[Crypto Bankruptcy Series] Staking, Yield Farming, Liquidity Mining, Crypto Lending – What are the risks for the customer?

By Matthias Lehmann et al. (University of Vienna)

Matthew Lehmann

Note: This post is the fourth in a series of posts about cryptocurrency company bankruptcies and the issues that are emerging. Previous posts in the series include:

1. The FTX Bankruptcy: Week One Filings, Litigation and Other Unusual Developments, by Megan McDermott

2. Quantifying Cryptocurrency Claims in Bankruptcy: Does the Dollar Still Rule Sovereign?, by Ingrid Bagby, Michele Maman, Anthony Greene, and Marc Veilleux

3. The Public and Private of the FTX Bankruptcy, Diane Lourdes Dick and Christopher K. Odinet

This series is administered by the Bankruptcy Roundtable and Xiao Ma, SJD at Harvard Law School, xma [at] see [dot] Law [dot] Harvard [dot] education.

Check the HLS Bankruptcy Roundtable regularly for additional input from academics and practitioners from institutions across the country.

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The consequences for customers if a crypto exchange like FTX goes bankrupt are huge, but they can be even more severe if they previously used their digital assets or were involved in a similar transaction. Indeed, it is not unreasonable to fear that a bankruptcy court could interpret such a transaction as a transfer of assets to the exchange or to a third party. In this case, the crypto assets – bitcoin, ether or token – would be considered part of the bankruptcy estate or property of someone else. The customer would have no title to it and would be relegated to mere creditor status with the prospect of receiving only a fraction of the asset.

It is of crucial importance how the relevant transaction is to be characterized from a legal point of view. Characterization is the process by which an empirical phenomenon is assigned to a particular legal category. This exercise is not always easy, and it is especially difficult in terms of operations in the crypto space. There is little literature on them because, for the most part, they are novel and unprecedented. The legal nature and effects of such transactions depend primarily on the conditions to which they are subject. But many of them use very general terms and are legally imprecise. In order to achieve unambiguous results, a court will likely attempt to intuitively place the transactions described into a known category. This will be important in two ways.

First, the category chosen for a particular transaction determines the conditions for its validity as well as its impact. In particular, it decides whether the customer has transferred his rights in full and thus bears the full insolvency risk of the counterparty, or whether the transaction merely establishes a more limited right in rem for the crypto exchange or a third party.

Second, characterization is also important to identify the national law governing these transactions. Conflict of law rules are used by a bankruptcy court to determine as a preliminary question whether an asset is part of the bankruptcy estate or whether it belongs to someone else. There are different conflict of laws rules for different transaction types, which refer to different laws depending on the transaction characteristics.

In which category a transaction is classified will therefore be decisive for the position of the crypto investor in several respects. But how can they be legally characterized?

Admittedly, this is not easy. To give just one example: the legal nature of staking is quite dubious. Potentially, it could be considered a secured transaction as it allows to “short” the investor’s crypto asset in case of manipulative activity or node inactivity. But it can also be compared to a deposit or a loan of cryptos. It is even not out of the question to look at staking through the lens of a partnership that can exist between all nodes of a platform, or as constitutive of a trust.

Similar problems arise for yield farming, liquidity mining and crypto lending. These operations must be distinguished from staking and from each other, even if the boundaries are often blurred. How these are to be legally characterized is highly relevant for the position of the crypto investor.

Any characterization must reflect the terms of the transaction, the typical intent of the parties, and the commercial purpose of the transaction. Above all, however, he should be informed about the consequences for investor protection. Unless clearly stated in the contract and strictly necessary for the achievement of the business purpose, it cannot be assumed that the investor intends to part with her property or other prospective rights. If the terms and conditions are ambiguous or ambiguous on this point, they should be construed against the person who formulated them, in accordance with the well-established “contra proferentem” principle of creating constructs. The decisive question will be when and in which transactions a transfer of property or other rights can be assumed. The debate on this problem has only just begun. In a new paper, Felix Krysa, Emeric Prévost, Fabian Schinerl, Robert Vogelauer and I have examined various options and made suggestions for precise characterization.

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