Introduction
What are NFTs?
What is "crypto lending"?
Are cryptoassets "property"?
What type of security can be created over NFTs?
Implications of using NFTs as loan collateral
Comment
"Cryptoasset" is an umbrella term for instruments that include cryptocurrencies (eg, Ethereum and Bitcoin) and non-fungible tokens (NFTs).(1) While there is no universally agreed definition for what a cryptoasset is, the United Kingdom's Financial Conduct Authority (FCA) has suggested the following:
a cryptographically secured digital representation of value or contractual rights that is powered by forms of [digital ledger technology] and can be stored, transferred or traded electronically.(2)
The FCA also classifies cryptoassets as "security tokens", which bear a resemblance to securities (ie, shares or debt instruments), amongst other things. In view of this resemblance, the door has been opened to allow borrowers the opportunity to offer their cryptoasset holdings as security for loans from lenders.
This article examines the possibility of using NFTs as security in a secured loan transaction in light of recent developments in the Singaporean courts and some potential issues that may arise in connection with cryptoasset-backed loans.
NFTs use blockchain technology to identify the ownership of digital assets such as art, collectibles, music and videos.(4) Ownership of an NFT is evidenced by a cryptographically-secured record on the blockchain, and owning an NFT would mean owning the rights encapsulated in the NFT. Compared to fungible items (eg, cryptocurrencies), NFTs are neither fungible nor interchangeable due to their unique properties and can be bought or sold (or exchanged) on any NFT market, based on the same blockchain.
In a secured loan transaction, a lender loans a borrower a sum of money that is secured by a security interest in the borrower's property. The secured property should be sufficiently valuable to allow the lender to use the proceeds of enforcement of the security to satisfy the borrower's debt, if the borrower defaults on repayment or other terms of the loan.
"Crypto lending" involves a crypto-owning borrower using its cryptoassets (eg, NFTs) as collateral to secure a loan from a lender, with the lender obtaining a security interest in the borrower's cryptoassets. If the borrower fails to repay the loan or defaults in its performance of the terms of the loan agreement, the lender may enforce its security interest, which may include the right to liquidate the secured cryptoassets in satisfaction of the debt.
Before addressing whether cryptoassets can be offered as security, it would first be necessary to establish whether the law considers cryptoassets to be a form of property. In Singapore, it appears that cryptoassets are in principle regarded as property. This position was reflected in the unreported case of Janesh S/O Rajkumar v Unknown Person ("Chefpierre"), where the Singapore High Court recognised NFTs as legal property.
In Chefpierre, the plaintiff, Janesh, owned the unique Bored Ape Yacht Club NFT No. 2162 (BAYC 2162).(5) Due to BAYC 2162's rarity and high monetary value, Janesh would often use it as collateral to borrow cryptocurrencies on a community platform. The dispute arose when Janesh used BAYC 2162 as collateral for a loan provided by an online persona known as "chefpierre". There were disagreements between Janesh and chefpierre as to whether the loan in question could be foreclosed by chefpierre. Notwithstanding the disagreements, chefpierre listed the BAYC 2162 for sale on an online NFT marketplace, OpenSea. In response, Janesh's filed an application to repossess BAYC 2162 and the Singapore High Court ultimately granted an injunction to freeze the sale of BAYC 2162. Although little information is provided on this ruling due to the case being unreported, it is significant as it acknowledges that an NFT is "property" under Singapore law, that people who invest in NFTs have rights that can be protected and that the Singapore courts are willing to take jurisdiction over digital assets sited in the decentralised blockchain.
What type of security can be created over NFTs?
Singapore law recognises a limited number of types of consensual security interests:
- mortgages;
- pledges;
- contractual liens; and
- charges (assignments by way of security; while sometimes referred to as a separate type of security interest, these are essentially a type of mortgage).
Pledges and liens are, by nature, possessory security interests, so are inappropriate forms of security to be granted over NFTs.
From a conceptual point of view, it should be possible to create a charge over an NFT (if the title to the NFT remains with the chargor) or a mortgage (including an assignment by way of security) over the NFT (if the title is transferred to the mortgagee or assignee, subject to the mortgagee's or assignee's agreement to re-transfer the NFT to the mortgagor or assignor upon the satisfaction or discharge of the debt).
Implications of using NFTs as loan collateral
There has recently been a surge of NFT-backed loans in Singapore as more cryptoasset holders have realised that it is possible for them to use their digital assets to obtain additional liquidity without selling them. As discussed above, securing a loan with NFT(s) is – in theory at least – similar to a conventional secured loan transaction; at its most basic, it involves a borrower securing a loan by using its assets as collateral. However, novel issues may arise concerning NFT-collateralised loans and the risk allocation considerations, as such loans may differ from those in traditional secured financings which are backed by "traditional" property.
One issue is the fluctuation in the determined value of the collateral. In a secured loan transaction, the value of the collateral is predominantly determinable or fixed and is not usually subject to drastic change (although this same issue may arise where listed share security is provided in a volatile market – although volatility of the stock market does appear to be less than that in the cryptoasset space). For instance, the value of a solar powerplant provided as collateral for a loan facility can quite easily be determined by referencing the value of the land, buildings and fixtures, as well as by reference to the value of similar other facilities. Conversely, the value of an NFT is volatile and assessed subjectively – often seeming to be very much led by sentiment rather than by intrinsic value. Lenders should therefore be cautious when engaging in crypto-lending and negotiating the terms of the loan agreement and should consider the ability to make calls to top-up the security, as it is not inconceivable that a loan which was secured by a cryptoasset originally worth a certain amount would find itself in a position where the cryptoasset eventually traded at a fraction of that value.
Another issue involves risk allocation for the loss of the collateral. In a secured loan backed by "traditional" tangible assets, it is not uncommon for borrowers to be required by lenders to obtain insurance coverage for the secured assets. In that situation, if the secured assets are damaged or destroyed, the lender's interest is mitigated by the existence of the insurance policy (which will often be assigned in favour of the lender). Meanwhile, an NFT-backed loan is more similar in this respect to a loan backed by security over intangible assets (such as shares or bonds – although potentially one of a much more volatile nature), and a borrower would not be able to obtain insurance coverage for the pledged NFT, which would, in any case, be escrowed in a third party's smart contract rather than being possessed by the borrower.
NFT-backed (and more generally, cryptoasset-backed) loans are a feature of the loans market that will become more common and is something that lenders will have to come to grips with – or at least consider – at some point in the near future. The recent Singapore case involving BAYC 2162 does provide some indication as to how the Singapore courts would treat NFTs that are provided as loan collateral (essentially – similarly to security over other intangible assets), but the market and legal landscape currently suffers from a lack of certainty or a generally accepted market practice.
It is, however, an issue that lenders and lawyers who practice in the loan markets should be aware of, particularly given judicial recognition of cryptoassets as a form of property, which leads to the inevitable conclusion that loans can properly be secured against cryptoassets.
For further information on this topic please contact Daniel Tan, Javier Yong or Dominic Soh at CMS Cameron McKenna Nabarro Olswang LLP by telephone (+65 6720 8278) or email ([email protected], [email protected] or [email protected]). The CMS Cameron McKenna Nabarro Olswang LLP website can be accessed at cms.law.
Endnotes
(1) Tang Hang Wu, "Trustees' investment duties and cryptoassets" (2020) 26 Trusts & Trustees 183 at 184.
(2) Financial Conduct Authority, "Guidance on Cryptoassets" Consultation Paper, CP 19/3 (January 2019).
(4) Further information is available here.