Insurance in the crypto space: the emerging international market for insuring NFTs with a focus on the Commonwealth Caribbean

Non-Fungible Tokens (NFTs) have grown in popularity as sources of ownership and investment in an increasingly digital world, thanks in part to the many successful sales of NFTs by auction houses such as Christie’s and the Commonwealth Caribbean, is not to be left behind in any respect.

The region is also rapidly developing a market for their NFTs, with particular focus on the creative industry with reggae artists, musicians of all genres, and fashion houses developing NFTS and trading directly on the international market.

What do NFTs represent?

Non-fungible tokens, or NFTs, are singularly unique representations of digital or physical assets of value and their ownership. For instance, the Bahamian technological company P08, utilizes the blockchain technology on which NFTs exist to create NFT representations, or "tokenize", recovered underwater artifacts and their subsequent ownership. In other words, P08 creates a digital representation of the ownership of an artifact and is a representational equivalent of the market value of the said artifact. The potential market value of discoverable P08 artifacts is estimated to be in the billions of dollars as the shipwrecks in Bahamian waters are estimated to date back to the days of the Spanish Empire and its Spanish Galleon treasure ships.

Similarly, Trinidadian fashion designer, Ayoung Chee, created and launched the first NFT in the Caribbean fashion world called WYLD TING, now called WYLD FLWR, during the Fall of 2021 to represent her brand. The NFT was an entirely digital representation in the form of fashion photographs converted to art pieces and set to the music of local artists.

The great value of an NFT is that each is entirely distinguishable from every other NFT and therefore one cannot be exchanged for another, i.e. non-fungible; which differs from the entirely fungible assets utilizing blockchain technology, such as cryptocurrencies, i.e one cryptocurrency type can be exchanged for that same type, e.g. mMoney in Barbados. Each NFT contains unique metadata encoded per the associated "smart contract" and is currently created or "minted" using the industry standard, ERC-721, on the Ethereum blockchain.

The technology

A participator in the NFT market must first set up and maintain a digital wallet with an established and reputable company in order to begin minting and/or purchasing and selling NFTs. Currently, the most used cryptocurrency for trading in NFTs is Ethereum. Each creation and trade of an NFT is recorded on the blockchain.

The distributed ledger technology, of which "blockchain" is the most commonly known version, behind the creation and trading of NFTs and cryptocurrencies was developed as a way to obviate the need for trust, and therefore third-party intermediaries, e.g. banks, by providing for a cryptographic hashing process that through the use of blocks (made up of a series of transactions) in a chain, secured the veracity of transactions. This process, primarily built on a decentralized ledger, provides anonymity for transacting parties, whereby various effectively autonomous nodes, or computer terminals, are responsible for the recording and storing of transaction data, thereby allowing two parties to transact with one another, anywhere in the world, without an intermediary.

Though, as we have seen with the evolving digital currency market in the Caribbean, such as the Bahamian "sand dollar" and the Eastern Caribbean "Dcash", it is possible to re-insert the role of a third-party intermediary through a cryptocurrency verification process. NFTs are, however, not fungible cryptocurrencies and instead represent an immutable "digital certificate of ownership" secured by the same distributed ledger technology as cryptocurrencies, wherein its authenticity and provenance are verified similar to pieces of art, especially in fine art and specie insurance.

The distributed ledger technology provides an increasingly reliable method of transaction record keeping as each block in a chain is linked using cryptography and contains a cryptographic hash of all the surrounding data associated with the immediately previous block, and so the entire chain of data is structured and further verified by consensus, i.e. known as "proof of stake" on Ethereum and "proof of work" on Bitcoin.

The NFT market and valuing NFTs for insurance

NFTs have been in existence since approximately 2017 but gained the attention of the larger economic market when graphic designer, Michael Winkelman sold his NFT entitled "Everydays: The First 5,000 Days" for sixty-nine (69) million dollars in 2021. According to various reports, none of his previous work had sold for more than one-hundred dollars. Similarly, in the same year, Jack Dorsey, co-founder of Twitter, sold an NFT of his first tweet for 2.9 million dollars. It has since been reported that as of mid-2022, Dorsey’s NFT was valued to be only in the thousands of dollars.

Therein lies one of the many problems insurers have found when attempting to devise policies to cover risks associated with NFTs - they, particularly those representing virtual assets, show difficultly in establishing a stable value. The NFT market, itself, is still in its infancy. On the other hand, the value of NFTs representing physical assets, such as with P08’s artifacts, is equivalent to the value placed on the physical asset itself.

Generally, the nature of an NFT, and therefore the value of it, has been difficult to define. For instance, some NFTs have been categorized as securities while others have not. For example, in the Bahamas, NFTS may be described as securities based on the following rubric:

The U.S. Supreme Court case of S.E.C. v. W.J. Howey Co., 328 U.S. 293, more specifically defined a security as "a contract, transaction, or scheme whereby 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." As such, the US Securities and Exchange Commission (SEC) has declared that NFTs have the potential to be called securities given certain conditions such as those described under the Bahamian policy above.

Securities are not traditionally insurable. Therefore, NFTs where considered to be securities would likely not be insurable. However, theories have circulated that the principles and policy forms applicable to either property, cyber, or crime insurance policies could also be applicable to NFTS. Further, fine arts and specie insurance has also been considered to be applicable to NFTs with the NFT being categorized as specie - an asset of high value.

The fall of FTX, inherent risks of NFTs and existing insurance products

The Monday evening arrest in the Bahamas, pending extradition to the United States, of the collapsed cryptocurrency exchange FTX’s founder, Sam Bankman-Fried, reveal the uncertainty still plaguing the cryptocurrency industry and related NFT markets. Charges by U.S. federal prosecutors against Bankman-Fried include conspiracy to commit securities fraud and wire fraud - all of which has called into question not only the stability and reliability of cryptocurrencies and, by extension NFTs, as financial products but their ability to be effectively regulated.

In September 2021, FTX relocated from Hong Kong to the Bahamas likely as a result of the favorable regulatory environment. Unlike the Chinese regulatory environment which had become increasingly restrictive of  the cryptocurrency industry, the Bahamas made regulatory strides in its 2020 enactment of the Digital Assets and Registered Exchanges Act, 2020 (DARE) regulating the fledgling digital assets business and cryptocurrency business on the island.

The failure of FTX has so far been tied to the mass withdrawal of assets by depositors revealing a US$8 billion deficit in the company’s books, leading to its November 2022 bankruptcy filling. However, the precursor to FTX’s failure is being investigated by US officials and has, to date, been reported as connected to the company’s potentially illegal transfer of billions in customer assets to crypto hedge fund Alameda Research - a company also owned by Bankman-Fried.

The details of the cause of the collapse, potential regulatory failures, the liquidation process for digital assets, and likely network of subsidiaries and other companies involved in the FTX collapse remain to be revealed, and to be discussed in Part II of this article. But what can still be openly speculated from events thus far is whether digital assets such as NFTs are inherently vulnerable to systemic vulnerabilities brought about by the novel technology underpinning the assets and any potential failure in regulation.

The Bahamian DARE Act, which entered into force on 14 December 2020, is administered, per section 4 of the Act, by the Securities Commission of the Bahamas (SCB) which is made up of a governing Board and multiple sub departments including Supervision, Examinations, and Enforcement divisions to execute the administration of acts in its remit. The Act provides the legal framework under which FTX operated, and other cryptocurrency exchange powerhouses such OKX, continue to operate.

The key question is whether the failure of FTX is a reflection of inadequate regulation of novel financial assets or whether it is just the unremarkable result of corporate corruption the likes of Enron Corp. in spite of set regulatory frameworks. The answer is not quite clear at this stage as it will likely be many months before sufficient details surrounding FTX’s collapse emerge

Nonetheless, the DARE Act does provide a strong prototypical infrastructure for the regulation of digital assets. The Act defines a digital assets as a "digital representation of value distributed through a DLT Platform where value is embedded or in which there is a contractual right of use and includes without limitation digital tokens"; here DLT refers to distributed ledger technology. The Act further defines digital tokens to include virtual currency tokens and non-fungible tokens (or NFTs).

The purpose of the Act, that is the regulation of the issuance, sale, or trade of digital assets in or from within the Bahamas, is realized under Section 5(1) which empowers the SCB to:

1. "Regulate, monitor and supervise the issuance of digital assets and persons conduction digital asset business in or from within The Bahamas"; and
2. "Develop rules, guidance and codes of practice in connection with the conduct of digital asset business and initial token offers".

Section 39 provides the SCB with power to inspect and investigate businesses such as FTX, OKX, or P08 that are registered under and regulated by the Act. Section 40 ensures that the SCB can retain qualified external agents to conduct the necessary inspections and investigations of registered entities thereby ensuring the manpower to monitor registrants under the DARE Act. Part VI of the Act details the offences, penalties and sanctions for violation of the Act and describes such offences as failure to comply with the Act which attracts a finde to willful misrepresentation which can attract both fine and imprisonment of up to ten years.

The DARE (Amendment) Act, 2022 further empowers the SCB with quasi-judicial powers such as the ability to compel witnesses and the production of documents, per section 40A. If any witness fails to comply per section 40A, section 40B states that the SCB can apply to the court for that witness to be held in contempt. Section 46A further empowers the SCB with cross-jurisdictional enforcement powers in devising the power to issue five-day freezing orders staying any dealing in digital assets or other property in order to assist in the "administration of the digital assets legislation of another jurisdiction" if it deems it to be in the public interest.

The SCB also sets annual examination, supervisory and enforcement priorities in its administration of the DARE Act. The 2021 priorities focused on corporate governance and investigation of fraud schemes as based on, for example, global financial crime trends.

Therefore, the risks associated with an NFT are as varied as the NFT itself. However, an NFT falls into two main categories generally, a wholly digital asset like Ayoung Chee’s NFT or an NFT representing physical ownership of an asset of underlying value such as the type offered by P08. In the case of the latter, insurance can certainly be provided for the underlying asset, likely in the case of P08 but the likelihood of loss to be suffered in the NFT itself remains as yet an undefined concept.

However, it is indisputable that the owner of, for example, the Winkelman sixty-nine million dollar NFT would certainly want to know that any and all potential risk of loss, whatever it may be, is insurable. The issue here is that popular consensus holds that the distributed ledger technology backing an NFT is fairly stable and secure and as such the risk of "loss" of an NFT is minimal. However, the limitation in this reasoning is that the technology is new and so the associated risks have not made themselves fully known.

For example, though quite stable and secure the blockchain is not immune to attack or disruption. The level of security of the blockchain is equivalent to the hash rate or computing power used in the proof of work of the blockchain. Therefore, the more powerful the computing systems used to do this work, the more secure the blockchain and the less vulnerable it is to attack. Still, there are various attacks to which the blockchain, and thus NFTs, are vulnerable, the most well-known being the 51% attack.

The 51% attack involves a bad actor taking control of over 50% of the processing power of the blockchain network allowing them to have majority control of the consensus algorithm - the algorithm that authenticates the metadata in a block in the blockchain and, therefore, would also authenticate an NFT. The proof of work consensus used by Bitcoin is by majority opinion much more secure than the proof of stake consensus used by Ethereum which supports NFTs. In this manner, an NFT could effectively be "stolen" or falsely validated, creating exposure to loss for the owner of the NFT. This is where insurance products such as property, cyber, or crime policies would come into play.

Further, case law emanating out of the United States District Court, Southern District of New York, exemplifies the type of risk associated with NFTs particularly in the case of Playboy Enterprises International Inc. v. www.Playboyrabbitars.app, et al., No. 21 Civ. 08932 (VM) (S.D.N.Y. Nov. 13, 2021). In that case, Playboy Enterprises brought suit against defendants for violating trademark and unfair competition law when defendants sold "fake" Playboy Rabbitars NFTs on counterfeit websites using the Playboy trademark. NFTs, are therefore, subject to counterfeit similar to knock-off designer apparel.

Trademark infringement is, then, another avenue of exposure to loss that could be suffered, not by owners of NFTs but their creators. Coverage for trademark infringement liability may be available under a Commercial General Liability policy and provides cover for defense costs, for example, in defending against a trademark infringement claim, or even counterclaim if the covered is the one filing suit.

Conclusion

Insurance solutions will vary according to the risk exposure of a particular NFT which is tied to the nature of that NFT as well as the inherent property, cyber, crime or even potential intellectual property-related risks; particularly with highly damaging risk potential as discussed earlier, in large part because NFTs remain a highly unregulated market.

Nonetheless, the Commonwealth Caribbean region as a whole, and especially novel regulatory jurisdictions such as the Bahamas, is a hotbed of development in the NFT, and cryptocurrency, space and so will likely become a notable part of the evolving digital world market.

Whatever the development in the NFT market and associated national regulations, Kennedys, with its breadth of insurance practice covering the very areas of insurance likely to apply to NFTs and with offices spanning the globe, is well placed to continue to monitor this evolving asset market and advise clients on evolving risk solutions, potential risk exposure and management.