Virtual Perfection: Digital Assets On a Blockchain

Written by Russell DaSilva and Andrea Tinianow

We are moving into a digital world in which nearly everything of material value can be represented digitally on a blockchain. Assets will be in unit form and native to the blockchain, like cryptocurrency; or a digital avatar of something that exists outside the blockchain, such as a car or house; or an intangible asset, such as a right to intellectual property, or securities, such as shares in a corporation. Having things represented digitally makes them easier to track and transfer. The units on the distributed ledger become a store of value whose ownership can be moved around easily. Moreover, because the blockchain maintains an immutable record of all the transactions for which it maintains custody, each unit that is transferred retains a perfect record of its provenance. That is, every transfer becomes part of a complete record of all of the transactions that preceded it and provides complete transparency into the history of the unit being purchased.

This particular aspect of digital ownership makes the U.S. system for recording security interests in personal property as collateral (which is codified primarily in Article 9 of the Uniform Commercial Code (UCC) and in effect in each state of the United States) a very good candidate for blockchain technology. Under Article 9, creditors who have been granted a security interest in personal property by means of a security agreement can “perfect” that security interest, at least for most types of personal property, by filing a UCC-1 financing statement (also referred to as a “financing statement”). This filing effectively puts the public on notice that the secured party claims a security interest in the debtor’s collateral described in the financing statement.

The system arose not only to permit certain creditors to obtain a priority interest in a debtor’s assets but also in part to provide a measure of protection to creditors against debtors that pledge the same collateral to multiple creditors. It is an attempt to solve the problem of which creditor has priority in the collateral in the event that the debtor defaults and the collateral needs to be sold to repay the creditor. Without the UCC system, there is no way for the creditor to know without relying on the debtor’s word whether the relevant types of collateral already have been pledged by the debtor and, of so, which creditor has superior rights. Article 9 of the UCC has been adopted with minor variations in every state of the United States, the District of Columbia, Puerto Rico and certain other jurisdictions within or associated with the United States.

If you consider the problem being solved by the UCC system — to establish priorities among competing creditors, each of whom has a claim against the same assets of a debtor and some of whom may have extended credit without knowledge of the existing lien — it bears a strong resemblance to the problem that Satoshi Nakamoto attempted to solve with the Bitcoin blockchain: that one person would transfer the very same bitcoin to two different people — which he dubbed the “double spend” problem.

Just as the Bitcoin blockchain was created to fix the “double spend” problem, so too can blockchain technology address more efficiently (and with less risk and more upside potential to the trade finance ecosystem) the multiple-pledge problem that the UCC system seeks to address. The current system merely identifies the collateral of a debtor and the interest of a secured creditor, but if the UCC filing system were to be moved to a blockchain, the public could have a record that incorporates the actual ownership information about the collateral, as well as the creditor’s security interest in that collateral.

This is of particular value because when a debtor defaults on a loan, the creditor must snap into action to set in motion a series of activities that lead to a liquidation of the collateral that was pledged in connection with the loan or to some other series of activities that enable the creditor to be repaid. Typically, the creditor’s remedy is a public or private sale of the collateral, and the creditor usually must physically gather the collateral, prepare information, send statutorily prescribed notices and conduct an auction or other mechanism of sale. In its current form, this process is laborious and time-consuming, laden with risk and added expense. Blockchain technology could streamline the process, especially if the debtor, any guarantors and all prospective purchasers have visibility into the same body of information. And, of course, if the underlying loan were to be issued and tracked on the blockchain along with the collateral, additional value would accrue to all of the parties to the transaction as well as those who may buy and/or securitize the loan (or bundle of loans).

Consider the following illustration: A creditor takes a security interest in a dealer’s inventory of rare crystal vases. At the time of purchase, unique identifiers are added to each vase using facial recognition or other emerging technology so that each vase can be tracked and published to a blockchain. When a creditor takes a security interest in the vases, the collateral is not described on the UCC-1 financing statement merely as “inventory” or “vases,” but rather by each of the unique identifiers that correspond to the vases that are being pledged. As the vases are sold, the change in ownership is recorded to the blockchain and, as new vases are purchased (with the proceeds of the sale of the original inventory) the new vases are also recorded to the blockchain. At every step, there is a complete record of the provenance of the vases, including the amounts that were paid, each transfer and the moment when security interests attached to each of them.

The application to more commercial types of inventory is even more dramatic. A manufacturer and distributor of metal pipes that sells on consignment and delivers items to the consignee on a biweekly basis would normally file a UCC-1 financing statement describing the collateral simply as “all pipes from time to time delivered to the consignee pursuant to the Consignment Agreement dated __________”. It may already be the case that each pipe bears a serial number that uniquely identifies that particular item, but it would be impractical to expect the consignor to amend its UCC-1 financing statement every two weeks to identify each consigned pipe by number. Using blockchain technology, the UCC-1 financing statement could be automatically updated as each pipe is delivered, and could identify each pipe by number.

Imagine all of the benefits that this precision and timeliness would generate. A more efficient system that records title, transfers and security interests in a single information source and can be updated in real time could mean, for example, that due to the reduced risk and increased efficiencies, instead of lending against 55% of the value of eligible inventory, creditors might be willing to lend against 60% or more. This could open up billions of dollars for asset-based financing. Moreover, a blockchain-based system could also enable assets that traditionally have not been pledged in connection with trade finance to serve as collateral for asset-based lending.

Consider, too, that with blockchain technology owners of illiquid assets now have an easier way to sell ownership rights in their property. Expensive pieces of artwork, jewelry or rare musical instruments can now be fractionalized, digitized and sold using blockchain technology much more easily than using traditional corporate structures. As those fractionalized units become collateral to secure financing, a blockchain-enabled UCC filing system will become even more attractive. Not only title, transfers and security interests but also the existence of the asset itself (i.e., the fractionalized interest) could be contained on the same blockchain.

In 2016, the State of Delaware, in recognition of the value that digital UCC filings would create, announced that it would put UCC filings on a permissioned blockchain. That project is still in progress. It is our hope that, as more and more state jurisdictions explore how best to deploy blockchain technology, they consider a UCC filing system that integrates with a permissioned blockchain so that efficiencies, transparency and other benefits described in this article can be realized.

A version of this article was published in the Fall 2018 International Bar Association Banking Law Newsletter.