With increasing demand for crypto custody services, the question of what happens to client’s crypto assets in the event of a crypto custody service provider’s insolvency arises. The subject receives even more attention in light of the recent events surrounding international crypto custodians informing their clients, that the safeguarded crypto assets would in case of insolvency be part of the insolvency estate of the respective crypto custodian and that therefore the insolvency risk of the crypto custody service provider is bourne by the clients. This in turn, the question raises of how the German law handles this subject. The question is more complex from a legal point of view than it appears at first glance.

Crypto Assets Are Part of the Insolvency Estate of the Crypto Custodian

As a digital representation of value that can used for payment or investment purposes, crypto assets will become part of the insolvency estate in the event of an insolvency of the debtor according to German insolvency law. The insolvency estate is comprised of the entirety of the debtor’s assets at the time of the opening of the procedure as well as of the assets which the debtor gains during the procedure. Crypto tokens are assets in the required sense and as such they will generally also be part of the insolvency estate of the debtor. However, the assets that are eligible for being part of the insolvency estate are limited to objects that could also be subjected to foreclosure proceedings. According to the majorities’ view in German legal literature, crypto assets can be subject to foreclosure proceedings and are therefore generally eligible for being part of an insolvency estate. The consensus stops when it comes to the question of which foreclosure provisions exactly are applicable. This is because the German law in its foreclosure provisions differentiates between the execution in movable physical objects, in immovable assets and in claims. Crypto assets cannot be qualified as neither movable nor immovable objects. The courts have not yet positioned themselves in this matter. The legal literature also did not position itself with regards to the exact way of solving this problem, nevertheless all proposed solutions come to the conclusion that by utilizing some sort of analogy, foreclosure of crypto assets is legally possible.

No Right of Segregation in Case of Insolvency of Crypto Custodians

This primarily results in uncertainties for crypto custodians. Without any further legislative action, clients of crypto custody service providers in Germany must assume today, that their crypto assets would be part of the insolvency estate of their crypto custodian in case of insolvency. In contrast, bearers of securitized securities which are safeguarded by depository banks have a legal right to segregate their securities from the insolvency estate of the depository bank, should it fall into insolvency. This is because securitized securities are subject to German property law and custody clients are regarded as the owner of these securities even if they use custody services of a depository bank. However, this is different with crypto assets and other tokens, as they are not considered to be objects in the sense of the German property law and it is therefore impossible to establish ownership of them in the sense of the German property law. There is therefore no legal basis for a segregation right in case the custody service provider becomes insolvent.

Creating Certainty for Crypto Custody Service Providers and Clients

According to the current legal situation, clients of crypto custody service providers have no right to segregate their crypto assets from the insolvency estate of the crypto custodian should it become insolvent. Instead, the crypto assets of custody clients would become part of the insolvency estate of the crypto custodian resulting in the fact, that custody clients would qualify as insolvency creditors and merely receive a quota of the countervalue of their crypto assets back from the insolvency estate. The legislator should therefore as quickly as possible amend the German insolvency law and introduce a right for clients of crypto custody service providers to segregate their crypto assets from the insolvency estate of the crypto custodian. Especially with regards to the high volatility of the crypto market where massive price crashes are by no means rare, a corresponding legislative initiative would be an urgently required measurement.

Attorney Lutz Auffenberg, LL.M. (London)

Ref. jur. Hanumsha Beluli

I.  https://fin-law.de

E. info@fin-law.de