Law Commission Digital Assets Reform Proposal - The Big Issues

Background

In the wake of a wave of recent developments in the digital assets space, on 28 July 2022 the Law Commission published their landmark consultation paper setting out its recommendations for reform to ensure that the law recognises and protects digital assets, given the difficulties caused for legal and regulatory frameworks by their intangible nature. This consultation paper represents arguably the most significant contribution to date, and shows the UK positioning itself at the forefront of innovation with regards to regulation and recognition of distributed ledger technology underpinned digital assets (including crypto-tokens). The consultation follows a string of related activity by the Law Commission, including their call for evidence in April 2021 and the interim report published in November 2021.

The paper is lengthy, proposing a number of detailed recommendations and points for discussion, and in this piece we pull out only a few headline areas.
Overall, the key focus and recommendation made by the paper is the explicit recognition as an extension of the common law of a new third category of personal property ("Data Objects") which would encompass certain digital assets, and render them distinct from things in possession and things in action. This comes in the wake of feedback received by the Law Commission that current conceptions of possession under the law of property are inappropriate for digital assets.

In addition to the new proprietary classification for digital assets, the paper also provides recommendations regarding a number of other distinct issues in the digital assets arena. We have identified in this piece four key topics arising from these recommendations, including (i) the provision of clarity on the definitions of 'digital asset' and 'crypto-token', (ii) expansion on how digital assets can be transferred, (iii) considerations on how digital assets can be held in custody and (iv) the discussion of mechanisms for utilising cryptoassets as collateral.

Key Issue 1: Defining digital assets as items of property

One of the key aims the consultation seeks to achieve is the demystification of the definitions of "digital asset" and "crypto-token" as a subset of digital assets, and the application of property law concepts to these definitions. To this end, the paper identifies a crypto-token as a thing capable of having property rights attached to it (i.e. the right to possess and transfer possession), due to a number of key features that analogise crypto-tokens to more 'conventional' classes of property including that:

• Crypto-tokens have both a form and a function. Their form being a data structure (a set of linked or associated data) and the function being that which arises when the data structure is instantiated within the crypto-token system, triggering the active operation of protocol rules; and
• Crypto-tokens are not, in practice, copyable. Although the code that makes up the token can be copied, the instantiation of a data structure within a network cannot be, as it is not possible to exactly replicate the network or the physical infrastructure running the software required for the network.

Importantly, the Law Commission recognises that, in their opinion, crypto-tokens can fall under their new classification of personal property, Data Objects, due to the features that distinguish them from other proprietary classes, notably their existence independent of the legal system and of persons, their rivalrousness, their representation via electronic medium, and their ability to be divested on transfer.

The most contentious elements of this classification of crypto-tokens centre around the notions of rivalrousness (i.e. consumption of a crypto-token by one person inhibits use or consumption of that token by another) and divestability on transfer, and the Law Commission engages in extensive debate as to whether these concepts truly apply to crypto-tokens.

Key Issue 2: Transfer

One of the more contentious interpretations given by the Law Commission in the paper is around the operation of transfer in relation to crypto-assets. In Chapters 12 and 13 of the paper, the Law Commission discuss transfer of a digital asset in such a way as to give rise to the assumption that a new digital asset is created on each occasion – given that transfer effects a 'state change' within crypto-token systems that leads to the replacement, modification, destruction cancellation or elimination of a pre-transfer crypto-token.

Although the fact is that a crypto-token is essentially represented by a set of data parameters, which may indeed be modified on transfer, the concept of them as non-fungible assets and distinct is (for the most part) misleading, and a somewhat confusing way of representing the transfer of ownership to the asset. In our opinion, to view a transfer of a crypto-token or digital asset as giving rise (in law) to the creation of a new asset on each and every occasion when the blockchain is altered misunderstands the reality. Moreover, the outcome is counterintuitive in terms of the complex legal and fiscal relationships that this interpretation would give rise to.

The reality is such that the substance of the property qualities and value embedded in a digital asset remains absolute and is unaltered by a transfer action. We would encourage a deeper debate on this topic as any attempt to treat title to a digital asset as derivative could store tremendous problems, and is highly undesirable particularly in the financial market context where certainty of a clean title or interest in tokenised traditional securities is paramount to a scaled adoption.

It is important that responses to the consultation consider structures for the transfer of digital assess which take into account (perhaps via statute) the fungible nature of the digital asset (with the exception of the NFT).

Key Issue 3: Custody

As with conventional assets over which persons hold property rights, users of crypto-tokens are increasingly seeking to utilise their crypto-tokens in facilities and arrangements in which they relinquish a degree of control over access and usage. These kinds of facility, arrangement or relationship are often described, in a generic sense, of being one of custody. This notion should be distinguished from what is understood in financial markets for custody to be which is essentially a regulated activity requiring both a license and prescribed and appropriate systems and controls to ensure safeguarding of assets belonging to others.

The Law Commission considers that custody is a fact-specific arrangement which gives rise to a variety of consequences, and goes on to seek to define the core features of custody arrangements. The consultation considers a range of crypto-token holding structures, how these can apply to crypto-tokens and then outline the different options for recognising/building a legal foundation for what is a direct custody arrangement, based on existing contract and trust frameworks.

One of the key distinctions drawn by the Law Commission in the digital assets arena is that between (i) what they term 'direct custodians' (who have both positive and negative control over a crypto-token or other digital asset) and (ii) custodial/technology and hybrid service providers. The Law Commission implies that the latter are not (as such) 'true' custodians. Firms should consider whether the solutions they currently use to hold clients' crypto-tokens (including tech solutions) fall under the definition given of 'direct custodian', and the appropriateness of this if so.

This is an area in which the Law Commission considers that the law as it stands offers a sufficient degree of malleability to apply to crypto-tokens and digital assets without significant reform. They set out two plausible frameworks:

•  Contract based – which involves outright title transfer/title retention (direct custody), along with contractual and personal non-contractual duties; and
• Trust based arrangements for direct custody.

The paper goes on to explore a variety of issues with applying these frameworks, notably (as regards to the trust framework) with satisfying the three certainties required for a valid constitution of trust and the appropriateness of the duties and boundaries of commercial trust relationships for crypto-tokens and digital assets, where the fiduciaries may be unknown parties using a decentralised system.

We would expect that the analysis set out by Law Commission is sufficient for financial regulators and market participants to advance their thinking on how existing regulatory and legal models applicable to custody of traditional form of financial investments can be adapted to digital assets. In the context of private permissioned DLT networks there is considerable level of flexibility to design the precise features that a custodian would need in order to secure positive and negative control. What is equally interesting is the dividing line in legal liability/responsibility between traditional or neo digital assets custodians and the operators of DLT networks on which digital assets are created, registered and settled. This requires further thought, although there are existing models such as Central Securities Depositories where this has been satisfactorily resolved.

Key Issue 4: Utilisation of crypto assets

One of the key use cases for crypto-tokens (particularly given their increasing value) is as the basis for an extension of credit with or without the possibility of a yield secured or covered by crypto-token collateral arrangements. Broadly, the Law Commission defines such arrangements as the grant of recourse to "certain specified property or pools of property to secure or cover a payment obligation or performance of an undertaking". In the case of crypto-tokens, these arrangements are used to extract value from otherwise underutilised assets.

The Law Commission considers this point through three lenses, (1) the options for granting security in respect of crypto-tokens, (2) the extent to which the Financial Collateral Arrangements (No 2) Regulations 2003 ("FCARs") can or should be applied to crypto tokens, and (3) whether it would be desirable to develop bespoke statutory provisions for collateral arrangements in respect of crypto-tokens.

On the whole, the Law Commission identifies that, in theory, it is feasible for crypto-tokens to be utilised as collateral both via title transfer arrangements, and through structuring as a security interest, without law reform. However, possessory security options are identified as a particular area of concern, given the lack of a centralised register of title (as is the case with, say, the Land Registry), and the potential issues with being aware of which assets are used as collateral.

On consideration of the current framework for security interests, the Law Commission identifies this as a particular area where input is encouraged (given the inappropriateness of existing frameworks, including the FCARs and historical dissatisfaction with this regime more broadly).

What next?

The consultation is open for responses until 4 November 2022, and interested parties should submit responses using the online form if possible, or via email to digitalassets@lawcommission.gov.uk if not.

Those operating or looking to operate in the digital assets/crypto space should keep a watchful eye on developments, as we have seen regulators and trade bodies becoming increasingly active in this space. In just the last few months, we have had material contributions from the Bank of England, the Financial Conduct Authority, and ,most recently, LawTech UK published a legal statement on securities on 4 August 2022 (which, although more specific in focus, shows that attention has extended beyond broad-brush considerations of how to adapt the legal framework to digital assets generally, to encompass specific areas).

This consultation represents only the start of wholesale legal and regulatory change, and represents a unique opportunity for interested stakeholders to have a say in how this should look.

Co-author: Penny Chamberlain