lender has keys. Otherwise, the lender’s security interest is “collateral” for academic purposes only.
There are smart contracts and dapps that perform these functions. For a commercial lender without these tools, the bitcoin should be transferred to the bank’s wallet, and kept there until repayment.
What should the borrower seek to negotiate? A few things:
- Coins should be transferred back to the borrower’s wallet as the loan is paid down, as the coins appreciate in value, and/or as replacement collateral is offered.
- A borrower should also get insurance or indemnities from the bank, to ensure that the bank does not lose the wallet keys. Again, “no keys, no cheese.”
- Clear provisions in the loan agreement to confirm that the transfer of the coins to the lender’s wallet is not intended as a true sale, so as to trigger capital gains taxes.