Technological advancements of recent years have given birth to a strange and interesting creature: cryptocurrencies like Bitcoin, Ether, and Facebook’s upcoming Libra. Many of the advantages offered by these tokens stem from their underlying technology – a decentralized ledger, which automatically records any transfer of tokens between individuals, without any involvement from a centralized authority. Transfers can only occur when token holders use their “private key” (comparable to a username and password) to match the token’s “public key” (comparable to an account number), and once they are completed, all transactions are grouped in immutable inter-connected blocks (yielding the technology’s common name, “blockchain”). Yet, this decentralized trait creates a conceptual problem: Do tokens constitute property that can be owned by anyone? And if so, how should the rights of an owner be protected?

The U.S. Internal Revenue Service has said cryptocurrencies should, in fact, be viewed as property for tax purposes.[1] Courts around the world seem to concur, with cases in the U.S. federal courts and courts in Canada, Singapore, and the UK willing to recognize that cryptotokens are (possibly) eligible to be considered property.

However, the courts starkly diverge on the type of remedy that should be applied when rights in cryptocurrencies are infringed. Some judicial decisions impose an in rem property rule that enables token holders to recover misappropriated tokens (e.g. due to theft or scams) from the hands of any person, including third parties. Other decisions adopt an in personam liability rule that grants token holders only monetary damages. However, these various decisions make no distinction among the types of tokens, in effect adopting a one-size-fits-all (property or liability) rule that implicitly applies to any type of token.

Such a rule, however, seems inefficient from an economic perspective. In particular, economic policy typically seeks to maximize allocative efficiency, where goods are allocated to whomever values them the most. Building on this goal, the economic analysis of law (law and economics) offers a simple criterion to decide whether property or liability rules should be adopted: [2] Property rules should be adopted when parties can bargain at zero-cost. Otherwise, liability rules should be adopted. The rationale is that, if parties do not incur any transaction costs, they will voluntarily agree to assign the goods efficiently, irrespective of who has an official property right, as this will create a surplus that can be shared by the parties. Respectively, if parties cannot negotiate without incurring costs, they might be unable to reach an agreement, e.g. if transaction costs exceed the potential surplus.

Applying this insight to the trade of cryptocurrencies reveals that different types of tokens entail very different transaction costs. For instance, transaction costs likely depend on factors such as whether or not the tokens can be traded online via a crypto exchange (so that they are liquid); whether the parties require the assistance of a legal or technological expert to design their agreement; and whether parties must invest costs to determine the token’s value. Thus, there are good economic arguments for imposing property rules for some tokens and liability rules for others.

Though a case-by-case distinction might be too costly, different token groups can be used – where the commonly used taxonomy that classifies tokens into “currency,” “security,” and “utility” seems helpful.  In a nutshell:

• Utility tokens provide a specific utility, such as granting access to a product or a service.
• Security tokens provide financial benefits, such as revenue-sharing or dividends.
• Currency tokens are used as a substitute for traditional currencies, i.e. as means of payment.

While it is not always easy to classify which token falls under which group, the taxonomy can assist in identifying the relevant transaction costs. For instance, in negotiations surrounding security tokens, the parties must invest resources to evaluate the underlying project from which revenues are expected – making the trade complex and costly. Thus, property rules are plausibly better for security tokens. Conversely, for currency tokens, parties need not spend time overthinking the value of the token, as it serves merely as a standard means of payment. Thus, liability rules might be better for currency tokens. For utility tokens, a more intricate evaluation may be inevitable.

Designing an optimal regime requires careful thought about the aforementioned economic aspects, as well as the incentives of the parties prior to the trade (e.g. whether efficient precautions are taken to prevent thefts) and other considerations (distributional effects or fairness). However, acknowledging the problematic nature of a one-size-fits-all rule is a useful first step.

ENDNOTES

[1] See Notice 2014-21, IRB 2014-16, as well as “Frequently Asked Questions on Virtual Currency Transactions”, https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtualcurrency-transactions.

[2] This prescription was suggested in a seminal paper by Guido Calabresi and Dougles Melamed, which builds on the canonical “Coase Theorem” (see Guido Calabresi & Douglas A. Melamed. Property rules, liability rules, and inalienability: One view of the cathedral, 85(6) Harv. L. Rev. 1089 (1972)).

This post comes to us from Dr. Roee Sarel at the University of Hamburg’s Institute of Law and Economics. It is based on his recent article, “Your Bitcoin Is Mine: What Does Law and Economics Have to Say about Property Rights in Cryptocurrencies?” available here.