Legal aspects in connection with wallet service providers
Author: Simon Schnetzler
Date: 24 October 2018
Note: This article was first published in the Newsletter 2018/2 by Legis Rechtsanwälte AG.
The segregation of bitcoins in bankruptcy proceedings can be justified because bitcoins allow custody and sufficient individualisation. The prerequisite is, of course, that the bankruptcy administration has the private keys and is thus able to transfer the values. Another prerequisite is that the bitcoins or their fractions are still with the custodian and that the same bitcoins or their fractions can be transferred back. In case of wallet service providers, however, most of the time there is no agreement on custody, but an agreement to return the same amount of bitcoins as transferred at the beginning. A segregation is therefore limited to the very narrow field where the parties have agreed on returning the same transferred bitcoins or their fractions and where the custodian is in fact able to transfer these values.
A wallet is needed to store and manage cryptocurrencies such as bitcoins. The following article analyses the legal side of wallets, especially the consequences of a bankruptcy of a wallet service provider.
Bitcoin as a “transaction”
To understand how a wallet works, it is first necessary to explain how Bitcoins work and their underlying concept. Like a coin, bitcoins or their fractions can be passed on via a chain of authorised persons. Depending on their size, they must either be broken up further or transferred together with other existing fractions in order to reach a certain target amount. Bitcoins can be compared to stones: Their smallest form is a grain of sand or, in the case of bitcoins, a satoshi. Unlike coins, however, the focus of Bitcoins is on the transaction and not on an object, located at a specific place.
Central to the understanding of the transaction is the Bitcoin address. Values are transferred from one Bitcoin address to another address in the basic application. For the transfer, the values are linked to the destination address. This is done by blocking the values with the public key from which the destination address has been generated and which is known to all users. Only with the corresponding private key however these values can be used again to send them to another address (or more precicly to block them with the corresponding public key of this address). Anyone who knows the corresponding private key can dispose of the blocked value. If the blocked value is not transmitted further, it is called an “unspent transaction” (UTXO). In this case, the value has been sent to an address or blocked with the corresponding public key, but has not yet been transmitted by the owner of the private key. This is the main use case of a transaction, after the so-called pay-to-public-key hash script (P2PKH).
Wallets are applications that allow the wallet user to manage their bitcoins. Classic wallets contain a collection of public/private key pairs. To determine the credit balance on the blockchain, the wallet searches for addresses of the user on which the unspent transactions are located and shows the user the sum of these values as a credit balance. Via his wallet, the user can then access the values blocked with the public keys and dispose of the values with the corresponding private key by transferring the values to new addresses. A paper that shows the two keys pictorially (as a long combination of numbers or as a QR code) is called a paper wallet and is probably the most rudimentary form of a wallet. With a paper wallet, it is of course not possible to see which unspent transactions are stored at the address or are linked to the corresponding public key.
However, some “wallet” provide other services, allowing a certain administration of Bitcoins, but do not grant access to the private keys of these Bitcoins and only allow a user to dispose of their assets with the cooperation of the wallet service provider (so-called custodial wallets). Without the involvement of the wallet service provider, it is absolutely impossible to dispose of the assets. Only the wallet service provider or possibly even a third party knows the private keys that enable the disposal of the assets. In such a case, the user is entirely dependent on the wallet service provider for the management or any transfer of his Bitcions. Wallet service providers often offer much more through their platforms and focus on user-friendliness. For example, they allow the purchase of cryptocurrencies, the exchange via trading platforms or fast and fee-free “offline transactions”, carried out only in the provider’s books.
Two well-known wallet service providers are Coinbase and Freewallet. Coinbase distributes its service in Europe through a company registered in the English commercial register (Coinbase UK, Ltd). With Freewallet, on the other hand, the verifiable information is already very sparse. The website refers to a “Wallet Services Limited” with an address in Hong Kong. The word limited thus takes on a whole new meaning when you think of the legal possibilities to access such company from Switzerland. As far as can be seen, no actual custodians are domiciled in Switzerland. Providers such as exchange platforms require an existing address of the user or use foreign custodians for the settlement of their transactions.
In the case of Coinbase and Freewallet, bankruptcy proceedings would therefore not be governed by Swiss law, but primarily by the corresponding foreign legal jurisdiction. Nevertheless, the question of the consequences of the insolvency of a wallet service provider – based in Switzerland and suject to Swiss law – arises equally.
Insolvency of a wallet service provider
In the event of bankruptcy of a wallet service provider, one central question needs to be answered for any user of such wallet: Can the user demand the invested assets in the liquidation proceedings or will the user only receive a dividend on the deposited assets? In order to legally answer this question the preliminary question needs to be answered: what is the legal nature of bitcoin.
In this regard, it can be stated soberly: The legal nature of Bitcoins has not yet been clarified. And this despite to combined forces of the legal community, which – like a safe – has been trying to get at the Bitcoin with all available tools in order to qualify its legal nature. Nothing helped, neither cession nor tradition could crack the Bitcoin. Bitcoins do indeed have a strange feature: their custody or disposal can be controlled almost better than with physical things, and like physical objects they can be individualised, but like claims they are wihtout body and and are intangible. They combine the best of both worlds, so to speak, and thus legally fall between the chair and the bench. Neither fish nor bird, neither thing nor claim.
Prerequisites for segregation
According to the classic view, segregation requires a physical object to which a material claim to surrender can be referred to (such as the title of ownership). The owner can then segregate the property from the bankruptcy estate and thus exclude the object from the insolvency proceedings. The owner has the substantive title of ownership, and the asset can be sufficiently individualised. A differentiation is made in the custody of money: Money can be segregated if the values can still be individualised and separated. If this is no longer possible, ownership of the money has ceased as a result of commingling (“Vermischung”). The depositor only has an “ordinary” claim against the custodian without title to the coins. The necessity of individualisation also applies to the segregation of money in a fiduciary relationship.
The possibility of custody and sufficient individualisation are thus central to segregation. Until now, however, these characteristics were only given in the case of physical objects. Bitcoins are not physical objects, but they can be individualised, their position can be tracked and they can be held via the private key. This means that segregation should also be permitted for them. This always presupposes that the bankruptcy administration can effectively dispose of the Bitcoins, i.e. it (alone) has knowledge of the debtor’s private keys or was able to transfer the values to its address. Incidentally, only then is segregation necessary at all. Anyone who holds the private key to a token like Bitcoin does not have to segregate.
Analogous to the situation in the case of a commingling of money, the traceable custody of bitcoins may be said to have ceased if the custodian transfers the deposited bitcoins to a third party and is subsequently no longer able to transfer back those bitcoins that were originally transferred to him or whose trace can be traced back to the first transfer to the custodian. If the custodian is not able to do so and the origin can no longer be traced, only an abstract claim of the depositor for retransfer in the amount of the deposited values remains. However, as long as the deposited bitcoins or their fractions are on the addresses of the custodian and the custodian (alone) holds the private keys to the values, a segregation is justified. In such a case, the administration should therefore be obliged to hand over the private keys.
Situation with Wallet Service Providers
The segregation in the context of wallet service providers is thus limited to the (relatively narrow) scope of application where it was the intention and agreement of the parties to keep the Bitcoin safe and to return the individual Bitcoins (or their traceable fragments) in the sense of a deposit.
In the case of the wallet service providers, however, it is apparent that they do not return specific bitcoins or the bitcoins that were actually paid in, and that they probably could not do so technically at all (e.g. because they transfer the values to a cold wallet for security reasons, detached from the network, and thus have to use other values for the user’s transactions). Accordingly, allowing segregation would not be justified in such a case. The same also applies if the agreement existed from the beginning to return only an unspecified amount of Bitcoins (irregular deposit). In both cases, the claim is limited to an obligatory claim for the restitution of a justifiable amount of Bitcoins and, in bankruptcy, to a bankruptcy dividend. The situation would be different for banks, where deposit protection would have to apply. At present, there is unlikely to be any reliance on segregation under banking law, especially in the case of chains of custody that lead abroad.
As so often at the end of a legal treatise on blockchain, the verdict is: the situation is still unclear in many areas. In connection with segregation, there are contradictory opinions in the literature, and there are also no known rulings. However, a parliamentary initiative is currently pending that demands that non-physical assets can also be segregated in bankruptcy (Dobler parliamentary initiative).
And finally, the Federal Council wants to quickly press ahead with ‘the work on the legal qualification of bitcoin’, as it says in its report on the fintech bill. It makes little sense to teach the fish to fly and to generally qualify bitcoins or tokens via classic institutions such as claims or property. For the clarification of the legal position and transfer, one should stick closely to the technical reality. If there is a publicly visible and unchangeable register such as the Bitcoin blockchain, it is unnecessary to use a disposition such as assignment for transfer or to map it on the blockchain. This would be akin to a hippo trying to sit in a cat box. It just doesn’t fit. In any case, regulations should take into account the specific characteristics of the systems to be regulated, so that only selective adjustments are necessary. Until these issues are clarified by the legislature or the courts, legal uncertainty will unfortunately remain.