Crypto’s hip, but will it flip the script?

By Allen Maggard

Following his restoration to the presidency earlier this month, Vladimir Putin unveiled a new package of executive orders outlining national development targets in socioeconomic and technological policy. These May decrees include a directive calling on the government to increase the GDP share of the domestic digital economy by a factor of three. It is likely that this mandate stems less from a genuine desire on the part of the Kremlin to cultivate a competitive tech sector, than from a recognition among the Russian elite that digital platforms hold opportunities for personal enrichment. Nowhere is this dynamic more apparent than in the Putin administration’s campaign to regulate cryptocurrency.

A recent bankruptcy case sheds light on the emerging relationship between the government and cryptocurrencies. On 7 May 2018 – the same day of Putin’s inauguration and the publication of the new May decrees – the Ninth Arbitration Appellate Court (9-AAC) became the first Russian court to recognize cryptocurrencies as a form of property. The case dealt with a debt-recovery lawsuit against a debtor named Ilya Igorevich Tsarkov. Tsarkov originally filed for personal bankruptcy to obtain protection from an 18 million ruble surety debt owed to a financial services provider. The court granted this protection and assigned Aleksei Igorevich Leonov – an accredited member of the Moscow Self-Regulating Association of Bankruptcy Trustees – to Tsarkov’s case to ensure he declared all his property when putting together his bankruptcy estate for audit.

Tsarkov subsequently informed Leonov that he possessed a Bitcoin wallet through cryptocurrency services provider Blockchain.info. Leonov advised that Tsarkov include the contents of this wallet in his bankruptcy estate, but Tsarkov refused, arguing that his cryptocurrency assets did not constitute property. Leonov brought the matter to the Arbitration Court of Moscow, which ruled in Tsarkov’s favor. The court contended that cryptocurrencies did not fit neatly into conventional categories of property because of their digital origin. The court also noted that the decentralized and anonymous nature of cryptocurrencies made it difficult, if not impossible, to determine whether individuals actually ‘owned’ the contents of cryptocurrency wallets.

Leonov appealed this decision, arguing that the language in Article 128 of the Civil Code was sufficiently expansive to permit the inclusion of even the most unconventional forms of property in a bankruptcy estate. Leonov contended that questions of ownership were immaterial because Tsarkov was required to disclose the worth of his cryptocurrency assets during the trial, thereby establishing ownership. The sum value of his cryptocurrency wallet turned out to be a paltry 0.2 Bitcoins, worth roughly US$1,860, but Leonov won the legal fight – the 9-AAC heard the case and overturned the lower court’s ruling.

Issuing its opinion on the matter on 15 May, 9-AAC determined that Article 128 allowed for the “widest possible interpretation” of cryptocurrency’s status in property law. It referred to a draft law (FZ 424632-7) that proposes amending several articles of the Civil Code to establish a formal legal regime for digital property rights. Although FZ 424632-7 does not legalize cryptocurrencies as such, it does classify “digital codе(s) or signature(s)” as a sort of verifiable property claim. Bitcoin users employ these unique 64-character codes known as private keys to access or “unlock” Bitcoins under their control for use in transactions; FZ 424632-7 would thus implicitly recognize a private key as a legal title to cryptocurrency assets.

The Federation Council approved FZ 424632-7 one day after the publication of 9-AAC’s judicial opinion on the Tsarkov dispute. It may be tempting to interpret this synchrony as evidence of judicial manipulation from on high, but it is no less plausible that 9-AAC referenced FZ 424632-7 in the hope of gaining the Kremlin’s attention and favor, especially given the government’s increasing interest cryptocurrencies. Indeed, former First Deputy Minister Igor Shuvalov quipped last June that Putin himself had become “ill” with the crypto bug. Later that October, Putin directed the Russian government to partner with the Central Bank in developing a legal framework for regulating cryptocurrencies and other related technologies. At the very least, the passing reference to FZ 424632-7 suggests that the 9-AAC took note of the existing momentum towards cryptocurrency regulation when developing its judicial opinion on the Tsarkov matter.

What accounts for the Kremlin’s interest in regulating cryptocurrencies? Writing for this blog last November, Olivia Capozzalo and Smith Freeman suggested that the Kremlin believes that being among the first to give a legal status to cryptocurrencies will give Russia a competitive technological edge over Western economies. Moscow may also have aims to escape the orbit of the US-dominated international financial system by setting up alternative system of its own. Some commentators have ascribed more cynical motives: writing in August 2017, Daily Beast contributor Marc C. Johnson theorized that Putin and his coterie had awakened to the “vast array of possibilities that cryptocurrencies could offer in the service of money laundering,” adding, “it’s not hard to imagine a situation where [cryptocurrency] regulations are either designed to be ignored for the benefit of certain people”.

There is some weight to this latter argument. In January 2014, amidst mounting government efforts to crack down on cryptocurrencies, Sberbank CEO Herman Gref announced that he had personally petitioned the Presidential Administration, the Ministry of Finance, and the Central Bank to refrain from banning the technology outright. Gref’s stance ultimately triumphed over the objections of the security services, implying some degree of elite rent-seeking using the Russian cryptocurrency industry. Regulating cryptocurrencies conforms to Putin’s mission to combat illegal financial activity because it restricts the ability of individuals to convert and anonymize assets through opaque peer-to-peer Bitcoin transactions; however, such legal restrictions also implicitly confers advantages on elites who stand to gain most from new regulations.

Gref is one such person. According to Bloomberg columnists Andrey Biryukov and Anna Baraulina, in 2017 alone Sberbank facilitated around 1 trillion rubles (approximately US$290,768) in online peer-to-peer (P2P) transfers. They estimate that Sberbank handles roughly two-thirds of all online P2P transactions in Russia, making the company the undisputed market leader in online financial services. Gref had ample incentive to champion the legalization and regulation of cryptocurrencies, since Sberbank was well-positioned to take advantage of its effective domination over the online financial services industry to corner the emerging crypto-market.

 

The fact that FZ 424632-7 does not legalize cryptocurrencies per se does not diminish Sberbank’s growing monopoly over the Russian digital economy. In March 2017, months before Putin called for increased cryptocurrency regulation, Prime Minister Medvedev ordered his cabinet to study how the same blockchain encryption technology used to verify cryptocurrency transactions might be used for the purposes of public administration and the management of the Russian economy. Several months later, in January 2018, Sberbank established a laboratory dedicated to exploring the potential applications of blockchain technologies. Sberbank’s research paid off quickly: earlier this month the company announced that had successfully issued a series of ruble-denominated bonds with “smart contracts” employing blockchain verification techniques.

Sberbank and other state-owned financial services providers like VEB thus began reaping the fruits of Putin’s digital economy drive even before regulatory frameworks were implemented. This has allowed the Kremlin to moderate the introduction of new technologies that might otherwise undermine the status quo by undercutting the economic interests of Russian elites who profit from close commercial relations with the state. Yet policing market entry in this fashion also requires regulation. There must be a set of codes governing the punishment of potential competitors who threaten to upset or, in the parlance of Silicon Valley, “disrupt” the enrichment of those close to Putin.

As a bankruptcy matter, the Tsarkov case does not lend itself immediately to this end. Even so, legal experts predict that Russian courts will increasingly seek to apply the case law precedent set forth in the 9-AAC’s ruling to other economic disputes. Lyudmila Merkulova of the Higher School of Economics argues that the 9-AAC’s ruling opens the door to administrative, civil, and “other” types of litigation arising from disputes involving cryptocurrencies.

Tsarkov notwithstanding, most individuals are unlikely to voluntarily hand over information regarding their cryptocurrency holdings if that information is not already available in the public sphere. Why disclose information about your cryptocurrency assets if they are already more or less anonymized? For this reason, Aleksandr Zhuravlev – a lawyer who specializes in cryptocurrency disputes – recommends that creditors immediately request that the courts recognize debtors as the responsible custodians of whatever digital assets they might possess. This would allow individuals to be held personally liable for judicial non-compliance and thereby expose them to all manner of potential legal penalties, including Article 315 of the Criminal Codex, which, inter alia, governs penalties for commercial entities and controlling principals who refuse to fulfill court orders.

In this sense, the “other” type of litigation referred to by Merkulova may entail the deployment of criminal charges against firms and private citizens who refuse to turn over cryptocurrency assets. This would allow a situation where state bodies and politically-connected businessmen alike to coerce ambitious digital entrepreneurs into surrendering their assets using the threat of compulsory bankruptcy proceedings. Time will tell what other new legal frameworks might appear as a result of the Kremlin’s digital economy initiative. But if the Tsarkov case is any indication, whatever new laws do emerge will be written with an eye towards disrupting the disruptors and benefitting the economy’s traditional benefactors.

 

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