In developed financial markets, a fundamental principle of the legal regime is that a financial institution’s assets and its clients’ assets are kept separate. That way, if the institution goes bust, clients should not lose money.
But there have been multiple past cases where financial institutions failed to perform this duty of care. The collapses of Lehman Brothers and MF Global each exposed multi-billion dollar holes in client money accounts. And even the giants of the custody business, such as BNY Mellon, have recently been sanctioned for poor practices in this area.
In theory, crypto-assets, whose ownership can be secured using unbreakable mathematical algorithms, offer a way to increase standards of care. However, the rules for the safe-keeping of assets like cryptocurrencies and other digital tokens are still evolving, and often depend on legal principles developed over centuries of common law.
James Burnie, senior associate and head of the blockchain and crypto-assets practice at Eversheds Sutherland, throws light on the law for the custody of crypto-assets in this exclusive interview with New Money Review.
New Money Review: James, the UK Jurisdiction Taskforce recently released a legal statement saying that crypto-assets should be treated as property.
The Taskforce went on to say that since crypto-assets cannot be physically possessed, they cannot be the object of a ‘bailment’—which is a concept in common law systems for a transfer of possession without a transfer of ownership.
Your firm has released a statement saying the Taskforce’s approach doesn’t give the full picture. What do you think is missing?
James Burnie: When people talk about crypto-assets, they often focus on bitcoin and ethereum. But there are many other crypto-assets out there. Some crypto-asset tokens are linked one-to-one to gold, for example. And that gold can be subject to bailment.
So although it’s correct to say that the tokens themselves are not subject to bailment, you may be taking bailment of the underlying asset, and you may be recording part of that information in the token itself. We think it would have been helpful if the report had recognised this.
In fact, lots of our clients who are holding physical assets on a blockchain will use bailment as part of their legal set-up.
“The problem you face with any physical asset is the question of whether the asset really exists”
New Money Review: Could you give a practical example to explain why this legal point is important?
James Burnie: The problem you face with any physical asset is the question of whether the asset really exists.
There’s an old legal case where someone had a gold bar, wrote a number on it, gave it to someone and said ‘this is your gold bar’. But then they gave everyone the same gold bar with the same number. In effect, they resold the same bar many times over and so, when insolvency happened, we were left with a single gold bar being split between all the buyers, rather than a gold bar for each buyer.
To get around this risk, the asset should be set up in a specialist legal structure. This should make it clear that the assets do not belong to the holder of the asset and are free from the risk of the holder’s insolvency. And in the case of a physical asset, that legal structure will usually take the form of something like bailment.
“he who has access to the bitcoin private key effectively has the power”
New Money Review: But even though the UK Jurisdiction Taskforce has just said that crypto-assets cannot be the object of a bailment, Wyoming, in the US, passed a law earlier this year saying the opposite: that crypto-assets can be held under a bailment. These are both common law systems. Why the difference in approach, and does it matter?
James Burnie: A common problem is that different jurisdictions will take the same word and interpret it to mean different things. Lawyers can get excited over whether a particular structure is a trust or a bailment.
But from a practical perspective, what matters is whether my assets are being held in a way that’s safe. And, if the person holding them goes bust, do I have a problem.
There’s a pragmatic reality—he who has access to the bitcoin private key effectively has the power. You can have the world’s most beautifully drafted bailment agreement. But if the actual physical asset disappears, together with the people holding it, I’ve got a problem.
Equally, although a trust is useful, and if everyone involved is being honest and clean, it works, there are other things people will want to see to give them the satisfaction that you offer a credible and legitimate way of holding crypto-assets.
New Money Review: How do you see the market for the custody of crypto-assets evolving?
James Burnie: First, we are seeing the rise of pure crypto custodians. It’s an unregulated market, so long as you stay clear of security tokens. Apps to store crypto-assets like bitcoin and ether are now appearing on Apple and Android devices.
Second, there’s another set of custodians for crypto-assets linked to real world assets like commodities. They will tend to use trust or similar structures. In that world, the person setting up the crypto-asset trading platform will have an arrangement with a separate group that looks after the property. For commodities, that means a relationship with someone specialised in holding the particular asset.
The third group of custodians looks after security tokens: tokens representing shares, bonds and so on. Here, you start going back quite quickly towards the existing infrastructure for securities, and you are generally going to have to navigate the usual legal frameworks for these crypto-assets.
“As long as a private key is held securely, it’s the best form of signature possible”
New Money Review: In its statement, the UK Jurisdiction Taskforce said it recognises a cryptographic private key as adequate for signing legal documents where there’s a statutory requirement for a signature. How significant is this? Will it lead to a boost in the commercial applications of crypto-assets?
James Burnie: I think it will definitely assist. We’re still in a world where if you do an M&A transaction, there’s a whole number of people waiting to sign documents in wet ink, scan them, pass them on to lawyers, and so on. This is not legally required, not in keeping with how businesses are run, nor does it fit how normal people see the world.
As long as a private key is held securely, it’s the best form of signature possible. A wet ink signature can be fraudulently copied. So if you see a wet ink signature on a legal document, the next thing you usually see is a witness’s signature, verifying that the first signature is what it says it is.
This recognition of the uses of private keys by the Taskforce should help give blockchain firms a boost.
“The global picture for crypto-asset regulation is incredibly varied”
New Money Review: How does the UK Jurisdiction Taskforce’s statement fit into the global picture for crypto-asset regulation?
James Burnie: The global picture for crypto-asset regulation is incredibly varied. And that’s true even within individual countries, such as the US, where each state has its own approach.
The short answer is that jurisdictions like Singapore have stolen a march in this area, for example because they changed their payment services regulation to refer specifically to crypto-assets. Other countries like Abu Dhabi have also introduced a dedicated legal regime for digital assets. There hasn’t been a similar development in the UK.
But the key point is to separate reality from perception. The UK isn’t unfriendly to crypto-assets, even though there hasn’t been a specific change to the legal framework. And the UK Jurisdiction Taskforce’s statement will help cure any perception of the UK lagging in this area.
New Money Review: What are the broader implications of these legal developments? For example, how has the introduction of crypto-assets changed our concept of money?
James Burnie: A lot of the original cryptocurrencies were never designed to be money—even if they could perform some of the functions of money.
But we may one day go in that direction. For example, a government could introduce a cryptocurrency to address an issue of credibility with its population. The cryptocurrency would have to play by the rules of the blockchain, so the government would be limited in how it could interfere.
And blockchain technology offers other potential advantages. Take ERC tokens, the standard that’s been developed on the back of the ethereum network. Here, there’s a move towards each token being individually identifiable.
Let’s compare this with the way investment funds are currently managed. If you take money into a fund and mix it, no one knows whose money is represented by which assets. As a result, we have to create a whole lot of rules on top, for example, determining how client money is managed.
But if you can have a token telling us who owns exactly which pound coin within the system, there could be very significant implications for how shared investments are managed.
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