Written by:
Ciarán McGonagle
Ciarán McGonagle is Tokenovate’s Chief Legal & Product Officer, developing blockchain and smart contract-based solutions for financial markets. Previously, he was Assistant General Counsel at ISDA, Vice President at Deutsche Bank, Associate at Morgan Stanley, and trained at Allen & Overy after earning a Law degree at Queen’s University Belfast.
Andrei Kirilenko
Andrei Kirilenko is part of the Finance group at Cambridge Judge Business School. From 2010 to 2012, he was Chief Economist of the US Commodity Futures Trading Commission (CFTC), applying modern analytical tools to regulate financial markets. Previously, Andrei spent 12 years at the IMF working on global financial crises. Between 2015 and 2019, he directed the Centre for Global Finance and Technology at Imperial College Business School. Before Imperial, he was a Professor of Finance at MIT Sloan and Co-Director of the MIT Center for Finance and Policy.
ABSTRACT
- Digital assets have emerged as a disruptive force, challenging the foundational principles of property law with their unique characteristics and technological complexity. Recognised under English law as a “third category” of property, these assets blur the boundaries between physical and intangible property, introducing new legal ambiguities.
- The Law Commission advocates for a flexible, technology-sensitive approach to digital asset disputes, cautioning against reliance on rigid, outdated analogies. Instead, courts are encouraged to evaluate each asset on its specific technological features to ensure appropriate legal remedies.
- Yet, the D’Aloia case underscores the significant practical difficulties of this approach. The case reveals how traditional principles of tracing and following struggle to accommodate the nuances of account-based blockchain systems, illustrating the ongoing challenge of adapting legal frameworks to evolving digital technologies.
- A key factor in this analysis is the underlying blockchain architecture. UTXO-based systems, which trace discrete units of value through transactional outputs, may support quasi-possessory remedies akin to those available for physical property. In contrast, account-based systems, which aggregate user balances, often obscure individual ownership, complicating legal remedies like tracing and following.
ARTICLE
Early 20th century theoretical physicists faced an existential dilemma. For almost 200 years, classical Newtonian physics had viewed the universe as predictable. Deterministic. Particles possessed fixed properties, composed of observable matter. Max Planck’s discovery in 1900 of what later became known as “Planck’s Constant” and subsequent discoveries by Albert Einstein of “wave-particle duality” seemed to reveal an alternative reality.
Observed at the sub-atomic level, it quickly became apparent that both energy and matter – the core building blocks of everything that has ever existed or will exist – behaved in ways that defied existing thinking, fundamentally challenging – both literally and figuratively – the foundations upon which all of past physical theory was based.
Thus, quantum theory was born, sparking decades of research, discovery and disagreement, none more so than in the debates between Werner Heisenberg and Erwin Schrödinger. Heisenberg’s ‘Uncertainty Principle’ suggested that there is some fundamental limitation in our ability to simultaneously know certain properties of subatomic particles, such as position and momentum. This principle supports the probabilistic nature of quantum mechanics, where particles exist in a superposition of states – capable of being in multiple states simultaneously – until they are observed. Schrödinger’s famous thought experiment, involving a cat in a sealed box, sought to highlight the paradox at the heart of this idea. According to quantum mechanics, the cat would be both alive and dead until the box is opened, illustrating the challenges of applying quantum principles to the macroscopic world.
Almost a century later, the evolution of quantum theory bears a striking resemblance to the evolving legal treatment of digital assets. Like the discovery of sub-atomic particles, the evolution of digital assets challenge foundational legal principles by existing in states that defy easy categorisation.
For centuries, English property law has been able to rely on a relatively stable foundation where assets are identifiable, and ownership can be established and enforced with relative clarity and predictability. Digital assets, however, introduce characteristics that seem to blur the boundaries of these traditional categories. Unlike physical property, digital assets exist as mere data entries on a distributed ledger. Unlike incorporeal assets or ‘things in action’, digital assets may not (depending on their structure and purpose) represent a claim that can be enforced through legal action.
It is now largely settled under English law that digital assets can attract property rights. Yet this is only the first part of the equation. The purpose of recognising a property right as enforceable is to provide an ‘owner’ with a clear legal mechanism for enforcing that right. Recognising a property right that is inherently unenforceable presents a paradox: it acknowledges the existence of a right while simultaneously admitting it cannot be upheld, thereby undermining the very purpose of recognising it. This is the point from which our analysis must begin – or, as Niels Bohr, Nobel Prize winner and father of quantum mechanics, wryly observed, “How wonderful that we have met with a paradox. Now we have some hope of making progress.”
It is important to first note that this issue does not arise for all types of digital assets. For example, many tokenised security structures incorporate embedded rights and obligations that are enforceable under traditional legal frameworks. In such cases, the holder’s rights are typically supported by both the underlying legal structure and the blockchain technology that records ownership.
However, there are many types of digital assets that do not exist within such frameworks. For example, cryptoassets such as Bitcoin and Ether exist independently of any such “backing” and do not inherently confer enforceable rights. Instead, ownership and control of these assets rely solely on possession of the cryptographic keys required to authorise transactions, with no direct recourse to traditional legal structures in the event of a dispute over ownership or recovery. Such assets could therefore be seen as existing in a kind of ‘legal superposition’ – extant and observable on the blockchain, but effectively beyond recovery or enforcement if cryptographic keys are not in one’s possession or control.
The recent High Court judgment in D’Aloia v. Persons Unknown and others [2024] EWHC 2342 (Ch) serves as a practical case-study of these challenges.
In D’Aloia, the claimant was induced to transfer approximately £2.5 million in cryptocurrency, including Tether (USDT), to an online trading platform that falsely claimed to be affiliated with legitimate financial institutions. This platform was, in reality, a fraudulent operation. The transferred funds were then moved through a series of blockchain wallets and partially converted into fiat currency via crypto exchanges, complicating efforts to trace them.
The claimant pursued claims of unjust enrichment and advanced equitable property claims, including the imposition of a constructive trust, arguing that the fraudulently obtained assets could be traced back to him. While the court allowed the claimant to serve proceedings out of jurisdiction, the case involved significant challenges in proving that specific funds reached the entities or addresses he alleged to be involved, particularly the exchange in question.
Determining whether an asset can be traced or followed into the possession or control of third parties may not be as complex as quantum theory, but it is nonetheless a question that generations of bleary-eyed students of common law and equity – the author included – have tended to encounter with a resigned sigh.
At the risk of over simplification, we can broadly say that ‘following’ is a technique available under the common law and which can be used in the context of things in possession, where the asset moves “hand to hand.” Tracing, on the other hand, may be conducted under either the common law or equitable principles, depending on the nature of the claimant’s legal title to the asset and the legal framework under which the claim is brought.
One can see immediately the challenges that might arise when applying these principles to digital assets. Under English law, digital assets are not things in possession. Arguably, therefore, the technique of ‘following’ is not available. Nor, however, are digital assets things in action. Rather, they represent a distinct new third category property right, exhibiting some, but not all, characteristics of the other two.
D’Aloia suggests that ‘following’ might be permitted where specific digital asset(s) remain identifiable after transfer. Although this was not established in the case of USDT, the exercise highlights an important but underexplored point: the characteristics of the underlying technology protocol on which the asset is based may ultimately determine the success or failure of such an exercise.
There are, of course, many different protocols and standards, each designed for different purposes and, consequently, offering different functionalities. Distinguishing among these features has been a central discussion point in debates surrounding the regulatory categorisation and utility of specific digital assets, with many competing taxonomies developed to elucidate upon these – often superficial – distinctions. Consider, for example, debates as to whether a digital asset is a “utility token” or a “security token.”
Less frequently discussed are the technological features that could inform the property analysis of a specific digital asset. These features, the author contends, are crucial to determining the types of legal and practical remedies available to asset owners in cases of misappropriation, loss of access, or disputes over control. As discussed below, such features may directly or indirectly affect the feasibility of asset tracing, the applicability of possessory remedies, and the enforceability of ownership rights.
A central technological feature is the type of blockchain. Broadly speaking, blockchain systems fall into two categories: UTXO-based (Unspent Transaction Output) and account-based. The UTXO model, originating from the original Bitcoin whitepaper, operates by linking each transaction to specific outputs from previous transactions. In this way, transactions can be seen as creating a clear, traceable chain of ownership that can often be followed through successive transactions, providing a form of digital “paper trail” for each notional unit of currency.
In contrast, account-based models, like those used on the Ethereum blockchain, aggregate user balances in omnibus accounts, rather than tracking each individual transaction output. This aggregation can obscure the specific origins of funds, as account-based structures only reflect the net balance of transactions within an account, rather than preserving discrete, identifiable units of value.
This fundamental difference impacts not only the traceability of digital assets but, light of D’Aloia, perhaps also the potential legal remedies available to owners in cases of misappropriation or dispute.
For example, the traceability of discrete, identifiable units of value within a UTXO-based system might arguably imbue such assets with quasi-possessory characteristics, making them more amenable to possessory remedies available under common law, including the technique of “following.”
On the other hand, the commingling of assets within account-based systems can make it challenging, if not impossible, to identify or “follow” specific units once they have been recorded on-chain. In this way, account-based assets appear to resemble something more akin to a partial claim to a shared pool of value rather than a discrete, tangible item, aligning more with the characteristics of things in action.
It is worth noting that in D’Aloia neither following nor tracing techniques were found to have been credibly applied to the USDT transactions, rendering the potential applicability of these remedies largely academic. However, one wonders how either technique could practically be applied to such account-based tokens at all.
The development of blockchain bridges adds additional layers of complexity. The ostensible purpose of blockchain bridges is to collapse these cross-chain distinctions, by facilitating the transfer of tokens and data between incompatible blockchains. This is typically achieved by “locking” an asset on one chain and “minting” a corresponding representation of that asset on another. And yet, this very mechanism – intended to bridge technological gaps – raises profound legal questions. For example, what is the legal nature of the “minted” asset? Is it a new, independent crypto-asset or a mere record of the original? Perhaps it is a derivative? Or some kind of trust arrangement? The answer, elusive and context-dependent, could be shaped not only by the underlying technology but also by jurisdictional interpretations, compounding the difficulties in classifying and enforcing rights over these assets.
These blurred boundaries directly challenge the coherence of the newly established third property category for digital assets under English law. While the third category acknowledges the hybrid nature of digital assets, blockchain bridges demonstrate how fluidly these characteristics can shift. Consider an asset transferred across multiple chains; through account-based systems. Its lineage may be obscured, leaving it “present” on several chains but bereft of clear fungibility or enforceability. This stands in stark contrast to the harmonised frameworks that govern intermediated securities in traditional finance, such as the Geneva Securities Convention and IOSCO standards, which ensure consistent protection of investor rights across jurisdictions.
Operational vulnerabilities deepen this uncertainty. High-profile exploits, such as the Wormhole and Poly Network breaches, have exposed the fragility of blockchain bridges, resulting in hundreds of millions of dollars in losses. These incidents underscore the precariousness of systems reliant on smart contracts, oracles, and other intermediaries. As these risks compound, the importance of the Law Commission’s call for a flexible, technology-sensitive approach to digital asset disputes becomes clear. Without such adaptability, blockchain bridges risk amplifying the uncertainties exemplified by D’Aloia, leaving courts to confront an ever-growing constellation of legal and technological challenges.
As lawyers, we find ourselves cast adrift in our own personal state of Heisenberg uncertainty – we know where we’ve been, but we perhaps don’t yet know how quickly we are moving. Just as physicists grappled with quantum mechanics and the unsettling implications it had for predictability and determinism, we are now confronted with a new type of ‘thing’ that appears resistant to traditional property categorisation, forcing us to rethink foundational principles.
In this regard, Professor Kirilenko’s characterisation of these assets as existing in a state of conceptual “superposition” seems apt – they are neither tangible things nor do they (necessarily) represent a claim against any identifiable counterparty or entity. By creating a third category of property, English law has now effectively acknowledged that digital assets will continue to defy conventional property classifications. But rather than resolving the ambiguity, this categorisation could potentially amplify the uncertainty by highlighting the distinct limitations of certain digital asset structures compared to others.
For UTXO-based systems, the new category may reinforce quasi-possessory rights, enabling these assets to be traced in a way more akin to physical property. In contrast, for account-based assets – where individual ownership becomes harder to pinpoint due to commingled balances – this third category still leaves significant room for ambiguity.
These questions may only be capable of being answered once further disputes have arisen and been tested through the courts – much like sub-atomic particles that remain in a probabilistic positional state until the point at which they are observed.
The author agrees strongly with the the recommendation set out in the Law Commissions Digital Assets Report, that legal principles should not be automatically applied to the transfer of third-category digital assets but should instead be evaluated on a case-by-case basis with specific attention to the technology involved
However, the D’Aloia case, where the court faced difficulties tracing cryptoassets on an account-based blockchain, underscores the practical challenges associated with this guidance. In D’Aloia, the court’s reliance on traditional tracing principles highlighted the difficulty of applying established legal concepts to digital assets without risking misinterpretation or generalisation of their technological structures – for example, the distinction between UTXO and account-based systems described above. This reveals the practical challenges of implementing the Law Commission’s recommendation, as courts may struggle to consistently interpret digital assets on their own terms rather than by analogy to centuries-old common law or equitable principles.
To align with the Law Commission’s guidance, the author urges the courts to avoid relying on technologically ambivalent approaches to these questions and instead recognise the limitations of traditional frameworks when addressing the unique properties of digital assets. D’Aloia suggests that this will be a complex task; without deeper judicial familiarity with digital asset technologies, the third category risks perpetuating conceptual ambiguities, as courts may fall back on analogies with traditional property, with predictably unsatisfactory results.
Future innovations in digital assets are likely to introduce increasingly complex structures and technologies, continuously challenging courts to adapt. As the Law Commission suggests, the law must remain flexible to avoid rigidly applying outdated analogies that may not align with new forms of digital property. Emerging technologies like AI and quantum computing may further deepen this uncertainty, underscoring the importance of a legal framework that can address these evolving risks. The mind-boggling enormity of this task can scarcely be overstated. Perhaps, therefore, it is fitting to leave the final word to Bohr, who sagely observed that, ‘Prediction is very difficult, especially about the future.’
This article was originally published in February 2025 in JIBFL – the Journal of International Banking and Financial Law (link here).
