Introduction

Beyond the mere promise to repay loans, prudent business entities and financial institutions generally rely on security in advancing loans to borrowers. The idea of security is the underlying assurance tied to something of value which flows from the borrower to the lender. In the law of secured credit transactions, under general groupings, we have Real Security (mortgage, charge, pledge, and lien), Personal Security (guarantee and indemnity). Real property (land) and personal properties may be used as security for loans and different legal regimes govern these secured transactions and enforcement procedures. Personal property may be tangible assets (vehicles, jewelleries, collectibles, etc) or intangible (stocks, bonds, bank accounts, etc). Cryptocurrency may safely be categorised as an intangible personal property. 

In September 2020, the Securities and Exchange Commission (SEC) in Nigeria issued a Statement where it defined Crypto Assets as a digital representation of value that can be digitally traded and functions as a medium of exchange; and/or a unit of account; and/or a store of value but does not have legal tender status in any jurisdiction. 

Further, the SEC placed virtual/digital assets into four different categories:

1. Crypto Assets – to be treated as commodities, if they are traded on a Recognized Investment Exchange and issued as an investment in line with SEC Rules). 

2. Utility tokens – to be treated as commodities. Utility tokens have functionalities that can be used to access a product or service built on a blockchain and can be exchanged with the use of the virtual currency native to the blockchain.

3. Security token – These are tokens with functionalities similar to securities such as shares. To be treated as securities in line with the relevant provisions of the Investments and Securities Act (ISA).

4. Derivatives and Collective Investment Funds involving crypto assets would be regulated as Specified Investments under the ISA and the Regulations. 

Note that the classification or categorization of a virtual asset will enable a particular regulatory agency to bring the asset within its jurisdiction. Thus, if crypto assets are to be treated as currency, the SEC in Nigeria may lack jurisdiction since by the law setting up the Commission its statutory mandate is to regulate investments and securities business in Nigeria. It is from this viewpoint that we will try to understand what the SEC attempted to do by classifying digital assets as outlined above. 

Cryptocurrency has been found to be one viable tool for secured lending. In this piece, we shall consider how this works especially in transactions involving crypto assets holders in need of loans in fiat currency. 

Legality of Cryptocurrency

As a refresher, cryptocurrency transactions are legal in Nigeria. No law in Nigeria has made dealing in cryptocurrency illegal or criminalized it, including cryptocurrency trading. Engaging in cryptocurrency transactions does not amount to “illegal transactions” under Nigerian law. It is what the user does with the cryptocurrency or in the process of the transaction that determines illegality or otherwise. In a recent case (Suit No: FHC/ABJ/CS/822/2021: CBN Governor v. Rise West Technologies Ltd & 5 Ors.), the Federal High Court was of the view that currently, there is no law in Nigeria that effectively prohibits cryptocurrency. By this decision, the Court effectively whittled down the “executive excesses” of the apex Bank which sought to freeze the bank accounts of some persons accused of dealing in cryptocurrency. 

It is acknowledged that banks and other financial institutions in Nigeria remain restricted by the Central Bank of Nigeria (CBN) from dealing in bitcoin or any other cryptocurrency. Notwithstanding, bitcoin or other cryptocurrency is not illegal in the country, but remained unregulated in Nigeria until 11 May 2022. This is in the light of the recent rules rolled out by the SEC. A seeming light at the end of the tunnel in terms of regulation, this is what the industry needs and not ban, unlimited restrictions, or conduct that appears to stifle innovation.

The new SEC Rules which are in five parts cover rules on issuance of Digital Assets, registration requirements for Digital Assets Offering Platforms (DAOPs), registration requirements for Digital Asset Custodians (DACs), Virtual Assets Service Providers (VASPs), and Digital Assets Exchange (DAX).

Cryptocurrency as Security

Also ranking as a digital asset, cryptocurrency may be used to obtain loans in fiat through a crypto exchange or crypto lending platform like Ayubafi. It works like a mortgage loan as you lose the right to deal with the crypto used as collateral during the lifetime of the loan period. Upon repayment of the loans, ownership rights would be retransferred to the borrower. 

A simple illustration runs thus: A is in need of One Million Naira, but A has Ethereum, a cryptocurrency. A decides  to use his cryptocurrency as security to obtain the One Million Naira loan from company B. Company B owns a platform which enables it to accept the deposit of the cryptocurrency and advance the loan. A is expected to deposit the crypto asset into a designated wallet provided by Company B. In order to minimize the risks, A is usually required to deposit cryptocurrency worth twice the amount being borrowed. This is what is known as loan-to-value (LTV) ratio of 1:2 or 50%. The repayment plan involves payment of both the interest and the principal as agreed. Upon full repayment, the cryptocurrency deposited in the lender’s wallet will be retransferred to the borrower.

As a potent security, cryptocurrency deposited with the lender such as Company B above is highly secured, since cryptocurrency itself enjoys the efficiency and efficacy of the blockchain technology under which it runs. The volatility of cryptocurrencies may be a factor. However, as observed above, accepting cryptocurrency worth twice the value of the loan (in fiat) as collateral or security gives the lender a higher sense of safety in cases of fluctuation in the crypto value. Most lenders also specify the kind of cryptocurrency acceptable, as not all coins may be accepted as collateral or security.

A person with poor credit rating may not be able to easily access loans in the traditional way. But this will not be the case if the person owns crypto assets that may be used as security. 

From the foregoing, it has become imperative that in crypto-backed loan deals, entities who function as fiat lenders need a watertight loan agreement drawn by legal professionals with expertise in digital assets and versed in industry knowledge. Such contracts must reckon with the regulatory climate and compliance, status of the parties, nature of the crypto asset and scope of the transaction. All these need to be captured in the terms of use which are often in the form of standard contracts to be accepted by users of the enabling platform.

Crypto lending generally has gained popularity among players in the industry. Here, we are talking about depositing your crypto asset to be used for lending (in expectation of valuable returns in the form of APY – Annual Percentage Yield or crypto dividends) to borrowers willing to surrender their own crypto as a security.

But why will a person deposit crypto as security to take another crypto on loan? The answer lies in value—value of the crypto and the likelihood of appreciation within a given period. To illustrate, if A holds bitcoin at the value of $30,000 today and A believes that the bitcoin will be worth $40,000 or more in the near future, rather than trade that bitcoin with another cryptocurrency which may not be as promising as bitcoin, A could consider depositing the bitcoin as security for another cryptocurrency, for example, Ethereum, which is currently about $2,000. If bitcoin appreciates, A would be able to benefit since the bitcoin deposited as collateral would have appreciated in value, compared to If A had actually “lost” the bitcoin by trading it for cash or another cryptocurrency that is less rewarding.

The transaction is facilitated through a decentralised finance (DeFi) lending application known as decentralised applications (DApp) or a cryptocurrency exchange (running centralised ecosystems like Binance). It thrives on the same concept of LTV ratio. Thus, when the value of the crypto asset used as security falls below the loan’s value or acceptable limit, the borrower may need to inject more funds or the asset may be liquidated. The beauty of the transaction is that the process is automated, being enabled by smart contracts. Although it has its pros and cons, it remains attractive considering the ease and global outlook. 

The idea of crypto-backed loans in secured lending advances the frontiers of the digital assets industry. The boost in economic activities which it attracts is definitely good for the economy as a whole. While we await the CBN’s favourable reconsideration of the restriction on banks and other traditional financial institutions, the activities of entities dealing on crypto-backed loans is a pointer to the fact that this amazing innovation has come to stay.

Conclusion

Persons who own cryptocurrencies as their only asset and who are in need of fiat, have the option to consider taking up loans from trusted entities using their crypto assets as security. By this, they need not embark on outright sale of the cryptocurrency when in need of funds. It is worthy of mention that before embarking on such a transaction, the importance of seeking the advice of legal experts in the field like Infusion Lawyers can never be overemphasised. There is the need for players in the crypto lending business who wish to play in the Nigerian market to be on sound footing especially as it pertains to the regulatory climate particularly under the new SEC Rules which captures VASPs.

*This article written by Stephen Azubuike was first published by Infusion Lawyers.