UK Law Commission urges special legal framework for crypto collateral to enhance market liquidity and address risks, while emphasizing residual legal uncertainties and alignment with UK’s vision of becoming a digital asset hub.
The Law Commission of England and Wales has proposed the establishment of a specialized legal framework to govern the use of cryptocurrencies as collateral. The commission, which is funded by the Ministry of Justice, highlighted the advantages of utilizing digital assets as collateral for loans, such as enhancing market liquidity and enabling investors to access the value of otherwise dormant assets. However, the commission also acknowledged the risks faced by borrowers who provide such collateral, particularly if the lending institution becomes insolvent, potentially resulting in the loss of their funds.
Risks And Legal Uncertainties Surrounding Crypto Collateral: Insights From The Law Commission’s Report
In a comprehensive 304-page report published recently, the commission explained that in the event of insolvency proceedings, collateral providers would only possess an unsecured claim to surplus proceeds, rather than a proprietary claim to the assets themselves. Crypto-backed loans are frequently utilized by individuals who possess substantial holdings of digital assets as a means to access additional resources. These loans are often utilized for leverage, allowing borrowers to acquire more cryptocurrency by borrowing against their existing holdings, such as Bitcoin.
Nevertheless, there are significant risks involved. If the value of the crypto used as collateral by the lender falls below a certain threshold relative to the loan amount, the collateral will be liquidated, and the borrower’s funds will be retained by the lender to ensure profitability. Furthermore, borrowers may not be safeguarded if lending firms rehypothecate their collateral and subsequently lose it, as happened with Celsius and BlockFi prior to their bankruptcy.
While the commission acknowledged that existing UK legislation has been adequate in accommodating digital assets thus far, it emphasized the presence of residual legal uncertainties as the market continues to expand and evolve. In addition to addressing collateral-related concerns, the commission advised policymakers to review the laws governing the tokenization of equity and other corporate securities by UK firms, with the aim of clarifying and potentially expanding the range of legally permissible blockchains and arrangements for such activities.
The commission also suggested that lawmakers consider how a legal framework for crypto collateral could differentiate between off-chain and on-chain arrangements, as well as its interaction with broader financial markets.
The goals of the Law Commission align with UK Prime Minister Rishi Sunak’s vision of transforming the country into a prominent hub for digital assets. The regulatory clarity provided by the UK, as opposed to the legal challenges faced by cryptocurrencies in the United States, has been commended by Coinbase CEO Brian Armstrong.