Decentralized finance (“DeFi”) is a financial alternative offered through various cryptocurrency platforms where liquidity pools are available to investors without the need for third-party lending institutions. In the years to come, the nascent DeFi industry may shape, transform and even eliminate the need for traditional legal recovery mechanisms such as loan and security packages.
While excitement around DeFi has begun to boom in the past year, with a yearly transaction volume of just under $1 trillion in ethereum (“ETH”) alone in 2020,[1] it is important for both personal and institutional consumers to be aware of the legal implications of investing in the DeFi industry. Existing legal enforcement strategies, such as traditional insolvency or debt litigation, may need to adapt to the fast pace of cryptocurrency asset recoveries in the case of borrower insolvencies or bad loans. This article outlines the basics of DeFi itself, as well as a summary of recent litigation and regulatory news that will shape the emerging growth of the industry within Canada.
The Basics: What is DeFi?
For the average consumer, cryptocurrencies can be difficult to understand. In simple terms, cryptocurrencies are ‘coins’ that act as a non-physical store of value. Cryptocurrencies are generated by cryptocommodities – blockchains – that are decentralized databases that record and often generate the ‘coins’ themselves. The first mainstream cryptocurrency, Bitcoin (“BTC”), was invented in 2008 by Satoshi Nakamoto, and was designed to be sent between individuals on a peer-to-peer network without any lending institutions or intermediaries facilitating the transfer. Satoshi Nakamoto’s white paper states the following about the purpose of BTC:[2]
What is needed [in the current financial system] is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party. Transactions that are computationally impractical to reverse would protect sellers from fraud, and routine escrow mechanisms could easily be implemented to protect buyers.
A common criticism of BTC, however, is its poor speed and slow transaction time. BTC has since evolved from its creation into a form of ‘digital gold’, where investors view it as an intrinsic store of value rather than a commodity capable of usurping entire financial systems.[3] Out of these flaws grew new cryptocurrencies (often referred to as second or third-generation cryptocurrencies) that aimed to solve BTC’s problems by introducing retail investors to the world of DeFi.
Smart Contracts
After BTC, newer cryptocurrencies presented the market with smart contracts, which are self-managing blockchain programs that can control asset agreements between parties. Smart contracts operate on a distributed basis, where participants have access to the relevant block. The potential benefits of smart contracts extend into multiple fields, such as:
- Insurance: Automated claims processes could pay out insurance holders after data fed into the blockchain through chainlinks to trigger the release of funds.
- Property: Property ownership, if outsourced to blockchain technologies, could be recorded ‘on-block’ to remove the need for real estate services and brokerages.
- Healthcare: Private keys that limit the access to blockchains could be used successfully in healthcare industries to store patient data and records, rather than organizations leaving private data on other easily breached internet services.
- Voting: Allegations of voting fraud would be close to impossible if voting systems were moved onto blockchains, where blocks are impossible to alter once recorded.
Staking
An even newer development in the cryptocurrency world is the wide-spread introduction of staking cryptocurrencies on their blockchains to support the security of the network itself. When investors ‘stake’ cryptocurrencies on their blockchain, the blockchain allows a return on the staked investment. Proof-of-Stake (“PoS”) is an energy-efficient mechanism which allows participants to lock coins (‘stake’) and randomly validate blocks in a network. This allows certain blocks to be produced without requiring mining, which is traditionally energy intensive and seen in older cryptocurrency such as BTC. A commonly-used analogy of staking to traditional finance is that staking is roughly equivalent to an ‘internet bond’.
The Canada Revenue Agency has taken the position that miners earn cryptocurrencies for their work and must include it in their income at the time it is received.[4] As of 2021, the CRA has still not released formal guidance to consumers on how to file taxes on staked cryptocurrency for Canadian consumers, beyond noting in 2019 that staking “may still result in earnings that have tax implications”.[5]
Non-Custodial Lending Platforms
Cryptocurrencies have further extended into the world of DeFi through the recent creation of non-custodial lending platforms, which are decentralized markets where users participate as depositors or borrowers. In short: people can lend and borrow large sums of money, without banks or credit approval processes.
While this may sound risky, the concept of these lending platforms are designed to mitigate any potential losses or defaults through controlling collateral on the blockchain.[6] Lenders or depositors are able to earn passive incomes by providing liquidity, while borrowers are able to access funds after depositing cryptocurrency as collateral. Where traditional lenders are only able to hold collateral in the form of security documents over certain forms of property, which can be difficult, impractical and often too expensive to enforce, retail lenders are able to quickly liquidate unhealthy loans on these lending platforms through the underlying technology of the platform itself.
As an example of the transformative power of cryptocurrencies, DeFi pools also have the potential of opening up liquidity in cross-jurisdictional markets that have previously not been able to transact. DeFi users in Canada are theoretically able to extend credit and liquidity through cryptocurrencies to users across the globe, including markets in developing countries that traditionally do not see influxes of western funds. The decentralization of commerce and lending through DeFi opens up the financial services sector to an exciting future of globalization.
Legal Implications
DeFi Jurisprudence
The world of cryptocurrency law is wide and uncharted. While the possibilities are vast and exciting, investors should still be aware of the nascent state of the common law. As of early 2021, across all of Canada there are no reported cases that involve DeFi platforms, although there is a growing body of case law which involves attempted recoveries of disputed, lost or stolen cryptocurrencies.
In large part, this dearth of cryptocurrency jurisprudence speaks to the failure of Canadian courts to ‘keep up’ with developing technologies and to the legal system’s inability to act speedily enough to trace digital assets. When tracing assets across multiple jurisdictions, the Canadian court system is largely ineffective for a cryptocurrency holder to reach off-shore pools without extensive litigation funding; even a Mareva injunction can take at the minimum a couple of days to be granted in a traditional court system between preparing legal materials and attendance. By the time that the legal system jumps into action, funds are often moved in seconds across jurisdictions through the use of mixers/tumblers and multiple wallets. However, if a well-informed consumer maintains control of the private keys to their wallets (and keeps their cryptocurrency stored safely off exchanges), there are strong arguments to be made that cryptocurrencies are not inefficient and untraceable assets that are incapable of being governed by legal systems – but instead that traditional legal mechanisms are inefficient when compared to cryptocurrencies. An excellent example of a recent case involving alleged stolen cryptocurrencies in Canada and their required burden of proof is the 2021 decision of MiningSky Technology Ltd. v. Zhang.[7]
MiningSky Technology Ltd. v. Zhang
In MiningSky Technology, a company providing hosting services for cryptocurrency miners (“MiningSky”) submitted that a former employee, Zetong Zhang (“Zhang”), stole approximately $84,000 CAD worth of cryptocurrency. After Zhang had helped set up wallets for MiningSky, MiningSky allegedly attempted to recover certain of its digital currency, including bitcoin, litecoin, dash, ethereum classic and zcash. MiningSky claimed that due to a disputed employment commission to Zhang, Zhang allegedly refused to allow MiningSky access to the company’s digital wallet or transfer of cryptocurrencies until MiningSky paid him the disputed commission. MiningSky argued that Zhang’s actions amounted to a breach of his written employment contract, which obliged him to return the company’s property upon termination, and further submitted that it was probable that Zhang was responsible for the removal of MiningSky’s cryptocurrency from its accounts.
Blok J. of the British Columbia Supreme Court held that Zhang’s credibility was a central issue in MiningSky Technology. Despite the fact that Zhang “probably had the means and opportunity to transfer the cryptocurrency out of the control of MiningSky, to his own benefit”[8], MiningSky failed to prove on a balance of probabilities that MiningSky did not have the necessary information to retrieve the cryptocurrency on their own. While the outstanding commission owed to the defendant could have provided Zhang with a motive, Blok J. concluded that as the case was circumstantial in nature and there was no further supporting evidence that Zhang took the cryptocurrency, the action by MiningSky was dismissed.
MiningSky Technology is a fascinating example of the growing body of cryptocurrency tracing jurisprudence which indicates that legal actors should always attend court with supporting evidence about the actual movement of funds. Without tracing reports or proof of the movement of funds, given the highly mobile nature of cryptocurrency assets, cases that are predicated on circumstantial evidence or suspicions are not enough to meet the requisite legal standards for damages.
DeFi Regulations
Another issue for DeFi platforms is how they will adapt to comply with money laundering and governmental know-your-client (“KYC”) regulations. Currently, Canada’s Financial Transactions and Reports Analysis Centre of Canada (“FINTRAC”) provides guidance on when entities are required to identify individuals for the following groups: accountants, departments/agents of the crown, certain notaries, casinos, dealers in precious metals/stones, financial entities, life insurance companies/brokers/agents, money service businesses (“MSBs”), real estate and securities dealers.[9] On June 1, 2020, amendments to Canada’s Proceeds of Crime (Money Laundering) and Terrorism Financing Act were enacted that legally recognized cryptocurrency exchanges and payment processors as MSBs in Canada. FINTRAC now defines ‘virtual currency’ as:
(a) a digital representation of value that can be used for payment or investment purposes, that is not a fiat currency and that can be readily exchanged for funds or for another virtual currency that can be readily exchanged for funds; or
(b) a private key of a cryptographic system that enables a person or entity to have access to a digital representation of value referred to in paragraph (a).
FINTRAC has since released publications that provide guidance on suspicious transaction reporting in respect to virtual currency, but it remains to be seen if their application in virtual spaces will be efficient or practical. An example of virtual currency money laundering indicators, as stated by FINTRAC, are where:[10]
- Portfolios only consist of privacy coins or have a high value in privacy coins;
- Client is unwilling or unable to provide information about the source of privacy coins they once held or currently have to a FINTRAC reporting entity; or
- A reporting entity notices a high volume and frequency of transfers between different types of virtual currencies.
It remains to be seen how “a high volume and frequency of transfers” is evaluated in the context of virtual currencies. As DeFi (and cryptocurrency generally) becomes more popular with consumers, regulators will need to further clarify these guidelines for reporting entities. It is difficult to imagine a practical situation where a user of a DeFi platform is able to provide the source of information about an exchanged private or non-private coin beyond one or two transactions.
These ‘gaps’ in regulating the DeFi industry are not comments on the failures of the DeFi industry, but are comments on how government agencies will need to be more flexible in facilitating newer forms of financial transfers using virtual currencies. As of 2021, cryptocurrency has entered the mainstream. From Wealthsimple to Paypal, financial institutions are looking to enter the market of digital asset sales, and efficient regulation that helps grow this nascent industry will facilitate liquidity options to a globalized audience of consumers.
If you have further questions on the legal enforcement mechanisms and regulations impacting the DeFi or cryptocurrency space, feel free to contact a member of our Financial Services or Restructuring team.
[1] Samuel Haig, “Ethereum set to become first blockchain to settle $1 trillion in one year”, Coin Telegraph (October 23, 2020), online: <https://cointelegraph.com/news/ethereum-set-to-become-first-blockchain-to-settle-1-trillion-in-one-year>
[2] Satoshi Nakamoto, “Bitcoin: A Peer-to-Peer Electronic Cash System,” online: <https://bitcoin.org/bitcoin.pdf>
[3] Mike Orcutt, “Coronavirus is forcing fans of Bitcoin to realize it’s not a ‘safe haven’ after all”, MIT Technology Review (March 19, 2020), online: <https://www.technologyreview.com/2020/03/19/905207/coronavirus-is-forcing-fans-of-bitcoin-to-realize-its-not-a-safe-haven-after-all/>
[4] Income Tax Ruling 2018-0776661I7 (August 2, 2019).
[5] Government of Canada, “Virtual Currency” (June 26, 2019), online: <https://www.canada.ca/en/revenue-agency/programs/about-canada-revenue-agency-cra/compliance/digital-currency.html>
[6] As an example, please see the following: <https://docs.aave.com/faq/>
[7] 2021 BCSC 198 [MiningSky Technology].
[8] Ibid at para 147.
[9] Financial Transactions and Reports Analysis Centre of Canada, “Know your client requirements” Government of Canada (February 17, 2021), online: <https://www.fintrac-canafe.gc.ca/guidance-directives/client-clientele/1-eng>
[10] Financial Transactions and Reports Analysis Centre of Canada, “Money laundering and terrorist financing indicators – Virtual currency transactions” Government of Canada (December 2, 2020), online: < https://www.fintrac-canafe.gc.ca/guidance-directives/transaction-operation/indicators-indicateurs/vc_mltf-eng>
