As bitcoin use continues to spread, lenders are increasingly likely to encounter borrowers that own the digital currency. This means that banks need to be aware of the credit risks associated with it. Below are five areas of risk with which all lenders and their counsel should be aware.

First, bitcoin prices are volatile. At the beginning of 2013, the value of a bitcoin was approximately $13.50. By December 2013, that value soared to $1,240. Bitcoin value has since dropped steadily; as of November 2014, it's down to $325. In fact, bitcoins are seven times more risky than gold, eight times more risky than the S&P 500 and 15 times more risky than the U.S. dollar, according to testimony by Boston University professor Mark T. Williams before the U.S. House of Representatives in April 2014.

Second, many observers believe that the bitcoin industry is in crisis. The black market website Silk Road, on which bitcoins were used to buy drugs and other illegal goods, was shut down over money laundering charges in October 2013 with an associated loss of $2.6 million worth of bitcoins held in escrow. Bitcoins have been stolen from multiple exchanges and banks, most famously including Mt. Gox, which failed when $450 million worth of bitcoins were stolen in February 2014. One of the most significant risks related to the currency is that more bitcoin exchanges and bitcoin banks are likely to go under. If that happens, the bitcoins at those institutions will likely be irretrievably lost forever. 

Potential government intervention is another issue. Bolivia, Ecuador and Thailand have outlawed Bitcoin use entirely, while the European Banking Authority has advised European banks not to deal in virtual currencies until regulations are in place. China has also restricted the use of bitcoins, and U.S. regulators are also debating potential regulations. Lenders need to be aware of the fact that governmental restrictions and regulations already exist and more are on their way.

Another problem is that bitcoins can easily be stolen. The public address and private key associated with a bitcoin are all that is necessary to sell or transfer it. Once the currency is stolen, there is very little that the owner can do. Bitcoin sales are irreversible and, for the most part, anonymous. Lenders should discuss the measures that their bitcoin-owning borrowers have taken to protect their public address, private key and bitcoin wallet generally.

Lastly, there is the issue of the limitations associated with exercising remedies against bitcoins as collateral. When lenders have a lien on borrower's money as collateral, they can send a notice of exclusive control and stop the borrower's access to their bank account. But lenders cannot put a control agreement in place with bitcoins, so after an event of default a borrower can move their bitcoins where a lender cannot find them.

There are several steps lenders can take to mitigate the risks associated with bitcoins and other virtual currencies. They should require borrowers to disclose whether they own bitcoins or any other virtual currency, and if so, what security measures are in place to protect their account information. It may also be worthwhile to require written notice prior to any virtual currency transaction and related information about the amount involved, price, location and security measures in place.

If any virtual currency is held as collateral, banks should consider addressing what will happen in the event of a cyberattack, a material decrease in the fair-market value of the digital currency, or any event where the borrower's virtual currency bank or exchange freezes their accounts.

When bitcoins are held as collateral, it may also be prudent for lenders to require that the public address and private key be held in escrow. However, such an escrow doesn't avoid the risk that the public address and private key could be stolen. If an escrow is not desirable or practical, then lenders should consider including covenants in the loan documents requiring the borrower to convert the bitcoins to cash and forward the cash to the lender in the event of a default. Alternatively, lenders could ask borrowers to provide the public address and private key for each bitcoin. But remember: even with such covenants, the borrower may refuse to comply, forcing the lender to seek a court order

Nobody knows what the future holds for the bitcoin industry. But prudent lenders should act proactively to assess the risks and take the necessary steps to mitigate them before a problem occurs.

David Lawson is an attorney with VLP Law Group.