Researchers at the Leiden Law School have argued that there’s currently a lack of clarity regarding the legal proceedings and investor rights if digital asset custodians become insolvent.
Matthias Haentjens, Tycho de Graaf and Ilya Kokorin from Leiden Law School noted in a paper titled, “The Failed Hopes of Disintermediation: Crypto-custodian Insolvency, Legal Risks and How to Avoid Them,” that they looked at how customers’ Bitcoin (BTC) deposits are managed by leading US-based exchanges including Coinbase, Gemini, and Kraken.
The researchers found that the rights of clients, if an exchange becomes insolvent, largely depend on applicable insolvency and property laws. However, this may be “complicated by a lack of harmonized private international law rules” that would specifically apply to cryptocurrencies and the business relations between digital asset custodians and their clients.
Going on to cite the Hague Securities Convention as a way to determine the relevant property laws, the Leiden Law research team said that contractually agreed-upon laws would be given priority, as they apply to contracts between the crypto-asset custodians and their customers.
The research team claims that it’s relatively simple or easy to check if the concerned parties are meeting obligations, which helps with providing legal clarity and predictability.
The researchers pointed out that customers’ revendication claims were rejected by courts who cited the cases of MtGox and BitGrail, two hacked digital currency exchanges that were forced to shut down.
The research paper argues that this could be because Bitcoin (BTC) can’t be treated as the object of ownership or because of complications created by commingling deposited digital assets.
Dutch law says that the situation may lead to different results or scenarios if an exchange is able to prove that individualized bitcoins kept with a custodian were not spent or reused for some other purpose.
Blockchains, by design, don’t let users commingle Bitcoins or other cryptocurrencies. This makes it easier to keep track of blockchain or distributed ledger technology (DLT)-based asset transfers. Users can accurately verify the amount of BTC (or any other digital asset) that is being managed by a custodian.
A users’ rights to their Bitcoin holding may be absolute according to applicable property law. The researchers note that if someone can provide the right public and private key-pair to a Bitcoin address to miners or transaction validators first, then they will have their transaction accepted. This may be the case even if they are not the actual owner of the cryptocurrency, the researchers claim.
Pooled custody involves potentially greater risks to clients because the deposited digital assets originally sent to one client may be used in a transaction involving a different party. This suggests that clients must know beforehand if and how their custodians will be using the deposited funds.
The researchers said that digital asset investors must know or be informed about whether the custodian will be using their deposited cryptocurrency.
Customers must also be aware of the fact that an investor’s claim to get back their bitcoins from an insolvent custodian may be considered contractual or “proprietary in nature.” Clients must also be aware that a custodians’ reuse of deposited funds may be restricted or completely prohibited.