Virtual Collateral 101: How to Take and Enforce Security Over Cryptocurrencies, Crypto-Assets and Central Bank Digital Currencies

In recent years, there has been a proliferation of lending secured by crypto-assets through online decentralized platforms. It is estimated that, during one month in 2021, more than US$122 billion in transaction volume occurred through such platforms.¹ This level of activity demands a close look at legal issues that arise when borrowing against cryptocurrencies and other virtual assets. Virtual collateral is not explicitly addressed in the personal property security law of Canadian common law provinces, as primarily set out in their Personal Property Securities Acts (collectively, the “PPSA”).² Lenders and insolvency practitioners therefore face open questions when dealing with loans backed by cryptocurrencies or other virtual assets – most importantly, how should secured parties best protect their interest in this online collateral?

Further complexity has been added by the recent adoption of bitcoin as legal tender in El Salvador and the Central African Republic and the introduction of central bank digital currencies (“CBDCs”) in other jurisdictions, which likely will split virtual currencies into multiple PPSA asset classes. Additional nuances arise in the case of other types of potential crypto-collateral, such as non-fungible tokens (“NFTs”), which have the potential to fall under yet another third asset class.

In the United States, lenders should soon gain more clarity as extensive relevant amendments to the Uniform Commercial Code (the “UCC”)³ were adopted and recommended for enactment by the Uniform Law Commission in July 2022 (the “2022 UCC Amendments”).⁴ New Article 12 will introduce rules for transactions involving a new category of assets called “controllable electronic records” (“CERs”) which will include cryptocurrencies and NFTs. Concurrent amendments to the definitions in UCC Article 1 and to the PPSA’s older cousin, UCC Article 9, will create rules concerning security interests in CERs as well as in CBDCs. At the time of writing, the 2022 UCC Amendments have been enacted only in two states, although bills in respect of the amendments have been introduced in 23 other state legislatures. Unfortunately, no similar amendments to the PPSA are pending.

This article aims to break down these issues of categorization to propose answers to the questions of how security over cryptocurrencies, other crypto-assets and CBDCs can best be attached, perfected, protected and enforced, from both a legal and practical perspective. A common theme throughout this article is the value for a lender of taking possession or control of any crypto-asset that is pledged as collateral. Depending on the PPSA and UCC collateral class that a crypto-asset falls into, possession or control by a lender may lead to attachment and/or perfection of a security interest in such crypto-asset. But even where possession or control does not further a lender’s legal rights, it still gives practical protection that may, in the end, be far more valuable than actionable legal rights.

Cryptocurrencies in Lending: A General Overview

Blockchain, which constitutes a decentralized, peer-to-peer network of computers, underpins the majority of existing cryptocurrencies.⁵ Digital signatures verify transactions in ledgers, which can be public or private, and users hold cryptocurrencies in secure hot or cold personal addresses that are commonly termed “wallets.” More specifically, hot wallets are wallets that are linked online (e.g., web-based or desktop), while cold wallets are immune to hacking, as they are not continuously connected to the internet (e.g., through physically separated USB devices).⁶

There are also various generations of cryptocurrencies which range from completely public (bitcoin) to private (Monero), among others. Privacy coins are cryptocurrencies that allow entities to transact in a decentralized manner without revealing owner, buyer or seller information.⁷ As an example, Monero, which holds the largest capitalization of privacy cryptocurrencies, protects sender anonymity by using ring signatures, which create groups of users and aggregate their transactions; each transaction can thus only be linked to the group as a whole. This protects both sender and receiver anonymity.⁸ In comparison, all addresses where bitcoin is sent to are publicly available on the blockchain.

Regardless of their privacy status, cryptocurrencies were designed to solve the issue of “intermediaries” in the world of financing, due to the transactional confidence created by blockchain. In a 2020 article, Xavier Foccroulle Menard aptly explains how cryptocurrency fixes what he terms the “double-spending problem” in digital finance, without the need for a bank intermediary:

“. . . physical cash can only be spent once, as once you hand it over in a transaction, you no longer possess it; on the contrary, digital files can be duplicated and falsified. Until the apparition of bitcoin, central trusted third parties like banks would verify whether the digital money, which constitutes most of the money circulating in the economy, has been spent twice. Commercial parties could trust each other because of the intervention of this trusted intermediary. With bitcoins, the intermediary is not needed for the establishment of trust between parties.”⁹

The elimination of banking intermediaries from cryptocurrency transactions allows funds to be transferred far more quickly, at a lower or non-existent cost, and often without significant regulatory oversight. These features of blockchain technologies, and the confidence that such technologies instil, allow cryptocurrency to be used with relatively little regard for government action, be it legislative or executive. In the secured lending space, these practices, which prioritize exploiting the immediacy and directness of blockchain technologies over adherence to the common and statutory law regarding lending and personal property security, often reign supreme. As will be discussed further in this article, secured online lending models tend not to observe PPSA requirements for attachment, perfection and enforcement of security. Commentators have suggested that, instead of adapting to existing, government-imposed personal property security regimes, notice of security over cryptocurrency should just be reflected in the blockchain itself.¹⁰

This same inclination toward independence and self-regulation, as well as a lack of judicial resources and inefficiency of the existing asset recovery system, has triggered the creation of new recovery mechanisms for crypto-assets that sidestep traditional legal systems. As an example, alternative options to legal enforcement mechanisms have flourished for crypto-recovery initiatives. In September of 2021, hackers allegedly stole approximately US$275 million from the exchange KuCoin in one of the largest online crimes to hit a cryptocurrency asset provider,¹¹ with the North Korean hacker collective, “Lazarus Group,” accused of carrying out the heist in question.¹² Following the alleged hack, Kucoin was able to recover 84 per cent of the stolen funds in question, not through legal processes, but largely through an alternative “freezing” offered by both: (i) other crypto-exchanges; and (ii) operators of the stablecoin Tether (“USDT”).¹³ The most interesting aspect of the KuCoin hack is that the majority of these other crypto-projects and asset providers were able to “freeze” hackers’ funds without any approval from courts or criminal investigative entities.¹⁴

In January of 2022, Tether froze an additional $150 million USDT in three accounts which may have been blacklisted due to cyberattacks and enforcement investigations.¹⁵ The total blacklist of addresses by Tether had reached 563 since November 28 of 2017.¹⁶ While Tether has commented that funds are regularly frozen upon “request[s] from law enforcement,”¹⁷ they also have the ability (as seen in the KuCoin hack) to freeze funds upon requests from private entities. There is no current clarity into which law enforcement agencies regularly sends requests to Tether for freezes, or which request correlates to which address.

The crypto community’s impulse to self-regulation has also resulted in at least one instance of what could be described as mob justice. In March 2022, angry token holders of Juno voted to strip tokens from a fellow investor who they felt had cheated the community by gaming the system when developers were issuing free promotional tokens.¹⁸

The crypto community does, however, regularly find its insular space pierced by formal insolvency proceedings where self-help remedies are not as viable. As an example, from 2017 to 2021, there were at least 19 global crypto-related insolvency proceedings ranging from jurisdictions including South Korea to Turkey.¹⁹ The pace of such insolvencies has, if anything, only accelerated since. One of the most common catalysts for crypto insolvencies are hacks and fraud.²⁰ In court-supervised insolvency or restructuring proceedings, rights will generally not be recognized if they are not legal rights.²¹ In light of the growth of these global crypto-related insolvency proceedings, it is thus always recommended that appropriate legal security be taken against crypto-assets to partly mitigate such risks.

Cryptocurrency As Money

There is no mention of cryptocurrency in the PPSA. In order to determine if and how security over crypto-collateral can attach and be perfected, it therefore is necessary to find a fit under existing PPSA asset categories. The obvious first category to examine is “money,” which the PPSA recognizes as a securable class of personal property.²² The PPSA defines “money” as “a medium of exchange authorized or adopted by the Parliament of Canada as part of the currency of Canada or by a foreign government as part of its currency.”²³ While this definition was once considered sufficient to exclude all cryptocurrencies,²⁴ that is no longer the case as the government of El Salvador adopted bitcoin as part of its currency, effective September 7, 2021, and the Central African Republic followed suit on April 22, 2022.²⁵ On a plain reading, bitcoin is now caught by the PPSA’s definition of money and, as a result, is explicitly excluded from the PPSA’s definition of “intangibles” which, as discussed further below, is the only category into which bitcoin would otherwise fit.²⁶

While we await enactment of the 2022 UCC Amendments, there also remains no mention of cryptocurrency in the UCC. Like the PPSA, the UCC recognizes money as a securable class of personal property²⁷ and the Article 1 definition of “money,” which applies throughout the UCC, requires adoption by a government.²⁸ Pending enactment of the 2022 UCC Amendments, bitcoin, as legal tender in two countries, is money and as a result is excluded from the definition of “general intangibles.”²⁹ Bitcoin’s current status as money is confirmed in the Uniform Law Commission’s summary of the 2022 UCC Amendments.³⁰

This situation is set to change in the United States as the 2022 UCC Amendments will amend the definition of “money” in UCC Article 1 to add the following sentence:

“The term does not include an electronic record that is a medium of exchange recorded and transferable in a system that existed and operated for the medium of exchange before the medium of exchange was authorized or adopted by the government.”

In short, the UCC will exclude from the definition of “money” any pre-existing cryptocurrency that is adopted as legal tender by a government. This amendment will therefore neutralize the effect of the adoption of bitcoin by El Salvador and the Central African Republic. Since bitcoin will no longer be money, it will not be excluded as such from the Article 9 definition of “general intangibles,” which definition will also be amended to explicitly include CERs.³¹

It had been argued that cryptocurrency did not fall under the old UCC definition of “money,” even if it were adopted by a national government.³² Although this question will soon be moot for purposes of the UCC, it is still relevant for the purpose of the PPSA. Professor Jeanne L. Schroeder reasons that the old UCC definition of “money” does not (explicitly) include deposit accounts, which are the most common form of money. Schroeder reasons, therefore, that the old UCC definition of “money” was intended to be limited to what she calls “hand-to-hand” currency, or physical cash, and she concludes that since bitcoin is not physical, it cannot fall under the definition of “money.”³³ In response, it should be pointed out that, for reasons we expand on below, a cryptocurrency such as bitcoin does not fall under the definition of “deposit account,” and thus the exclusion of deposit accounts from “money” does not entail the exclusion of cryptocurrency as well.

We are also required to employ the modern theory of statutory interpretation, whereby the provisions of a statute are to be read in their entire context and in their grammatical and ordinary sense, harmoniously with the scheme and purpose of the statute, and the intention of the legislating body.³⁴ This principle subsumes the older “plain meaning rule,” whereby the word of a statute were to be taken in their ordinary and grammatical meaning so long as it did not lead to an absurd result, but also requires a court to look beyond the language to its context. In Ontario, we also have to follow the Legislation Act, which requires us to interpret the PPSA as being remedial and thus to give it “such fair, large and liberal interpretation as best ensures the attainment of its object.”³⁵ Whether we take their plain meanings, or give them a more liberal and contextual interpretation, the PPSA’s definitions of “money” (like the old UCC definition) allows a place for bitcoin, now that it has been adopted by national governments, as long as no absurdity results.

Professor Schroeder’s second argument is that such an absurdity (or, in her words, a “perverse effect”) does result if the old UCC definition of “money” is interpreted to include a cryptocurrency that has been adopted as legal tender by a government.³⁶ She reasons that, since a security interest in money can only be perfected by physical possession and since bitcoin cannot be physically possessed, then, if bitcoin is money, security over it could never be perfected. Both of her premises are, however, false, at least in a PPSA context. As we discuss below, a security interest in money can, under the PPSA, be perfected either by possession or by registration. In addition, we will argue that cryptocurrency can be physically possessed – especially under a fair, large and liberal interpretation – through physical possession of a cold wallet.

It may seem odd that the adoption of a cryptocurrency by a minor trading partner like El Salvador³⁷ or, for that matter, by a country like Central African Republic with whom Canada has essentially no economic relations,³⁸ could change the effect of domestic personal property security laws. It also remains to be determined by the courts whether El Salvador’s and the Central African Republic’s adoption of bitcoin does bring it within the definition of money. It is worth noting, however, that a number of U.S. District Courts have found bitcoin to be money in the context of securities law³⁹ as well as in the context of criminal law pertaining to money laundering⁴⁰ and to unlicensed money transferring businesses.⁴¹ In contrast, some Canadian regulators already treat cryptocurrency other than as money. Regulations under the federal Proceeds of Crime (Money Laundering) and Terrorist Financing Act⁴² explicitly exclude “virtual currency” from the definition of “funds” which definition otherwise encompasses, among other things, cash and fiat currency.⁴³ The Canada Revenue Agency has published guidance that it treats cryptocurrency as a commodity, but it should be noted that such guidance is premised on the cryptocurrency not being legal tender and has not been updated since El Salvador’s and the Central African Republic’s adoption of bitcoin.⁴⁴ Further complicating the categorization of virtual currency is the rollout of CBDCs, which are government-backed digital versions of local currencies. CBDCs will be discussed in more depth later in this article, as they are categorically different than cryptocurrencies.

Under the PPSA, a security interest must first attach in order for it to be enforceable against a third party.⁴⁵ Where cryptocurrency is money, the only means for security to attach to it is through possession or through execution of a security agreement that contains a description sufficient to enable such money cryptocurrency collateral to be identified.⁴⁶ The description should include the exact storage address with an exact specification of the valuation of the cryptocurrencies being pledged. As a secured party will rely for valid security upon the crypto-asset address description given by the borrower, it is very important to confirm the asset location and the encoded cryptological description. As a practical matter, all crypto-asset collateral should be publicly re-checked prior to any loan advance to ensure that addresses are not empty. A properly attached security interest would be of little use if the wallet was suddenly drained or hacked, especially if funds are contained in a hot location.

Once attached, a security interest must be perfected in order: (a) to have priority over the claims of other third parties with an interest in the collateral; and (b) to be effective at all against a trustee in bankruptcy or an unwitting transferee of certain asset classes.⁴⁷ Broadly speaking, perfection is the act of either putting the world on notice that assets of the debtor have been pledged, or removing the pledged assets from the possession or control of the debtor so that no third party will mistake them for unencumbered assets. The PPSA allows perfection of an interest in money by possession or by registration.⁴⁸ The old UCC allows perfection of such an interest in money only by possession,⁴⁹ but, as will be discussed in the sections below on intangible cryptocurrencies and CBDCs, the 2022 UCC Amendments will allow perfection of security over CERs by registration or control and perfection of security over CBDCs by control.

Registration alone is of little practical value when it comes to collateral as liquid and fungible as cash. Perfection merely by registration would be even less desirable in the case of money cryptocurrency because cryptocurrency is even easier to transfer than cash. In addition, registration itself has drawbacks when the subject is cryptocurrency. On the one hand, any registration that includes a specific description of the cryptocurrency in an effort to discourage transfer would risk security breach and unauthorized transfer by a third party.⁵⁰ On the other hand, even if such details were not included in the registration, the registration would be a public statement that security is held and thus expose the lender to the risk of having to produce its security agreement to any judgment debtor or other person with an interest in the collateral who requests to see it.⁵¹ As previously discussed, that security agreement would have to have a description of the crypto-asset sufficient to enable it to be identified, in order for the security interest to attach and become enforceable against a third party.⁵²

Obligatory disclosure of such an agreement to a third party could risk a security breach, especially if secured parties accidentally include “keys” to wallets in their collateral descriptions instead of wallet locations. While a best practices guide has yet to be developed, security over crypto-assets held in cold wallets should contain:

• address location (and amounts, presuming the crypto-assets will not be transferred or moved during the period over which another party is secured);
• physical location of the cold wallet in question; and
• no reference to access keys, which should be provided separately to secured parties.

Fortunately, under the PPSA, possession is an alternate means to perfection of a security interest in money. When it comes to traditional money, possession means holding physical cash, which is usually an unattractive option for both a lender and a borrower for reasons including security risk, impracticality, inability to earn a return and challenges complying with anti-money laundering laws. Taking collateral possession of money cryptocurrency could be more attractive to the extent that there would be less concern about security risk (at least of the physical sort), impracticality or inability to earn a return.

Collateral possession of money crypto-assets would require either outright transfer of the crypto-collateral or transfer of the physical device containing a cold wallet for the crypto-collateral. Such possession would be an attractive option to a lender as it neutralizes the risk of unauthorized further transfer of the collateral. Commentators have even suggested that outright transfer to a lender would make traditional PPSA security unnecessary.⁵³ A lender in this position should not, however, be complacent about compliance with the PPSA, as outright transfer to facilitate collateral possession still falls squarely within the category of a “transaction without regard to its form and without regard to the person who has title to the collateral that in substance creates a security interest including . . . an assignment . . . that secures payment or performance of an obligation” and thus falls squarely within the application of the PPSA.⁵⁴ If a borrower were to enter formal insolvency or restructuring proceedings, a crypto-backed lender who eschewed PPSA protocols could find itself in a subordinate position and forced to relinquish its collateral.

From a borrower’s perspective, there may not be much to find attractive in giving a lender collateral possession either by outright transfer of pledged crypto-assets or the transfer of a cold wallet device. The borrower would have to have great confidence in the lender’s intentions, security practices and solvency. This is all the more true because the PPSA allows a lender in possession to, among other things, commingle fungible collateral and grant further security interests in collateral.⁵⁵ Borrowers should also ensure that any cold wallet device of which a lender is given collateral possession does not accidentally include crypto-assets that are not part of collateral being pledged.

Because possession under the PPSA includes possession through a third-party agent,⁵⁶ perfection could be achieved by placing money cryptocurrency into escrow,⁵⁷ which option might be more palatable to a borrower than outright transfer or handing over possession of a cold wallet device directly to a lender. As will be discussed further below, the 2022 UCC Amendments will also permit perfection by control through a third party, even though they will treat cryptocurrency as an intangible rather than money. Among other things, the terms and mechanics of escrow could mitigate the risks of contractual or security breach, lender insolvency and commingling. The arrangement could involve placement into escrow of both a cold wallet device and the password thereto or just placement in escrow of the password, with the cold wallet device resting in the lender’s possession. Whatever the arrangement, the cold wallet device itself needs to be possessed by someone other than the debtor or its agent in order for perfection to be achieved.

Third-party custody solutions also enable escrow-like management of crypto-assets by a solutions provider. This management is arranged through service level agreements (“SLAs”) which dictate storage, access and movement of funds; theoretically, these offer traditional bank-level protections for crypto security.⁵⁸ It is yet to be seen whether standardized versions of securities lending transaction documents, such as the International Securities Lending Association’s Global Masters Securities Lending Agreement (“GMSLA”)⁵⁹ become adopted by the crypto community as with traditional securities lending agreements. As an example, for transactions conducted under the GMSLA, absolute title of collateral is regularly transferred to a lender. In comparison, the cryptocurrency exchange Coinbase currently offers crypto-asset custody for global institutions, with all digital assets held in segregated trusts for the benefit of clients.⁶⁰

“Crypto custody” itself is a term that is used to describe the process of securing online assets from theft,⁶¹ and while it is unclear whether crypto-asset platforms satisfy the legal requirements for perfection of security under the PPSA, it will be interesting to see whether escrow arrangements through these third parties become more common as the industry continues to grow. Digital asset custodians often guard users’ private keys and, by January of 2022, the digital asset custody industry grew from US$32 billion to US$223 billion alone.⁶² Crypto custodians range from custodial banks to digital asset custodians to exchanges, and often fund themselves through custody, setup and withdrawal fees. There is a further growth of staking or lending options through crypto custodians, and many will further hold insurance over the managed assets in question; as an example, Gemini maintains US$75 million in insurance coverage over certain types of losses from crypto-assets stored on platform.⁶³

As we saw previously, possession (by escrow or otherwise) is a means not only to perfection of a security interest in money, but also to the initial attachment of that security interest. Collateral possession of money cryptocurrency therefore not only achieves the most practically secure form of perfection, but also achieves attachment of the security interest without the need to include risky detail in description of the collateral in either a PPSA registration or a security agreement.

The argument has been made that the involvement of an escrow agent would be at odds with one of the primary purposes and strengths of cryptocurrency, namely avoidance of intermediaries.⁶⁴ One answer to this crypto-purist objection is that a borrower seeking access to traditional currency has evidently already come to terms with the bank intermediacy inherent in the fiat money that the borrower wishes to borrow, so the intermediacy of a contractual third party would not likely be an existential hurdle.⁶⁵ More generally, one cannot expect to post any kind of collateral to secure borrowing without some combination of relinquishment of control, third-party involvement and/or inconvenience.

The intermediacy of an agent can also be avoided by interesting practical solutions that the cryptocurrency industry has developed to the legal question of escrow itself. A smart contract within the blockchain can regularly play the role of an escrow agent through three specific steps:⁶⁶

1. The smart contract is specified and deployed by either buyer/seller or borrower/lender;
2. The buyer/borrower transfers the crypto-asset to the escrow smart contract; and
3. When release conditions are met, the respective event is informed to the smart contract with the crypto-asset released to the seller/lender.

Due to the security of smart contracts, the immutable code can guarantee transaction confidence for users. While transaction fees will still be required for execution (and privacy concerns may arise due to transparent blockchain transactions), a growing number of crypto-asset businesses have begun to offer online escrow services for users.⁶⁷ In this way, contractual control could be taken by a third-party smart contract provider (akin to what is seen in tri-party escrow lending agreements). Note, however, that smart-contract “escrow” may not satisfy the PPSA requirement for perfection by possession, as no third party possesses the collateral on behalf of the lender.

It is also common for a lender of fiat currency to take security over an account to which a borrower has deposited money. Although this is commonly referred to as “cash collateral,” the collateral actually becomes the depositor’s right to repayment and no longer the money itself which, upon deposit, becomes the deposit-taking institution’s property.⁶⁸ While the UCC presently allows perfection of security over a deposit account by control, the term “deposit account” is limited to “a demand, time, savings, passbook, or similar account maintained with a bank” (emphasis added).⁶⁹ The PPSA, in contrast, does not allow perfection by control of any type of deposit account.⁷⁰ Security over cryptocurrency cannot therefore be perfected by, for example, treating a hot wallet on an exchange or centralized crypto-intermediary as a PPSA account or UCC deposit account, and taking control thereover. In any case, the very concept of an account is generally ill-suited to cryptocurrency to which title never passes, and which is not replaced by a chose in action against a deposit-taking institution.⁷¹ However, as will be discussed in the next section on intangible (i.e., non-money) cryptocurrency, the 2022 UCC Amendments will permit perfection of a security interest in CERs though a new type of control.

Although the PPSA does not allow perfection by control over a hot wallet on an exchange, there is a distinction to be made between control for the purposes of perfection, and control for the purposes of practical protection. While a lender in a Canadian PPSA province cannot perfect security over a deposit account by any kind of control agreement, cash collateral and blocked account agreements are still used because of their practical value (with perfection achieved by registration). Similarly, practical control over crypto-assets could be theoretically achieved by, for example, placing with an escrow agent the key to a hot wallet established solely for the transaction, or by using a smart contract within the blockchain, as discussed above.

Practical protection can also be increased by crypto-asset users through the use of multi-signature wallets.⁷² Specifically, multi-signature wallets require two or more private keys to sign and send transactions. However, these wallets can also pose issues, such as when the OKEx exchange was unable to share funds with customers due to a keyholder failing to authorize transactions.⁷³ Secured parties should always ensure that the only entities in possession of keys are the borrower and the lender, or, where applicable, an escrow agent. While this is practically difficult to control, a good idea for additional protection would be to enter into legal contracts which place liability on borrowers who fail to maintain the security of their crypto-holdings.

The most important legal reason to take possession or control of money cryptocurrency, regardless of perfection, is that the rights of a person who has received money from a debtor are to be determined at common law without regard to the PPSA.⁷⁴ Likewise, under the UCC¸ a good faith transferee of money takes the money free of any security interest therein.⁷⁵ The 2022 UCC Amendments, and specifically the amendments to UCC Article 9, will expand this priority to a good faith purchaser of CBDCs⁷⁶ and a good faith purchaser of cryptocurrency or other CERs.⁷⁷ A lender’s security can therefore be defeated by a transfer of its money cryptocurrency collateral. Even from a purely practical perspective, identifying the transferee of such collateral beyond the transferee’s blockchain address is very difficult and a transaction cannot simply be reversed as could an electronic transfer between banks or payment processors.

In terms of priority, a perfected security interest in money cryptocurrency, whether perfected by registration or possession, will have priority over any unperfected or subsequently-perfected security interest.⁷⁸

One situation where money cryptocurrency such as bitcoin could end up being just an intangible and not money would be where it has been ostensibly “lent” to an exchange in return for interest payments. In a January 4, 2023, decision in the Chapter 11 proceedings of Celsius Network LLC, the United States Bankruptcy Court for the Southern District of New York held that customers who had deposited stablecoins in Celsius’ high-interest “Earn Accounts” had in fact transferred title to Celsius and were simply unsecured creditors of the estate.⁷⁹ This came as an unpleasant surprise to customers who had thought they were somehow just lending their cryptocurrency to Celsius.

One of the first to provide such interest-earning cryptocurrency accounts was BlockFi Inc. (“BlockFi”), beginning in March of 2019.⁸⁰ Investors would purchase BlockFi Interest Accounts by depositing certain eligible cryptocurrencies with which BlockFi would fund its lending operations and proprietary trading. In exchange, investors were promised attractive interest rates, set by BlockFi at its sole direction, paid monthly in cryptocurrency. Investors relinquished control over the deposited cryptocurrency to BlockFi, leaving BlockFi free to use the assets as it saw fit, including commingling cryptocurrency with those of other interest account investors, investing those assets in the market, and lending those assets to institutional and corporate borrowers. The sale of these products quickly earned BlockFi a cease-and-desist order from the New Jersey Bureau of Securities, prohibiting BlockFi from offering any security for sale, unless the security was registered with the Bureau or is a covered security. The Bureau viewed the BlockFi Interest Accounts to be unregistered securities and not exempt from registration.

In either the Celsius or the BlockFi scenario, if the cryptocurrency being lent to the exchange had been bitcoin, it would have been transformed from money cryptocurrency into an intangible in the form of a debt or a security. Perfection of a security interest over such collateral would thus have to be made in the manner discussed in the next section. The additional concern, of course, is that the collateral quality of an unsecured debt or security instrument could be far less than that of debtor-owned bitcoin.

In summary, under the PPSA, security over bitcoin as money cryptocurrency:

• attaches through possession or execution of a descriptive security agreement;
• is perfected by registration or possession (including possession via escrow);
• may still be protected for practical purposes through control;
• will no longer attach once the money cryptocurrency is transferred to a third party; and
• will have to be treated as security over an intangible, rather than money, if and when the PPSA is amended to follow the 2022 UCC Amendments.

Cryptocurrency As an Intangible Asset

Since El Savador and the Central African Republic have only adopted bitcoin as legal tender, other cryptocurrencies which have not been adopted by any national government remain excluded from the category of money under the PPSA and UCC. As well, upon enactment of the 2022 UCC Amendments, bitcoin will, once again, be excluded from the definition of money under the UCC.

Although there is no specific case law on the point, legal commentators have argued that non-money cryptocurrencies would be “intangibles” under the PPSA or “general intangibles” under the UCC. Applying the reasoning of Menard, such cryptocurrencies:

. . . would also be characterized as an “intangible” by measure of elimination. [They] cannot be considered as “goods” under the PPSA because goods are defined as tangible personal property. . . . Similarly, the definitions of ‘‘chattel paper,” ‘‘documents of title” and ‘‘instruments” have very specific meanings and do not encompass bitcoin. What is left is the ‘‘intangible” category where intangible is defined as “all personal property that is not goods, chattel paper, documents of title, instruments money or investment property, including choses in action.”⁸¹

The same logic would apply under the UCC, with non-money cryptocurrencies falling under the definition of “general intangibles.”⁸² This will soon be formalized under the 2022 UCC Amendments with CERs to be explicitly included in the Article 9 definition of “general intangibles.”⁸³

Under the PPSA, the only means of attachment for security over cryptocurrency that is still classifiable as intangible is through execution of a security agreement that contains a description sufficient to enable such crypto-collateral to be identified.⁸⁴ Perfection can technically be achieved by registration, but, as noted in our earlier discussion of registration against bitcoin, registration cannot be an effective deterrent to transfer of collateral that is so fungible, liquid and digital. Unfortunately, except in the case of investment property, the statutes do not contemplate perfection by possession of intangibles. Forgoing perfection is not, however, a good option, because an unperfected security interest in intangibles (other than accounts) is not effective against an unwitting transferee.⁸⁵

It has been suggested that, because a physical drive acting as a cold wallet for the cryptocurrency can itself be classified as “goods” under the PPSA, collateral possession of the drive could perfect a security interest.⁸⁶ It does not, however, seem prudent to rely only on perfection against a piece of hardware when the real interest lies in intangibles worth orders of magnitude more.

In our earlier discussion of money cryptocurrency, the point was made that control over an account could be of practical use, even though it is not a means to perfection. The same is the case with possession or control of non-money, intangible cryptocurrency, even though neither is a means to perfection. Registration could thus be done to satisfy the statutory perfection requirement and possession or control could also be taken for protection. As previously discussed, a drive encoded with an intangible cold wallet could be physically possessed, or a cold wallet or the password to a cold wallet could be placed into an escrow arrangement to be possessed by a third-party agent. Similarly, practical control could be achieved by placing into escrow the keys to a hot wallet established for the transaction or by use of an SLA or smart contract.

Unfortunately, in the case of security over intangible cryptocurrency, possession cannot replace a descriptive security agreement or registration for purposes of attachment and perfection. The risk of including details of the collateral in a security agreement therefore cannot be avoided, but the risks can be greatly mitigated if possession or control is taken. The practical value of possession or control cannot be overstated, as it is extremely difficult to identify a transferee in an illicit transaction beyond its blockchain address, and the transaction is, in any case, not reversible. It would likely only be cold comfort for a lender that the rights of a transferee remain determined by the PPSA and are not exempt from the application of the Act in the way that the rights of a transferee of money cryptocurrency would be.⁸⁷

In terms of priority, a security interest in an intangible cryptocurrency perfected by registration will have priority over any unperfected or subsequently perfected security interest.⁸⁸ In our earlier discussion of money cryptocurrency, we cautioned against a lender feeling secure in possession alone, with regard to PPSA compliance. That goes double in the case of a lender in collateral possession of non-money cryptocurrency, as possession alone of such an intangible will not perfect the lender’s security interest and could, for example, reduce the lender to an ordinary unsecured creditor in a formal insolvency or restructuring proceeding.

As discussed previously, the 2022 UCC Amendments will exclude CERs, including cryptocurrencies, from the Article 1 definition of money and include them in the Article 9 definition of “general intangibles.”⁸⁹ In addition, UCC Article 12 will introduce a new concept of control for CERs. To have control over a CER, one will need to have:

1. the power, whether alone, with another person or through another person, to avail itself of the benefits of the CER and to exclude others from the same;
2. the power to transfer such control; and
3. the ability to evidence the forgoing powers.⁹⁰

Like other general intangibles, security over CERs will be perfectible by registration.⁹¹ However, a better form of perfection will be control in the new Article 12 sense, as control will give the security interest priority over any other competing security interest perfected by registration or otherwise.⁹² Because control can be achieved through an agent,⁹³ the 2022 UCC Amendments seem open to escrow arrangements for crypto-collateral.

Article 12 will also introduce the concepts of “controllable accounts” and “controllable payment intangibles” which, essentially, are obligations to pay evidenced by, or tethered to, a CER.⁹⁴ These collateral categories will be treated the same way as CERs themselves, both in respect of perfection and priorities, with control over the tethering CER being the gold standard.

As discussed in the prior section on money cryptocurrency, when a cryptocurrency is “lent” by “depositing” it into an interest-bearing account, that may transform the cryptocurrency into a debt or a security, with implications for how a security interest in that collateral is best perfected and on the quality of the collateral. The 2022 UCC Amendments would likely be of little assistance to customers or their secured lenders in this situation, as the party who was lent the cryptocurrency would likely, under Article 12, have been a “qualifying purchaser” to whom control was transferred and thus would hold the cryptocurrency free of any property claim by a customer or its lender.⁹⁵

Similarly, some cryptocurrencies can be “staked” to earn a return, with potentially the same risk of transformation into a debt. Cryptocurrencies typically utilize a decentralized consensus mechanism in order to validate transactions and make sure the same cryptocurrency is not being spent twice. This requires the computer processing power of network participants across the globe. Some cryptocurrencies, like Ethereum or Cardano, allow participants to “stake” their cryptocurrency in order to participate in this mechanism and thereby be rewarded with a percentage return on each transaction that is verified. The more currency that is staked and the longer it has been held, the more return a participant can earn.

Staking can be completed through various mechanisms, including pools operated by independent parties, exchanges and/or other crypto-custodians. While the authors of this article note that there are likely to be significant and advanced legal concerns revolving around the lending of staked crypto-assets, there are two general concerns that should be considered: (i) as discussed later in this article in the context of enforcement, the period of time for which certain staked cryptocurrencies will be “locked” before they can be unstaked; and (ii) control issues surrounding ownership if crypto-assets are staked through a third-party provider or through pools which could theoretically attempt to assert ownership rights. Holders and their secured lenders should be vigilant as to the implication of such pooling or direct staking options on their rights to the staked cryptocurrency. It would be best not to be surprised to learn, as did Celsius Earn Account customers, that all they have left are claims as unsecured creditors – or even have to pursue third-party staking operators for assets.

In summary, under the PPSA, security over cryptocurrency that is classified as intangible:

• attaches only through execution of a descriptive security agreement;
• can be perfected only by registration;
• may still be protected for practical purposes through possession or control by escrow arrangements or otherwise; and
• will be perfectible by control if and when the PPSA is amended to follow the 2022 UCC Amendments.

Initial Coin Offerings and Tokens

Initial coin offerings (“ICOs”) are innovative ways for funding early-stage technology companies. In short, an ICO is a crypto-version of an initial public offering, except that the digital currency sold does not represent an ownership stake and is instead a digital asset used in connection with the application or community in question.

In a 2018 staff notice, the Canadian Securities Administrators (the “CSA”) stated that an ICO may be considered an offering of securities if, among other things, the coins on offer can be categorized as an investment contract because the ICO involves an investment of money in a common enterprise with the expectation of profit to come significantly from the efforts of others.⁹⁶

Some ICOs have been extremely notable. As an example, the Filecoin ICO, which was to raise funds for a decentralized storage network to secure data, secured US$186 million within the first hour of its offering in September 2017.⁹⁷ Similarly, the communications application Telegram raised almost US$1.7 billion in the pre-ICO phase to private investors; as a result of this massive success, no ICO was eventually required.⁹⁸

To the extent an ICO is a security under the Securities Transfer Act, 2006, (“STA”)⁹⁹ it would also be a “security” and thus both a species of “financial asset” and a species of “investment property” under the PPSA.¹⁰⁰ A security interest in such crypto-assets could then attach by control in addition to attaching by execution of a descriptive security agreement.¹⁰¹ Perfection would then come by registration or by control, but not by possession.¹⁰² Perfection could also come through perfection of the account in which the collateral is held.¹⁰³ However, these thoughts are speculative and also dependent upon the structure of each ICO; in fact, certain ICOs within Canada have faced issues with raising funds due to “weak guidance” from Canadian securities regulators.

As an example, Kik Interactive, an Ontario-based company which developed the popular messaging app Kik, faced issues when raising funds through an ICO which was designed to release a new digital currency called “Kin.”¹⁰⁴ Canadians were eventually banned from investing in Kin in 2017 due to “weak guidance” from regulators.¹⁰⁵ The ICO further faced significant issues when the SEC sued the company for allegations that the company’s sale of Kin amounted to an illegal offering of securities.¹⁰⁶ The CSA has since released an infographic for ICOs which cites them as “fertile ground for fraud” with “high failure rates” for investors.¹⁰⁷ Given the unclear guidance beyond the CSA’s position in earlier staff notices,¹⁰⁸ ICOs are analyzed on a case-by-case basis for whether they may constitute a securities offering and thus trigger the application of Canadian securities law.

The same issues of PPSA classification arise in the case of other crypto-assets such as tokens and any initial token offering in respect thereof. There are fundamental differences which distinguish digital currencies from tokens, such as:¹⁰⁹

• cryptocurrencies constitute the native asset of blockchain networks which can be traded and used as stores of value;
• cryptocurrencies are issued directly by the blockchain protocol on which it is run, and are understood to be each blockchain’s native currency;
• cryptocurrencies can help stabilize each digital currency’s operating network;
• tokens are units of value developed on top of each blockchain, which is a separate asset class from cryptocurrencies;
• tokens can help users to participate in decentralized finance mechanisms on the platforms on which they are built; and
• while tokens can hold value and be exchanged, they also regularly represent physical assets such as art, as seen in NFTs, or governance mechanisms for voting protocols within each blockchain.

While there are various types of complex tokens, the easiest example is seen in NFTs. In short, NFTs are digital assets that connect ownership to specific collectable items, such as pieces of art.¹¹⁰ A simple way to understand an NFT is to view them as a one-of-a-kind digital trading card. NFTs are usually found on the Ethereum blockchain and function as an evolution of fine art collection through the digital space.¹¹¹

In terms of classification, the most obvious fit in the PPSA for NFTs would be under the definition of “intangibles.” As an intangible, an NFT would, like non-money cryptocurrency, be subject to attachment of security only through execution of a descriptive security agreement, and such security could only be perfected by registration. Because an NFT is non-fungible, registration of a security interest in an NFT could be a more effective deterrent to transfer than would be registration of a security interest in cryptocurrency.

Canadian securities regulators have, however, indicated that some ICOs, initial token offering (“ITOs”) and tokens will be considered securities. In a 2018 staff notice, the Canadian Securities Administrators (the “CSA”) stated that an ITO may be considered an offering of securities if, among other things, the tokens on offer can be categorized as an investment contract because the ITO involves an investment of money in a common enterprise with the expectation of profit to come significantly from the efforts of others.¹¹²

Like an ICO, to the extent an NFT is a security under the STA, it would also be a species of “investment property” under the PPSA.¹¹³ A security interest in such crypto-assets could then attach by control in addition to attaching by execution of a descriptive security agreement.¹¹⁴ In theory, this could develop in unique ways – such as through control of an account on an NFT auction website and/or the NFT itself. It remains to be seen exactly how perfection would function. Perfection would then come by registration or by control, but still not by possession,¹¹⁵ although perfection could also come through perfection of the account in which the collateral is held.¹¹⁶

As with intangible cryptocurrencies, possession of NFTs has practical value, even though it does not amount to perfection under the PPSA. Possession of NFTs can occur through digital wallets which have the functional capability to house NFT assets. As an example, both Coinbase and MetaMask offer digital wallets to buy and store NFTs. Significantly, some third parties will even hold NFTs for consumers¹¹⁷ through marketplaces themselves; these entities function as custodial platforms where NFTs are stored in secured wallets without incurring transfer fees to move NFTs between a marketplace to a private wallet. However, it remains to be seen how these platforms function in situations of hacks or technological failures. NFTs have a history of being hacked and stolen off of marketplaces, which can trigger losses in the millions for users through phishing attempts.¹¹⁸

If a lender’s crypto-asset collateral is a security and therefore investment property, the lender ought to perfect by control where possible because such control will give the lender priority over all other security interests, including already perfected interests, in departure from the general PPSA first-in-time-of-perfection priority rule.¹¹⁹ It will also prevent another creditor from priming the lender by itself taking control where the lender has failed to do so.

Under the 2022 UCC Amendments, an NFT that is controllable in the Article 12 sense will be a CER. Security over an NFT will be perfectible by registration or control, with control giving first priority.

In summary, under the PPSA, security over crypto-assets that are securities rather than intangibles or money:

• attaches through control or execution of a descriptive security agreement;
• can be perfected by registration or control;
• should be made subject to control in order to prevent any other creditor from gaining priority through control; and
• may still be protected for practical purposes through possession (including possession via escrow), while security over an NFT that is an intangible, rather than a security, will be attached by a descriptive security agreement and be perfectible only by registration, at least until such time as the PPSA may be amended to follow the 2022 UCC Amendment to allow perfection by control.

Central Bank Digital Currencies

In October 2020, the Bahamas launched the first CBDC, the Sand Dollar, with a fixed value, tied to the existing Bahamian Dollar.¹²⁰ In March 2021, the Eastern Caribbean Central Bank followed suit with DCash, tied to the existing Eastern Caribbean Dollar used in eight different countries.¹²¹ Nigeria’s “eNaira” was then launched in October 2021.¹²² Most recently, the Bank of Jamaica launched the Jam-Dex in May 2022.¹²³

Eighteen other central banks have CBDCs in pilot stages.¹²⁴ Notable among these is the People’s Bank of China with the digital renminbi, e-CNY,¹²⁵ which reportedly already had 261 million users at the end of 2021.¹²⁶ CBDCs were being considered by 90 per cent of the central banks recently surveyed by the Bank for International Settlements.¹²⁷ Among those are the United States Federal Reserve, the Bank of England and the Bank of Canada.¹²⁸

Most CBDCs, like those mentioned above, will be retail focused, aimed to be used alongside cash. At this point the e-CNY is exclusively a retail CBDC. Others are hybrids intended to be used at the wholesale level for settlements amongst commercial banks. Commercial banks and other financial intermediaries also play the roles of facilitating transactions in real time, facilitating opening of wallets and, in some cases, distributing CBDCs once they have been issued by a central bank. Nigeria’s eNaira is also designed to be used for cross-border transactions.

For some CBDCs, like the eNaira and DCash, accounting is done on a public, blockchain-based distributed ledger. Others like the Sand Dollar and e-CNY rely on a hybrid infrastructure of both a blockchain distributed ledger and a private centrally controlled database.¹²⁹ The Jam-DEX is at this point unique, in that it operates only through a centrally controlled database.

Regardless of their blockchain dependence, CBDCs are categorically different than other cryptocurrencies in that they are direct liabilities of a central bank. In contrast, the use of bitcoin as legal tender in El Salvador, for example, does not, in and of itself, create any liability for the Central Reserve Bank of El Salvador.¹³⁰ While CBDCs, as mediums of exchange authorized or adopted by a foreign or domestic government, fall under the PPSA and UCC definitions of “money,” they are, as debts owed by a central bank, also potentially “deposit accounts” as defined in the UCC or “accounts” as defined in the PPSA. This could be especially true in the case of CBDCs such as Jam-DEX, eNaira and E-CNY that are account-based rather than token-based. This ambiguity would have significant impact on attachment and perfection of security interests in CBDCs. Definitional amendments would therefore be required to the current UCC or PPSA if the Federal Reserve or the Bank of Canada were ever to issue CBDCs.

If CBDCs are money under the current UCC, like we have argued bitcoin currently is, then security would only attach to CBDCs through execution of a descriptive security agreement and only be perfected by registration. Registration, as discussed previously in the context of cryptocurrencies, would not offer much protection against transfer of a retail CBDC, especially where security will be defeated by transfer to a good faith recipient.¹³¹

Fortunately, the 2022 UCC Amendments will address CBDCs. The new category of “electronic money” will be added to the definitions in Article 9, and the general definition of “money” will be amended to include electronic money that can be subject to control.¹³² The concept of control for electronic money will mirror that found in Article 12 for CERs.¹³³ Security CBDCs will be both attachable and perfectible by control if the secured party has:

1. the power, whether alone, with another person or through another person, to avail itself of the benefits of the CBDCs and to exclude others from the same;
2. the power to transfer such control; and
3. the ability to evidence the forgoing powers.¹³⁴

Although the PPSA does not specifically address CBDCs as will the 2022 UCC Amendments, it is still more conducive to security over CBDCs than is the current UCC. If CBDCs are money, a security agreement is not the only means to attachment of security and registration is not the only means of perfection; security over CBDCs can also attach and be perfected by possession. Such possession would likely have to take the form of absolute transfer of CBDCs to a lender or an escrow agent, albeit for collateral purposes.

While control will be the means to attachment and perfection of CBDC security under the 2022 UCC Amendments and while we previously discussed taking control over money cryptocurrency like bitcoin for additional practical (i.e., non-PPSA or non-UCC) protection, it is doubtful, in the case of CBDCs, that a central bank would enter into a tri-party control or cash collateral agreement. It remains to be seen whether a private bank who acts as a CBDC transaction processor could somehow fulfil the role of the third party to a control or cash collateral agreement. If not, control might only be achievable by collateral possession by absolute transfer.

If CBDCs are accounts or deposit accounts under the PPSA or the current UCC (rather than money), security could not attach or be perfected by possession. As with non-money cryptocurrencies, attachment of security over CBDCs would have to be achieved by execution of a descriptive security agreement. While the UCC (unlike the PPSA) allows perfection of security over a deposit account by control, a tri-party control or cash collateral agreement is not likely an option with a central bank. Unless a bank who acts as CBDC transaction processor can somehow fulfil the third-party role in such agreements, perfection would likely only be achievable by registration. Collateral possession via absolute transfer would still be an option to give a lender additional practical (i.e., non-UCC, non-PPSA) protection.

In practice, there may be few situations where a creditor would actually take security over CBDCs. Where a borrower might post cryptocurrency as collateral in order to gain access to legal tender while still retaining title to what it perceives to be an appreciating asset, CBDCs are, in contrast, already legal tender. Collateral for a letter of credit is one possibility, but a borrower is more likely to want to post an interest-bearing bank guaranteed investment certificate as collateral rather than tying up currency that bears no interest.

In summary, under the PPSA, security over CBDCs:

• will attach by possession or execution of a descriptive security agreement if CBDCs fall under the definition of “money,” or just by descriptive security agreement if CBDCs fall only under the definition of “accounts”;
• could be perfected by registration or possession if CBDCs fall under the definition of “money,” or just by registration if CBDCs fall only under the definition of “accounts”;
• could still be protected for practical purposes through possession; and
• will be attachable and perfectible by control, if and when the PPSA is amended to follow the 2022 UCC Amendments.

Enforcement Against Virtual Collateral

Through blockchain technologies, enforcement via liquidation of collateral is theoretically automatic if a decentralized system enables immediate recovery against another address. In that way, blockchain technology has the ability to drastically change standard lending practices by eliminating the need for formal security regulated by the PPSA or UCC.

As an example of this, secured lending platforms for retail users that trade cryptocurrencies often automate recovery mechanisms.¹³⁵ Traditional fiat currencies (such as USD or CAD) are borrowed against existing crypto-assets that are stored on the lender’s platform. Clients can apply for a loan without a traditional credit check and be funded with fiat against cryptocurrencies held by platforms as “security” for repayment.¹³⁶ Lenders no longer require traditional collateral security such as mortgages in order to “hold” and liquidate collateral upon default. Once the loan is paid off to the crypto-lender, the full cryptocurrency used as collateral is then returned to the investor. An increasing number of platforms offer these crypto-backed loans to fill a market void left open by traditional lending or mortgage providers who do not accept cryptocurrencies as collateral.

This type of extra-statutory enforcement solution is no doubt partly a consequence of how the crypto sector has generally been left to operate in the absence of specific regulation or enforcement of laws otherwise applicable to crypto-assets. It is risky, however, for a lender to enforce security over crypto-assets without regard for personal properties laws or, for that matter, the common law itself.

To begin with, any lender who seeks to enforce its rights, whether by civil suit or enforcement of security, is required at common law to make demand and give a reasonable time for repayment before taking any other action.¹³⁷ This principle has been codified, both in the Bankruptcy and Insolvency Act requirement that a secured creditor seeking to enforce against all or substantially all of the assets of a business must give 10 days’ written notice, and in the PPSA requirement that a secured creditor seeking to dispose of assets in enforcement of its security give 15 days’ written notice.¹³⁸ While the PPSA does provide an exception to the 15 days’ notice rule in the case of collateral “of a type customarily sold on a recognized market,”¹³⁹ which exception could apply to at least the more common cryptocurrencies, the Ontario Court of Appeal (the “Ontario CA”) has held that this exception does not relieve a secured creditor of its common law duty to provide reasonable notice.¹⁴⁰

To the extent it does away with human discretion, automated enforcement risks non-compliance with a secured party’s obligation under the PPSA to dispose of collateral in a manner that is commercially reasonable.¹⁴¹ As an example, MakerDAO is what is called a “decentralized autonomous organization” wherein users deposit other cryptocurrencies as collateral and are “lent” a stablecoin called Dai that is more or less pegged to the U.S. dollar.¹⁴² These lending transactions are governed by smart contracts. On March 12, 2020, as the price of Ether and other cryptocurrencies plunged in an event that became known in the crypto community as “Black Thursday,” the MakerDAO smart contracts triggered an auction of posted collateral at the very bottom of the market and even, due to a flaw in the smart contracts, sold some Ether off at $0.¹⁴³

One situation in which the PPSA could permit automatic enforcement against crypto-collateral is where the collateral is a security under the STA. In that case, subsection 17.1(2) of the PPSA would allow a secured party having control through possession or agreement to “sell, transfer or otherwise deal with the collateral in the manner and to the extent provided in the security agreement.”¹⁴⁴ The Ontario CA has suggested that such action can be taken without notice.¹⁴⁵ Although the Ontario CA did not specifically address the point, the implication would seem to be that common law demand would also not be required. As previously discussed, only certain initial offerings and tokens could be categorized as securities, but not cryptocurrencies in general. Section 17.1 of the PPSA therefore does not permit no-notice enforcement against cryptocurrency collateral.

Additional concerns can arise where a lender enforces its security by taking absolute transfer of crypto-collateral rather than selling it, thereby effectively foreclosing. Although there is the aforementioned exemption from giving PPSA notice where a secured creditor disposes of collateral “of a type customarily sold on a recognized market,” there is no such exemption in the case of foreclosure. Likewise, the Ontario CA held that PPSA subsection 17.1(2) does not allow a secured party having control of a pledged security through possession or agreement to foreclose without notice.¹⁴⁶ A lender who intends to enforce its security by taking absolute assignment of its crypto-collateral is therefore required to give 15 days’ notice to the debtor, any guarantor and every other party with an interest in the collateral.¹⁴⁷ This notice is required even where the lender is already in collateral possession of the property.¹⁴⁸ Where such notice is not properly given, the debtor retains its rights in the collateral.

Foreclosure under the PPSA results in satisfaction of the entire debt.¹⁴⁹ A secured creditor therefore may not want to foreclose in the situation where its crypto-collateral will not satisfy the whole of a debt. A lender in that situation who has imprudently proceeded without regard for the PPSA or its notice requirements is saved by the fact that neither the debtor’s ownership nor the lender’s claim to deficiency will be extinguished until proper notice of foreclosure is given and no objection is made by any recipient of the notice.¹⁵⁰

Some lenders offering loans to retail users require additional collateral, such as real property mortgages, in the case of larger loans. The PPSA does allow a lender holding security over both real property and personal property to avoid the application of Part V of the PPSA, including its notice requirements, by proceeding to enforce under real property laws.¹⁵¹ Enforcing under real property law would not, however, give the secured creditor any advantage in terms of time or convenience where the debt could be satisfied by crypto-collateral alone.

In the case of security over CBDCs, there is, in theory, no need for a secured creditor to dispose of the collateral because it is already legal tender. An enforcing creditor could, however, “dispose” of CBDC collateral by depositing it with a private bank, effectively trading a sovereign debt (the CBDCs) for a private bank debt (the deposit), which could be an attractive proposition to the extent the bank deposit accrues interest. Depositing with a private bank could also be attractive simply because it would be a disposition rather than an assumption of title. Because CBDCs would be collateral “of a type customarily sold on a recognized market,” there would be an exemption to the general PPSA requirement that an enforcing secured creditor need to give 15 days’ notice, in a prescribed form, to all parties with an interest in the collateral.¹⁵² While CBDCs might not be what was contemplated by the drafters of that exemption, they certainly fit the exemption’s purpose as their value is set by statute as the official currency and so they do not even need the price discovery mechanism of a “recognized market.”

This exemption for collateral whose value can be determined on a “recognized market” would not exist if the creditor were simply to retain, and thereby foreclose on, CBDC collateral.¹⁵³ Such an exemption might be warranted in future amendments, to the extent the lack of price discovery in foreclosure is not a concern with collateral whose value is set by statute. Note that the situation with CBDCs is different than a bank holding “cash collateral” which, as we discussed previously, is not really cash but rather just a debt owed by the bank to the debtor who deposited the money. With cash collateral, the bank has a right to set off the obligations owed to it by the debtor against the debt the bank owes in respect of the deposit or even to reach the same result by a “mere bookkeeping entry” without invoking formal set-off.¹⁵⁴

Whether the secured creditor disposes of or forecloses on CBDC collateral, it would still, at common law, have to make demand and give a reasonable amount of time for repayment.¹⁵⁵ One of the factors (and, indeed, the main factor under old English law) in determining what constitutes reasonable notice in a given case is the debtor’s potential ability to raise the money required in a short period of time.¹⁵⁶ Where CBDC collateral has been pledged as security, some or all of the money required is already raised, so the reasonable notice period upon demand could be very short.

A practical challenge in enforcement could arise in the case of cryptocurrency that has been lent into an interest-bearing account or that has been staked through pooling. As discussed in prior sections, there is, in either case, a risk that the cryptocurrency has been transformed into a mere unsecured claim. Not only would that likely have negative implications on the value of the collateral, but it could also make realization a two-step process, as the lender would first have to enforce security over its borrower’s claim and then enforce that claim against the party to which the cryptocurrency had been lent. Even if legal title has not been affected by such lending or staking, any resulting loss of practical control by a lender may be enough to trigger difficulties with enforcement and recovery proceedings. Furthermore, in the case of cryptocurrency that has been staked, there may be some amount of time for which the cryptocurrency is locked up and cannot be removed from its staking role.¹⁵⁷ There may also be a further withdrawal notice period that has to be waited out. For a lender seeking to enforce security over staked cryptocurrency, such lockup and wait periods will delay realization.

In summary, enforcement of security over virtual assets:

• should only be commenced after demand has been made, the appropriate Bankruptcy and Insolvency Act or PPSA notice has been given to the required parties and the corresponding notice period has expired;
• where exemption to the statutory notice requirements applies, should still only be commenced after demand has been made and reasonable time to repay has expired, unless the collateral is crypto-assets which are securities; and
• that takes the form of transfer of title to the lender will only be effective where the appropriate PPSA foreclosure notice has been sent to the required parties and the 15-day notice period has expired.

Governing Law

One important remaining consideration is what law will govern transactions involving virtual collateral that exists only on blockchain.

Under the PPSA, it makes a difference whether the crypto-asset serving as collateral is classified as money, an intangible or a security interest and, if it is money, who has possession of it. If the crypto-asset is money and is collaterally possessed by a lender, then the validity, perfection and priority of the lender’s security interest will be determined by the law of the jurisdiction in which the money cryptocurrency is situated at the time the security interest attaches.¹⁵⁸ If the collateral is money cryptocurrency not possessed by the lender, or if it is just an intangible, then the validity, perfection and priority of the security interest will be determined by the law of the jurisdiction where the debtor is located at the time the security interest attaches.¹⁵⁹ In the case of money cryptocurrency such as bitcoin, this is an additional reason for a lender to take collateral possession, as it will give the lender the comfort of the laws of its own jurisdiction. That would not be the case, however, if collateral possession was achieved through an escrow agent located in a different jurisdiction. These functional distinctions between money cryptocurrency and intangible crypto-asset collateral classes will also largely disappear if and when the PPSA is revised to follow the 2022 UCC Amendments, making money cryptocurrency like bitcoin once again an intangible.

As discussed previously, some types of ICOs and NFTs may be considered securities under the STA and, as such, would be categorized as a species of “investment property” under the PPSA. The validity of a security interest in such crypto investment property would be governed by the law of the issuer’s jurisdiction.¹⁶⁰ Perfection and priority would also be governed by the law of the issuer’s jurisdiction,¹⁶¹ unless perfection is made through registration, in which case perfection is governed by the law of the jurisdiction in which the debtor is located.¹⁶² If the lender has a preference between the laws of the jurisdiction of the issuer versus the laws of the jurisdiction of the debtor, that might influence the decision whether to perfect by registration or by control.¹⁶³

Under the 2022 UCC Amendments, the governing law for a secured transaction involving cryptocurrency will generally not be a function of the parties’ jurisdiction(s).¹⁶⁴ Under the amendments, a CER’s governing law for purposes of perfection and priority will be the law of the CER’s jurisdiction, which jurisdiction will be determined as follows:

1. if the CER itself expressly selects a jurisdiction for purposes of the UCC; or, if not,
2. the rules of the system in which the CER is recorded expressly select a jurisdiction for purposes of the UCC; or, if not,
3. the CER itself expressly selects a jurisdiction for general purposes; or, if not,
4. the rules of the system in which the CER is recorded expressly select a jurisdiction for general purposes; or, if not,
5. the District of Columbia.¹⁶⁵

The exception will be that the law of the debtor’s jurisdiction will apply if perfection is effected through registration.¹⁶⁶

A lender will still, therefore, have some control over jurisdiction under the 2022 UCC Amendments to the extent it can perfect security by registration in order to choose the borrower’s jurisdiction. This will be consistent with the PPSA rules of governing law discussed above. As a result, a Canadian lender could, for example, perfect by registration in order to take advantage of the laws of a state where the 2022 UCC Amendments had been enacted, if the lender preferred the certainty that those crypto-specific amendments would provide over the uncertainty of the PPSA.

Conclusion

Although the practical protection of possession or control of crypto-collateral is always desirable, security over crypto-assets should be properly taken and perfected in accordance with personal property security laws to ensure a lender has valid and defensible legal rights. While there is almost no existing guidance on how to take security over crypto-assets, the gating issue is how the particular assets should be categorized under applicable personal property security laws. To that end, a lender should ask the following questions about the nature of any virtual asset it seeks to collateralize:

1. Is the crypto-asset a currency or a token?
2. If it is a currency, is it a CBDC or a non-government-issued cryptocurrency?
3. If it is a cryptocurrency, is it:
   1. Money?
   2. Intangible?
   3. Staked?
4. If it is a token, is it producing “returns,” and could it thus potentially constitute a security?
5. In anticipation of enactment of the 2022 UCC Amendments (and any amendments to the PPSA which may follow), is it controllable?
6. What jurisdiction’s laws will govern the transaction?

   
   There are also a number of practical due diligence issues that a lender should consider before lending against virtual assets:

7. Are there methods in place to prevent the hack of your crypto-asset collateral?
8. Are there any market volatility concerns about the valuation of your crypto-asset collateral?
9. Is the security to be taken over the mutable contents of a wallet or a fixed amount of cryptocurrency?
   1. If the security is fixed, is the cryptocurrency isolated in a “cold” wallet or off of an exchange?
   2. Who holds the keys to the cryptocurrency location?
      1. Is the exchange location secured or verifiable?
      2. Is the exchange itself registered and legal in your jurisdiction?

For a discussion on how to protect your security interest in crypto-collateral, please contact the authors at Aird & Berlis LLP.

[1] Alexander Osipovich, “Upstart Peer-to-Peer Crypto Exchanges Take Aim at Coinbase” (24 May 2021), online:  The Wall Street Journal <www.wsj.com/articles/upstart-peer-to-peer-crypto-exchanges-take-aim-at-coinbase-11621848601>.