NFTs are now collateral for secured loans. Are you legally protected?

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Regardless of personal opinions, it has become almost impossible not to notice non-fungible tokens (NFTs). Even with recent downturns, total NFT sales volume could top $90 billion by the end of this year (after hitting a record high $40 billion in 2021). This success has sparked a new kind of interest from a new group of participants in the NFT ecosystem – lenders.

And with a new participant in the NFT space comes a new label for NFTs – collateral.

Whether it’s an NFT-backed loan, a used car loan, or multimillion-dollar leveraged financing of an entire business, the motivations of lenders and borrowers are constant. The lender is incentivized to give temporary funds to the borrower in exchange for an interest rate charged in addition to the principal amount of the loan. The borrower is willing to pay the interest rate because he needs an immediate source of cash without selling the asset.

What changes in each asset class is how the lender is protected against non-payment of the loan by the borrower, or “default”. In a used car market, the lender becomes the owner of the car if the borrower defaults. A solid foundation of secured lending regulations (primarily Section 9 of the Uniform Commercial Code, or UCC) gives lenders the necessary confidence that this transfer of car ownership will occur with or without the cooperation of the defaulting borrower.

So what secured lending regulations apply to NFTs?

Jeff Karas is an attorney at the law firm Anderson Kill. This article is excerpted from The Node, CoinDesk’s daily roundup of the most crucial stories in blockchain and crypto news. You can subscribe to take full advantage newsletter here.

Although simple in theory, and even in the execution of smart contracts (if the borrower does not pay, then the NFT is transferred from the borrower’s wallet to the lender’s wallet), the legal protections of using an NFT as collateral are a complicated matter of lender “perfection”. security interest. An NFT is not a car, and under current UCC regulations, an NFT is not even an “art”. It is most likely either a “general intangible”, which is effectively the UCC’s most commonly used overflow bucket for hard-to-categorize collateral, or an “investment property”, which is a term encompassing securities and other financial assets equivalent to securities.

If an NFT is a general intangible, the lender’s easiest path to perfection is to file a UCC-1 financing statement in the state where the owner of the NFT is deemed to be located. Knowing the legal name and location of a car owner can be simple, but in the digitally native and often intentionally anonymous world of NFTs, a lender can struggle to know the precise filing jurisdiction to perfect their interest in a Bored Ape belonging to “MoonBoiBallz99”. “This hurdle makes perfection by filing a UCC-1 impractical at best, and a maddening rush at worst.

The perfection of an NFT labeled as investment property may be more appropriate for crypto-focused lenders and borrowers. A security interest in investment property is enforceable by “control”. A lender may gain control under the UCC if (1) the NFT is deposited directly into the lender’s wallet, which may be uncomfortable for the borrower, or (2) the NFT is transferred to a third party and a agreement is signed by the lender, the borrower and the third party. Under this three-party arrangement, the borrower grants a lender security over the NFT, but the NFT is held in a specific account (or portfolio) with the third party. This third party, in turn, agrees to follow only the lender’s instructions, thus giving the lender “control” of the NFT, perfecting its security.

Tripartite agreements of this type, often referred to as an “account control agreement”, are common in traditional lending ecosystems where the third party is a bank or bank-like entity. However, banks are more often referred to as “enemies” than trusted intermediaries in the cryptocurrency and NFT space, so any legitimization of NFT lending will require new projects to fill this void.

Several teams have already dipped their toes in NFT lending waters with varying delivery models and wildly varying levels of real and perceived legal protections at their base. The most widely used example to date is the South African NFTfi project, which has facilitated almost 13,000 loans and a cumulative total loan volume of over $212 million since its inception (according to statistics available from Dune analysis). NFTfi’s agreements between borrower and lender are entirely based on smart contracts “signed” by each party, but it is not clear at first glance how strict these contracts are from a legal protection point of view. No plain language agreement is presented to a lender or borrower on the NFTfi system, but it is reported that over 20% of all loans are in default and there have been no failures made public in the transfer of the secured NFT in the event of default by a borrower.

Other NFT lending platforms have started popping up in recent months (including Arcade, which completed a $15 million Series A funding round in December led by Pantera Capital). Others are on the way. Some are mostly on-chain services like NFTfi, while others, like Nexo.iopromise a more nuanced, over-the-counter approach (including a application process for each borrower). Regardless of the method, it is unclear to what extent these new platforms will focus on the legal enforceability of their loan agreements.

It is possible that, as in many markets, there will not be a call for stringent legal protections until there is an issue worth challenging or an issue significant enough to make the one of the newspapers. When that time comes, crypto and secured lending lawyers should be ready to reclaim their old copy of UCC and understand the unique crossroads blockchain has brought to the space (again).

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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