Can We Eventually Agree on Whether and How to Take Security over Digital Assets?

As a significant pivot between China and the rest of the world, Hong Kong is leveraging the vast resources and population of its motherland. Further, state policies strongly support the development of scientific technology of Hong Kong – the Framework Agreement on Hong Kong/Guangdong Co-operation and the establishment of the Shenzhen/Hong Kong Innovation Circle are among the key indicators. The 14th Five-Year Plan of China affirms that exploration of scientific development shall be given top priority, and emphasises the core values of the Guangdong-Hong Kong-Macao Greater Bay Area (GBA) as an international innovation technology region.

In connection with the commemoration of the 25th anniversary of Hong Kong’s return to China, President XI Jinping travelled to Hong Kong and made special arrangements to visit the Hong Kong Science Park during his short trip to meet with relevant officials and science companies, giving the development and prospect of innovative technology in Hong Kong an unprecedented boost.

Heightened interest in the sector is also evidenced by the gazetting in Hong Kong of the long-awaited Anti-Money Laundering and Counter-Terrorist Financing (Amendment) Bill 2022 which introduces, among other things, a new licensing regime for virtual asset service providers.

Many international and Asian financial institutions, investors and fund companies have taken advantage of recent developments to access Hong Kong’s innovative technology market. Appleby has assisted in loan transactions for investments in digital business, advising on a wide range of related areas such as corporate structuring, leveraged financing, structured finance, digital assets licensing, employee incentive programs, etc. The past few years have also seen a marked increase of instances in which parties explored the suitability of digital assets as collateral in financing and investment transactions. However, the absence of unequivocal means of enforcement of security over digital assets remains by far the biggest challenge to any investor.

From a legal perspective, it is essential to ensure that any security over digital assets may be created, acknowledged, perfected and enforced under the applicable laws with the same, if not more, certainty than that enjoyed by security over physical assets. For a start, courts in a number of jurisdictions have already been challenged to make judgement on whether different forms of digital assets are “property” per se, and achieving a somewhat universally acceptable decision is still a long way off.  The decentralised nature and lack of clear ownership or a public register of digital assets make it almost impossible for secured parties, receivers and courts alike to enforce security over digital assets. Whilst the use of cold/segregated storage (such as private keys) may alleviate some of these concerns, other issues still require much discussion, including the medium of storage and choice of custodian/trustee. Leading custodians/trustees for this purpose are yet to emerge in the market and this reason and other relevant factors often contribute to the breakdown of negotiations – at least in relation to the use of digital assets as part of the collateral package. Indeed, as investors request additional collateral to support the risks of taking security over digital assets, parties may well end up relying on traditional collateral altogether.

If the innovation and technology sector is to continue to develop and flourish, remaining attractive to investors and businesses, difficulties associated with taking security over digital assets will need to be addressed.  It will be interesting to see how regulators and courts around the world tackle disputes, insolvency and other proceedings involving digital assets, and whether any uniform approach may eventually emerge to allow the financial markets to fully tap into the sector’s vast potential.