Highlights:
- US Commercial law (UCC) has concepts relevant to stablecoins incl. settlement finality
- Adverse claims – if someone innocently receives stolen coins usually they can keep them
- Discharging obligations – if payee hasn’t agreed to the mode of payment can reject it
- For stablecoins backed by short terms securities the holder has direct claim on assets
- Commercial law is not a perfect fit. Is issuer a bank? Bankruptcy is unclear
Back in February, the Berkeley Business Law Journal featured a paper about stablecoins. “How to Build a Stablecoin: Certainty, Finality, and Stability Through Commercial Law Principles” is written by Jess Cheng, in her personal rather than work capacity. Cheng is currently Senior Counsel at the Federal Reserve Board in Washington DC. She was previously with the IMF and Ripple.
The issue of legal certainty was highlighted in the Financial Stability Board’s recent stablecoin report for the G20. One of its ten recommendations was to provide legal clarity on redemption rights.
And the mother of all stablecoins Libra updated its whitepaper earlier this week with substantial changes. On the same day, Congresswoman Sylvia Garcia repeated that Libra remains a security, and she has a Bill to treat all stablecoins as securities.
Part of the motivation behind Cheng’s 27 page Berkeley paper is to encourage competition and show the fintech community that the legal aspects of stablecoins can be accessible and are not only possible for massive players like Libra.
Ultimately the purpose of stablecoins is to act as a medium of exchange, and Cheng’s goal is to enable technologists to move fast, but safely. Cheng told Ledger Insights: “The article is meant to be a constructive “how to” on how innovators can incorporate novel, technology-driven market practices and business models into the existing financial law framework in a proven and effective way — how to leverage what is working today and doesn’t need to be reinvented.” It’s well worth the read.
So does Cheng think Libra will be a security? She wouldn’t comment. The paper notes: “As the market has learned from Libra’s radical proposition, stablecoin arrangements can pose conceptual problems and create new incompatibilities that did not previously exist in what had been the simple, clear-cut world of payments and the separate world of investment securities.”
And the document outlines how a stablecoin’s classification depends on its design. It could be considered as (one or more of) a currency, a payment instrument, an investment security or a commodity.
U.S. commercial law and specifically the Uniform Commercial Code (UCC) can be applied to stablecoins. Plus, the UCC provides some protection against case law, because statutes overrule case law where there’s a conflict.
The UCC covers negotiable instruments, funds transfer (except consumers), investment securities and security entitlements.
Four handy commercial law concepts
The paper explores four concepts implemented in commercial law that apply to stablecoins.
The first is settlement finality, which provides clarity in situations when a counterparty becomes insolvent. The paper describes a fictional stablecoin case that bears a strong resemblance to the one that gave rise to the concept of Herstatt Risk. What happens when there’s an exchange of a bank balance for stablecoins (not involving the stablecoin issuer) and one of the legs fails? Here commercial law rules govern finality and hence provide certainty for both payments and securities settlement.
The second concept is the rule of adverse claims. ‘True Owner’ has the keys that control their stablecoin stolen by ‘Thief’ who passes the tokens to ‘Innocent Transferee’ who acts in good faith. The question is, who has legal title to the coins? Under normal property law, the answer would be ‘True Owner’. But in a marketplace this could cause havoc, so specialized commercial law rules of ‘adverse claims’ kick in, and the ‘Innocent Transferee’ would be free of most claims and retain ownership. This applies to a check, negotiable instrument, investment security and security entitlement, with some provisos.
Thirdly, there’s the idea of discharging an underlying obligation. The question is when has each party delivered their side of the bargain? For example, if the other side was expecting cash and you deliver stablecoins, is your obligation discharged?
The UCC has rules for checks and the point at which the payer has done their bit. It’s simpler because the recipient receives the check and actively deposits it. But for push transactions like funds transfers, which can happen without the payee’s acceptance, the payee can choose whether to accept or reject a transfer as payment. The same would apply to stablecoins. But this can be overridden by agreement in a contract.
The final concept is security entitlement, which states that intermediaries hold assets on behalf of security holders, so the security holder has the ownership rights. If the stablecoin is backed by something other than cash deposits in a local currency, it could be considered as investment property under the UCC. So, for example, if short term government securities backed it.
Furthermore, the Supplemental Commercial Law for the Uniform Regulation of Virtual Currency Businesses Act (Supplemental Act) which can be adopted on a state by state basis, aims to explicitly treat a virtual currency as a financial asset and investment property, without classing it as a security.
For investment property, commercial law gives legal recognition to security entitlement, which essentially means the coin issuer would be treated as a securities intermediary.
The fit is not snug
However, commercial law doesn’t have all the answers, and trying to retrofit the rules to stablecoins doesn’t always work neatly.
The UCC explicitly allows not just for contract rules but also sets of rules designed for private sector “systems”, and stablecoins behave very much like systems. In the case of stablecoins that are backed by cash deposits, applying something similar to the system rules used by the Clearing House Interbank Payments System (CHIPS) might be a better fit.
Also, the UCC code has some awkward definitions. For example, it is unclear whether or not a stablecoin issuer might be considered a bank. And even whether or not a stablecoin is money, especially if it is backed by a basket of cash and government securities. This is an area of law that’s getting some attention.
And finally, there’s the issue of bankruptcy. Even if under normal circumstances the stablecoin holder has a right to part of the bank deposits under commercial law, bankruptcy is something else. If the stablecoin issuer goes bankrupt, it’s a lot less clear whether or not the issuer’s creditors might have claims on the stablecoin assets.
The paper concludes: “The question remains as to what a given coin actually is as a legal matter: is it a payment instrument (designed to be used as medium of exchange) or a security (designed as an investment or risk-shifting medium)?
It continues: “Nevertheless, the UCC was designed to anticipate innovations in market practices and business models. It is this legal insight, as well as awareness of the commercial law tools available within the UCC, that will help clever stablecoin innovators to quickly but safely build a sound legal basis for market practices around their coin and enable innovative business models to thrive within our financial system.”
The author is not a lawyer and this information cannot be relied upon.
