Non-fungible tokens, or NFTs, as they’re more commonly known, are unique digital identifiers that are stored on a blockchain or digital ledger. NFTs are used to certify authenticity and ownership of digital or physical objects such as music, event tickets, video clips, art and real estate, and include an associated bundle of rights. These rights can, at the option of its creator, be sold or licensed to obtain royalties.1
Some view NFTs in the U.S. as largely unregulated, potentially because of the ongoing debates as to what asset class NFTs belong to – property, securities, a “scam” or something else.
The digital assets market, including NFTs, has grown significantly in the last few years, and is expected to continue to expand. But NFTs come with certain associated legal considerations, related risks and exposures, and other insurance coverage considerations around the developments that come with this new technology.
Legal considerations surrounding NFTs
Currently, some view NFTs in the U.S. as largely unregulated, potentially because of the ongoing debates as to what asset class NFTs belong to – property, securities, a “scam” or something else.2 From a legal perspective, if an NFT can be traded, it might make it subject to securities’ regulation and trigger various filing and compliance requirements. According to one commentator, the primary test of whether an NFT qualifies as a security is the “Howey Test”, “under which a transaction is deemed an investment contract if a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party”.3
NFT transactions are currently occurring in a system where a patchwork of regulations may be applicable, with none explicitly addressing NFTs to date, though a more explicit legal framework may likely evolve over time. From a federal regulatory standpoint, certain agencies, including the Commodity Futures Trading Commission, have issued guidance on their respective views of digital asset regulation.4 Others, such as the Securities Exchange Commission, are pursuing enforcement actions in accordance with their position that such activity falls under their supervision.5
There have also been multiple legislative bills regarding digital assets introduced in the U.S. Congress over the past couple of years.6 The current federal administration has also been executing provisions of a March 9, 2022, executive order related to responsible development of digital assets. Within this order and a supporting fact sheet, the current federal administration has outlined their new “whole of government” approach to addressing the risks and benefits of digital assets.7 At the individual state level, while many states are regulating virtual currency under existing money transmitter rules8, there does not appear to be regulatory guidance expressly on NFTs to date.
While we have started to see NFT-related civil litigation emerge over the last couple of years, with most actions filed in federal courts, these cases typically address trademark or other intellectual property-related claims. In terms of insurance coverage case law, there does not appear to be any cases to date. According to one observer, most claims are resolving prior to litigation, in part due to some insurers seeking to avoid potentially setting unfavorable legal precedent.9
Some potential NFT-related exposures
While the blockchain technologies where NFTs are recorded are typically viewed as secure, there have been instances where entities holding blockchain assets have experienced data breaches. In 2021, a crypto currency exchange’s database was breached, where hackers first gained unauthorized access to their customer’s accounts through a social engineering technique and then exploited a flaw in the exchange’s account recovery protocol to then steal digital assets from at least 6000 customer accounts10.
NFTs may be susceptible to theft, posing another potential exposure for insurers. Last year, a high-profile crypto start-up was dealing with backlash over "stolen and plagiarized digital assets”.11 Also, if an NFT is considered a security, in addition to any filing or compliance requirements noted earlier, it may also trigger Directors and Officers liability insurance coverage implications which typically address litigation and investigations involving securities.12 There may also be environmental exposures relating to creating or maintaining such NFTs. One study carried out by an NFT artist, estimated that a sale of one crypto art consumed as much energy as his studio used in two years13.
Insurance coverage considerations for insurers
From an insurance coverage standpoint, many crime coverage policy forms in use today were developed years prior to such emerging technological concepts as digital tokens, when covered instruments existed mainly in tangible, non-digital form. Recently, in response to the corresponding potential risks in the crime and fidelity insurance market, Verisk’s ISO team introduced an optional endorsement addressing loss involving digital tokens including NFTs. This option also generally reinforces the original design of the ISO Crime and Fidelity policies where coverage applies to tangible forms of covered instruments, unless otherwise provided.14
The potential exposures of NFTs and legal environment are likely to continue to evolve over time as the technologies change. As with other emerging risks and exposures, the insurance industry will need to remain vigilant, continue to monitor related developments and introduce responsive insurance solutions as this area evolves.