As the interest in cryptocurrency continues to increase, our financial institution clients have been asking about making loans secured by bitcoins. Clients periodically ask if, and how, a loan can be properly secured where a cryptocurrency asset like bitcoin is the collateral.
A cryptocurrency like bitcoin provides an electronic representation of value that, at times, can be used as a substitute for typical government-backed currency. Bitcoin relies on blockchain technology and a series of distributed electronic ledgers that facilitate the exchange of data over a decentralized network of computers. This technology utilizes digital keys to process a transfer of the underlying bitcoin. Because bitcoin is hard to categorize under existing legal frameworks, determining how to make a loan secured by bitcoin can be challenging.
Lenders often wrestle with just what bitcoin is and whether they need to focus on Article 8 or Article 9 under the Uniform Commercial Code (UCC).
Under Article 9, bitcoin does not fit the definition of “money,” because it is not a medium of exchange authorized or adopted by a government represented by a physical certificate. If not money under UCC Article 9, bitcoin likely falls into the “general intangible” definition, covering personal property that does not fit into other UCC Article 9 categories. Because perfection of a security interest in a general intangible is effected by filing a UCC-1 financing statement, treating bitcoin as a general intangible is a risky proposition for a lender. Filing a financing statement will not prevent those holding the digital keys to specific bitcoin from transferring that bitcoin to others.
Bitcoin can fit the definition of “investment property” under UCC Article 8. Investment property includes a “securities account” (whether certificated or uncertificated). Under UCC Article 8, a securities account is where a “financial asset” is or can be credited and financial asset, in turn, includes property that is held by a securities intermediary for another in a securities account (so long as the parties have agreed to treat the underlying asset as a financial asset under UCC Article 8).
One viable structure under the UCC to make a loan secured by bitcoin is to require the borrower to establish a digital wallet with a third-party wallet provider who will agree to hold the bitcoin under a control agreement with the lender. The third-party wallet provider would issue three digital keys to the related bitcoin: one to the borrower, one to the lender and one to the wallet provider. The underlying bitcoin would only be subject to transfer from the digital wallet if two of the three keys were used.
The borrower, lender and wallet provider would then enter into a control agreement that sets forth the circumstances under which the borrower is permitted to access the bitcoin and what events constitute a default entitling the lender to use its digital key (along with the digital key held by the wallet provider) to effect a sale or transfer of the underlying bitcoin. This type of structure requires that the third-party wallet provider agree with the borrower that the bitcoin is a financial asset under UCC Article 8.
In addition, because of the volatility of bitcoin, lenders should only consider virtual currency for significantly lower LTV loans and smaller loan sizes.
Christopher R. Rahl
(410) 576-4222 • firstname.lastname@example.org