Events have moved a long way since the 2008 whitepaper in which the pseudonymous Satoshi Nakamoto first outlined the idea of a digital currency that could operate without financial institutions acting as intermediaries. Tellingly, the paper was published just weeks after Lehman Brothers collapsed during the height of the financial crisis, shaking public confidence in those who look after our money. Over the following decade, the cryptoasset market simmered, then boomed, and the expectation born of a passionate group of supporters soon followed. There were multiple drivers for this success, according to HSF arbitration specialist Charlie Morgan: "Investments in crypto grew significantly, as did the breadth of crypto offerings, ranging from unpegged coins to stablecoins, utility tokens and assets such as NFTs [non-fungible tokens] catching particular attention. The huge amount of private capital flowing into crypto supported and funded developments in blockchain technology and of the layers of applications that build upon it."
What the metaverse stands for is a virtual world where you have an ability to have a singular presence which moves from place to place."
Alex Cravero
ROSE-TINTED VR
While blockchain technology is a crucial part of the infrastructure underpinning the metaverse network, it is a combination of powerful 3D rendering engines and physical hardware that underlies the metaverse experience. The preferred choice is virtual reality (VR) as it is fully immersive – once your headset is on, the virtual world completely replaces your physical surroundings. Herein lies another frontier of technological development, and another major hurdle. “There are three main obstacles: interface, interface, interface!," notes Pablo García Mexía, Head of Digital Law at HSF Madrid: Are you going to be wearing bulky goggles for hours on end? It might be feasible for short bursts of time, but not the several hours needed to watch a concert or go to work.” Both Meta and Microsoft are investing heavily in making VR more user-friendly, but many still struggle with using headsets for more than brief periods of gaming or streaming. “We have a few different headsets in the office, and they all get a bit uncomfortable if worn for too long,” agrees Cravero. "That said, you soon forgive the issues when immersed in a virtual world full of all sorts of exciting experiences and content."
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A HARSH WINTER
This cocktail of investment and rapid adoption of the DeFi ecosystem helped drive sharp growth. But while some of crypto's more enthusiastic backers touted digital currencies as immune to the pressures facing conventional currencies, an ominous mix of surging inflation, interest rate hikes, energy shocks and international tensions following Russia's invasion of Ukraine exposed the flaws in this analysis. "When the market got spooked by the changing macroeconomic and geopolitical outlook, the riskier assets were the first people ran from," says Morgan. "That was in large part why we saw such a quick reaction in crypto markets, which preceded the fall in stocks." One of the first illustrations of that fall came when Terra – an algorithmic stablecoin intended to mirror the value of the US dollar through a relationship with its sister-token, Luna – collapsed in May 2022. The aftermath, alongside Luna's simultaneous failure, saw a $40 billion chunk being wiped off the global cryptoasset market within days. Though a smaller industry player, Terra's fate came amid a wider challenge to market confidence. The growth in lending platforms since 2018 resulted in increased leverage, and financial interdependency between crypto firms. The debt came mostly in the form of vast unsecured lending from a small group of industry players. This drove contagion risk that only became clear when Three Arrows Capital went under shortly after Terra, while Voyager Digital, BlockFi and Celsius all endured distress.
THE PROMISE OF SPRING
Clear skies follow every storm, and the crypto players that have weathered 2022 are waiting for expected opportunities. "The crypto industry has seen a steep cashflow contraction, but the downturn will be seen by many as an opportunity to build over the long term, and to acquire at a discount," says Morgan. "We are already starting to see a degree of market consolidation with some of the bigger players snapping up smaller ones who may not have the runway to see it through this crypto winter." At the same time, the purist vision of an irreverent and decentralised environment defined by vestigial regulation is looking increasingly impractical for much of the sector. Says Lidgate: "It is inevitable that the industry will become more institutionalised, and professionalised. I don't see your average person on the street being very keen to invest on any other basis; it's no longer the get-rich-quick everyman prospect it once was." Senior policymakers are alert to this. The implosion of Terra and the continued woes of some crypto lenders have highlighted the risk to consumers. In July, Federal Reserve vice-chair Lael Brainard stressed a need to "future-proof [the US] financial stability agenda" and "ensure the regulatory perimeter encompasses crypto finance." But there is an important distinction to be made between cryptocurrencies and the technology that underpins them, argues Morgan. "Distributed ledger technology (of which blockchain is one type) can bring real benefits and is not going away. It will continue to evolve." Ethereum's recent high-stakes move to a new platform (dubbed 'The Merge' in the industry) is a striking illustration of the drive to reform. The second most dominant blockchain underwent a transition from its energy-intensive "proof-of-work" system – which relies on powerful computers solving complex puzzles to add new transactions to the blockchain – to a so-called "proof-of-stake" model.
How to survive 'Crypto Winter' – Reflections on risk and resolving disputes
THE CORPORATE PIONEERS
KEY LEGAL ISSUES – CRYPTO SANS CRYPTIC
While the popularity of the two largest cryptocurrencies by market capitalisation – Bitcoin and Ether – grew in their own right, the Ethereum blockchain platform advanced the technology by introducing smart contracts. This allowed developers to create their own decentralised applications (known as dApps) – much like software applications on the Apple App Store or Google Play. This opened the door to decentralised finance – or 'DeFi' – an alternative financial system that shuns central authorities and allows users to lend and borrow cryptoassets directly. By late 2021 around $230 billion of capital was circulating in DeFi projects, according to CryptoCompare. This comes in addition to a wave of broader interest in cryptoassets and blockchain technology. With global central banks sustaining low interest rates for over a decade, and early investors starting to make headline-grabbing gains, yield-starved investors were increasingly ready to dive in. Between 2016 and 2019 over $29 billion was invested into crypto projects by way of initial coin offerings, according to Coinschedule. During the following two years, venture capital firms committed over $38 billion to blockchain start-ups, reported Dealroom, while the more recent boom in NFTs has added another $40 billion to the crypto market, according to Chainalysis.
The new system validates transactions by selecting computers that hold more of the network's cryptocurrency. That move, which was completed in September 2022, is expected to slash Ethereum's energy use by more than 99% and paves the way for radical upgrades to the platform to enhance transaction speed and stabilise costs. It spikes one of the most potent criticisms of crypto markets – their vast energy consumption at a time of global warming and rising prices. "Current estimates suggest that even after The Merge, a significant amount of the total market cap of cryptocurrencies run on proof-of-work systems," notes Alex Cravero, Regional Head of HSF's Emerging Technology Group in UK, US & EMEA. "The energy these systems need can be astronomical and increases all the time. Take Bitcoin, which today consumes more energy than Argentina. The Merge is a good test case for an industry that is driving towards a greener future."
Sceptics argued vindication after this year's crash and resulting high-profile failures of stablecoin issuers and crypto platforms, which further dented confidence. As Rachel Lidgate, Herbert Smith Freehills (HSF) disputes partner, notes: "There's an inherent, almost irreconcilable tension between the fact that the things that make cryptocurrencies attractive – like decentralisation and anonymity – also make it risky and hard to regulate." But the story is far from over. The blockchain technology that forms the bedrock of the crypto landscape retains many admirers and can be deployed in many fields. Moreover, cryptoasset supporters argue the correction will have a Darwinian impact, consolidating and strengthening the market through corporate acquisitions and more robust regulation, in turn promoting further mainstream adoption. In this second instalment of our TechQuake series exploring the high-impact technologies currently reshaping business and society, we assess the crypto crash of 2022 and ask: what's next for the industry?
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Facebook (Meta): in a bid to expand beyond its core social media business, the US company in October 2021 changed its corporate name to Meta and unveiled plans to recruit 10,000 staff to develop its metaverse. Microsoft: in January 2022, the software giant acquired computer games business Activision Blizzard for $68.7bn in a move widely viewed as a metaverse play, and has been investing heavily in making virtual reality (VR) cheaper and more accessible. JPMorgan Chase: The US banking giant opened its Onyx Lounge in the Decentraland metaverse platform in 2022, allowing it to operate a branch in the virtual world, alongside publishing a paper on the metaverse noting that "opportunities presented by interactive, digital worlds seem limitless." Samsung: In January opened Samsung 837X, an immersive virtual world modelled on the company's Samsung 837 flagship New York store, with the company describing the experience as "a journey where technology joins art, fashion, music and sustainability." Coca-Cola: launched over 4000 digital collectibles on the metaverse since 2021, owners of which can enjoy real-life perks and experiences sponsored by Coke Studio and early access to new Coca-Cola products launched by Coca-Cola Creations. Selfridges: teamed up with Paco Rabanne and Fondation Vasarely to open its first department store in the metaverse, which used NFTs to inform visitors about key events and projects in Selfridges' history. Fortnite x Balenciaga: In 2021, Epic games launched a series of in-game Balenciaga apparel for video game characters in Fortnite, made using 3D scans of real-life garments. Balenciaga launched accompanying Fortnite x Balenciaga merchandise in the physical world. Nike: opened a virtual store – Nikeland – in the metaverse, and in January 2022 claimed to have received just under 7 million visitors in less than six months. Also acquired RTFKT, a virtual goods company that specializes in creating digital sneakers. Hyundai: launched "Hyundai Mobility Adventure" in the metaverse in 2021, which aims to familiarise young and tech-savvy consumers with Hyundai's futuristic concept vehicles and hydrogen fuel-cell technology. Ferrari: launched a digital model of the real-life Ferrari 296 GTB in the metaverse in 2021, as well as signing a multi-year deal with Swiss tech company Velas to create NFTs for its metaverse audience. Government of Indonesia: in 2022, state-owned telecommunications company PT Telkom Indonesia launched its own metaverse "metaNesia" with a view to helping small businesses compete against international technology giants.
Alex Cravero in the metaverse VIA DECENTRALAND
RACHEL LIDGATE, PARTNER
As corrections go, the cryptocurrency crash of 2022 was particularly brutal. In November 2021, the market had surged to a peak valuation of $3 trillion; by June 2022, it had lost over two thirds of its value as inflationary pressures and a gloomy economic outlook spooked investors. Market watchers dubbed this another 'Crypto Winter', a downturn coming just a few years after a pronounced sell-off in early 2018 first garnered the name. Investors are used to cycles, and the high and lows of markets, but only a few times in history have they moved at this pace and extremity. Inevitably, questions have been raised about the role of cryptoassets in the wider economy – a debate pitching passionate supporters against trenchant critics. Touted as a democratic alternative to conventional currencies, cryptocurrencies are considered by some to be an alternative to gold capable of beating stock market downturns and hedging inflation. But their short history has been plagued by volatility and controversy.
ALEX CRAVERO, Digital Law Lead (UK/US & EMEA)
Regulating Crypto – Australia bids to be a global hub for next-gen finance
© Herbert Smith Freehills 202 Modern Slavery and Human Trafficking Statement | Accessibility | Legal and Regulatory | Privacy Policy | Report Fraud | Whistleblowing
In the second part of our TechQuake series, we ask what the 'Crypto Winter' means for the sector as the industry moves to mount a sustainable comeback
BEFORE THE FALL
Many possibilities, many challenges – Applying law in the Metaverse
CRYPTO INFOGRAPHIC +
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There's an inherent tension between the fact that the things that make cryptocurrencies attractive – like decentralisation and anonymity – also make it risky and hard to regulate."
For many businesses, it's a case of dipping a toe in early and learning rather than relying on speculation. This helps inform long-term strategies not just for the metaverse, but for the technologies it comprises and puts those businesses in prime position to evolve if the time comes.
CHARLIE MORGAN, SENIOR ASSOCIATE
The crypto industry has seen a steep cashflow contraction but the downturn will be seen by many as an opportunity to acquire at a discount."
A wider range of market participants soon felt the chill, from crypto exchanges and brokerages to lending and borrowing platforms. Many retail and institutional investors, alongside venture capital funds, found themselves exposed due to rapidly declining investments and loan defaults. This spiral has not stopped, and more insolvencies are expected, as even the institutional crypto miners that underpin the most popular proof-of-work blockchains like Bitcoin are feeling the pressure of soaring energy costs and lower crypto prices. Many have departed from long-standing "hodl" strategies – what crypto-watchers call a hold-on-for-dear-life approach to investing – and are selling their earned tokens at an alarming rate, potentially triggering more knock-on impacts throughout the industry. But it is far from clear how and when insolvencies will materialise, according to HSF litigator James Emmerig: "Different jurisdictions measure financial health differently. In Australia, our concept of insolvent trading is measured by a company's ability to pay its debts in fiat terms – by cash flow, not balance sheet. Liquidity is important, and directors have duties in respect of creditors when a company trades while insolvent. It remains to be seen how this plays out where a firm’s assets and obligations are significantly denominated in crypto. You might be crypto-rich, but cash-poor." Crucially, cryptoassets themselves will be relevant during insolvency. While their precise status is still evolving under many existing legal frameworks, Australia, Singapore, New Zealand, and the UK are among the jurisdictions likely to consider certain types of cryptoassets as property which may be enforced against in proceedings. Whether a distressed company or third-party custodian holds cryptoassets, and the ability to secure them upon an insolvency event, are therefore front of mind for those on the lending side of the ecosystem.
Though some crypto evangelists are unconvinced by The Merge, believing it undercuts the democratic and decentralised ethos of blockchain, most consider the step a necessary one if crypto is to move into the mainstream. Susannah Wilkinson, Regional Head of HSF's Emerging Technology Group in APAC, comments: “The Merge was a key milestone for Ethereum. In addition to reducing energy consumption, it opens the door to future upgrades aimed at reaching an aspirational target of processing 100,000 transactions per second (t/ps) – significantly more than the 10 t/ps of the Bitcoin network and 1,700 t/ps of traditional card payment systems."
The plunge in crypto valuations has impacted many in the industry, creating a more litigious environment. To assess the risks, we canvassed HSF disputes specialists Rachel Lidgate and James Emmerig, alongside Brick Court Chambers rising star Sarah Bousfield.
What kind of advice can you give to businesses following the crypto sell-off? Sarah Bousfield: I would tell a client that, "Yes it is right that the value of cryptoassets has decreased, but these assets are still targetable in litigation." Moreover, there are some positive developments in the last...
It would be easy to imagine that institutional lenders – the entrenched financial elite which crypto often defines itself against – would feel a sense of schadenfreude since the crash. But many banks are watching as the technology advances and use cases diversify. The nimblest challenger banks have already started to capitalise on the enduring customer demand for cryptocurrencies. Most notable is perhaps leading challenger bank Revolut, which is the first to have been authorised by the UK Financial Conduct Authority as a cryptoasset firm. Whether cryptoassets are reasonable investments or speculative punts, though a justified question, misses the bigger picture: they – and the technology they run on – are increasingly moving into the mainstream and will continue to permeate the financial and digital landscape. The result is that regulatory scrutiny will continue to intensify, as regulators grapple to balance innovation with consumer protection. And counter-intuitively for an asset class born of libertarian ideals, the looming reality of tougher regulation looks to be one of the strongest reasons for believing cryptoassets can be credibly ushered somewhere approaching the investment establishment. Wilkinson predicts: “Over the coming years this technology will scale and fuel the tokenisation of a wide range of real-world and digitally-native objects, information, services and ideas. This tokenisation will drive new opportunities, efficiencies and connections in the digital economy, for example, tokenisation of bank liabilities and the provision of digital money by central banks through CBDCs.” The EU is in the process of implementing a landmark package, the Regulation on Markets in Cryptoassets (MiCA), which is designed to protect consumers and increase transparency in the European crypto market. At the same time, regulators in Australia have been exploring a draft bill to regulate certain providers of cryptoassets, while the UK is moving towards policing cryptocurrencies and stablecoins under plans to make the jurisdiction “a global cryptoasset technology hub".
Given the EU's clout in establishing global regulatory standards, the advent of MiCA ahead of an expected 2024 implementation is considered a significant chapter for the industry, particularly as it proceeds alongside the EU this year unveiling other reforms to bring cryptoasset regulation in line with traditional finance equivalents. MEP Stefan Berger commented on political agreement for the package: “We are the first continent to have a cryptoasset regulation. In the Wild West of the crypto-world, MiCA will be a global standard setter.” Far from a sign of a market whose days are numbered, increased engagement from legislators is a recognition that, while a sustained market dip is likely, cryptoassets are here to stay. Policymakers are increasingly focused on how they can be progressively brought into the tent. Cravero summarises the outlook: "Financial markets move in cycles and we are living through a significant and noteworthy cycle for crypto. How long that will take to run its course, and what it will look like on the other side, are anyone's guess. But blockchain technology and cryptoassets will continue to have a role in modern financial ecosystems – there is clearly value in them."
SUSANNAH WILKINSON, Regional Head, Emerging Technology (APAC)
This technology will scale and fuel the tokenisation of a wide range of real-world and digitally-native objects, information, services and ideas. This tokenisation will drive new opportunities, efficiencies and connections in the digital economy."
SUSANNAH WILKINSON, DIGITAL LAW LEAD, AUSTRALIA AND ASIA
TECHQUAKE
© Herbert Smith Freehills 2022 Modern Slavery and Human Trafficking Statement | Accessibility | Legal and Regulatory | Privacy Policy | Report Fraud | Whistleblowing
Blockchain technology...
Cryptoasset is a catch all term that refers to any digital representation of value that uses blockchain technology (or another form of distributed ledger technology) to verify and maintain records of transactions between parties or other data. It includes tokens and cryptocurrencies/coins. Cryptoasset is a subset of the broader term digital asset, which includes both cryptoassets and other digital representations of value that operate using centralised ledgers.
A token is a digital representation of a physical or digital item, which runs on blockchain technology and by virtue of its interoperability can act as a medium of exchange. Tokens are cryptographically secured and, in contrast to cryptocurrencies, can have additional functionality in their smart contract code. Tokens are developed using applications that run on blockchain platforms (ie, they are not the native cryptocurrency of a particular blockchain). For example, stablecoins like USD Tether (USDT) and non-fungible tokens (NFTs) like Bored Ape Yacht Club are types of token that run on the Ethereum blockchain (and others).
Stablecoins are a form of token which attempt to stabilise its market value by tying itself to the value of a specific asset such as fiat currencies, for example 1 token = $1, or to the price of a commodity such as gold. Some of the most popular stablecoins include Tether (USDT) and USD Coin (USDC). ‘Algorithmic stablecoins’ attempt to achieve price stability through on-chain algorithms that balance supply and demand between the ‘stablecoin’ and another cryptoassets intended to back the price - TerraUSD (UST) being one example.
Non-fungible tokens (NFTs) represent a uniquely identifiable and indivisible digital or physical asset such as digital art or classic cars. Unlike cryptocurrency they are not interchangeable one for one. They use a standardised format, refer to the digital or physical item, and can be programmed to carry out actions on certain events occurring, such as paying their original issuer a percentage of the purchase price on every future transfer. Some of the most popular NFTs include Cryptopunks and Bored Ape Yacht Club.
Governance tokens are issued by developers to allow and incentivise community participation in decisions affecting blockchain-based initiatives. This could include whether to accept an upgrade to the protocol or spend funds on a particular activity. Decisions are made via voting according to the applicable governance mechanism. The legal characterisation of governance tokens is currently a hot topic in decentralised autonomous organisations.
Utility tokens can be issued, bought, or traded for a range of specific purposes within a single blockchain ecosystem like a game. This could include earning rewards or buying items to enhance player experience (costumes, equipment, weapons, etc). These tokens have no intrinsic value but may have notional value within the game or other ecosystem within which they operate.
Central Bank Digital Currencies (CBDCs) are a digital form of a country’s fiat currency that is issued and regulated by that nation’s monetary authority or central bank (for example, the Bank of England, Federal Reserve, Reserve Bank of Australia, and Monetary Authority of Singapore). The People’s Bank of China has launched a digital renminbi. They may be either cryptoassets which run on a blockchain and cryptographically secured or more broadly characterised as a digital assets which run on centralised ledgers.
Blockchain is a type of distributed ledger technology. At its core, it is a type of database – a collection of data stored in a structured format distributed across multiple computer systems. It acts as a ledger, or record of transactions and data. New information can be added, but previous records cannot be changed. It offers three core benefits over centralised ledgers:
It is distributed, meaning an identical copy of the ledger is instantly shared among network participants each time it is updated. It is immutable, meaning it provides an unalterable record of all transactions. It is cryptographically protected, meaning it is secured from access and manipulation by malicious actors.
A cryptocurrency or "coin" is a digital representation of value that is not controlled by a centralised entity, uses blockchain technology, is secured by cryptography, is native to a particular blockchain and used by participants to execute transactions on that blockchain (ie, BTC and ETH). For example, Bitcoin runs on the Bitcoin blockchain, and Ether runs on the Ethereum blockchain. Cryptocurrencies can be divided and traded in fractions (ie, 0.0023 BTC)
Blockchain technology has given rise to new ways of storing value in digital form, creating an explosion of use cases for digital assets. This diagram provides a high-level introduction to the blockchain and digital asset ecosystem. Blockchain is one type of distributed ledger technology (DLT) and use cases for other types are emerging. There is no globally accepted classification system or terminology for cryptoassets, and we expect this to continue to mature.
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The plunge in crypto valuations has impacted many in the industry, creating a more litigious environment. To assess the risks, we canvassed HSF disputes specialists Rachel Lidgate and James Emmerig, alongside Brick Court Chambers rising star Sarah Bousfield
James Emmerig: If your business is experiencing financial pressure, consider seeking advice early. As legal advisers, we can sense check your position, explore potentially available protections, and help develop a turnaround or restructuring plan if needed.
PABLO GARCÍA MEXÍA, HEAD OF DIGITAL LAW - MADRID
How can businesses protect themselves from financial pressure?
Virtual worlds will be subject to many of the same issues we see in today's internet. The problem is the metaverse involves emerging technologies that are still being grappled with on a global scale by businesses and politicians and there will only be more of that to come as we see more advanced tech move into mainstream".
CAN IP RIGHTS PROTECT BRANDS AND PRODUCTS IN THE METAVERSE?
Immersive experiences create more compelling narratives. Greater community engagement and gamification in novel contexts will also generate new business opportunities."
Susannah Wilkinson, Digital Law Lead (Australia & Asia)
Sarah Bousfield: I would tell a client that, "Yes it is right that the value of cryptoassets has decreased, but these assets are still targetable in litigation." Moreover, there are some positive developments in the last year which assist those who wish to launch proceedings concerning cryptoassets. In the past there have been difficulties with serving applications for disclosure out of this jurisdiction. These applications facilitate obtaining information from third parties who hold information concerning the identity of wrongdoers or location of misappropriated property. Crypto is by its nature international and borderless, so the difficulties in serving these applications on foreign respondents created real problems. However, there's been a helpful change to Practice Direction 6B. This has opened the door to disclosure orders being useful tools for crypto property litigation once again. To any new claimant asking whether it was worth bringing a claim concerning cryptoassets, I'd say: "The value of the claim may be less now, but it’s still a valuable and targetable asset, and the path available to identify wrongdoers has become easier."
What kind of advice can you give to businesses following the crypto sell-off?
In lots of disputes, where we have successfully traced cryptoassets and identified the perpetrators, I have often found there was a willingness to hand over the assets and settle. This was because the asset value had increased so much that miscreants were willing to settle, and victims were willing to walk away provided the misappropriated assets were returned. It meant more to the client just to recover the crypto, so they weren't worried about pursuing other losses and legal costs. Now that crypto assets have dropped in value over the last year, we might start seeing cases fight to final judgment in circumstances where claimants are not content to just recover the asset.
What new disputes might we see thanks to the Crypto Winter?
SARAH BOUSFIELD BRICK COURT CHAMBERS
The value of the claim may be less now, but it’s still a valuable and targetable asset, and the path available to identify wrongdoers has become easier."
SARAH BOUSFILED BRICK COURT CHAMBERS
Rachel Lidgate: I expect there would have been a rise in crypto-related claims irrespective of the crash. The crash could have an impact on existing claims, because it may affect questions of causation and loss. Other types of claims I expect to see on the increase include those against exchanges for alleged trading losses, claims alleging mis-selling or misrepresentation about capability or risk, tracing and recovery claims, and claims arising from insolvency and business failures. Notwithstanding the settlement of the Tulip Trading Limited v Bitcoin Associate for BSV litigation, we may also see further attempts to establish duties of care, eg by users of a network against network developers or operators. Sarah Bousfield: I have been involved in various claims concerning interim relief over cryptoassets, including freezing orders and disclosure orders – and we've had success in tracing cryptoassets on numerous occasions. Many of those cases were held in private and then settled.
The tax treatment of cryptoassets is unclear in many jurisdictions as regulators seek to apply existing laws to new technology. Difficulties in characterising cryptoassets and applying existing laws to the practical reality of how the technology works can be difficult and result in overly burdensome compliance obligations. Different types of cryptoassets (and the activities surrounding them) may be subject to applicable tax obligations depending on the precise nature and surrounding circumstances of an asset. The lack of transparency and accountability in cryptoasset transactions can result in concerns regarding tax avoidance and tax disclosure regimes. The Organisation for Economic Co-operation and Development is working on a new global tax transparency framework to provide for the reporting and exchange of information with respect to cryptoassets to address these issues.
TAX
Games of chance that reward users with prizes are commonplace in the metaverse. In many games, for example, users can pay directly or indirectly to open a loot box (a type of treasure chest) which rewards the user with a random selection of virtual items such as clothing for their avatar. Gambling-style opportunities like these have started to attract significant scrutiny in some jurisdictions, and regulators are considering whether these may be a form of gambling under applicable laws (in part depending on whether there is a monetary value or active secondary markets for the in-game rewards outside the game). Where activities are regulated under gambling legislation they may require the person operating the activity to first obtain regulatory licences or approvals, and/or adhere to certain restrictions including those to protect children and other vulnerable persons. Contravention of certain of these laws can be a criminal offence.
Gambling and gaming
As with the physical world, disputes in the metaverse may arise in various contexts. Many 'traditional' disputes will arise in relation to the underlying digital infrastructure on which the metaverse depends and its ownership and governance. Users may also bring claims against platforms or other providers for perceived harms suffered in using the metaverse. However, more novel disputes will also arise within the metaverse, as users bring claims against each other, for example in respect of transactions. The nature of these disputes may challenge traditional resolution methods, lead to an increase in online dispute resolution. However, thorny legal issues arise around applicable law, jurisdiction and competent authorities to enforce any decisions on a peer-to-peer basis, particularly cross-border. An increasing number of entities enabling the metaverse are distributed autonomous organisations (DAOs) governed by token holders which have unclear legal status in many jurisdictions, which adds to that complexity.
Disputes
Although security is one of the major selling points of blockchain technology, unforeseen circumstances can lead to cybersecurity incidents and the loss of valuable cryptoassets. Such losses may be preventable with appropriate cybersecurity measures, controls, and policies, and historical incidents (or near-incidents) should be disclosed and assessed to the relevant authority. A significant amount of cryptoasset activity is carried out through interaction with computer programs or smart contract code. Vulnerabilities in the code of the smart contract can leave many holders of cryptoassets exposed to risk of significant losses.
CYBERSECURITY & RESILIENCE
The interplay between IP law and cryptoassets typically arises with respect to NFTs as they are usually associated or linked to a creative work. Many jurisdictions have not yet implemented specific regulatory regimes for NFTs and there is still substantial uncertainty regarding the IP rights that attach to their creation, sale and use. Without specific regulation, an NFT is just a certificate of authenticity for an underlying asset, it does not intrinsically transfer any IP rights from the asset itself to the purchaser of the NFT. This has parallels to fine art, where the acquisition of a painting does not of itself give the purchaser any right to the underlying copyright in the painting. This default position can be amended by contract. As things stand, although NFT projects may seek to define the IP rights in relation to their NFTs either before or after sale, many projects only set out limited or incomplete disclaimers or terms and conditions on a website. This means any IP rights being assigned or licensed under such terms are unclear and capable of being misunderstood (which may have consumer protection law implications). Further, depending on the jurisdiction and the rights being assigned or licensed, a statement on a website may be insufficient to meet the formality requirements for an IP assignment and/or licence, rendering the transfer incomplete.
INTELLECTUAL PROPERTY
Novel business opportunities and nuanced technical features of cryptoassets have given rise to heightened scrutiny by regulators of advertising practices by those promoting them. For example, many consumers may not completely understand how an NFT works, what the purchaser will own and how volatile the value of the NFT may be. Advertisers must follow rules set out by regulatory bodies, including those of fairness and transparency (for example, advertisers must be obviously identifiable as such). Additional requirements may apply to the marketing of financial products and services, as well as cryptoassets whether or not they fall within the regulatory perimeter. Cryptoassets can be applied to a wide range of use cases which presents challenges for organisations in terms of identifying the range of regulation triggered depending on the characteristics of the cryptoasset and the actions taken in respect of it. For example, e-commerce, data protection (given the widespread personalised advertising) and online harms or specific industries or sectors (such as gambling). Advertising of crypto assets is a high-priority issue for the UK Advertising Standards Authority (ASA). The ASA issued guidance in March 2022 covering advertising of cryptoassets and requiring crypto ads to include prominent statements that these products are unregulated. There are also plans for the Financial Conduct Authority to bring cryptoassets (excluding NFTs) within scope of the financial promotions regime. Spain has recently passed laws on the advertising of cryptoassets, and MiCA will introduce a marketing regime for some cryptoassets (excluding NFTs).
Advertising
Beyond the impact that the increasing interlinkage between personal and professional lives has on employee wellbeing and mental health, the increased use of virtual worlds provides new and different opportunities for behaviour inconsistent with employers on standards of conduct, including codes on diversity and inclusion. Reports of inappropriate conduct using avatars are already plaguing some platforms. In the same way as remote and hybrid working presented new challenges in dealing with allegations of bullying, harassment and discrimination, employers may need to adapt internal rules and processes to address issues of workplace behaviour. This could include regulating the likeness of any avatar to the user it represents, matters relating to the way in which they communicate with other users or even access by employees to certain areas of the digital universe or metaverse platforms. Additionally, surveillance in the metaverse (whether to investigate or prevent misconduct or merely eye-tracking tools inherent in virtual-reality headsets) raises further complications for employers.
Employment
The global market in cryptoassets has recently seen a substantial downturn, losing approximately $2 trillion in value since the market highs of 2021. This downturn has exposed poor practices around financial risk management and asset allocation within firms that invest in cryptoassets, with a number of high-profile firms entering into insolvency. The vulnerability of firms with large positions in cryptoassets is partly attributable to the rise of DeFi and lending platforms since 2018, which has resulted in increased debt and leverage throughout the market, as well as increased contagion risk between firms. While there is still some uncertainty about the legal character of cryptoassets, it seems likely that they will be treated as property in at least some jurisdictions, including the UK, Australia, Singapore and New Zealand. This is relevant from an insolvency perspective as many cryptoassets still hold value and will likely be the primary asset holding of crypto firms that go insolvent. In this regard, identifying and securing control of any remaining cryptoassets will be important and identifying whether they might be subject to custodial arrangements or held by the firm itself (in which case the relevant private keys will need to be identified) will be important. Moreover, public blockchains provide an immutable record of all cryptoasset transactions entered into by a firm prior to insolvency, which could be useful evidence from an insolvency perspective.
INSOLVENCY
Data flows need to be analysed within the distributed ledger technology solution (on which the cryptoasset is enabled) and across interfacing parties, as well as associated policies. If personal data is processed or stored by the solution, the geolocation of nodes and role they play must be analysed as the distributed nature of the solution can cause extra-jurisdictional data transfers. Secondly, the technical measures that the solution uses to process data must be considered as the immutable nature of blockchain technology may by incompatible with rights afforded to data subjects. Compliance with banking secrecy requirements may also need to be assessed.
DATA PRIVACY
The rise of cryptoassets has opened a new world of alternative digital banking and finance, ranging from speculative trading and peer-to-peer lending to yield farming, attracting large sums of capital from traditional institutions and consumers. The volatility of cryptoassets combined with increasing use creates challenges as financial services regulators try to balance encouraging innovation with protecting consumers. Certain features of cryptoassets and the activities carried out in relation to them fall within the scope of existing financial regulations (which includes anti-money laundering, licensing, conduct and disclosure requirements), often in different ways for different jurisdictions. Cryptoassets are also often held by third-party custodians, which can give rise to additional security and regulatory risks in multiple jurisdictions. Many regulators are exploring the creation of crypto-specific regulations – the European Markets in Cryptoassets Regulation (MiCA) being the most notable.
Financial regulation
Traditionally, among common law systems, personal property rights, particularly ownership, have revolved around either physical/tangible items (such as chose in possession) or the right to sue (chose in action). However, neither of these categories comfortably accommodate digital assets due to the difficulty in translating property rights and associated concepts onto things that are information-based, easily shareable and open to all. The ability for a cryptoasset to be linked to a real-life asset, such as a non-fungible token (NFT) linked to an artwork, has also introduced new ways of arranging ownership (eg, one can own a cryptoasset but not the underlying asset). Such complexities have prompted regulators around the world to consider whether their property law regimes adequately recognise and protect the nuanced features of cryptoassets. For example, the Law Commission of England and Wales is considering a potential third class of property called ‘data objects’ which would introduce regulatory clarity for certain cryptoasset transactions under the laws of England and Wales.
OWNERSHIP (PROPERTY)
Cryptoassets have challenged traditional legal concepts and frameworks, leaving many regulators and governments playing catch up. If that sounds daunting, we provide much-needed clarity
As the EU and UK strive to keep pace with crypto, Australia aims to carve a key position in the Asia-Pac region. We assess the G20 nation's progress building a regime fit for tomorrow's digital economy
Australia has long been recognised as a hub for emerging technologies and a centre to promote the growth of cryptocurrencies and fintech. Crypto is generally unregulated in Australia, with many market players opting to fall outside the net of various oversight regimes. There are exceptions, however, with entities such as digital currency exchange providers required to comply with anti-money laundering (AML) rules administered by the government agency, the Australian Transaction Reports and Analysis Centre (AUSTRAC). Meanwhile, where a cryptoasset is a financial product, entities must hold an Australian Financial Services Licence (AFSL) and “finfluencers” must now comply with national financial services laws where they provide financial product advice. Below we outline crypto's growing place in Australia's financial regulatory framework.
What is on the horizon?
The regulation and treatment of cryptoassets in Australia is at a crossroads. We are seeing unprecedented engagement from Australia’s government and agencies, numerous consultations on regulating emerging technologies without stifling innovation and greater regulatory certainty now on the horizon. In particular, New South Wales Senator Andrew Bragg put forward a private members’ bill on 19 September 2022, the Digital Assets (Market Regulation) Bill 2022. Among the proposals is a licensing regime for digital asset exchanges, custody services and stablecoin issuers; requirements for Australian and foreign currency to be held in reserve in Australia’s banking regime; and reporting requirements for China's official digital currency, the eYuan. Moreover, the Senate Select Committee on Australia as a Technology and Financial Centre released its final report in October 2021, which made 12 recommendations in relation to crypto, including a new markets licence for digital currency exchanges as well as custody requirements. However, with this year's change in Australia's federal government, many of these recommendations are now on hold. Other significant developments have seen the Treasury recently announce it will engage in a ‘token-mapping’ exercise to identify how cryptoassets should be regulated. The Reserve Bank of Australia is, meanwhile, conducting a pilot project to explore innovative business models, use cases, risks and operational models for potential wholesale and retail central bank digital currency (CBDC).
Design and distribution obligations (DDO): If the cryptoasset is caught under the DDO regime, the issuer or distributor is required to have in place a product governance framework and a defined target market to ensure cryptoassets and services are marketed towards a specific category of customers.
Key regulatory touchpoints
If brands are thinking about entering the metaverse (as many already have), or promoting and selling NFTs, the terms under which any proprietary content is licensed or sold needs to be carefully considered, as these will determine the extent to which the content can be used in the metaverse and the real world. In either case, content owners will need to police the metaverse to identify where their content may be being used without permission, in particular where they may seek to use it for their own NFT portfolio in future. Enforcement may be problematic if the agent providing the NFT is not identifiable or blockchains prevent further identification of sources. To read more about NFTs in particular, see our briefing The IP in NFTs – Strategies for protecting your brands and products in the metaverse.
PROTECTION OF IP THROUGH LICENSING
In terms of dealing in crypto assets and NFTs, the Law Commission of England and Wales has recently recommended law reform to recognise a third category of personal property – referred to as ‘data objects’ – to deal with digital assets such as NFTs, in addition to things in possession (such as physical objects) and things in action (such as contractual rights). The paper acknowledges the flexibility of English law to accommodate digital assets within existing legal principles but recommends reform to ensure ‘data objects’ are treated consistently under English law and promote greater legal certainty. For a more detailed review of the consultation paper (which is open for responses until 4 November 2022), and court decisions in the UK which have considered cryptocurrencies and NFTs, see our blog post here.
NFTs – a new legal form of property needed?
George McCubbin SENIOR ASSOCIATE (AUSTRALIA), LONDON
If brands are thinking about entering the metaverse (as many already have), or promoting and selling NFTs, the terms under which any proprietary content is licensed or sold need to be carefully considered"
Giulia Maienza ASSOCIATE, MILAN
Rachel Montagnon Professional support consultant, London
Andrew Moir GLOBAL HEAD GLOBAL HEAD OF CYBER & DATA SECURITY, LONDON
Financial product or service: If providing a financial service in Australia, you are required to hold an AFSL or be exempt. There is a risk that the cryptoasset is a financial product and/or the entity is engaging in a financial service. The Australian Securities & Investments Commission has provided some regulatory guidance (see ASIC Information Sheet 225 Cryptoassets). Where the rights, characteristics or features attached to the cryptoasset resemble a financial product, then the cryptoasset will be treated as a financial product and the entity must hold an AFSL or rely upon an exemption. This would include attachments such as a security, derivative, non-cash payment facility or managed investment scheme.
Credit licence: Where the cryptoasset also involves the provision of credit, financing or a margin lending facility, you may need to hold an Australian Credit Licence or rely upon an exemption.
Anti-money laundering: Where an entity engages in certain financial services activities, known as designated services, and has a geographic link to Australia, it is required to enrol and/or register with AUSTRAC. In particular, digital currency exchanges are required to comply with AML obligations such as compliance with an AML/Combating the Financing of Terrorism programme, appointing an AML Compliance Officer and conducting customer identification procedures, transaction monitoring and reporting obligations.
Purchased payment facility (PPF): A PPF is a facility under which a holder of stored value makes payments to another person on behalf of the user of a facility. Depending upon how this is structured, an entity may need to hold a PPF licence with the Australian Prudential Regulation Authority (APRA).
Collection of data: Under the Financial Sector (Collection of Data) Act 2001 (Cth), a firm that provides finance and has an asset threshold of A$50 million must register with the APRA to share statistical data on their business with APRA and the Australian Bureau of Statistics.
METAVERSE
Everything you wanted to know about the metaverse (but were afraid to ask)
In the first of our Tech Quake series exploring disruptive technologies, we ask how seriously the business world should take the metaverse
THE NEW FRONTIER
According to Susannah Wilkinson, Digital Law Lead of the Emerging Technology Group at Herbert Smith Freehills (HSF): “The metaverse advances how people experience online interactions, and the scope of those interactions, thanks to improvements in user interface hardware and developments in Web3 technologies like blockchain.” These advancements open the door to a wealth of new business opportunities, and not just for companies like Meta, Microsoft and Nvidia who are building metaverse-related technologies. Banking and consumer businesses are seeing fledgling platforms like Decentraland as opportunities to engage with younger generations, while real estate businesses (and Snoop Dogg) are buying plots of virtual land. The reality, though, is a single unified metaverse is a long way off, if it ever materialises at all. That is partly down to technical limitations; it would require a thousand-fold increase in current computing capability, according to Intel, and there are ongoing challenges with technological interoperability. But mostly it is a matter of business logic. Competitors are simply not motivated to connect their products to each other to create one universal network.
...the metaverse in many respects is a natural evolution of established and world-changing platforms and technologies like the internet, social media and smartphones."
Jaded observers dismiss it as marketing, little more than an evocative buzzword to lure investors. The initiated say it is our shared digital future: a virtual world of abundant possibilities that exists in parallel to our physical world. Most find themselves in the middle ¬– unsure, confused… or awaiting an explanation. Welcome to the metaverse! Surrounded by a strikingly utopian sales pitch, making sense of concept and understanding practical realities of the metaverse can be hard. To begin with, there are so many definitions floating around, each seem to differ in subtle yet fundamental ways. In essence, the metaverse is generally characterised as a growing 3D virtual universe where you can spend your digital life as an avatar - working, playing, shopping, or just hanging out. This vision of a borderless digital realm is not new; the metaverse takes its name from the 1992 science fiction novel Snow Crash by Neal Stephenson, whose idea of a single virtual world was further popularised in the book and film Ready Player One. But most agree Facebook's 2021 rebrand as Meta and commitment to hire 10,000 people to develop the concept is the major source of fuel for today's metaverse fire. That is not to say everyone is convinced by the concept. Serial tech entrepreneur and Tesla chief, Elon Musk, has poured cold water on the metaverse, labelling it nothing more than “marketing”. But many see it as the natural evolution of established and emerging technologies.
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NEW WORLD, NEW RISKS?
THE WHEEL TURNS
ENTER THE METAVERSE
Q&A 1
Q&A 2
FACEBOOK
HSBC
CHarlie morgan Senior Associate, London
DLT and its applications continue to mature notwithstanding the 'Crypto Winter'. The trend is towards greater decentralisation of business processes and relationships, across multiple jurisdictions. This trend holds true in both the B2B and B2C contexts. As digital asset and Web3 companies continue to buy, build and grow, they need to think carefully about how disputes (which are unfortunate but inevitable over the life of a business) will be resolved. In particular, how they are resolved in a manner that best meets operational needs, but also ensures maximum certainty and enforceability of legal rights. In addition to thinking about contractual remedies and disputes, businesses should also reflect upon how to structure their investments to ensure they are protected under available international treaties too.
What next?
The broader flexibility that arbitration affords also enables parties to tailor the arbitration to meet their commercial objectives."
While self-executing smart contracts and Web3 apps may promote certainty and efficiency in commercial dealings, being able to compel a party to take action beyond what the code requires is essential."
With the crypto market enduring its most significant test to date, we explore how arbitration has become the industry's go-to forum for solving complex disputes
CODE IS NOT LAW — ARBITRATION'S CRITICAL ROLE IN RESOLVING CRYPTO DISPUTES
Market volatility breeds disputes, and the 'Crypto Winter' is no exception. Crypto-related disputes are on the rise, and they can take many forms. From traditional disagreements about the meaning of a contract to technical disputes about the operation of particular networks, software or transactions — arbitration has established itself as a preferred forum.
The contentious side of crypto
Crypto-related disputes generally involve familiar legal issues, but many also require novel application of established legal principles, given the unique characteristics of distributed ledger technology (DLT), digital assets and the broader Web3 environment. However, there are common features to all crypto disputes, whether the issue is about ownership and governance of a particular project or company, legal rights arising from control of digital assets, liability for misappropriated cryptocurrency or the impacts of regulatory change. These disputes generally involve assets and parties across multiple jurisdictions, operating in nimble markets where speed counts.
Why you need a legal dispute resolution mechanism
Code is not law: while code executes in a pre-ordained way, those online actions, and the participants in the relevant transaction, cannot (and would not want to) altogether escape the reach of the law. Indeed, legal certainty is the bedrock of business operations. It is the law that ensures parties can protect their investments and would not, for example, be held to the output of obviously erroneous code or a transaction brought about through fraud. As such, parties' online relationships and the contracts that govern them require legal rights that can be upheld and enforced both online and in the physical world. While self-executing smart contracts and Web3 applications may promote certainty and efficiency in commercial dealings, being able to compel a party to take action beyond what the code requires is essential. Because of that, it is important commercial relationships in Web3 are anchored within a valid legal framework and that parties identify, at the outset of their transactions, the dispute resolution mechanism that will apply if things don't go to plan. Parties who disregard these realities face substantial legal risks. Determining how and by whom disputes will be resolved is a real entanglement, with real-world uncertainty and costs. Procedural disagreements that result from a failure to consider upfront how disputes would be resolved can lead to years of delay and unnecessary legal costs. This can significantly hamper growth and expansion of a business, as well as shareholder returns. The decentralised and borderless nature of DLT and its users only exacerbates already complex conflict of law issues in this context.
Why arbitration is well-suited to resolving crypto disputes
Arbitration is a non-national and neutral dispute resolution forum, which results in a final and binding legal award enforceable around the world. It is also a process with party autonomy at its heart, such that parties can choose the shape and characteristics of the process for resolving their disputes. The flexibility of the arbitral process – with the procedure tailored by the parties’ agreement – enables the parties to, for example, nominate a tribunal of industry or technical specialists. This is particularly appealing in crypto disputes, due to potential complexity of the legal and technical issues that may arise. The broader flexibility that arbitration affords (when considered carefully in the context of the laws that would apply to the arbitration) also enables parties to tailor the arbitration to best meet their commercial objectives.
Is arbitration fit for Web3?
Despite being more flexible than court litigation, arbitration can still be a lengthy and costly process involving submissions, document production and factual and expert witnesses. For complex and high-value cases, a detailed process with full exchange of evidence and submission is often desirable to ensure justice is done. However, parties can agree to streamline the process to better fit with their commercial drivers. As discussed above, parties can limit the disclosure exercise in advance, forgo an oral hearing in favour of a decision 'on the papers' or limit the number of factual/expert witnesses and/or arbitrators. A still-nascent area of online dispute resolution seeks to embed arbitration processes within smart contracts/software. Notwithstanding the exciting potential for on-chain arbitration, the 'code is not law' disclaimer applies here too: an arbitration protocol running on a blockchain (and its output) must be consistent with the mandatory laws that apply to the transaction and, therefore, enforceable in the real world. It must include legal safeguards necessary to address unforeseen contingencies or coding/software bugs. A failure to do so will see such protocols add time and complexity to the resolution of disputes, rather than the opposite. Again, this militates in favour of parties taking specialist advice before deciding how best to resolve disputes that arise from their relationship. Failing to do so can have costly consequences financially and in the implementation of a business' vision.
CHarlie Morgan Senior Associate, London
SIMON CHAPMAN KC REGIONAL HEAD OF PRACTICE - DISPUTE RESOLUTION, ASIA, HONG KONG
KEY CONTACTS
Arbitration is a non-national and neutral dispute resolution forum, which results in a final and binding legal award enforceable around the world. It is also a process with party autonomy at its heart, such that parties can choose the shape and characteristics of the process for resolving their disputes. The flexibility of the arbitral process – with the procedure tailored by the parties’ agreement – enables the parties to, for example, nominate a tribunal of industry or technical specialists. This is particularly appealing in crypto disputes, due to potential complexity of the legal and technical issues that may arise. The broader flexibility that arbitration affords (when considered carefully in the context of the laws that would apply to the arbitration) also enable parties to tailor the arbitration to best meet their commercial objectives.
WHAT NEXT?
DAN HUANG TRAINEE SOLICITOR, LONDON
A significant issue in the insolvency of a large crypto exchange is likely the quantity of creditors with claims against the company: it has been reported the number of creditors of the FTX estate may surpass one million."
At least one exchange has publicly stated that creditors will only have an unsecured contractual claim in the event of an insolvency, meaning customers will be at risk."
With distress in crypto hitting headlines, we unpack the key risks and legal issues facing the industry and investors
What the Crypto Winter means for insolvency
There has been no shortage of high-profile insolvencies in the crypto market in recent months across a range of market participants and geographies. These include the US Chapter 11 and Bahamas provisional liquidation of FTX as well as the US Chapter 11 filings of BlockFi, Singapore-based crypto hedge fund ThreeArrows Capital, US-based lenders Celsius Network and Voyager Digital, US-based crypto mining data centre Compute North and German crypto bank Nuri. While the number of insolvencies poses questions about the risk management and governance of crypto businesses, below we address what it means legally and practically for users, lenders and other market participants when a crypto custodian falls into distress and even an insolvency process.
John CHetwood Partner, London
Andrew cooke Patner, London
Philip lis Senior associate, London
CONCLUSION
Much ink has been spilled in the last few years on the question of whether the assets of a crypto business are capable of being treated as property. This, of course, is a key question for customers and creditors facing the prospect of a counterparty's insolvency. In short, the English law answer seems to be 'yes' – cryptoassets are property in the ordinary legal sense. AA v Persons Unknown and others [2019] EWHC 3556 (Comm) (considered here) and Ion Science Ltd v Persons Unknown (unreported, 21 December 2020) (commented on here) held that cryptocurrencies are a form of property capable of being the subject of a proprietary injunction. This view has been extended to non-fungible tokens in Lavinia Deborah Osbourne v (1) Persons Unknown (2) Ozone [2022] EWHC 1021 (Comm) (considered here). This analysis is relevant to the availability of proprietary tracing. Judge Pelling QC has expressed an opinion (albeit in the context of fraud claims) that this direction of travel is likely to continue. The UK Jurisdiction Taskforce (UKJT) has taken the view cryptoassets are property for the purposes of the Insolvency Act 1986 (IA 1986). As considered in further detail below, the Law Commission has also published a consultation on recognition of digital assets which considers issues around the legal categorisation of cryptoassets. However, some uncertainty remains pending substantive judicial determination or legislative reform on this issue.
Cryptoassets as property
- Be composed of data represented in an electronic medium, including in the form of computer code, electronic, digital or analogue signals. - Exist independently of persons and exist independently of the legal system. - Be rivalrous. This means something which cannot be used by others in an equivalent way simultaneously. However, this is not intended to mean that it is unique or non-fungible. Finding a way to make electronic data rivalrous, when it can otherwise be reproduced near-infinitely at close to zero marginal cost, is a key innovation of blockchain technology.
Jurisdiction and governing law
Jurisdiction is another key question in the context of cryptoassets, but particularly in the event of distress and insolvency. Establishing the jurisdiction of the English court in proprietary claims to cryptoassets held by insolvent businesses will likely require consideration of where those assets are located. The location can be difficult to determine given cryptoassets usually operate in a decentralised way, often with offshore structures and minimal local presence. They do not have a physical presence in the traditional sense, and transactions can involve servers and software operating in multiple jurisdictions. Challenges will likely arise in cross-border insolvencies where creditors across countries could seek to commence proceedings in different jurisdictions. These complex issues of cross-border insolvency and comity are yet to be explored fully in different jurisdictions and could potentially lead to scrambles for assets. These issues could also be of critical importance given the differences in legal and regulatory regimes in different jurisdictions. Recent English case law indicates it is the domicile or the residence of the person or company owning the coin or token which determines the location of the cryptoasset which is relevant to the court's jurisdiction and the applicable law. Again, there remains some uncertainty in relation to this analysis, not least as to what ownership means in the context of cryptoassets. The conflicts of law rules applicable in other jurisdictions may, of course, be different.
Claims into insolvent crypto estates
The potential for theft and difficulties with tracing fraudsters are well known risks of dealing with cryptoassets and are fast becoming the subject of increased regulatory scrutiny. In the context of insolvency, a risk for investors is cryptoasset custodians not offering deposit protection if they do not have sufficient assets to meet their liabilities to their users. How losses are allocated would depend on the business' terms and conditions and their operation in practice. At least one exchange has publicly stated that creditors will only have an unsecured contractual claim in the event of an insolvency, meaning customers will be at risk. Other market participants may have arrangements in place which purport to back deposits in a way that allows unlimited withdrawals, even in insolvency, and gives protections to customers in an insolvency context. If a crypto custodian enters an insolvency proceeding, the allocation of losses will be dependent on the legal nature of the custody facility and the rights granted to users under it. If the facility is purely contractual, then users will have no proprietary rights of recourse to any specific cryptoasset retained by the insolvent estate but will instead rank as general unsecured creditors. However, where cryptoassets (or entitlements to them) are subject to a trust but held on an unallocated commingled basis for the benefit of multiple parties, there is uncertainty as to the correct approach to apportioning shortfall losses among such parties under English law. For pools subject to substantial volumes and high frequency of transactional activity, it has been argued courts should allocate losses among all affected participants on a proportionate (or pro rata) basis, particularly where the application of traditional tracing rules to determine the appropriate distribution of losses would be unduly complex. But, unless there has been an express affirmation of a pro rata apportionment of shortfall losses, there is the possibility certain creditors could seek to recover using traditional tracing rules adopting the rule in Clayton's case or a 'first in, first out' approach. From an English law perspective, we understand this has not yet been tested in the crypto context. In the event of a custodian insolvency, the Financial Services Compensation Scheme will not provide compensation because claims against crypto custodians would not fall within its remit (as noted by the Law Commission).
Insolvency officeholders' control over cryptoassets
Cryptoassets generally require private cryptographic keys to access the wallet the assets are stored in and transact with such assets. More complex arrangements may have multiple private keys such that several entities share control over the asset. To gain control over any cryptoassets in the insolvent estate, insolvency officeholders will need to access these keys, either through the insolvent business' co-operation or by initiating court proceedings. The UKJT has previously taken the view a private key is information (as opposed to property). An insolvency practitioner should therefore be able to apply to the court to summon relevant persons under section 236 of the IA 1986; although doing so formally would be time-consuming and could risk the dissipation of assets in the meantime. The court may require such persons to produce books, papers or other records (presumably including information regarding private keys) in their possession. If cryptoassets are property, then it should be possible for officeholders to demand delivery up of such property under section 234 of the IA 1986.
Value of the debt and distribution of proceeds
Lenders advancing loans in cryptocurrency bear the risk of the fiat currency value of their debt fluctuating. For example, the US dollar value of a loan advanced in Bitcoin in November 2021 would have been significantly higher than at today's date and would likely fluctuate during the pendency of insolvency proceedings. What does that mean for the orderly resolution of insolvency proceedings? Insolvency practitioners and courts will have much to consider, including: the point in time the debt should be valued; how the entitlement should be distributed (ie, in cryptoassets or fiat currency); and how to distribute any excess and apportion any loss as a result of a decrease or increase in the fiat currency value of a debt. Again, these issues are yet to be handled by an English court. An interesting question would be whether the English court would follow in the footsteps of the High Court of the British Virgin Islands which, in a liquidation order for ThreeArrows Capital, held that the liquidators would be entitled to convert any cryptocurrencies into US dollars or into USD coin (USDC) or Tether (USDT) to safeguard the value of the company's assets from market volatility. It classified USDC and USDT as being cryptocurrencies pegged to the US dollar, which has caused debate. As has arisen in the context of the FTX bankruptcy, a significant administrative issue in the insolvency of a significant crypto exchange is likely to be the quantity of creditors with claims against the company: it has been reported the number of creditors of the FTX estate may surpass one million.
Avoidance of transactions
In certain cases, insolvency officeholders may seek to exercise their powers under the IA 1986 to unwind certain transactions in the run up to a company's insolvency. This includes those amounting to a preference, those made at an undervalue and those defrauding creditors, with a view to maximising the pool of assets available to creditors. Since cryptoasset transactions are not straightforward to trace and beneficiaries may remain anonymous, identifying these transactions may require insolvency officeholders to seek assistance from technical experts and obtain from the court injunctions against unknown beneficiaries or information orders against cryptocurrency custodians. There may also be practical difficulties with reversing transactions once they are permanently recorded on the blockchain. Such steps may not be practical in every circumstance given the time and expense involved.
Taking security over cryptoassets?
When advancing finance, lenders may wish to take cryptoassets as collateral for the loan. The Law Commission has noted that creation of collateral by transfer of ownership, such as mortgages and charges, should work for cryptoassets as it does for other property. Against that, the Law Commission has expressed the view that cryptoassets may not be capable of being "possessed", but instead are subject to "control". This suggests possession-based arrangements such as pledges and contractual liens cannot be created for cryptoassets. These are not definitive legal statements, so some uncertainty remains in this analysis. As it stands, there is no tried-and-tested method of taking security over such assets as there is with other assets. This may give rise to some risk, particularly where cross-border issues arise.
With continuing distress in the crypto sector, it seems highly likely that we will see further developments and clarifications of insolvency laws across jurisdictions. Market participants will be watching keenly to understand what this means for them.
In response to market distress, in May 2022, the UK Treasury introduced a consultation for law reform to manage the failure of systemic digital settlement asset (DSA) firms, including stablecoins. Stablecoins are cryptoassets whose value is pegged to other assets, with a view to maintaining price stability. The consultation recognises that there is uncertainty in respect of the regime that applies in case of failure of a DSA firm and proposes for this to be the Financial Market Infrastructure Special Administration Regime (FMI SAR) as opposed to the Payment and E-Money Special Administration Regime. It does so on the basis the Bank of England (BoE) rather than the Financial Conduct Authority should be the lead regulator in these instances, and the objective should be the continuity of operations of the DSA. The Treasury also proposes modifications to the FMI SAR as applicable to DSA firms, such as an additional objective covering the return or transfer of customer funds and private keys and empowering the BoE to direct administrators on which objective should take priority. The consultation closed on 2 August 2022 and public feedback is now being analysed. The Law Commission also published a consultation in July 2022 on recognition of digital assets in the law of England and Wales (our summary of the Law Commission's position is available here). Most significantly, the Law Commission has proposed the creation of a third category of personal property (beyond "things in possession" and "things in action") called "data objects". The proposal sets out three criteria for identifying a data object:
UK legal reform
The Law Commission has also suggested reform to clarify what would happen if there was a trust over pooled assets in insolvency. It has proposed statutory reform modelled on the Investment Bank Special Administration Regulations 2011 – adopted in response to the Lehman Brothers International (Europe) insolvency – which provides for pro rata allocation of shortfall losses where assets are held in a pooled multi-client account. Legally, this would be on the basis that beneficial interests in commingled holdings are co-ownership rights under an equitable tenancy in common. The outcome of this consultation is awaited.
Alex cravero Digital law lead - UK/US & EMEA, London
Vrinda Vinayak Associate, London
There has been no shortage of high-profile insolvencies in the crypto market in recent months across a range of market participants and geographies. These include the US Chapter 11 and Bahamas provisional liquidation of FTX as well as the US Chapter 11 filings of BlockFi, Singapore-based crypto hedge fund ThreeArrows Capital, US-based lender Celsius Network, US-based lender Voyager Digital, US-based crypto mining data centre Compute North and Germany-based crypto bank Nuri. While the number of insolvencies poses questions about the risk management and governance of crypto businesses, below we address what it means legally and practically for users, lenders and other market participants when a crypto custodian falls into distress and even an insolvency process.
