Crypto lending: Legal implications for taking security interests in cryptocurrency

On November 10, 2021, the global market capitalization of cryptocurrency reached US$2.95 trillion, shattering the first historic peak of US$835 billion set on January 7, 2018 (see https://coinmarketcap.com/charts/). Since last November, it has oscillated between US$1.5 trillion and US$2 trillion. This indicates three things: the cryptocurrency market has witnessed astronomical growth, it remains extremely volatile and cryptocurrencies are now a significant and permanent asset class. 

The fact that cryptocurrencies are often held as assets, rather than being used as a substitute for money as currency, creates an opportunity for lenders to offer cryptocurrency holders facing cash liquidity issues the possibility of borrowing money to expand and develop their business activities, using the cryptocurrency as collateral.

This legal update focusses on the issues related to using cryptocurrency as collateral to secure a loan of money. It is important, however, to mention that the term “crypto lending” sometimes refers to the practice of “lending” cryptocurrency to a person in exchange for some sort of income stream. This type of crypto lending is not discussed in this legal update. Regardless, readers should be aware that such arrangements are potentially regulated under securities laws and failure to comply with those securities laws could result in significant liability. A crypto services company, for example, recently agreed to pay US$100 million in penalties as well as pursue registration with the SEC of its crypto lending product.

Current crypto lending explained: Securing loans using cryptocurrency as collateral

In a secured loan transaction a lender provides the borrower with a certain sum of money under a loan agreement and takes a security interest in the property, or collateral, of the borrower. The collateral is a security that provides the lender with a means of obtaining repayment of the debt should the borrower default under the terms of the agreement, as various remedies allow the lender to seize and sell the collateral in satisfaction of the debt. In crypto lending, the borrower uses its cryptocurrency as collateral to secure a loan of money. 

A significant difference between traditional assets (such as personal property or shares) and crypto-assets is that the latter are entirely decentralized and can be managed automatically. In current crypto lending, parties to a loan agreement have access to lending platforms operating on smart contracts, which are self-executing contracts where the terms of the agreement are set out in code. These smart contracts determine interest rates, lock and hold cryptocurrency, automate payouts, liquidate collateral upon default, and release collateral upon completion under the terms of the agreement. At this moment, there are various types of crypto lending platforms, including: 

• peer-to-peer lending (P2P) where the borrower is automatically matched with the lender through the platform;
• peer-to-contract (P2C) where the borrower is connected to a pool of lenders, all participants in the platform; and
• direct lending where the service platform lends the money directly to the borrower. 

Crypto lending platforms allow the borrower to leverage its cryptocurrency to obtain money without having to sell the crypto. The lender benefits from a decentralized self-executing arrangement that is safe, simple and minimizes many risks associated with lending to cryptocurrency holders, especially in the case of a default. Traditional institutions such as banks and investment funds will soon follow and join the crypto lending sphere as more and more projects, start-ups and corporations they lend to have revenue, investments or currency in crypto-assets.

Key legal implications for potential lenders

Preparation, Due Diligence & Loan Structures and Characteristics:

Compliance with Regulations

In all Canadian provinces except Quebec, a comprehensive statutory framework governs security interests in personal property and sets out rules dealing with their creation, perfection, priority and enforcement. In Ontario for example, relevant legislation includes the Personal Property Security Act and the Securities Transfer Act. In Quebec, security interests are governed by the Civil Code of Quebec. Even though cryptocurrency or crypto-assets are not explicitly mentioned in these regulatory regimes, lenders must comply with these rules to ensure their security interests are valid and enforceable.

In addition, lenders must consider tax regulations, transfer limits and currency regulations applicable to both cryptocurrency and other crypto-assets as these may impact the loan structure, the transfer of proceeds as well as the repayment of principal and interest. 

Protection of Lenders Against Market Volatility

Lenders must consider and establish effective protection against potential risks due to market volatility, especially in cases where crypto-assets represent a large portion of the secured collateral. When the value of cryptocurrency decreases significantly, so does the value of the collateral, effectively changing the loan-to-value ratio and exposing the lender to significant risk of under-recovery in the event of a default. 

As a result, lenders must design appropriate mechanisms and processes to obtain additional collateral from borrowers in the event of value fluctuations. Crypto lending platforms can require a borrower to either provide additional collateral or make payments under the loan to restore the original ratio under the loan agreement. While sometimes maintaining the loan-to-value ratio involves a monthly borrowing rate calculation based on protocol formulas, in particularly volatile environments it could involve immediately covering the percentage of the collateral value lost by volatility. 

Lenders might also opt for over-collateralization as a condition for granting the loan in the first place. The preferred option depends on the type and structure of the loan itself, for example, whether it consists of a revolving credit facility or a term loan. 

Use of Cryptocurrency by Borrowers and Due Diligence

Lenders must clearly delineate the rights held by the borrowers in their cryptocurrency serving as collateral throughout the crypto-loan term. Many options are available to the parties depending on whether a borrower is comfortable putting its cryptocurrency under the care of a trustee or a custodian, with limited to no access, or if it wants to continue to use it in some way or another. There are also advantages for the lenders should they set up a trustee or custodian structure, since in doing so they obtain control over the collateral and gain the possibility of earning yield revenues on the cryptocurrency deposits under their management, on top of earning the usual interest payments and credit fees. 

Thorough due diligence is also very important. Before granting credit facilities to a borrower, lenders must take steps to ensure all cryptocurrency wallets related to the collateral under the loan agreement are disclosed in sufficient detail. Due diligence also ensures the intended use of the collateral by the borrower is clearly set out and compliant with the terms of the loan agreement. Questions of due diligence should cover the ownership of cryptocurrency portfolios as well as all their business activities involving cryptocurrency, among other things. 

Terms of Repayment

Lenders and borrowers must agree on a method of repayment of the principal amount and interest. Crypto-loan agreements must be clear on, and provide for at least the nature, frequency, value and manner of payments. To illustrate, payments could be in money or cryptocurrency, weekly or annually, at proportional rates or absolute rates, fixed or variable, automatically collected or manually paid by the borrower. 

Security Interests, Collateral Protection & Enforcement:

Taking Security Interests in Cryptocurrency

As with any type of secured lending, lenders are best protected by taking a first-ranking security interest in the cryptocurrency to ensure the best enforcement position against third parties and to maintain their priority in receiving payments under the loan. 

When using cryptocurrency as collateral to secure a loan, the security interest must first attach to the collateral, by contract, and then be perfected, either through possession or control or registration of the security interest. Generally, cryptocurrency is controlled by the party who has the private key information. 

What counts as “possession” or “control” can be defined by the terms of the loan agreement and could include (i) taking physical control of cryptocurrency, for instance kept in a cold wallet on a flash drive and then delivered to the lender, (ii) placing the cryptocurrency in a wallet held by the lender, with or without access to the private key, or (iii) transferring the cryptocurrency to a third party to hold it for the duration of the loan, as a trustee or custodian. 

Lenders comfortable with additional risk may offer loans without obtaining possession or control of the collateral and can perfect their interest by publicly registering notice of a security interest against the collateral. 

Collateral Protection Against Digital Risks

Like other digital assets, cryptocurrency is subject to risks of cyber theft, phishing scams and loss of access information such as keys and passcodes. Moreover, cryptocurrencies at times undergo changes in their blockchain protocol that may affect the collateral, such as splits and forks, token swaps and roll-backs. Lenders and borrowers must develop and establish contractual and practical protective measures to safeguard the collateral and access to it for the duration of the loan and to ensure the secured cryptocurrency, no matter how formulated, remains within the scope of “collateral” under the loan.

Enforcement of Security Interests

The current regulations on enforcing security interests and recovering assets in Canada do not reflect the fact that blockchain transactions are completed quickly, are irreversible and can be, in some instances, almost impossible to track. This means a lender looking to exercise its rights as a secured creditor against cryptocurrency collateral might be at a loss to find any asset at all if it has been improperly transferred. Absent trustees and custodians with special expertise in holding crypto-assets, lenders in this market are best protected with contractual mechanisms and remedies built into the loan agreement itself and reflected in the smart contract, ensuring timely enforcement of the security interests if needed. 

Although beyond the ambit of this legal update, similar implications arise for taking security in all crypto-assets, including NFTs and stablecoins, or what might soon be known as “controllable electronic records” for the purpose of secured transactions law. Considering the significant risks associated with these developing markets, if you have any interest in offering or using loans secured by cryptocurrency and other crypto-assets, you should contact a lawyer with experience in crypto lending.

The author wishes to thank law student David Brazeau for his help in preparing this legal update.