Custody Problems with Bitcoin and Other Crypto Assets

Corporate Counsel Business Journal (CCBJ)

PUBLISHED ON: September 30, 2020

While 2020 may be a year on pause, cryptocurrency is continuing at full speed. Preston J. Byrne, Robert V. Cornish and Stephen D. Palley of Anderson Kill offer their insights.

One of the few bright spots in 2020’s unquestionably challenging business environment has been the Bitcoin and cryptocurrency markets. The prices of Bitcoin and Ethereum, the two most dominant cryptocurrencies in terms of market share, currently hover at yearly highs. Square, a Silicon Valley-based merchant processor, reported that its popular "Cash App" mobile app – one application in one country – generated $875 million in Bitcoin sales in the second quarter of 2020 alone.

Interest from the retail segment is mirrored by interest from institutional asset managers and banks. At the beginning of 2019, asset management powerhouse Fidelity was the first globally significant financial institution to announce that it was launching a digital assets division. At the beginning of August, it was joined by Goldman Sachs. Outward-facing public developments in the cryptocurrency arena also hint at significant furtive work by institutional players to lay the groundwork for future business. A blinking green light for cryptocurrency custody Growth of business and market activity will by necessity bring many legal issues to the forefront, as cryptocurrencies appear poised to make their way into the financial mainstream. One of these issues is “custody” – what it means for financial and other regulated institutions to hold an asset that can be transferred permanently and irretrievably with a private key (akin to a password).

Because the math problem represented by a Bitcoin key is very hard, indeed so hard that it is generally thought that no assemblage of computers currently in existence could crack one on a commercially practical timescale, the presence of a positive Bitcoin balance plus the knowledge of the secret key associated with that balance is generally referred to as “possession” of cryptocurrency which is then “held” by the person with knowledge of the private key, because it is exceedingly unlikely that such a secret would be randomly guessed or happened upon by another person, even though nothing physical is actually possessed.

The problem here is that coins spent improperly or by mistake are nigh-impossible to claw back.

Whereas land passes by deed, chattels pass by possession, and intangibles might transfer by assignment, effective control of Bitcoin is conferred by knowledge of a 64-character password that cannot be changed. There are two ways to confer control. The first is to write down the key and provide it to the recipient, but this is problematic given that it provides no guarantee that the transferor has not retained a copy for himself. The second is for the transferee to provide the public, or non-secret, component of a Bitcoin address where only the transferee knows the secret key, and require that the transferor send coins (or, in industry parlance, ‘spend coins’) to that address. The problem here is that coins spent improperly or by mistake are nigh-impossible to claw back.

“Possession” as used in common parlance can mean that a forgotten key to a large cryptocurrency balance is potentially less retrievable than a chest full of gold thrown into the deepest reaches of the Pacific Ocean. This is a hard technical problem which numerous technology companies and financial institutions are hurriedly competing to solve; equally difficult is the problem that virtually all aspects of custody of financial instruments, whether securities or currency, are, and in the case of cryptocurrency will be, governed by state-by-state adaptations of the Uniform Commercial Code (“UCC”). The very definitions of “property,” “security interest” and “bailment” for digital assets fit nowhere in the OCC’s guidance. This precludes any commercial commonality required to make custody of digital assets and related functions as envisioned by the OCC (such as swaps and secured lending) practicable.

Banker beware: State law not yet there

Although some states, such as Wyoming, began last year to provide the basic UCC tools for financial institutions in the state to facilitate lending and custody in digital assets, including definitions of the arcane definitions that serve as the bedrock of financial markets, most states’ legislative efforts in this arena are below-par.

In essence, the recent OCC letter is what Merle Haggard once called “Rainbow Stew” for virtually all of the United States. That is, perhaps a very nice idea but, considering the current reality of federal
regulation and rule making, impossible to implement. For the time being, those with “Rainbow Stew” visions of leveraging recent OCC guidance should consider establishing operations in progressive states like Wyoming at the risk of awaiting either harmonized UCC revisions from 49 states and 5 territories, or a well-funded banking market disruptor from abroad who can unscramble disparate legislation to its benefit.

Inadequate or legally uncertain custodial provision ahead of time can lead to disasters (such as the loss of access to an estimated nine-figure fortune by the estate of banking heir Matthew Mellon, who was unable to make such provision before his death in 2018 and is reported to have taken his cryptocurrency keys to his grave).

Counselling your clients – whether they be high net worth individuals seeking to pass on their wealth to the next generation, or companies seeking to accept payments through non-traditional rails, comply with government orders or act in a fiduciary capacity – requires an understanding of how difficult the custody problem really is and how important it is for custody to be provided correctly.