Are Investments in Cryptocurrencies Protected under the BIT regime?

In the backdrop of the 2007 financial crisis, a person or a group that used the name “Satoshi Nakamoto”, created the first cryptocurrency, Bitcoin, in 2008. The growing distrust towards the existing banks and financial intermediaries nudged the financial market towards ‘disintermediation’, boosting peer-to-peer transactions and leading to the development of Bitcoins. Presently, the world is flush with several such cryptocurrencies, and their value has skyrocketed since 2008.

The rapid increase in the global development of cryptocurrencies has led to the growth of literature on their treatment in international investment arbitrations. Through this post, we seek to add to the discussion, by analyzing in detail one key issue that has emerged in this area: whether investments in cryptocurrencies would be protected under the bilateral investment treaty (BIT) regime. This post will be limited to analyzing the jurisdictional issues concerning only cryptocurrencies, and will not address other digital assets such as initial coin offerings, central bank digital currencies (CBDCs),  stable coins or NFTs.

I. What are cryptocurrencies?

Bitcoin, one of the most popular cryptocurrencies, has been described as “an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party”. Cryptocurrencies, unlike fiat currencies, are not backed by central banks or legacy financial intermediaries. They also do not have any underlying assets. New units of cryptocurrencies are created/mined by solving complex mathematical algorithms on decentralized networks of computers using open-source software. While cryptocurrencies can be used as a medium of exchange.given the high volatility of cryptocurrencies, they are  primarily being used as speculative investments, and an alternative to other stores of value such as gold, as discussed here.Transactions through cryptocurrencies are verified and secured using public-key cryptography. Once validated, the transactions are irrevocably logged in a publicly distributed ledger which is visible to all the network participants, thus preventing fraud and double-spending.

While cryptocurrencies may not be legal tender in most countries (unless you are in El Salvador where Bitcoin is legal tender), purchasing or investing in cryptocurrency requires substantial resources. Further, mining cryptocurrencies also demands significant investment in electricity and sophisticated computer hardware. For instance, Bit Digital, a NASDAQ listed global mining operator had an operating expense of approx. USD 35.91 million between January 01, 2021 and June 30, 2021. During the same period, Bit Digital mined 1576.46 Bitcoins, at an operating expense of USD 22,780 per Bitcoin. Further, only a finite number of Bitcoins can be mined (approx. 21 million), therefore with increased competition to mine the remaining bitcoins, the cost of mining Bitcoins is likely to increase further going forward.

Thus, there are primarily two types of investments in the crypto market: investments in crypto-mining farms and investments in the cryptocurrency itself. Both types of investments involve huge risks. While there are ongoing debates (as discussed here, here and here) on whether cryptocurrencies are securities or commodities, investor risk is universally accepted, especially since the cryptocurrencies do not have any underlying assets. In 2021 alone, the price of Bitcoin fluctuated between USD 29,795 and USD 67,549, depending on the perceived value, supply-demand and regulatory risks. Prima facie, these risks are somewhat similar to trading in securities or derivatives contracts in commodities.

Further, an economic venture in setting up a crypto-mining firm has additional operational risks. Crypto-mining is energy-intensive, and disruption in the steady supply of cheap electricity can potentially cripple crypto-mining. Moreover, regulatory crackdowns on cryptocurrencies and crypto-mining create further risks in the investments of a crypto-miner. Given that crypto-mining farms consume industrial amounts of energy, they also cause an environmental risk, drawing further regulatory attention to the sector.

For example, in June 2021, the Chinese government banned all crypto-mining activities; previously China hosted two-thirds of global Bitcoin mining activities. As a result of China’s crackdown, crypto-miners were en masse forced to relocate to other jurisdictions with cheap electricity and favorable regulations. Similarly, in January 2022, the Russian central bank advocated for a complete ban on issue and circulation of private digital currencies, and on crypto-mining to curb financial instability risks and environmental harm. However, the Russian government has instead drawn up a ‘road map’, that calls for restrictions on cryptocurrencies, rather than a complete ban (as proposed by the Russian central bank). As Russia is the third largest country in the world for crypto-mining, and home to 11.2 percent of Bitcoin’s global mining, investors in this field will have to keep a close watch on the government’s final move in the next few weeks.

II. Can investments in cryptocurrencies be protected under the BIT regime?

There is no doubt that the players in the crypto market are at the mercy of the state’s regulators. For example, the crypto-miners in China have suffered huge losses due to China’s sudden crackdown on them. [The price of cryptocurrencies also plummeted when China banned cryptocurrencies. To determine whether these losses can be recovered under the BIT regime, two principal issues need to be analyzed: a) whether there is a valid investment under the BIT; and b) whether the investment is in the territory of the respondent state.

A. Whether there is a valid investment?

In case of an arbitration under the ICSID Convention (the most popular institution for investor-state arbitration), tribunals tend to adopt a double keyhole approach i.e., determine whether the claimant has a valid investment under both the BIT and the ICSID Convention.

i. Validity requirement under the BIT

BITs, generally, define investments broadly, and include rights in both movable and immovable property, and assets such as equity, debentures, licenses and intellectual property, as well as rights under a contract having an economic value. As this definition is typically non-exhaustive, a tribunal may deem cryptocurrencies to be a financial instrument or intangible asset; and these may fit within the scope of such a clause.

Further, as crypto-mining firms resemble an economic venture or company, they should qualify as an investment under such definitions, without much debate. However, BITs, particularly, the recently negotiated ones, also tend to contain clauses allowing the states to implement measures to protect the environment. Given that crypto-mining farms pose a risk to the environment, any challenge to a measure banning or regulating these farms, is also likely to be tested against such clauses of the BIT.

In addition, the definition of an investment in a BIT also typically includes a legality requirement i.e., the investment must be made in accordance with the host state’s laws. This is very relevant for the present purposes, as the regulatory regime of cryptocurrencies varies drastically from state to state – ranging from complete lack of regulation to an outright ban. There is no doubt that if cryptocurrency has been banned by a state, then, any investment subsequent to the ban would not be protected under a BIT.

However, it remains to be seen how a tribunal would interpret the legality requirement clauses in BITs for investments made in states which has no laws for either recognizing or regulating cryptocurrencies. In such situations, it may be challenging for the investor to establish that it had legitimate expectations that the investment would be protected under the BIT.

ii. Validity requirement under the ICSID Convention

Separately, to check the validity of an investment under the ICSID Convention (Art. 25), tribunals tend to apply the Salini test – whether the investment involved a) contribution of an asset for a significant duration, b) an element of risk, and c) contribution to the economic development of the host state. Regarding the first and second elements, some tribunals, like Postova Bank v Greece, have held that this contribution must be towards an economic venture and the risk involved must be of an operational nature. An investment in cryptocurrencies may not be perceived to be linked to an economic venture, as it is akin to investing in a financial instrument, and therefore may fail to meet this test. Further, such investments entail speculative market risks, but do not involve operational risks generally associated with an economic venture. On the contrary, an investment in crypto-mining is similar to running an economic venture, with the miners having to lease a place and invest significantly in hardware resources. Therefore, these types of investments may[will likely] pass the Postova test.

With respect to Salini’s third element, while tribunals have not universally adopted it, it would be difficult to establish that an investment in crypto-currency would benefit the economy of the state. Nevertheless, there is perhaps an arguable case at least in favor of investments in crypto-mining farms. As discussed above, these mining farms require substantial capital investment, and the location of the investment is dependent on the country’s infrastructural capacity and regulatory policies. Further, governments may also want to attract crypto-mining, as it creates employment, and attracts investment for these mining ventures. For example, in early 2021, Riot Blockchain Inc., (a leading bitcoin mining company), bought a crypto-mining farm in Texas for USD 80 million and the en masse relocation of crypto-miners from China to rural Texas is also likely to stimulate the economy, create jobs and improve the state’s tax base. That said, it will be challenging to establish how an investment in just cryptocurrency will boost the development of the economy of the state.

On the contrary, tribunals such as Abaclat v. Argentina declined to adopt the Salini test, as it was limiting the definition of investment given in the BIT. In that case, the Argentina-Italy BIT broadly defined investments to include “obligations or any right to performances of services having economic value, including capitalized revenues”. The tribunal deemed these obligations to refer to security instruments such as bonds or debentures. Therefore, under the Abaclat approach, investments in both cryptocurrencies and mining farms may be deemed to be valid, subject to the wording of the BIT and the regulatory landscape of the host state.

B. Territorial nexus of the Investment with the Host State

BITs are meant to promote and protect investments in the territories of the contracting parties. Thus, the question of whether the subject investment was made within the territory of the respondent state is an important jurisdictional issue. Traditionally, investments constitute projects or enterprises which are physically located in the respondent state, thus, making it easier for tribunals to test this element. While there should be no debate on whether the investment in the mining farm has a territorial nexus with the respondent state, it will be problematic to establish the same in relation to investment in cryptocurrencies.

Since cryptocurrencies closely resemble financial instruments, it would be apt to refer to the Abaclat.v Argentina decision. Here, the tribunal had to deal with the question of whether the purchase of Argentine government bonds in international financial markets from third-party underwriters would be considered to have been investments made in Argentina’s territory. The tribunal held that “with regard to investments of a purely financial nature, the relevant criteria should be where and/or for the benefit of whom the funds are ultimately used, and not the place where the funds were paid out or transferred.”  The tribunal concluded that such bonds would be investments, as the funds were ultimately used by the Argentine government.

There are several challenges for investments in cryptocurrencies to pass the Abaclat territorial-nexus test. First, trading in cryptocurrencies is jurisdiction agnostic. In the absence of financial intermediaries, and trades being recorded in a globally available ledger, it is difficult to peg trading of cryptocurrencies to a particular jurisdiction. Second, there is no clarity on how the funds used to purchase cryptocurrencies are inuring to the benefit of anyone in the respondent?  Host? state.

That said, it may be argued that countries may wish to push for domestic transactions through cryptocurrencies (at least till CBDC becomes more prevalent) to boost their economy. In the case of El Salvador, the government adopted bitcoin as a legal tender to control inflation and prevent further dollarization of their economy. Therefore, with a fast-changing regulatory landscape, there is perhaps going to be a stronger case for investments in cryptocurrencies to be protected under the BIT regime in the future.

Conclusion

Under existing arbitral practice, investments in crypto-mining farms are likely r to be considered to be valid under the BIT regime as they are similar to an economic venture with operational risks, and are located physically in a particular jurisdiction.
However,  it is unlikely that an investment in cryptocurrencies would be deemed to be valid. While cryptocurrencies may be deemed to be included in the definition of investments in a given BIT, a tribunal may hold that the Salini factors are not met. This is because cryptocurrencies are neither linked to an economic venture nor are there any operational risks associated with it.

Moreover, even if a tribunal, following Abaclat, chooses to restrict itself only to the wording of the BIT, it would be challenging for an investor to prove territorial nexus of the investment with the respondent state. Nevertheless, with (future) changes in regulatory perspective, with at least one state declaring Bitcoins to be legal tender, there may be a way for a tribunal to deem these investments in cryptocurrencies to be protected.

Abhik Chakraborty and Rishi Ray