The use of virtual currencies, which seemed novel just three years ago, continues to increase and gain momentum with consumers and in various business channels. As this use continues to expand, lenders may increasingly encounter borrowers and guarantors whose current and/or future assets include or will include some form of virtual currency. Despite their rising popularity, lenders need to be aware of and prepared to address certain risks inherent in securing credits with virtual currencies and/or including virtual currencies as a material source of repayment. The following article provides a brief overview of virtual currencies and identifies some of the significant lending risks associated therewith.
Generically speaking, virtual currencies are electronic representations of value that may or may not have an equivalent value in an actual government-backed currency. Virtual currencies are not legal tender and typically do not have a central administrator. Nonetheless, virtual currencies can be used to purchase goods and services from a growing network of merchants that accept virtual currencies as a form of payment. There are currently hundreds of virtual currencies in existence, with Bitcoin being the most common and most discussed. Virtual-currency commerce can involve businesses and consumers that use virtual currencies to purchase goods and services, merchants that accept virtual currencies as a form of payment, intermediaries that exchange virtual currencies on behalf of merchants, agents that exchange virtual currencies into actual government-backed currency and businesses that provide electronic wallets to the holders of virtual currencies.
The values of virtual currencies are typically not managed by any central authority and can be impacted by the confidence of those using them. As such, the valuations of virtual currencies can be extremely volatile and influenced by traditional factors such as low volume and limited acceptance. Lenders must account for this volatility when underwriting credits involving borrower or guarantors who own virtual currency assets. To the extent virtual currencies are a significant component of a collateral package or a debtor’s assets, lenders must be aware of the price volatility of the specific virtual currency and should attempt to mitigate this risk by including covenants and events of default in loan documentation that protect against material decreases in the value thereof.
Virtual currencies reside in the electronic domain and, as a result, are vulnerable to theft from cyberattacks. These cyberattacks can include, among others, direct theft from a business, intermediary or exchanger or from accessing the owner’s electronic wallet or other virtual currency account. Regardless of method, once stolen, most virtual currency transactions are anonymous and irreversible. Additionally, it is unlikely that insurance is available to specifically insure these virtual currencies from theft. To mitigate this risk, lenders must understand how the virtual currency is held and the security measures in place and then include the necessary covenants and events of default in loan documentation to prevent unauthorized changes.
Perfection of Security Interest
Virtual currency that is held in electronic wallets or other nondeposit accounts domiciled outside of traditional financial institutions will not be considered to be held in "deposit accounts" as that term is defined in the Uniform Commercial Code (UCC), since these electronic wallets and nondeposit accounts are not maintained with "banks." As a result, these electronic wallets and nondeposit accounts are likely "general intangibles" under the UCC. To perfect a security interest in a general intangible, a lender would need to file a UCC 1 financing statement with the appropriate state authority sufficiently describing the virtual currency in a manner that would allow the lender to be able to access the debtor's private key, electronic wallet or other virtual currency account. Perfecting an interest in such an account may be difficult or impossible due to the characteristics of the particular virtual currency. Additionally, it is uncertain at this time whether virtual currencies could be considered "money" under the UCC. In the event virtual currencies are "money" under the UCC, lenders must perfect through possession thereof.
Lack of Control
As virtual currencies are likely "general intangibles" under the UCC, security interests therein cannot be perfected through control. It is not possible for a lender to put a control agreement in place on an electronic wallet or other nondeposit account, which means there would be no agreement between a lender and an account provider that would permit the lender to access and remove funds upon an event of default. Moreover, with a lack of control and the anonymous nature of some virtual currencies, if a borrower or guarantor were to transfer its virtual currency to a third party or different account, it may be impossible for the lender to trace the virtual currency. To mitigate against this risk, lenders should include covenants in loan documentation that specifically address converting virtual currencies, accessing virtual currencies and delivering the same to lenders following an event of default or, in lieu thereof, lenders could require that debtors transfer virtual currencies to them until repayment has been made.
To mitigate the risks associated with credits secured, in whole or in part, by virtual currencies or for which virtual currencies are a source of repayment, Lenders must understand the particular virtual currency and be proactive in their loan documentation to mitigate the associated risks. Nonetheless, even with efforts to mitigate, lenders must proceed with caution and be open to a certain level of risk when virtual currencies are included in the underwriting of a credit facility and collateral package.