DeFi Common Sense: The Risks of Crypto-backed Lending

Decentralized finance (‘DeFi’) through smart contract technology has been touted as a major use case for blockchain technology ever since the launch of the Ethereum blockchain. One area within DeFi that received particular interest from an early stage is secured lending. Yet, in both Commonwealth and UCC jurisdictions, doubts exist over how such assets function as a security, many of which stem from continuing uncertainty over the jurisprudential nature of cryptoassets as property. It has been suggested that it is unclear whether cryptoassets fall within the scope of Article 9 of the UCC, although it is probable that they might be regarded as a ‘general intangible’ under the category of ‘personal property.’ Even if they do, there is uncertainty over how security interests in cryptoassets are created, perfected, and traced.

Across the Atlantic and throughout the Commonwealth, the nature of property in cryptoassets remains hotly debated: see, for example, Low and Teo, ‘Bitcoins and other cryptocurrencies as property?’; Fox, ‘Cryptocurrencies in the Common Law of Property’; Chan, ‘The Nature of Property in Cryptoassets’. In July 2022, the UK Law Commission released a compendious consultation paper containing suggestions on property law reform to accommodate cryptoassets. Many aspects of this ongoing conversation are capable of application across different jurisdictions. Indeed, the bankruptcy judge overseeing the Celsius proceedings went out of his way to indicate to the parties that legal principles applicable in the UK may be persuasive. That comparative inclination is also reflected in the developing crypto jurisprudence of other Commonwealth jurisdictions such as Singapore, New Zealand, and Hong Kong. In particular, given Singapore’s early efforts to attract investment from the crypto world, it is unsurprising that it has been the source of many interesting decisions.

One such case is the decision of the Singapore High Court in Janesh s/o Rajkumar v Unknown Person (“CHEFPIERRE”), which is the subject of our forthcoming note. This case is particularly interesting because it is believed to be the first reported judgment involving a property dispute specifically over a DeFi arrangement (particularly a DeFi security arrangement). In this case, a borrower applied (successfully) for an interlocutory proprietary injunction to restrain a lender from dealing with an NFT that the borrower had previously provided as security for a loan on a DeFi platform known as ‘NFTfi.’ The latter describes itself as a ‘simple p2p marketplace for collateralized NFT loans’ and has reportedly facilitated more than 35,000 loans with a cumulative loan volume of $365 million at the time of writing.

Two aspects of the case are noteworthy. First, in granting an interlocutory proprietary injunction, the court followed a number of earlier Commonwealth judgments in recognizing cryptoassets as property. But, importantly, the court expressed reservations about the recent judicial trend of focusing on what is known in those jurisdictions as the ‘tertium quid’ argument and the Ainsworth test (from the case of National Provincial Bank v Ainsworth [1965] 3 WLR 1). In our note, we argue that both do little to justify the recognition of property in cryptoassets. While internal difficulties plague these doctrines, even taken at their highest, they do not amount to positive arguments regarding a new ‘thing’ as property. We suggest that it is time for the courts to grapple squarely with that question. They should begin articulating normative reasons for why cryptoassets should be regarded as property, such as the institutionalization of social conventions. Courts have historically been reluctant to recognize new forms of property rights because of the political nature of this question. Yet, if conceptualized narrowly as some form of control over a ledger entry, it is hard to see how recognizing property rights in cryptoassets could interfere with the legitimate liberties of others. It follows that it is crucial for the courts to articulate why cryptoassets constitute property and explain what rights follow.

The second and equally interesting point is the DeFi angle to the dispute. Since Chefpierre was an interlocutory decision, the full ramifications of NFTfi’s DeFi arrangement were not explored. Yet, the case demonstrates the extensive legal uncertainty and commercial risks involved in such arrangements, some of which have not been fully appreciated nor priced in. One such issue arises from the ongoing uncertainty over the nature of property in cryptoassets, as we have explained above. The NFTfi platform holds the NFTs put up as security in an ‘escrow smart contract’ until the borrower either repays or defaults; in the latter scenario, the lender can ‘foreclose,’ unilaterally transferring the NFT to themselves. But while the NFT is held by the smart contract, who has property in the NFT? This is not a true escrow arrangement. The smart contract has no legal personality and cannot be the owner. It seems, therefore, that it is necessary to resort to the parties’ intentions regarding the proprietary consequences of their transaction, however poorly formed they may be. Even where the relevant terms can be ascertained, the courts may face difficulties in characterization. As we explain, in NFTfi’s case, no traditional form of security fully reflects the parties’ intention. While parties advising on or contemplating entering into DeFi arrangements may be conscious of risks arising from market fluctuations, counterparty default, and regulatory compliance, there has been little discussion of the characterization risks involved.

Admittedly, legal risks have seldom restrained innovation. Yet, crypto-backed lending involves unusual commercial risks that ought to give most investors pause. Such assets are notoriously illiquid and volatile: how does one hedge against the market when token prices can fall by 98 percent within 24 hours? Illiquidity and volatility may not be fatal to using assets as security per se. However, they pose particular risks in a broader market filled with questionable risk-management practices, rife with extraordinary leverage, and vulnerable to cross-institutional contagion. In the aftermath of 2022’s spectacular collapses (such as Three Arrows Capital; Celsius; Voyager; FTX), there is no doubt that more cases involving smart contract technology will come before courts worldwide. It is, therefore, worth pondering on Chefpierre, if only as a preview of what is to come.

Kelvin Low is a Professor at the National University of Singapore.

Timothy Chan is a Sheridan Fellow at the National University of Singapore.

This post first appeared on the Duke Financial Economics Center’s FinReg Blog on 30 March 2023.