In Brief:

  1. The digital asset sphere currently represents a trillion dollar market
  2. Regulation varies greatly amongst different jurisdictions
  3. Regulation is needed in order to protect investors and allow digital assets to be provided as security in finance transactions

There is no doubt that the market for digital assets has grown significantly in the last couple of years and is continuing to grow exponentially- currently representing a trillion dollar market. Some of the many rationales for their growing popularity and widespread use and creation thereof range from perceiving them as a new form of collectible- in the same way that art is- to creating an “alternative” to conventional financial institutions.

Although there is no universal standard definition of digital assets, in the simplest terms, digital assets are digital representations of files or objects that have value and can be owned and transferred by individuals without the need for an intermediary or a bank. All crypto assets are digital assets, but not all digital assets are crypto assets. Cryptocurrencies, such as bitcoin, are the most common type of digital asset- however, other digital assets include security tokens (tokens that are similar to conventional instruments like shares or debentures); utility tokens (digital tokens that provide value to investors by giving them access to a future product or service); stablecoins (digital assets that peg themselves to a stable asset such as the US Dollar) and e-money tokens (tokens representing electronic money that represent a claim on the issuer and are accepted by persons other than the issuer).

Caution and advice against various types of digital assets is widespread, given the numerous risks and issues involved- ranging from theft, money laundering, cyber security risks and even environmental concerns in relation to the mining of certain digital assets such as bitcoin- and such caution ranges from regulatory advice and warnings to investors to complete prohibition of specific types of digital assets in certain countries. Although regulators in different countries across the world have adopted different approaches to legislating digital assets, it does seem clear that there is increasingly a need to do so in order to prevent- or at least reduce- the theft and hacking commonly seen in the digital asset sphere and to crack down on the money laundering and other illegal activities that are facilitated by the anonymity granted by the digital asset sphere.

There is also no doubt that, with so many retail and institutional investors holding digital assets, the desire to use them as a means of security in obtaining financing will strengthen.

The question now, however, revolves around documenting such means of security; working out the practical mechanics of taking such security and determining the applicable legislation in regard to such security- if any. Part of the issue currently is that several types of digital assets remain unregulated in many jurisdictions- or to the extent there is regulation, it does not cover the possibility of digital assets being provided as a form of security. There is also not, on the whole, market standard documentation which allows for digital assets to be secured, unlike other types of assets which can be readily secured because of existing legislation which governs such security.

However, there are numerous issues that need to be considered- and resolved- before security can effectively be taken over digital assets. One of the key issues is determining how the relevant digital asset is defined or what it represents- that is, does it represent a property, what is the underlying function of the digital asset and what rights does it confer on the owner?

It is possible that security tokens that represent shares, debentures or warrants- which represent a right that may be enforced against a third party- may be able to be taken as security. Essentially, the classification of a digital asset will determine the regulatory approach and requirements and the subsequent determination of what type of security may be given in respect thereto.

Another consideration is what type of security may be created over a digital asset. This will differ between jurisdictions, depending on the types of security that are legally recognised in the applicable jurisdiction that can be taken over intangible assets.

If a charge, pledge or mortgage is taken over the digital assets, one would require the digital asset to be transferred from the borrower’s wallet to the wallet of the secured party- which is slightly different from taking conventional security. It is vital however that the digital asset is transferred as the borrower otherwise has control of it as it knows the digital key. In order for the security agent to exercise control and avoid double trading in the digital asset, it needs to be transferred to the wallet of the security agent.

Perfecting security is important to ensure it is effective against third parties. Considering that one of the fundamental aspects (and risks) of digital assets is the anonymity granted thereto- it is difficult to see how a buyer of a digital asset (or a lender in a financing) would know whether or not the digital asset had already been secured, unless it was informed by the seller.

In the US, there has been some evidence of margin loans being secured over bitcoin and other cryptocurrencies. This is likely to increase, with the increase of the number of borrowers holding digital assets and wishing to use such assets as security. However, the extent to which courts would classify these as security- rather than a purchase of a crypto currency with an agreement to sell it back at a specified time- has not yet been seen.

Other issues need to be considered in the context of a margin loan secured over digital assets- including price fluctuations and volatility, which can be extreme in the digital asset sphere. Cryptocurrencies operate 24/7- hence thought has to be given as to the steps to be taken if there is a need for a margin call over a weekend or non- business day, when the lender or custodian may not be available. One also has to consider what collateral is necessary to post for the margin call and what exchange or framework can be used for conversion purposes.

Digital assets are typically held either directly by owners or stored with a custodian. If held by a custodian, regulations need to be reviewed or enacted to ensure appropriate safety mechanisms are in place (so that digital assets cannot be transferred out of the wallet before an event of default) which will enable a lender to enforce its security if necessary.

If full ownership of a digital asset is granted to a custodian- effectively handing the private key data to the custodian- then regulators need to consider the consumer’s rights, certainty of security and future security threats including the omnipresent risk of hacking.

A fundamental point to consider is that many digital assets can be considered to be “global”- or at least- not linked to a particular jurisdiction- and that applicable regulations (including the classification of digital assets) vary between jurisdictions, thus creating uncertainty as to which know which regulations may apply.

The regulation of digital assets varies from jurisdiction to jurisdiction and it seems that it is not until the particular digital asset itself is regulated that there may be the necessary consequential legal documentation to be able to provide for the security of such digital assets. Analysis also has to be made of existing regulations to determine the extent to which they adequately provide for appropriate custodian options in order to manage the use and safe-keeping of digital assets. Many jurisdictions currently do not provide certainty regarding the status of digital assets and hence although there is a trillion dollar market comprising digital assets, until such time as there is sufficiently robust legislation governing the particular asset itself, it seems unlikely that there will be market standard documentation providing for the security of such digital assets. The digital asset market is continually evolving and while it may take some time for legislation generally to cover the whole gambit of digital assets (if it is in fact wholly regulated in the future), regulators should examine the extent to which current regulations can be harnessed in order to protect investors and capitalise on the enormous market of digital assets that can be tapped by entities providing such assets as a form of security in financing transactions