With the proliferation of digital assets, lenders should be familiar with virtual currency and non-fungible tokens (NFTs), which borrowers may want to pledge as collateral.
Virtual currency is just that – a non-physical medium of exchange not recognized as legal tender by governments. Popular examples include Bitcoin and Ethereum. NFTs, on the other hand, are unique digital assets stored on a blockchain that represent ownership or proof of authenticity of a specific item or piece of content such as artwork, music, videos or in-game items. Banks and lenders can benefit from these new collateral options if they know how to protect their interests.
The laws surrounding security interests in digital assets are relatively new. In 2021, the Arkansas legislature amended its Uniform Commercial Code (UCC) to address security interests in virtual currency (not NFTs). Here are some things to remember:
- A security interest in virtual currency may be perfected by filing or control, but control is better to protect a secured party’s interest;
- What constitutes “control” will vary on a case-by-case basis, but there are several “must do” steps in any case;
- A secured party needs to be able to identify itself as having control through the virtual currency or a related system, and there are different ways to accomplish this;
- Use of digital wallets, either online or offline (a secured cold wallet), can be useful if they are hack resistant; and
- Trustees or custodians may sometimes be employed to hold virtual currency.
Regardless of how “control” is established, it is critical that the private key/digital wallet is protected. Anyone who has the private key can sell or transfer the digital asset. Digital assets are routinely stolen by cybercriminals who successfully access the digital wallet—transferring the virtual currency contained in the wallet with little hope for recovery.
Currently, Arkansas law does not provide for perfecting security interests in NFTs. But, in 2022, a new UCC Article 12 was proposed at the national level regarding transfer of property rights in certain digital assets including NFTs. The approach to NFTs is similar to that used with virtual currency. States have not yet adopted the newly proposed UCC amendments regarding NFTs; however, it is anticipated that Arkansas will adopt the clearly defined approach to the perfection of security interests in NFTs.
Lenders should understand how virtual currency and NFTs can be used as new collateral options. The banking law attorneys at WLJ can help ensure lenders’ security interests are protected in a manner consistent with adopted and proposed legislation, as well as talk through practical considerations regarding control and security.