Crypto View - September 2022

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We hope you have had a good summer – we took a bit of a break in August but are back and raring to go now. Luckily we had a number of consultations and new pieces of legislation published to keep us busy (entertained) while enjoying our holidays – and we round up a number of those for you here. The big (literally – it is 548 pages long!) news came from the Law Commission, which published a consultation on Digital Assets, covering its proposals for how they should be treated as property. The UK government published the Economic Crime and Corporate Transparency Bill, which looks to make it easier for law enforcement agencies to seize, detain and recover cryptoassets. In Germany we saw new legislation to allow for the tokenisation of units in funds – a pretty exciting development. There has also been a huge competition class action case initiated against a number of exchanges. We also take a look at the developments in MiCA that have happened since the last issue. A lot to pack in!

Law Commission Consultation

On 28 July, the Law Commission published a Consultation on Digital Assets (the Consultation) – this follows its Call for Evidence in April 2021. The Consultation is certainly comprehensive, and considers the principles of private property law in respect of digital assets. Clearly, at such a length it would not be possible to detail the entire consultation here, but there are some key points worth drawing out.

• The Consultation looks at the traditional view of personal property – things in possession and things in action — and suggests that neither is entirely suitable to cover digital assets. Its proposal for a third category of property – “data objects” – is the central feature of the consultation. Data objects have three proposed constituent elements:
  • it is composed of data represented in an electronic medium
    By this, the Commission means that the property in question must be composed of data represented in an electronic medium, including in the form of computer code, electronic, digital or analogue signals. This criteria distinguishes data objects from things in possession, which are constituted of a collection of physical particles or matter within a defined boundary of three-dimensional space. It also acknowledges that an important constituent part of data objects is that they have an informational quality and are represented in an electronic medium which, in general, is optimised for processing by computers.
  • it exists independently of people and the legal system
    By existing independently of people, the data objects class admits only those things that are properly identified as distinct objects, existing independently from any particular person. By existing independently of the legal system, this removes the possibility of things in action from satisfying the criteria for data objects, even if a particular right has become so readily assignable that it is treated, in effect, as if it were an independently existing object.
  • it is rivalrous
    This means that the thing in question must be something whose capacity for use is not unlimited; people must therefore compete with one another for it. The Consultation elaborates: “a resource is rivalrous if use of the resource by one person necessarily prejudices the ability of others to make equivalent use of it at the same time”

The Consultation does not make a recommendation as to whether this introduction of a third class of property should be formalised through common law reform or (limited) statutory intervention, outlining the potential pros and cons of each, but leaving it to respondents to put forward their views.

• The Consultation considers how factual transfers of cryptoassets operate. It notes, in line with the UK Jurisdiction Taskforce’s Legal statement on Cryptoassets, that while normally a transfer of a physical object involves someone receiving it in an unchanged state, the same is not true of cryptoassets. Instead, the data of the cryptoasset is fundamentally changed on transfer - the transferor typically modifies the public key, or generates a new one, so as to create a record of the transfer (including details of the transferee). This means that, in terms of the factual transfer of a cryptoasset, there are three key factors:

  • a transfer involves the replacing, modifying, destroying, cancelling, or eliminating of a pre-transfer cryptoasset and the resulting and corresponding causal creation of a new, modified or causally-related cryptoasset.
  • a transfer operation that effects a state change will also result in a change of control; and
  • a transfer will mean a change of state of the distributed ledger or structured record in accordance with the protocol rules of the cryptoasset system

• As well as the factual transfer of cryptoassets, the Consultation also considers how a legal transfer of a cryptoasset might operate, by reference to principles of original and derivative acquisition of title. It makes the case that the legal rules on derivative transfers of title can apply to cryptoassets within cryptoasset systems, notwithstanding that a transfer operation effecting a state change will typically result in the causal creation of a new, modified or causally-related cryptoasset – this is in contrast to the UKJT. It also suggests that the record on the ledger, while providing strong evidence of title, is not definitive with regards to a record of legal title. There is also a proposal for an explicit clarification that the special defence of good faith purchaser for value without notice should apply to cryptoasset transactions. This defence essentially allows a bona fide purchaser of property, who purchases that property for value and without notice of any other party’s claim against the property to take good title to the property despite competing adverse claims. Those other parties holding competing adverse claims may bring an action only against the party who fraudulently transferred the property to the bona fide purchaser.

• The Consultation also considers how custody (and custody-like) arrangements can be structured with regard to cryptoassets. It also looks at the current legal problems in the structuring of collateral arrangements in relation to cryptoassets. With regard to collateral involving the transfer of title, the Commission sees no reason why this would not work equally with regard to cryptoassets. However, where a security interest is involved, there are potential difficulties. For those instances where no possession is required when taking collateral (mortgages and charges), security can be taken over cryptoassets. However, where possession is required (liens and pledges), the Commission acknowledges that it is not possible to grant security over a cryptoasset (as it is not possible to possess them) – however, it does not see the need for reform in this area.

The deadline to respond to the consultation is 04 November, so you should still have time to read it if you get started soon.

Digital securities

We’ve seen a noticeable uptick in activity relating to digital securities in recent months. Digital securities (aka ‘blockchain bonds’ in a debt context) are securities which utilise distributed ledger technology in some shape or form. Two variants exist: securities issued directly onto a distributed ledger (‘digitally native securities’) and securities issued in a conventional manner but represented on a distributed ledger (‘tokenised securities’). Proof-of-concept projects have been completed for both variants over the past few years, but focus is now shifting towards scalability, interoperability, and regulatory issues.

There was certainly no shortage in summer holiday reading in this area. In August, the UK Jurisdiction Taskforce announced it will produce a legal statement on digital securities in the Autumn, and published a short consultation paper inviting feedback on questions the legal statement will address. Consultations were also published earlier in the summer by ESMA in relation to the templates used by firms applying to participate in the EU’s DLT pilot regime (ahead of its launch in Spring 2023) and by BIS on the prudential treatment of cryptoasset exposure. The Law Commission’s broader Digital Assets consultation paper (as discussed above) contained several chapters relevant to digital securities, too.

In the coming months we expect the Financial Services and Markets Bill to be enacted and more detail on the UK’s new financial markets infrastructure sandbox emerge (as was looked at in previous Crypto Views). The sandbox will be highly relevant to those in the digital securities space, and is likely to present an opportunity to test digital securities technologies in a quasi-regulated environment.

Economic Crime Bill

There have also been developments in relation to law enforcement issues for cryptoassets, with the publication of the Economic Crime and Corporate Transparency Bill. It contains new powers to make it easier for law enforcement agencies to seize, detain and recover cryptoassets.

Broadly, the Bill proposes reforming criminal ‘confiscation’ powers in Parts 2, 3, and 4 of the Proceeds of Crime Act (POCA) to enable law enforcement agencies to recover cryptoassets in a similar way provided for tangible property, so that those assets can be confiscated at a later date. This principally involves expanding the search, seize and detention powers to make it clear that officers have the authority to recreate cryptoasset wallets and transfer assets into a law enforcement-controlled wallet. The civil forfeiture regime under Part 5 of POCA will also be expanded so as to bring cryptoassets in scope for the first time.

Some notable points from the Bill:

• There is a new concept of a “cryptoasset-related item” - which can be seized - this property that contains or gives access to any information that is likely to assist in the seizure of any cryptoassets (e.g. pieces of paper that have a recovery seed phrase written on them or an electronic hardware wallet);
• Officers will have the power to retain, dispose of or destroy such property if it is not collected within a year of its release;
• There will be a new powers for the destruction of cryptoassets subject to an enforcement receivership where the re-entry of the cryptoassets into circulation may facilitate criminal conduct by any person;
• New powers to require cryptoasset exchanges and custodians with a UK connection (which is broadly defined and includes firms with terms of business that provide for the English courts to have jurisdiction) to realise customer cryptoassets subject to an order and pay the resulting sum over to the court;
• New civil powers to seek a “crypto wallet freezing order” over a crypto wallet administered by an exchange or custodian; and
• Civil powers to require detained cryptoassets to be converted into money.

There is still a while to go in terms of the parliamentary process before this would become law, but we will be keeping an eye on its progress.

The next step in Germany crypto regulation: crypto fund units

Earlier in the summer, BaFIN, the German regulator, published a new regulation, Verordnung über Kryptofondsanteile (KryptoFAV) Although the new regulation is only one page long, it marks another important step in the evolution of crypto regulation in Germany. The KryptoFAV paves the way to a change in the distribution of fund units, allowing market participants to issue fund units in tokenised form via a decentralised crypto securities register - typically based on DLT. KryptoFAV refers, to a large extent, to the German electronic securities act (eWpG) which came into force mid-2021, which allowed the issuance of electronic securities for the first time. The eWpG introduced two different types of electronic securities registers, the central register and the crypto securities register. With the new eWpG it became possible to issue fund units in electronic form but not as a token – something which the KryptoFAV has now introduced. The KryptoFAV also allows the offering of units of one fund partly as crypto fund units and partly in the traditional form.

Unlike the general rules, under the KryptoFAV, only the appointed custodian of the investment fund, or an undertaking instructed by the custodian which is authorised to act as crypto register provider, may act as the registrar agent. With this provision, it is now also possible for other companies to act in a similar role as the custodian, providing they hold the relevant crypto securities register licence.

The new KryptoFAV opens new ways of distributing funds into the German market and is therefore particularly interesting for foreign asset managers who traditionally found it difficult to promote their products to German clients. It may also over time lead to new settlement structures which can have substantial cost effects. We expect to see the first of these products in the German market very shortly, and with white labelling funds there are also routes for foreign asset managers to utilise this new option.

Competition litigation comes to the crypto market

In a legal first, a £9.9 billion class action claim has been brought against a number of major crypto exchanges on behalf of 240,000 UK investors in BSV. The claim, which is brough in the UK Competition Appeal Tribunal by BSV Claims Limited on behalf of investors, alleges that BSV investors suffered loss as a result of the exchanges colluding anti-competitively to damage BSV by delisting it in 2019. BSV was founded by Craig Wright, who has recently been involved in a number of cases before the English courts, and is a fork of Bitcoin Cash (itself a fork of Bitcoin). The case argues that the exchanges’ actions curtailed BSV’s ability to become successful, despite its (allegedly) inherently superior technology. The case is likely to increase scrutiny around exchanges’ listing processes and could signal the start of a trend towards more collective or group actions in the crypto market.

This Month in MiCA

While we had political agreement on MiCA in June, this month we have seen the finalisation of the technical negotiations, essentially “locking” the text. We still await a parliamentary vote and the translation of the final text, before the law is published in the Official Journal, but that date is coming (likely December of this year or January 2023). This would mean that the rules that apply to cryptoasset service providers would be coming into effect in mid-2024.

We have had sight of the latest agreed text and would be happy to talk to anyone that is developing their MiCA strategy. It looks as though there may have been a couple of late developments to the text. Firstly, is the introduction of algorithmic stablecoins into the definition of “stable tokens”, which broadens the definition significantly. Though this seems to be where such tokens use an algorithm to stabilise value by reference to an underlying currency or actual assets. It is not entirely clear whether this is intended to cover algorithmic stablecoins where the issuer links the token to assets that it does not control. It also empowers ESMA to take enforcement action directly against a cryptoasset service provider – where a national competent authority fails to do so. They will also be able to temporarily ban certain products and activities.

When further details of the publication of MiCA become available we will be carrying out a series of webinars covering the key topics. These will be announced as soon as MiCA is published.