Blockchain, or distributed ledger technology (DLT), is widely heralded as the next cornerstone technological advancement of the digital age. Financial institutions are partnering with technology companies and startups to explore potential applications of this technology in all aspects of their business. The rush to implement DLT in the financial services sector is in full swing and institutions have been testing applications of DLT in equity swaps processing, the syndicated loans market, payment messaging, regulatory reporting, contracts and transaction management. Early adopters of this technology hope to achieve a competitive advantage by efficiently managing data, quickly processing transactions and increasing overall transaction security.

As with any new technology, DLT applications create new and different risks, particularly in the earliest stages of development and application. Despite the increased security touted by innovators and early adopters, once any system accumulates enough value, hackers will find new ways to exploit vulnerabilities in that system – and DLT is no different. In addition to the specter of black-hat actors and insider threats, DLT adoption, by an institution or its third-party vendors, potentially exposes institutions to new regulatory compliance risks. Finally, though DLT itself is autonomous in many ways, the intersection of DLT, customers and business operations creates opportunities for human error.

These risks pose potential liabilities that can and must be managed by effective compliance and security programs. Even the most robust systems, however, fail some percentage of the time, and in these instances, it is imperative that the proper insurance policies are already be in place to mitigate the impact of the resulting liabilities.

Insurance Coverage for DLT Risks

Due to the potentially transformative implications of DLT, multiple types of insurance coverage could be implicated by a DLT-based liability.

  • Cyber liability insurance potentially provides coverage for external attacks on a DLT system and, in some cases, may provide coverage for regulatory actions by government entities.
  • Commercial crime or fidelity insurance potentially provides coverage for breaches of a DLT system via employee dishonesty or computer fraud.
  • Professional services (also known as errors and omissions) insurance potentially covers losses resulting from improper implementation or use of a DLT system.
  • Directors and officers insurance potentially covers claims asserting misconduct or negligence at the board-level with respect to the implementation of DLT.
  • Business interruption insurance could cover lost profits due to an unexpected shutdown of a DLT system.

While there may be the availability of coverage, because these policies were likely procured prior to the adoption of DLT, there are likely gaps in an institution’s current coverage or situations where common definitions are ambiguous when applied in the context of DLT.

4 Potential DLT Coverage Pitfalls

  1. Indirect Damages Commercial computer crime policies for financial institutions generally provide coverage for losses due to computer fraud causing “property” to be transferred, paid or delivered. “Property” is defined to include certificated and uncertificated securities, money, electronic data, computer programs and items of tangible property. Even though this coverage grant appears to cover losses related to fraudulent modifications to a DLT system, consider a situation where an unauthorized person gains access to the ledger of equity swaps. Instead of transferring assets for his own benefit, however, the unauthorized user modifies the ledger to make future transactions of his appear legitimate, causing the institution to make payments it would not otherwise have made. In this situation, the subsequent payments might be excluded if the policy in question contains an “indirect or consequential damages” exclusion, which excludes losses that are proximately but not directly caused by a covered event. In this context, the institution might not be covered for the improper payments it erroneously approved based on the modified ledger, because the approval of subsequent payments was not itself fraudulent, but rather the approval was indirectly caused by a fraudulent transaction.
  2. Business Interruption Business interruption coverage forms generally only provide coverage for suspension of operations caused by a direct physical loss and often contain clauses limiting coverage for electronic data or computer operations. Even in cases where such losses are covered, the covered loss may be limited to reconstructing the lost electronic data and specifically exclude profits or income that would otherwise have been generated during the suspension period. Furthermore, unless specifically purchased, cyber liability and computer crime policies often provide very limited or no coverage for first-party liabilities, potentially leaving losses caused by a suspension of operations for a DLT system uncovered if the cause of the suspension is anything other than a “direct physical loss.” While this potential gap in coverage exists with other forms of electronic data, the widespread adoption of DLT only serves to further highlight the need to review applicable business interruption coverage.
  3. Professional Services Professional services coverage, which traditionally provides for negligence or mistakes in the performance of services in exchange for a fee, often contains limiting definitions and exclusions that could bar coverage for a loss related to a mistake in the development or implementation of a DLT system.
  4. D&O Policies Directors and officers policies traditionally provide coverage for the company, board members and executives for claims relating to regulatory and governmental investigations and actions. These types of policies, however, often contain exclusions for professional services that may apply to activities related to the development or implementation of DLT. For example, if a financial institution developed an in-house DLT system for brokerage transactions that was subsequently compromised, leading to a government enforcement action, that action might not be covered if the policy in question contained a professional services exclusion.

Recommendations and Action Items

  • Develop the use case and understand the strategic plan for DLT at your company and any third-party vendors in the short to medium term.
  • Assess the risks associated with the development of DLT based on the intended use.
  • Review applicable insurance policies to assess potential coverage.
  • Consult with counsel and insurance professionals to ensure existing policies provide sufficient coverage for DLT applications and, if necessary, endorse or modify coverage to ensure identified risks are covered.

Republished with permission. This article first appeared in Corporate Compliance Insights on December 16, 2016.