By Dr. Philipp Paech, Attorney-at-law, Associate Professor of Financial Law, London School of Economics, and Elisabeth Noble, Senior Policy Expert, European Banking Authority, Visiting Fellow Robert Schuman Centre for Advanced Studies
With the total market capitalisation of crypto-assets again nearing $1 trillion, it is clear that crypto-assets and associated services are continuing to proliferate with increasing cross-border application.
Theoretically, the capacity to scale the associated technologies across borders is limitless. In practice, however, scaling is currently constrained, including by interoperability and standardisation issues, divergences in regulatory and supervisory approaches, and legal risk as regards the enforceability of claims in the event of dispute or insolvency.
Legal risk is a growing focus in emerging policy measures, including the latest Basel Committee on Banking Supervision (BCBS) consultation on the prudential treatment of banks’ exposures to crypto-assets (June 2022),1 which sets out clear expectations for “legal enforceability”. But how is this to be achieved when different parties may assert that a different jurisdiction’s law applies to an asset or system? In this article, we reflect on the importance of clear rules in private international law—i.e., the rules that tell the parties and courts which law applies to a specific legal question and explain how clarity will help achieve legal certainty for crypto-assets and crypto-asset systems.
Legal certainty: a fundamental condition for a functioning global financial system
Legal certainty is a critical prerequisite for a well-functioning financial system. Without it, financial-market participants cannot give accurate assessments of the legal enforceability of their positions should a matter be disputed or insolvency arise.
In turn, without confirmation of legal enforceability, under the requirements set out in the Basel Accords and other international and national standards, financial institutions cannot secure compliance approval to enter into financial transactions, benefit from lower-risk weights under capital rules or secure eligibility to use assets for certain financial processes—for instance, as financial collateral.
Knowing which State’s law applies (jurisdiction A, B, C, or D…) to relevant assets or arrangements, including a counterparty’s insolvency, is logically the first step in establishing legal certainty.
In some instances, the financial sector’s rules make this job easier by mandating which laws apply to specific situations. For example, Directive 2002/47/EC of the European Parliament and of the Council of 6 June 2002 on financial collateral arrangements (the Financial Collateral Arrangements Directive or FCAD) sets out how the applicable law is identified in relation to book-entry securities collateral. By way of another example, Directive 98/26/EC of the European Parliament and of the Council of 19 May 1998 on settlement finality in payment and securities settlement systems (the Settlement Finality Directive or SFD) makes clear the applicable law that applies in the event of the insolvency of a participant in a securities-settlement system. As a consequence, all courts within the European Union (EU) would reach the same outcome if asked to adjudicate on which is the applicable law. Similar rules at the international level—in particular, a convention drawn up under the auspices of the Hague Conference on Private International Law (HCCH)—determine for adhering states which law applies to securities held through a chain of custodians located in different jurisdictions. This convention has been signed by the United States and Switzerland, while EU Member States rely on the rules set out in the FCAD.
However, while traditional finance, to some extent, benefits from clear rules of private international law, crypto-assets and systems lag behind in terms of clarity regarding the applicable law.
Legal (un)certainty in the crypto-asset sector
Crypto-assets take many forms, and their legal characteristics and consequent regulatory classifications require a case-by-case analysis.
When crypto-assets take the form of tokenised traditional financial instruments, in the EU, the “normal” financial acquis apply—including the rules relating to legal enforceability contained in the FCAD and the SFD. However, issues may still arise even when the scope of application is clear. For instance, the FCAD defines the applicable law using the location of the relevant securities account as a “hook”, but in a given case involving crypto-assets, there may not be any account, as distributed ledger technology (DLT)-based holdings are held in a distributed manner.
For other types of crypto-assets (i.e., those that are not regarded as financial instruments), there are no specific rules at all. This does not mean that these crypto-assets transact in a “lawless space”, but it does mean that parties may have an absence of clarity as to which jurisdiction’s law governs claims relating to those assets.
Consequently, parties to a transaction within a crypto-asset system may make different assertions based on legal doctrines in their own jurisdictions or may content themselves by choosing the law that appears “nearest” to their cause or the one they regard as most favourable.
At the same time, the more decentralised the crypto-asset landscape becomes, the more limited the parties’ influence over the question may become.
Legal certainty and the regulatory implications
Not knowing precisely which law applies significantly complicates any assessment of the legal enforceability of rights over crypto-assets in the event of a dispute or insolvency. This may sound like a technical matter confined to the structuring of specific transactions, but it has wider and more meaningful prudential and other regulatory consequences.
For example, the BCBS, in its second consultation on the prudential treatment of crypto-asset exposures, specifies that to qualify for Group 1 capital treatment, which is more favourable than Group 2, “all rights, obligations and interests arising from the crypto asset arrangement are clearly defined and legally enforceable in all the jurisdictions where the asset is issued and redeemed” (classification condition 2, emphasis added).
Similarly, the Financial Stability Board (FSB), in its “Review of the FSB High-level Recommendations of the Regulation, Supervision and Oversight of ‘Global Stablecoin’ Arrangements: Consultative report” (October 2022),2 proposes that authorities should require that “[global stablecoin arrangements] provide a robust legal claim to all users against the issuer and/or underlying reserve assets and guarantee timely redemption” (emphasis added).
However, because many crypto-assets and systems on which crypto-assets are transacted currently fall outside of traditional financial-services laws (and, therefore, any specific rules that expressly identify how a governing law is to be established), there is no general answer to whether something is “legally enforceable” or a legal claim is “robust”. Instead, these questions can only be answered in relation to a specific governing law; however, as set out above in the absence of clear express agreement by the parties, there may be no clear answer to the question of which is the applicable (i.e. governing) law and whether, under that law, the claim is enforceable.
So, how can this situation be resolved?
Complementary improvements: clarifying and harmonising private international law
The rules of private international law determine which (national) law governs the various relationships between different parties (legal or natural persons) in an international context. A court uses its own jurisdiction’s rules of private international law to find out to which law to look to determine the enforceability of a right. For example, an English court may find that French law determines whether a party has a claim to a crypto-asset or not (and will probably ask a French legal expert for his or her opinion in this regard).
If there are, within a given jurisdiction, clear private international law rules as to which law applies to the acquisition and disposition of crypto-assets—great! However, if these rules are unclear (or do not apply at all) concerning crypto-assets, the parties may face the problems identified above. Therefore, all jurisdictions should assess their own rules of private international law regarding the application and suitability of crypto-assets.
Some jurisdictions are already acting. For instance, the Government of the United Kingdom recently asked the Law Commission of England and Wales to undertake a project entitled “Digital assets: which law, which court?”3 to clarify how national rules of international private law apply to crypto-assets.
Ideally, any reforms should be coordinated between jurisdictions because significant uncertainty can be instilled if the private international laws of different jurisdictions use different criteria to determine the applicable law—potentially leading to different outcomes. This is especially relevant for markets with actual or potential international or global reach—such as the crypto-asset sector.
International harmonisation can improve this situation—as evidenced by the FCAD and SFD as well as the Hague Securities Convention, which provide good examples of the tangible benefits to be gained from coordinated reforms.
However, harmonising rules of private international law between jurisdictions can be a complex business because states’ internal rules are calibrated to match the remainder of their laws; hence, states may typically be reluctant to commit to a change.
So, for crypto-assets that are not within the scope of existing financial laws, is anything being done?
The International Institute for the Unification of Private Law (UNIDROIT)4 has established a Working Group with the objective of developing principles and legislative guidance regarding the law of crypto-assets. This effort is intended to promote global convergence in the rules of private international law regarding crypto-assets; in the ideal case, jurisdictions will follow the resulting principles and guidance, and the identification of the law governing crypto-assets will follow clear, common international standards.
Overall, the initiative will be crucial in facilitating the modernisation of the rules of international private law for innovative financial products and services. As seen from the draft BCBS requirement cited above, regulation will penalise situations in which the legal framework is not clear and legal risks arise. Therefore, the UNIDROIT project is a necessary complement to international initiatives to promote convergence in regulatory and supervisory approaches to crypto-assets and overcome inadvertent impediments to cross-border scaling. The project is also of wider relevance to digital assets, including digital art, tokenised real estate and even central bank digital currencies (CBDCs). We will explore these subjects in more detail in our upcoming paper, “Crypto-assets and the case for common private international law,” which will be released on SSRN (formerly Social Science Research Network) in early 2023.
The views expressed in this article are Elisabeth’s (and her co-author’s) and should not be taken to represent those of the European Banking Authority (EBA) or to state EBA policy. Neither the EBA nor any person acting on its behalf may be held responsible for the use to which information contained in this publication may be put or for any errors that, despite careful preparation and checking, may appear.
1 Bank for International Settlements (BIS): “Basel Committee publishes second consultation document on the prudential treatment of banks’ cryptoasset exposures,” June 30, 2022.
2 Financial Stability Board (FSB): “Review of the FSB High-level Recommendations of the Regulation, Supervision and Oversight of ‘Global Stablecoin’ Arrangements: Consultative report,” October 11, 2022.
3 Law Commission: “Digital assets: which law, which court?”
4 UNIDROIT: International Institute for the Unification of Private Law
Elisabeth Noble is a Senior Policy Expert and Team Leader at the European Banking Authority (EBA). She leads the EBA’s work on crypto-assets, DLT, MiCA implementation and structural change in the EU financial sector. She represents the EBA on EU and international standard-setting workstreams relating to FinTech, market access and the regulatory perimeter.