The outbreak of COVID-19 has led to significant limitations on trade and travel, severe economic stress and massive state interventions. This has been reflected in the financial markets and led to extreme volatility. Similar to the Global Financial Crisis of 2007/8, current financial market volatility has put the spotlight on cryptocurrencies such as Bitcoin, as a possible source of liquidity and a safe-haven asset. At the same time, it is widely recognized that cryptocurrencies may be used to launder money, evade capital controls and taxes, and finance crime. They also pose serious risks for crypto-investors, especially when the services of crypto-exchanges and other crypto-custodians are used.

In the paper ‘The Failed Hopes of Disintermediation: Crypto-custodian Insolvency, Legal Risks and How to Avoid Them’, we explore the legal risks involved in depositing cryptocurrency with crypto-custodians such as crypto-exchanges when they become insolvent, and suggest ways how regulation and practice can mitigate such risks. The custody of cryptocurrencies merits close investigation, as most cryptocurrencies now seem to be held through custodians rather than by crypto-investors directly.

The founding fathers of cryptocurrencies, however, wished to free value transfers from the interference of governments, banks, brokers and other intermediaries. It was the control by, and frequent failure of such intermediaries, as well as the high transaction costs arising from their involvement that created a fertile environment for bitcoin’s origins. In reality, such disintermediation has not occurred and a large number of bitcoins and other cryptocurrencies are currently stored with crypto-exchanges. While such custody may be attractive because it is (usually) free of charge and user-friendly, it creates significant risks related to the possible insolvency of crypto-custodians.

Recent years have witnessed the demise of crypto-exchanges such as Cryptopia (New Zealand), QuadrigaCX (Canada), BitGrail (Italy), Cointed GmbH (Austria) and a host of other crypto-exchanges around the world. These cases demonstrate that the qualification of contractual and property law rights of crypto-investors is problematic. This is why our paper discusses which rights crypto-investors or customers of crypto-exchanges can and should be able to assert in case of insolvency of a crypto-custodian. To answer this question, the (legal) qualification of bitcoin is analysed (can it be owned and if so, how can such ownership be created and transferred?) and the status of deposited bitcoins is assessed (do stored crypto-assets form a part of the crypto-custodian’s insolvency estate or can they be revendicated by customers?). Private international law aspects form the starting point of our legal analysis (which court has jurisdiction to open insolvency proceedings and hear crypto-investors’ claims, and what law applies to such claims?). The analysis is based on the terms and conditions of the major crypto-exchanges such as Coinbase, Gemini, Kraken, and Bitfinex.

Some of the key findings of our paper are the following. First, rights of customers in insolvency proceedings ultimately depend on the applicable insolvency and property law. Determination of the applicable law is therefore critical. However, it is complicated by a lack of harmonized private international law rules that are appropriate for the specific nature of cryptocurrencies and the relations between customers and crypto-custodians. Traditional connecting factors, such as lex rei sitae or the location of a physical carrier or an account are ill-suited for blockchain transactions and cryptocurrencies in general. If a customer’s claim for the retrieval of bitcoins from a crypto-exchange is to be qualified as proprietary in nature, we argue in favour the amended version of the Hague Securities Convention to determine the applicable property law. This approach would give priority to the contractually agreed law between a customer and a crypto-custodian, with the fallback option of applying the law of the crypto-custodian’s place of incorporation. Both of these connecting factors are easily verifiable by the relevant parties involved, and thus should guarantee legal certainty and predictability.

Second, in the MtGox and BitGrail cases, the courts refused customer’s revendication claims, either on the basis that bitcoin cannot be the object of ownership (MtGox) or due to the commingling of deposited crypto-assets (BitGrail). Under other laws such as Dutch law, the result may be different, provided that a customer of a crypto-exchange can prove that individualized bitcoins deposited with a crypto-custodian have not been spent or re-used, ie transferred to third parties. It is important to note that unlike cash on a bank account, the technical features of blockchain do not allow the commingling of bitcoins. Thus, it is possible to trace each on-chain transaction and value assigned to it and to show proof that the exact deposited bitcoins have not been spent and remain on the blockchain address of the crypto-custodian. We demonstrate such traceability of blockchain entries with a case study and a number of real-life transactions on blockchain.

Third, from a property law perspective, rights to bitcoins can be qualified either as absolute rights or rights embodied in a documentary intangible, ie the physical carrier containing the wallet in/or which the public and private keypair of the blockchain address is stored. Whether a certain legal system allows for bitcoin rights to be made to bearer, depends on the law applicable to such rights. The Netherlands, for instance, has an open system of documentary intangibles which allows parties to put their rights to the bearer of a documentary intangible. In case of exercising rights on blockchain, whoever presents a public and private keypair to a particular blockchain address to the miners and nodes first (in the same way that a bill of lading can be presented to a carrier to effectuate the rights embodied in the bill of lading), is the one whose transfer will be accepted, even though the person presenting those keys might not be the real owner of the bitcoins in question.

Fourth, crypto-custodians store cryptocurrency for customers roughly in two ways: in a pooled (omnibus) blockchain address (eg Coinbase, Wirex, OKEx) or in the segregated blockchain addresses (eg Gemini). Pooled custody presents higher risks for customers, since the operation of a pooled blockchain address makes it highly likely that the deposited bitcoins originally allocated to one customer are used for the benefit of another customer (eg when another customer withdraws bitcoins from the crypto-exchange). Such re-use will oftentimes bar a revendication claim in case of insolvency. In any circumstance, customers of crypto-exchanges should be well informed whether the crypto-custodian uses or may use the deposited bitcoins.

Fifth, in order to protect customers against the risk of crypto-custodian insolvency, it could be considered to prohibit or limit the re-use of the assets deposited. The risk that such a prohibition is violated can be diminished if the deposited bitcoins are stored in segregated (separate) blockchain addresses rather than in omnibus or pooled addresses. Inspiration for this type of regulation can be drawn from Article 16(8) MiFID II (2014/65/EU), which prescribes that when holding financial instruments belonging to clients, an investment firm shall ‘make adequate arrangements so as to safeguard the ownership rights of clients, especially in the event of…insolvency, and to prevent the use of a client’s financial instruments on own account except with the client’s express consent’. Along the lines of 15 of the Securities Financing Transactions Regulation (2015/2365), the reuse of financial instruments may be subject to at least two conditions: (1) appropriate information of the party providing financial instruments (providing counterparty) and (2) prior express consent in writing given by such a party.

Matthias Haentjens is Professor of Law at Leiden Law School.

Tycho de Graaf is Associate Professor of Law at Leiden Law School.

Ilya Kokorin is a PhD Candidate at Leiden Law School.