The Law Commission of England and Wales publishes new proposals to reform the law relating to digital assets  

On 28 July 2022, the Law Commission of England and Wales (the “Commission”) published a consultation paper (the “Paper”) on Digital Assets where it considers property rights issues, and specifically, private personal property law, in relation to digital assets (“Digital Assets”). The Commission acknowledges the importance of Digital Assets in a modern society and discusses how the evolvement of legal regulatory development can enable Digital Asset technology to continue to evolve for the future. While the law of England and Wales does accommodate Digital Assets, certain areas of the law need reform to ensure that Digital Assets benefit from legal recognition and protection, such as new reforms on personal property law and how it applies to Digital Assets.

background

What is a Digital Asset?

Digital Assets use electronic files of data, that can be used to make transactions, or to store intangible assets, examples include:

  • Cryptocurrencies: any form of currency that exists digitally or virtually and uses cryptography to record transactions. For instance, crypto tokens are a type of cryptocurrency that represent an asset or facilitate a specific use which may be used for purchase and/or investment purposes).
  • Cryptoassets: a digital representation of value that can be transferred, stored, or traded electronically and can be used for payment and/or investment purposes. This includes non-fungible tokens which can come in the form of art, music, and videos.
  • Asset-Backed Tokens: these are physical assets, such as gold and oil. They can be tokenised and traded on a blockchain through the use of asset-backed tokens.

Ownership of such Digital Assets are held on decentralised databases, or an electronic ledger, known as a blockchain; this is where information on transactions is recorded in blocks of data which are chained together and are placed in a specific order, and is protected using computers, or nodes, before being added onto the ledger. This unique structure makes transactions efficient and allows users to transfer Digital Assets without having to depend on an intermediary.

Digital Assets and their importance in modern society

Digital Assets offer various products and services and provide opportunities in the world of business and the financial services sector, such as:

  • Reduction in use of Intermediaries: the use of Digital Assets, used with electronic ledgers, known as blockchain, reduces the number of intermediaries required and improves efficiency. There is no requirement to have an intermediary such as a clearing agent or a bank, saving time and costs, because of the decentralised database.
  • Transparency: as Digital Assets are distributed on a blockchain, this improves transparency allowing investors to have easier access to asset documentation and relevant information. Increased transparency also gives financial institutions the confidence to provide more competitive loans.
  • Availability in different jurisdictions: the various products and services of Digital Assets are available at any time and, any place. Transactions made between two banks in different jurisdictions may take a few days to clear, however, by digitalising the asset, payment can be made instantly.

Personal property law and Digital Assets

In the United Kingdom (“UK”), in order for an asset to fall under the definition of property in the legal sense, legal ownership by a natural or legal person must be established. Once legal ownership is established, property can be used as security or consideration. Such property can come in two forms: real and personal. Real property includes, lands, buildings, structures, roads, and anything that is man-made. Personal property on the other hand, is property that can be owned by an individual, such as, objects and tangible items.

Digital Assets are intangible and at present, issues remain as to their legal standing, and specifically, whether they fit into the current property law definition in the UK. Digital Assets do not exist in one place, and instead exist online connected via a global network, and are held on blockchains, where no one entity or place holds the final record. Such assets are quasi financial investments; this means that there are a number of contracts involved between buyers, sellers, operators, and facilitators. Concerns remain over how UK law handles disputes that arise in relation to Digital Assets, such as ownership rights, and rights to title.

FACTUAL background proposals set out by the law commission

The Commission published the Paper which contains provisional law reform proposals that aim to ensure the legal recognition and protection of Digital Assets (including crypto-tokens and cryptoassets) for the future of the digitalised world. In the Paper the Commission states that some Digital Assets (including crypto-tokens and cryptoassets) are treated as objects of property by market participants and should thus, be recognised by the law. The Commission further argues that certain aspects of the law need to be reformed in relation to personal property rights. Reforming the law will provide certainty and set a strong base for the development of Digital Assets and will also incentivise the use of English and Welsh law and the jurisdiction of England and Wales in transactions concerning Digital Assets. The key proposals made by the Law Commission in the Paper include among others, the following:

  1. Proposed third category of personal property

Digital Assets currently do not fit under the categories of personal property of things in action. The Commission proposes the need for a third category of personal property established under UK property law.

According to the Commission, in order for a ‘‘thing’’ to fall within the proposed third category of personal property, it must be characterised as a data object. Data objects should have the following three characteristics:

  • Data represented in an electronic medium: The object must be comprised of data, which is represented in an electronic form such as, computer code, electronic, digital, or analogue signals which is required in order to distinguish between the third category of data objects and the first category of things in possession.
  • Independent existence: The object must exist separately from the legal system (as long as it is treated separately from a thing in action and that the Commission consider would be excluded as a data object, even if in digital form).
  • Rivalrousness: The object must be rivalrous (a resource is rivalrous if use by one person necessarily prejudices the ability of others to make equivalent use of it at the same time).
  1. Transfers of Digital Assets

When a Physical Asset is transferred from one person to another, that property remains in its original form. The transferee receives the property the transferor had in possession. The transferee becomes the legal owner or may have an equitable interest in the property. The Commission discusses how ownership can be transferred during the transfer of a crypto token, and what happens on a transfer.

The Law Commission explains that currently it is the assumption that on a transfer of a Digital Asset, a new digital asset is created on each occasion. For instance, the transfer of a crypto token results in the replacement, modification, or elimination of a pre-transfer crypto token. The Commission states that crypto tokens are represented by sets of data, which may be subject to change on a transfer, the concept of them not being able to be exchanged or mixed is an incorrect way of representing the transfer of ownership to the asset. The substance of the property qualities and values embedded in the token remains absolute and is in fact not altered by a transfer action.

  1. Custody arrangements for crypto tokens

A custodian within the context of a crypto token, means a person holding crypto tokens on behalf of, or for another person, this may be for improving the security of their holdings (holding refers to a custodian having the capacity to exercise, or to coordinate or direct, the exercise of factual control), or having access to different trading markets, with access to different token functionalities. In such circumstances, the owners of the token do not have direct control of the arrangements, as it will be controlled by other persons.

In the Paper the Commission discusses various crypto token structures and lists the options and legal frameworks for what a custody arrangement is, based on the current contract and frameworks. The Commission refers to the distinction of ‘direct custodians’ (those who have control over a crypto token or other Digital Asset) and custodial/technology and hybrid service providers. Therefore, the Commission recommends that firms should consider whether the solutions they currently use to hold clients’ crypto tokens fall under the category of ‘direct custodian’ and whether this is appropriate. Thus, the Commission provisionally concluded against law reform amounting to a default rule of interpretation that crypto token direct custody arrangements take effect as trusts, in the absence of an explanation to the contrary.

next steps

The Commission’s recommendations are designed to ensure that the law remains dynamic, operative, competitive, and flexible, so that it can support transactions or other arrangements involving the technology. The Commission aims to deliver wider recognition and legal protections for Digital Assets, in turn allowing a diverse range of people, and companies to interact and benefit from Digital Assets, encouraging and furthering technological innovation.

The consultation remains open for interested parties to submit their responses using the online form or by emailing digitalassets@lawcommission.gov.uk by 4 November 2022.

To access the Consultation Paper, click here.

For more information, and any guidance or advice on the reform of the law relating to Digital Assets, Cleveland & Co External in-house counsel™, your specialist outsourced legal team, are here to help.

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