What’s All the Fuss About? Debt Tokens

We recently started a new feature on the Blog. In addition to our Friday Frivolity, Teaching Assistants, and Reefer Brief installments, we now have “What’s All the Fuss About.”  These posts are devoted to scholarship that tops the charts on the SSRN Top Tens.  This time, all the fuss is about Debt Tokens, by Diane Lourdes Dick (left), Chris Odinet (below right), and Andrea Tosato (below left), collectively The Authors.  The Article has now racked up well in excess of 3000 downloads.  If you are not responsible for one of those downloads, here’s a quick summary. 

Caveat lector!  I emerged from reading this article with my knowledge of the field vastly improved.  I have progressed from infant to toddler.  I hope that I did not make too many infantile mistakes and that people with greater knowledge will feel free to offer suggestions and corrections and will do so gently.

The Article does three things.  First, it describes an existing phenomenon, debt tokens, which are digital assets that purport to provide a mechanism that allows creditors of bankrupt crypo-companies like FTX to liquidate distressed assets swiftly and advantageously.  The Article describes some existing variations on debt tokens that evolved in connection with the bankruptcies of Voyager Digital Holdings, Inc., Celsius Network, LLC, and FTX.

Debt tokens have an intuitive appeal.  There has long been a market in bankruptcy claims.  Creditors who need immediate liquidity can sell their bankruptcy claims to entities willing to pursue the claims through the bankruptcy proceedings.  The market in distressed assets may be as large as $300 billion/year.  Not surprisingly, that market is dominated by big players, who can leverage their economic power to buy debt cheaply and then maximize the return on their investment at their leisure.  In the cases of the three bankruptcies that the Authors discuss, customers lost access to their accounts once the entities entered bankruptcy proceedings.  FTX customers, who held unsecured claims against the company, sold their claims at 5-8 cents on the dollar.  Speculators were eager to swoop in and buy. Ordinary creditors are disadvantaged in the current markets.  Debt tokens have the potential to offer ordinary creditors an optimal range of options. 

However, the Authors warn, in their current form, debt tokens have inherent flaws.  The debt token exchange opened in connection with both the FTX and Celcius bankruptcies, OPNX, does not really deal in debt tokens. The bankruptcy claims of people who invest in OPNX assign those claims to OPNX.  The people who purchase tokens through OPNX do not have any rights against the bankruptcy estate; they have rights only against OPNX.  The token, the Authors claim, is an illusion.  OPNX claims to offer its customers liquidity and stability.  In fact, its products do not have those features.  If over 3000 people downloaded the Article because they needed to receive that message, then the Authors will have performed an important public service of consumer protection.

The products have no stability because ultimately the contract that customers enter into involves only them on OPNX.  The terms of conditions of that contract involves the following risk disclosure:

We provide no warranty as to the suitability of the Digital Assets traded on OPNXand assume no fiduciary or any other duty to you in connection with your use of our platform for any purpose whatsoever.

Yikes.

As to liquidity, what OPNX offers is not the ability to exchange tokens for actual U.S. dollars but the ability to exchange tokens for a "stablecoin."  That’s right.  Got burned by cryptocurrency?  Why not invest in another cryptocurrency.  But the stablecoin at issue, oUSD, is not even a real stablecoin, if there is such a thing, as OPNX discloses that the value of oUSD may not always be equal to one dollar.  Moreover, OPNX cannot guarantee its ability to redeem the token at any given moment. 

Editorial aside:  I don’t understand the mindset of these cryptocurrency enthusiasts.  Having just lost 90-95% of the value of your deposits in a cryptocurrency bank, why would you think that another digital asset will be any more secure?  On the other hand, I think I understand the mindset of the people who set up these debt token exchanges.  If this were a good model, I think it would be a good model for bankruptcies generally and not just for bankruptcies in the digital asset sector.  But the people behind debt tokenization know that investors who do not play in untamed waters of digital currency markets would be unlikely to play in the shark-infested waters of debt tokenization.  Want to sell some new snake oil?  Find people who bought the last batch. New and improved.  2.0.

The Article’s second contribution consists of a better model for debt tokens within the framework of the 2022 Amendments to the Uniform Commercial Code (UCC).  The Authors maintain that the legal path to the tokenization of bankruptcy claims is worth pursuing, but it is narrow and beset with legal and commercial difficulties. My hunch is that the Article is motivated in part by the Authors' desire to show crypto-enthusiasts and the world at large that the 2022 UCC revisions can facilitate the use of digital assets in commercial transactions.  

This part of the Article begins with a useful introduction to the UCC’s new Article 12 and its new category of “controllable electronic records” (CERs), a category of intangible assets that a person can enjoy directly without the need for an intermediary.  Article 12 grants CERs the status of negotiability, greatly enhancing their usefulness in commercial transactions, including facilitating the use of CERs as collateral.  The 2022 Amendments include a special perfection regime for CERs that allows for perfection by control, a mechanism of perfection that gives the secured creditor who perfected by control priority over all completing claims, even over prior secured claims perfected by filing.

For the most parts, the 2022 Amendments do not cover tokenization.  However, one form of tokenization that is addressed is controllable accounts.  It is through this mechanism that the 2022 Amendments can facilitate the tokenization of trades in distressed assets.  The Authors lay out the options for how to do so, ranging from approaches without intermediaries to a completely intermediated approach.  I won’t go into the details here except to say that if over 3000 people downloaded the Article in order to learn how to do this right, the Authors will have performed an important public service of consumer education.

Finally, the Authors address the broader socio-economic implications of debt tokens.  In short, digital bankruptcy tokens may become a tool that can assist vulnerable creditors in recovering from bankrupt entities, but they also might become yet another vehicle for irrational speculation.  The upside is that Article 12 provides a vehicle for simplifying the process for making debt tokens negotiable, transferable, and trackable.  Trade in such tokens can proceed securely and with finality around the world and among parties that need not even know each other’s identities.  Article 12 thus could render trade debts significantly more liquid, greatly expanding the commercial market for them while also facilitating access to those markets by parties for whom the barriers to entry were previously insuperable.

However, if like me, you experience navigating this level of financial transaction as akin to walking a slippery tightrope strewn with banana peels while sadistic baseball pitchers attempt to bean you with fastballs, the Authors warn, a steep learning curve awaits you. And, given the crowded marketplace of ideas relating to digital assets and the very poor ratio of signal to noise in this realm, most creditors, debtors, practitioners, and judges will operate without the safety net of the Authors’ wise counsel.  Ever on brand, the Authors point to past episodes of irrational exuberance in this sphere (I’m looking at you, NFTs), and urge guardrails to protect the unwary. 

Although the Authors hold out some optimism for debt tokens as a vehicle for the democratization of markets in distressed assets, they predict that the primary acquirers of debt tokens will be highly specialized distressed debt funds.  Tokenization can improve bankruptcy outcomes and social welfare, but this realm will require careful watching, and the authors encourage empirical studies to follow up on their model.   If over 3000 people downloaded the Article because they want to undertake further study on the socio-economic impact of the tokenization of debt, the Authors will have anchored a new sub-field.