Law Commission proposes revolutionary rules for ownership of crypto tokens and NFTs

Introduction

There is a major earthquake happening in the sphere of digital assets, which is expected to create shockwaves that will impact tech not only in the real world but also in the metaverse.

These potentially revolutionary changes appear in an innocuous-looking, if lengthy, consultation paper titled “Digital Assets: Consultation paper,” published by The Law Commission of England and Wales, the public body for reform of the law in the U.K.

What this document proposes is that digital assets are recognized as a new form of personal property, potentially creating an “internet of property,” which could have huge implications for the U.K.’s position as a hub for distributed ledger technology (DLT) and fintech.

Why are property rights important?

Property rights are indispensable to the creation and deployment of capital. A proper legal foundation for ownership of digital assets will have a host of real life ramifications, such as allowing the creation of security over digital assets — meaning they can be used as collateral for loans — providing people or businesses with greater protection in the event of fraud and enabling digital assets to be distributed like other property in the event of insolvency.

For instance, if somebody takes your NFT, you might want to start a legal action to get it back, seek to prevent the taker from transferring it to another account, report them to the police for theft or take action against somebody who helped them. None of this is possible without clear recognition of digital assets as property. If your NFT is then transferred to an innocent purchaser, should they get to keep it? There is no answer to this without knowing what sort of property is a digital asset.

The entire decentralized finance (DeFi) industry, which includes cryptocurrencies such as bitcoin, is based on transferring crypto assets to other accounts where they may then be deployed in accordance with smart contracts or other sets of rules. 

Do these movements count as a sort of legal transfer of the asset or a security arrangement or a form of custody? These questions may seem unimportant when everything is working smoothly, but as soon as something goes wrong, participants will suddenly care about them enormously. They will determine who gets back any remaining assets and whether anybody else — cryptocurrency exchanges, developers and so on — might be liable for any losses. And again, there is no clear answer to any of this until the nature of digital assets as personal property is settled.

Capitalism is based on the clear recognition of property rights. A functional economy involving digital assets will ultimately depend on a clear and sensible approach to property rights in those assets. Despite being so fundamental to the success of digital assets and the tech industry as a whole, the proper treatment of digital assets as personal property has been the subject of intense legal debate and uncertainty in many jurisdictions. A wrong turn could lead to inadequate and inconsistent laws damaging the development of NFTs, DeFi and similar areas.

What does the Law Commission’s paper say?

The Law Commission’s consultation paper has considered the many opposing views and settled decisively on one option: treating digital assets as a new form of property. This would be similar to tangible, real-world property but with “control” replacing the concept of “possession.”

Astutely, it rejects analogies with intangible assets such as legal rights, recognizing that digital assets have more in common with physical objects — Bitcoin works more like an electronic coin than an electronic bank account. But it has decided not to assimilate digital assets wholesale into the category of things that can be possessed (except for certain digital assets used in electronic trade finance) — they are sufficiently different to be given their own space to develop alongside existing forms of property.

In adopting this approach, the Law Commission takes advantage of the ability of English law to expand into new areas by judicial innovation working on a case-by-case basis: It sets out the broad ambit of the rules and allows judges to fill in the details as new facts arise.

What this new form of property covers

NFTs, in-game assets, email addresses, domain names, media and program files, and other forms of data are all considered by the Law Commission. Of these, only digital tokens such as NFTs and similar native crypto assets, including cryptocurrencies such as Bitcoin, fall within their definition of property. But that only affects the NFT itself, not any objects in the real world or legal rights linked to it.

Recognizing property interests in an NFT, the Law Commission stresses, does not directly improve the owner’s rights to any linked object. Owning an NFT of a picture, for instance, does not necessarily give you the copyright to the picture or ownership of any hard copy of the picture, or even rights in the digital copy linked to the NFT.

While giving comfort to owners of digital assets, the Law Commission consultation also highlights the fragility and uncertainty of rights in assets linked to NFTs. These changes will have knock-on effects in the regulation of crypto finance. Regulators are increasingly focused on crypto assets, particularly in the regulation of DeFi and tokens that may be linked to or analogous to securities. The scope of regulation will be influenced by the treatment of crypto assets as property.

For instance, the regulator would need to know how crypto assets pooled together in omnibus accounts by exchanges or custodians, or as part of a DeFi arrangement, might be treated in the law of property before it can impose sensible regulations on them. Similarly, how NFTs or other digital assets are distributed on insolvency will influence insolvency regulation for participants in the crypto markets.

Cross border law

Cross-border law and regulation will also be affected. Blockchain tends to work independently of borders between countries. Laws tend to be national. Formulating legal rules that can successfully underpin crypto assets and blockchain transactions within a single jurisdiction is a challenge for legislators and making them work across borders is even harder.

The Law Commission is careful to state that its proposed rules are confined to the U.K. It proposes a further consultation that will address how to decide which country’s rules should apply to digital assets (other international organizations such as UNIDROIT are currently grappling with the same problem).

Inconsistent rules between countries make this process harder and create yet another brake on the development of the international crypto financial markets. If the Law Commission approach to digital assets as property is followed by other countries, it will make the task of achieving cross-border consistency much easier.

Conclusion

Importantly, even before any legislative changes are made, the consultation paper is likely to be followed by English judges. This new approach will be the benchmark for the future legal treatment of digital assets, and, combined with the innate flexibility and other benefits of English law, increases the U.K.’s attractiveness as a location for digital asset businesses.