Will the Law Commission’s digital assets final report make the UK a DeFi jurisdiction of choice?

Laws and regulations for digital assets tend to arrive either too early or too late. Too early when they include details that turn out to be awkward or irrelevant when technology moves in a different direction. Too late when they wait for certainty and meanwhile leave important areas unregulated and vulnerable to fraud.

The English Law Commission, in its final report on digital assets, proposes to solve this riddle with a new approach that might make the U.K. a jurisdiction of choice for DeFi and other digital asset structures.

As a holder of NFTs or a participant in DeFi, you might think that legal uncertainty does not affect you — cryptoassets exist independently of any legal system and do not need to be controlled by regulations. But a lack of clarity in how they are treated by the courts prevents DeFi and the digital asset economy from developing more widely. Here are a few examples:

• If you hold your cryptoassets via an exchange, you might not actually hold any cryptoassets at all. This is what cryptoasset exchanges themselves have argued in a series of recent English cases. Victims of fraud attempted to freeze cryptoassets held in exchanges or obtain remedies against exchanges through which their cryptoassets had passed. They were largely unsuccessful. In many circumstances, all that an exchange customer will have is a contractual right against the exchange, enforceable by the courts. Legal uncertainty means it might not be clear whether they actually own a cryptoasset.
• If you post cryptocurrency collateral as part of a DeFi transaction and there is some problem with the structure — error or fraud — and some cryptocurrency is lost, perhaps from a different account that is part of the same structure, you might not be able to get your cryptocurrency back. This will depend on whether, in legal terms, you have transferred your cryptocurrency to somebody else or merely shared control over it. Again, legal uncertainty makes it impossible to gauge this risk and thereby inhibits growth in DeFi. And a myriad of custody and private key management possibilities make it hard to come up with clear legal rules that will apply in all situations.
• You are the proud owner of a rare NFT when somebody emerges with a claim that they previously owned it and were induced to part with it by fraud. Assume that this is true and that you are completely innocent and purchased the NFT for a large sum of money from a purchaser who cannot now be traced. Who keeps the NFT? There are legal rules that apply to exactly this sort of situation, but, again, without a settled legal status for digital assets, it is unclear how they apply.

But legal bodies that try to set out a clear set of legal definitions and rules for cryptoassets have run into another problem: Their rules cannot keep up with the technology. Unidroit — a European organization looking at law reform — has come up with a detailed set of rules that may well be adopted in EU countries. Their rules have many positive aspects, but one much commented upon conclusion is that their definition of digital assets includes, in some circumstances, Microsoft Word files. This illustrates the difficulty in creating comprehensive definitions and rules that keep up with the latest innovations while satisfying the needs of industry.

The Law Commission’s approach tries to deal with this problem by proposing a framework that is suited for innovative technology. Their solution has three pillars:

• Legislation to confirm that there is a separate category of property that includes digital assets. This simple change will unblock the English courts from devising new rules that apply to cryptocurrency, NFTs and other digital assets. The English Law Commission does not intend to be overly prescribed. Rather, it seeks to allow the English courts to gradually develop nuanced rules covering custody, transfer, security and similar situations.
• Creation of an advisory group consisting of technical experts, academics, legal practitioners and judges. This group’s advice would not be binding but is expected to be highly influential. Existing groups set up to advise on new technology, such as the U.K. Jurisdiction Taskforce (which includes senior judges as members), have already been widely quoted in legal decisions.  But handing a formal role to an advisory group with technical expertise would still be a remarkable innovation. Judges would have the technical support to create sensible rules adapted to the latest technology, and industry would have the means to evaluate its latest innovations and develop them in legally robust ways.
• There are a few specific areas where existing legislation is not adapted to digital assets. Taking security over financial collateral is the most prominent example. Here, the Law Commission does propose new legislation.

The Law Commission’s idea is to take advantage of the inherent flexibility of English common law — the ability of the judiciary to expand law into new areas with steady, incremental change — by combining it with technical guidance that will steer that change in the right direction. To do this, English common law needs an initial push — the statutory creation of a new category of property.  Incremental development taking account of the precise features of digital assets can then fill in the details.

Another key contribution of the Law Commission is its use of abstraction in reasoning about computer systems. Rather like a coder, it recognizes that computer systems are built using multiple layers of abstraction, and reasoning about them is most effective if you use a single layer. Digital assets, for instance, are defined in the context of the system as a whole, as notional entities manifested by the combination of software, data and a network of participants. Using this scientific perspective, the Law Commission makes cogent suggestions for the future development of custody, collateral, remedies and exchanges for digital assets.

The U.K. government now has to decide whether to implement the Law Commission’s recommendations. Initially, only a single, short piece of legislation is required, plus support for the creation of the technical group. It should be a straightforward decision for an administration that is vocal in its support for the U.K. being a hub for cryptoassets.

As the crypto economy matures, it must be integrated into the legal and social networks of society. Victims of fraud demand legal remedies, DeFi structures must calibrate their control over cryptoassets against legal collateral requirements, and so on. Ultimately, things of value that can be owned and transferred may lose that value if there is no effective legal protection. The Law Commission’s proposal is a simple but innovative way to start that integration. Using the flexibility of English common law, it promises to create rules that are responsive to new technology.