A recent case in London’s Commercial Court has decided a novel point of law concerning the legal status of cryptocurrency transactions in a dispute about two related contracts. This case is significant as it provides an illustration of the potentially high level of counterparty risk involved in the process of transferring cryptocurrency (Tezos) into the account of another to undertake ” baking” through a ” bond pool“.
Zi Wang, the claimant, and Graham Darby, the defendant, had agreed to exchange specified quantities of respective cryptocurrencies — Bitcoin and Tezos — on terms as to reciprocal restoration of the same amounts of each currency upon or after an agreed period of two years. Following the swap, Darby had failed to return the Tezos, which had been significantly increasing in value, to Wang.
Stephen Houseman QC, sitting as a deputy judge of the High Court, said that the Tezos platform underwent its initial coin offering (ICO) in mid-2017 and that both parties to this dispute had purchased Tezos tokens at the ICO. Tezos is a platform and the Tez (plural “Tezzies”, acronym XTC) is the native token.
In his judgment, Houseman refers to the tokens as “Tezos”. He described the Tezos token as an ” altcoin“, denoting the fact that, due to its scale, it is not commonly used as a primary trading currency, in contrast to Bitcoin. Altcoins are also described as private digital currencies created since Bitcoin, for use in specific national and regional economies.
Houseman also said that individual tokens lacked any unique identification but that their functional identification was achieved by reference to the unique digital wallet (account) in which they were held at any given time. In addition, they were readily transferable and completely fungible, and could be traded in return for other cryptocurrency and/or “fiat” currency.
Breach of contract
Wang’s case was that there had been a breach of contract, but he was also asserting a proprietary claim that he was the beneficial owner of the 400,000 Tezos which he had transferred to Darby and that they had been held on trust by Darby. This initial hearing concerned, inter alia, this proprietary claim. Proprietary claims create rights which attach to the property itself, rather than to a person as in the case of personal claims such as breach of contract.
This difference is particularly important, for example, when a company enters insolvency, as assets subject to proprietary claims will not form part of the distressed company’s estate, so the holder may be able to make a full recovery, rather than having to prove as an unsecured creditor in the liquidation/administration.
This judgment concerns, inter alia, Darby’s application to have the proprietary claim struck out, which is a procedure whereby the whole or part of a statement of case which discloses no reasonable grounds for bringing or defending a claim is struck out. He also applied for a reverse summary judgment whereby the court may decide a claim or a particular issue without a trial in favour of the defendant.
Tezos is a blockchain network linked to a digital token whose holders receive a reward for “baking”, taking part in its consensus mechanism. Tezos says that it has published dedicated modules on baking — which is complicated for inexperienced users — and that a more accessible alternative is to delegate rather than engage in baking. It acknowledges that “self-baking” lets a user earn a higher yield, but by delegating Tezos tokens, it says, a token holder avoids this process altogether.
Tezos explains on its website that baking is how blocks are produced and validated on a Tezos blockchain using liquid proof-of-stake (LPoS), which allows token holders to loan their validation rights to other users without relinquishing their token ownership.
Bakers (also known as “delegates”) obtain the right to create (i.e., bake) a block when a roll of tokens (1 roll = 8,000 ꜩ) they own (or that is delegated to them) is randomly selected to produce or validate a block. Furthermore, as the maintainers of a Tezos network, bakers are also the voters in a Tezos formal upgrade process, with their votes proportional to the size of their stake (including delegations).
Houseman characterised Tezos baking as a process whereby individual tokens were utilised so as to yield rewards in the form of additional tokens credited to the relevant account-holder by the global issuer. He said it required the signing and publishing of a new block in the blockchain, thereby validating transactions and growing the digital system organically so as to increase its capital base. He said baking required the relevant holder — known as the “baker” — to run a blockchain node with appropriate software and to keep it online and current. He also pointed out that there was a minimum capital margin requirement (deposit), which was frozen.
The baker, he said, was required to hold at least 8.74% of the currency being baked at any given time. He said also account-holders may designate or delegate the voting rights associated with some or all of their Tezos to another account-holder for baking without any transfer of currency.
Payment methods for delegation
He said, further, that it involved a private arrangement between account-holders that would determine the baking service fee or any baking reward split. He said the delegator in this scenario was “staking” their Tezos by authorising another account-holder to bake them without receiving or holding such units. He also said that if the baker held less than the required margin, he would be over-delegated.
He also said that an account-holder may transfer currency into the account of another to undertake baking through a “bond pool”, i.e., a mixed account or wallet. The account-holder in this case loans or entrusts their currency to another to undertake third-party baking known as “stake bonding”. The additional currency in the latter’s wallet/account enables them to undertake a higher volume of baking for other third-party delegators by reference to the 8.74% margin requirement.
This may be reflected in enhanced economic benefits to the staking party (i.e., transferor) as compared with delegation, depending on the terms of the parties’ private arrangements. As part of the second of the two contractual arrangements in this case, he said, Wang had enhanced entitlement to baking rewards and stake bonding profits. Stake bonding does, however, create counterparty risk with regard to the whole amount of the loaned Tezos, as opposed to just the baking reward in the case of simple banking.
“You’re trusting the baker with your Tezos entirely — they’ll be holding onto your Tezos and not you. So if the baker runs off with your Tezos, they’re all gone. This isn’t like delegating to a baker where you’re only giving them your voting rights; you’re literally sending them all your Tezos! So it’s no different than giving all your money to someone you trust to invest it for you — if that person runs away with your money, it’s gone. If they have a security breach, it’s gone,” as one website commentator put it.
Wang wanted to trade Bitcoins and bake Tezos
Houseman said Darby was an experienced and sophisticated cryptocurrency trader and a registered baker of Tezos who operated an extensive and complex web of digital accounts/wallets. He said Darby held himself out publicly online (including through social media) as an experienced cryptocurrency trader offering baking and equivalent services. Houseman outlined the online negotiation that had been engaged in between Wang and Darby. He said Wang was interested in trading Bitcoins and had initially requested Bitcoins from Darby on the basis of a collateralised loan arrangement whereby he would borrow Bitcoins from Darby in exchange for his Tezos being used as collateral.
Darby counter-offered to buy some Tezos in return for Bitcoins. Wang said that he did not want to sell the Tezos as he wanted to bake them, and suggested that Darby could add his Tezos to his baking pool. Darby rejected the loan but Wang said that it was not a loan, it was a temporary swap. Darby then suggested a sale and buy-back as an alternative to Wang trading Bitcoin through an exchange, suggesting that he could sell the Tezos to Darby and then buy them back so Wang would not need to deal with exchanges.
Houseman said Wang had confirmed that the proposed swap would not be a loan and that he wished to “bake together”, and offered 300,000 Tezos to Darby. After exploring other baking options, Wang then made a revised offer of 200,000 Tezos.
“Just give me 50% and the profits from staking we can share 50:50 even though I’m contributing more,” Wang said. Houseman interpreted this as a reference to the baking profit share on the basis that the additional 200,000 would represent more than 50% of the Tezos in Darby’s trading account (referred to as his “OTC account”) – 200,000 out of 356,000 at that time. Darby agreed, offering 12 Bitcoin on the basis that Wang would not want the first 200,000 back for at least one year. This was so that he could increase his delegates without the risk of being over-delegated.
This was a reference to using the first 200,000 for stake bonding in his account. He added that he would be happy to give Wang 50% and then Wang could buy them back for 12 Bitcoin.
Houseman said that the 50% reflected the fact that Darby would be transferring Bitcoins of half the current value of 200,000 Tezos. Darby then gave Wang the link to his OTC account for transferring 200,000 Tezos. The parties then agreed a minimum term of at least two years for this swapping arrangement and struck on an exchange price of 13 Bitcoins for the first 200,000 and 17 Bitcoins for the second 200,000.
Were the Tezos held on trust?
Darby’s reverse summary judgment application concerned the proper legal characterisation of the relevant contracts pursuant to which Wang had transferred two separate parcels by way of simultaneous digital exchange. The main issue was whether some form of trust had arisen in respect of the 400,000 Tezos transferred by Wang to Darby.
Citing AA v Persons Unknown and Ion Science Ltd v Persons Unknown, he said that fungible and non-identifiable digital assets such as Tezos could constitute property that was capable of being bought and sold as well as held on trust as a matter of English law.
Wang argued that the Tezos transferred to Darby were held by him on express trust, Quistclose trust, or constructive trust. Darby argued that the arrangement between the parties was essentially a form or sale and repurchase (repo). Houseman held that it was not intended to be a loan arrangement, nor was it a unilateral transfer by principal to agent solely for the purposes of stake bonding.
He also said he did not have to decide the precise definition of the arrangement due to the economic reciprocity in the arrangement.
Notwithstanding that point, he said that no case had been identified in which such a trust had arisen over property transferred as part of reciprocal exchange of assets and on terms whereby its re-transfer was expressly conditional upon a reciprocal or equivalent re-transfer of value from beneficiary to trustee. It was that obligatory economic reciprocity that precluded a trust of any kind.
Further information on compliance matters can be found https://podcasts.apple.com/gb/podcast/compliance-clarified-podcast-by-thomson-reuters-regulatory/id1548510826 here.
