Pledge over digital assets



The Law on Digital Assets (“Official Gazette of the RS”, No. 153/2020) (the “Law“) has interested almost every user of cryptocurrencies and they are curious regarding effects of certain provisions introduced by the Law. Having in mind that blockchain promised freedom from intermediaries and was promoted as a technology of trust, without the need for participants to know each other, and with a guarantee from the technology itself that the agreement reached by participants will be fulfilled, one of the matters concerns trust in people, to which we return again.

In accordance with the provisions of the Law, digital assets may serve as security of receivables as it is envisaged that a pledge, as well as fiducia security, which is for the first time introduced in Serbian legislation and will be subject of a separate analysis, may be established over digital assets.  A lien may serve as security of pecuniary claims in domestic or foreign currency, as well as for non-pecuniary claims with value determined in digital assets.

Pledge right over digital assets

The model of pledge establishment over digital assets has been taken from the Law on Pledge on Movables and Rights inscribed in the Register (the “Law on Pledge on Movables”), with two important differences:

  1. The Law on Pledge on Movables regulates the pledge on movables in such manner that a pledgor retains possession on the subject of the pledge, while when it comes to the pledge on digital assets a pledgor is not in possession of the pledged assets, which is the pledge establishment manner envisaged under the Law on Contracts and Torts, and
  2. Unlike the register of pledge on movables maintained by the Pledge Register of the Business Registers Agency, the register of pledges on digital assets may be maintained by a legal entity licensed by the supervisory authority to provide services of keeping the register of pledge on digital assets, as well as storage and administration of digital assets for the account of users.

Therefore, introduced model according to which possession over digital assets has to be transferred for purpose of creation of a pledge, is essentially a model envisaged under the Law on Contracts and Torts which regulates the establishment of a pledge on movables by handing over a movable into possession of a creditor or third party and does not need to be registered, with the difference that the storage of digital property is not entrusted to a creditor, but to the pledge register.

Another important difference in comparison to the pledge register on movables is that the pledge register on digital assets is not unified and centralized, but there can be an unlimited number of individual registers, kept by each entity that obtained a licence from the supervisory authority. (NBS issues licences if virtual currencies are in questions, while Securities Commissions is competent for digital tokens).

Pledge Agreement

The first step in establishing a pledge on digital assets is the conclusion of a pledge agreement, which may be concluded in traditional paper or electronic form as a separate act or may be contained in another general agreement.

The Register of Pledge on digital assets

The Law prescribes the content of the register of pledge on digital assets, while data contained in this register will be available free of charge and publicly available on the website of the service provider that maintains this register.

However, in order to register a pledge on digital assets with the pledge register, the legislator envisaged one precondition – it is necessary to entrust digital assets that are subject of the pledge to the service provider that maintains the pledge register for safekeeping and administration prior to the registration.

This provision has raised the question: “How one can reasonably expect to give them keys?”

Anyone who has dealt with cryptocurrencies knows that these are cryptographic keys that allow access to a “virtual wallet” in which holders keep their cryptocurrencies, and as a rule, such a key cannot be returned in the event of loss. This is the issue of trust and this issue puts before service providers and those who need to prepare appropriate technological solutions the task to create such solutions that do not cause discomfort or distrust of potential pledgors, i.e. to eliminate any risk of misuse of pledged digital assets.

As a rule, the Law prescribes that pledged digital assets cannot be disposed and prescribes the obligation of an entity that keeps the register of pledge on digital assets to secure this until a pledge is deleted, with the exception that under the pledge agreement it may be contracted the right of disposal, whereby such digital assets will be kept by the service provider until the secured claim is settled and the pledge is deleted.

Settling the secured claim and cessation of the pledge

If a debtor does not settle its obligation on due date, the pledge creditor may initiate the out-of-court sale of the pledged assets. Based on the excerpt from the register of pledge on digital assets, the pledge creditor is authorized to, on behalf of a pledgor, conclude a sale and purchase agreement regarding digital assets, whereby a person who purchases the pledge subject in good faith acquires ownership without encumbrance.

Same as with the pledge on movables, the Law prescribes that under the pledge agreement regarding digital assets the pledge creditor may have the right to keep the subject of the pledge at that market price at due date, provided that the pledged digital asset has a market price.

Under the Law it is specially emphasized that the pledge agreement may be executed by a smart contract.

Having in mind that the Law regulated the manner of settlement on pledged digital assets entirely as settlement on pledged movables, prescribing that the creditor may conduct out-of-court public sale upon maturity based on the excerpt from the register of pledge on digital assets, the purpose of such regulation is questionable.

The basic discrepancy between a pledge on movables that is registered with the register and a pledge on digital assets is that in case of pledged digital assets, the pledgor is deprived from possession of the pledged digital assets at the moment of establishment of the pledge (the pledgor does not possess a cryptographic key for access to digital asset or transfers it to a “virtual wallet” of the pledge register or in some other manner). When it comes to movables over which the pledgor retains possession, the purpose of registration of the pledge is to inform third parties that a certain movable is the subject of the pledge, which should introduce legal certainty in legal circulation, whereby the excerpt from the register is an enforceable document based on which the creditor initiate enforcement and confiscation of the pledged movable from the pledgor, which in the case of a pledge on digital assets was executed already during the establishment of the pledge.

Taking into account a manner of establishment of the pledge on digital assets-deprivation of the pledgor from possession on digital assets, it seems that the establishment and execution of the right of pledge is more simplified and efficient without a register, as all activities starting from establishment of the pledge until settlement, may be carried out in accordance to (slightly amended) rules envisaged under the Law on Contracts and Torts. The necessary amendments to these rules could have been done under of the Law.

The introduction of the register of pledge on digital assets results in the impression that there is an intermediary, who does not play big role in terms of providing additional security to the business participants and damage that the pledge register may cause is potentially greater. Namely, if the creditor has possession over the pledged digital assets, the creditor is responsible for safekeeping and destroying, which means that any negligent action by the creditor releases the pledgor from the obligation (or part of the obligation) secured by the pledge. In the event of the negligent conduct of the pledge register, the pledgor will be still obliged towards the creditor, while the creditor’s claim will be unsecured, and under this scenario the pledgor has the right to seek damage compensation in court proceedings before a Serbian court.

Smart contract, pledge and liability

Although the Law provides that the supervisory authority may prescribe additional elements that the pledge agreement on digital assets must contain, as well as special rules governing the execution of the pledge agreement on digital assets using a smart contract, an adequate solution must be addressed when passing bylaws, whereby it will not derogate provisions of the Law regarding the settlement procedure (as it must not be the effect of a bylaw), but which will really enable the application of a smart contract.

One of the possible solutions may be that a smart contract can be used in the settlement only if the parties have agreed that the pledgee has the right to keep the digital asset at market price on due date, provided that the pledged digital asset has a market price. In this scenario, assets that have a market price (e.g. cryptocurrencies) would be suitable for conducting settlement through a smart contract.

Another solution could be a use of a smart contract during settlement, provided that the smart contract contains a mechanism for conducting the out-of-court public sale procedure according to the rules prescribed by the Law.

In our opinion, possible solutions proposals may provide entities that intend to run a pledge register and who already have certain solutions or are preparing them. They may be valuable participants in the process of creation of bylaws, in order to prepare bylaws based on real business needs as this is definitely an unknown area for all participants.

Each of the solutions that include the application of a smart contract includes a risk, but also the issue of responsibility for it.

Namely, if a smart contract is applied, there is a question who will prepare it, and therefore who will be responsible for it. It remains to be seen whether the pledge registries will offer templates of smart contracts or whether smart contracts will be proposed to the registry by the contracting parties. It is also a question of liability for an error that may be contained in the smart contract code and the possibility of the impact of such error (or some other functionality in the smart contract) on the registry and other registered pledge rights.

One of the most notable examples of damage that was caused due to implementation of a smart contract is DAO, which due to an error in the code enabled drain of 3.6 million etherium that was in the system, but also a division in the community https://www.coindesk .com/understanding-dao-hack-journalists Therefore, when using smart contracts, one should be wise, patient, and careful.

Will the pledge come to life in practice?

With the proposed model under which the pledge is established by entry in the pledge register, entities that intend to obtain licenses and perform pledge register services, bear a huge responsibility starting from creating adequate technological solutions and models based on which they will gain the trust of users of such services, while it is expected to minimise risk of abuse or error.

The profitability of such business model remains questionable, as the price for such a service is unknown and it is unknown whether the supervisory authorities will determine the tariffs at which such a service can be charged or whether determining a fee for such services will be left to the pledge registries.

In addition, equally important open issue is the responsibility for smart contracts and possible errors in the smart contract code and damage that can occur due to application of smart contracts.

It seems that the pledge registers will not be considered as an interesting business opportunity. Also, it seems that the model taken from the Law on Pledge on Movables might not be the most adequate. The fact that the pledge is acquired by transferring digital assets to possession, leads to the conclusion that the same effect could be achieved by handing over the subject of the pledge to the creditor (so the pledge register is not necessary-until it gains the authority of a trusted institution), while enforcement could be entrusted either to a smart contract or a creditor, with very few amendments to the existing model envisaged under the Law on Contracts and Torts.

This text does not represent a legal opinion, but the position of the author. To be continued with more detailed elaborations of certain terms defined by the Law on Digital Assets.

Authors: Aleksandra Vuković, Attorney at Law and Željka Motika Attorney at Law, Motika Law Office