Digital assets in a crypto winter
In 2013, IT engineer James Howells was cleaning out his house. He had two identical hard drives: one he put in a safe place, the other he threw away.
One hard drive was blank and the other contained files from an old computer, including the private keys needed to access a wallet containing 7,500 Bitcoin.
Unfortunately for Mr Howells, he had mixed up the two drives.
Today, Mr Howells’ discarded Bitcoin are worth about $170 million. For the last five years, his efforts to persuade Newport City Council in Wales to permit excavation of the local dump have failed.
This, despite offering the city 25 per cent of whatever is recovered.
Perhaps one day, Mr Howells will find his hard drive. In the meantime, all those involved with digital assets can learn a valuable lesson from his mistake, which highlights the unique nature of such assets.
Digital assets may feel, superficially, like securities, bonds or other financial arrangements. But due to their design, they are uniquely unsuitable for certain transactions where a security interest is involved.
In the event of breach under a traditional transaction, the innocent party can enforce over any security, enforce damages awards against assets, or secure an order that a register recording ownership of assets is changed.
In a digital assets transaction these options can be unavailable.
Enforcement over assets, in the face of continuing default, may ultimately be achieved by the court ordering the goods seized or appointing a receiver over them. In the case of digital assets, however, if the storage device for the private keys needed to access digital assets is lost, damaged or stolen, there is no physical asset to enforce against.
Information about ownership of digital assets is stored on the blockchain, a decentralised register that is agreed and constantly reformulated by consensus between many different parties throughout various jurisdictions.
There is no single authority that can effect changes to the blockchain. That is the point of the blockchain.
But this means that in the event of a dispute about ownership of a digital asset, the court cannot order that records of ownership are rectified. Such an order would be meaningless.
Conversely, with traditional securities, there is almost always a third party who holds a register confirming ownership, such as a register of members. In the event of a dispute, the court can compel changes to that register to reflect any order of the court.
To try and prevent the worst from happening, the first safeguard that digital asset businesses can effect is the means of storage. Cold storage, i.e. storage on media not connected to the internet, is best practice.
The Bermuda Monetary Authority requires a licensed digital asset business to hold not less than 90 per cent of client private keys in cold storage unless they are being actively used. Redundant storage (i.e. duplicate copies), while not required, is prudent.
Where digital assets are not pooled, i.e. each client’s asset is held behind a separate private key in a segregated wallet, it is strongly advisable to store these keys on a separate physical device. That way, in the event of a dispute, there cannot be two parties with a claim to information on the same physical device.
Service agreements between digital asset businesses and consumers can be drafted to give the consumer an exclusive right to possession of the storage medium in, for example, the event of the digital asset business’ insolvency.
Coupling a digital asset with an exclusively owned, safely stored physical asset allows for some traditional concepts about ownership of assets to apply indirectly to the digital assets, which may alleviate some enforcement difficulties.
The Digital Asset Business Act 2018 requires that a digital asset business holding client assets maintains a surety bond, trust account or indemnity insurance for the benefit of its client approved by the BMA.
The terms of these client protection measures should be kept under review to ensure that they remain workable under current market conditions.
The strength of Bermuda’s digital asset legislation may be tested by a market currently experiencing significant contraction. Prevailing financial conditions, which have seen high rates of inflation and the Federal Reserve System increasing interest rates, have seen investors rushing to safe-harbour investments.
Bitcoin’s value has tumbled, which will impact digital asset businesses, their clients and employees.
For everyone else, the real world effects of this “crypto winter” are only just beginning to be felt. Digital asset businesses should have, in addition to business continuity and disaster recovery plans, contingency plans in place for prolonged periods of depressed, low-value trading.
Our insolvency and restructuring team have already received several enquiries seeking assistance with such contingency plans.
Traditional investors may take (mild) comfort from the fact that digital asset markets are insulated from traditional financial markets in a way that, for instance, credit markets were not, prior to the global financial crisis.
Nevertheless, it may be too early to say to what extent this froth in the digital asset markets will spill over into other areas.
John Wasty is the head of Appleby’s dispute resolution practice in Bermuda and James Batten is an associate in the department. A copy of this column can be obtained on the Appleby website at www.applebyglobal.com.
This column should not be used as a substitute for professional legal advice. Before proceeding with any matters discussed here, persons are advised to consult with a lawyer.