The somewhat nebulous term "crypto" is commonly associated with cryptocurrencies, and bitcoin in particular, described by its creator as "an electronic payment system based on cryptographic proof instead of trust." However, it is important to recognize that bitcoin is only one aspect of the burgeoning crypto ecosystem that is built on the revolutionary blockchain technology, which has many practical applications and uses.

The currently in-vogue terminology is "digital assets," which encompasses bitcoin, other cryptocurrencies, coins and tokens. Some of these are "stablecoins," meaning they are pegged to another "fiat" government-backed currency or other traditional financial asset.

Digital tokens may be fungible or non-fungible. Bitcoin is a fungible token: 1 bitcoin equals 1 bitcoin, just as $1 equals $1. In contrast, a non-fungible token (NFT) is unique. An NFT can represent digital art that does not exist in the physical world, or be used to transfer rights to a particular asset existing in the physical world, or be used for authentication and verification purposes.

NFTs are exploding in popularity and use in the metaverse (the virtual-reality space in which users can interact with a computer-generated environment and other users) and online gaming platforms where NFTs can represent everything from a personalized avatar to a customized virtual experience.

Separately, in the world of finance, the U.S. and other central banks around the world have an increasing interest in the development of "central bank digital currencies" (or CBDCs). According to the current White House Administration, the development of a U.S. CBDC has many potential economic, financial and political benefits such as to "foster economic growth and stability," "protect against cyber and operational risks," "safeguard the privacy of sensitive data," "minimize the risks of illicit financial transactions," "preserve U.S. global financial leadership" and "support the effectiveness of sanctions."¹

In essence, blockchain is based on a distributed ledger technology (DLT) whereby so-called blocks of digitized information are recorded in a secure format. Moreover, this information is immutable — meaning that it cannot be copied, altered or deleted. Additional blocks of information can be added, thereby creating a permanent chronological record of all transactions on a particular blockchain. The adoption of blockchain has been recognized by numerous industry sectors including automotive, health care, insurance, retail and finance, to name a few.

Consider, for example, the business case for use of blockchain for managing a business's supply chain that has become increasingly complex in the global economy, and further exacerbated by supply chain disruptions and delays caused by the COVID-19 pandemic and the Russia-Ukraine conflict. For instance, an auto manufacturer could use blockchain technology to track every vehicle from parts to assembly to shipment to the end consumer. The transparent or "distributed" nature of the blockchain would enable all users to track this movement in real time, permanently recorded in a single digital ledger.

Blockchain is at the core of bitcoin and other digital assets. Notably, bitcoin was developed in the aftermath of the 2008 financial crisis, which resulted in the collapse of New York investment bank Bear Stearns and the U.S. government's bailout of other financial, insurance and auto institutions considered "too big to fail." Critics lost faith in the government and the value of paper currencies that could be printed at will, increase the federal deficit and cause runaway inflation. (Sound familiar?) In essence, the creation of a digital currency untethered to the U.S. dollar was viewed as a potential hedge against inflation.²

Moreover, bitcoin and other digital currencies can be used to facilitate relatively anonymous peer-to-peer, decentralized financial transactions over the internet without the involvement of third-party intermediaries such as banks. Consider, for example, a scenario in which an individual uses a credit card abroad to pay for goods or services in a local currency.

The transaction is subject to oversight and regulation by intermediaries, including the credit card company and banks that have to verify the transaction for processing before it is sent via an electronic transfer payment system, which could take days.

There may be additional processing fees charged to the consumer for foreign transactions. Moreover, interim currency fluctuations may increase the real cost of the goods or services before the transaction is settled. In contrast, payment by bitcoin may occur over a decentralized exchange relatively quickly and cheaply without banks or other financial intermediaries.

Of course, the decentralized nature of cryptocurrency transactions has been exploited by cybercriminals and terrorist organizations alike. For instance, a cybercriminal launches a ransomware attack and demands that the victim organization pay a ransom in bitcoin. The payment is made to the hacker's bitcoin wallet, which is not linked to an identifiable individual.

The U.S. and other governments around the world have denounced these difficult-to-trace ransom payments, which can be used by criminals for nefarious purposes such as funding terrorist activities or even evading political economic sanctions imposed on nation-states, as in the recent case of Russia.

Transactions involving digital assets often take place on platforms or exchanges that may be either "centralized" (CeFi) or "decentralized" (DeFi). In the simplest terms, CeFi typically involves a financial intermediary with custodial responsibility for assets while DeFi is strictly peer-to-peer (i.e., without an intermediary).

One of the perceived benefits of DeFi is that it requires no permissions and is open to everyone. DeFi does not require trusting third party intermediaries such as banks or brokerages. Instead, DeFi users rely on the technology embedded in smart contracts to securely execute transactions. Furthermore, CeFi typically requires users to provide their personal information to open an account and facilitate transactions, while DeFi has no such requirement.

As digital asset transactions become more mainstream, an increasing number of traditional, heavily regulated financial institutions and investment firms have jumped into the fray. Recently, one of the nation's oldest banks embraced an integrated approach to conventional financial systems and technology to provide custodial services for cryptocurrencies and other digital assets.³

Such institutions must comply with stringent laws and regulations regarding know your customer (KYC), anti–money laundering (AML) and countering the financing of terrorism (CFT), in addition to the Bank Secrecy Act (BSA). For some investors, this provides an added layer of security and protection. For others, it defeats the purpose of relatively anonymous peer-to-peer transactions.

As noted by the U.S. Department of the Treasury, "Proponents of DeFi protocols see the purported absence of intermediaries as a benefit that allows users to make trades and move their [digital] assets wherever and whenever they want."⁴

Treasury has cautioned that "the concept of 'custody' for digital assets is different from traditional financial assets with which a customer may be familiar."⁵ For instance, if an unregulated digital asset firm enters bankruptcy (which has happened more than once), its customers may not receive the same legal protections afforded to customers of traditional financial firms. Moreover, they may not be able to access or liquidate their digital assets. In recognition of this custody risk, some insurers have developed a specialized product to provide custody insurance for digital assets. This includes coverage for the loss of digital assets stored by third-party custodians.⁶

The explosion of the crypto markets worldwide is disrupting global financial markets. Investors from Wall Street to Main Street U.S.A. are embracing crypto investing, trading, borrowing and lending in all its forms. The U.S. government and central banks around the globe have recognized the increasing need for regulatory oversight of the crypto markets to rein in abuses and excesses that could potentially destabilize conventional financial systems.

On September 16, 2022, the White House released its "Framework for Responsible Development of Digital Assets," which builds on President Biden's March 9, 2022, Executive Order. The intent of the framework is to advance six key objectives of the Biden Administration with respect to crypto and digital assets, including (1) protecting consumers and investors, (2) promoting financial stability, (3) countering illicit finance, (4) promoting U.S. leadership in the global financial system and economic competitiveness, (5) establishing financial inclusion and (6) encouraging responsible innovation.

With respect to investor protection, federal regulators such as the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) are encouraged to "aggressively pursue investigations and enforcement actions against unlawful practices in the digital space."

SEC Chairman Gary Gensler has been outspoken in promoting the SEC's active role in curtailing crypto market abuses under existing federal securities laws — regardless of whether the underlying digital assets are officially registered as "securities." Indeed, Gensler has suggested that most cryptocurrencies and digital assets, with the possible exception of bitcoin, are in fact securities that fall under the jurisdiction of the SEC's regulatory oversight role.

In a recent headline-grabbing enforcement action, the SEC fined mega businesswoman and social influencer Kim Kardashian $1.26 million to settle alleged securities law violations for failing to disclose that she was paid for promoting and peddling cryptocurrency. On his Twitter account, Gensler stated "This case is a reminder that, when celebrities / influencers endorse investment opps., including crypto asset securities, it doesn't mean those investment products are right for all investors." This is only one of the latest examples of the SEC's and other agencies' enforcement activities to curb investor abuses in the crypto marketplace.⁷

At the same time, the SEC announced that it filed an emergency action to stop an ongoing fraudulent and unregistered crypto asset offering targeting Latino investors.⁸ According to the unsealed complaint, the SEC charged defendants with using the "attraction and novelty of crypto assets to solicit money from unsophisticated investors with no previous knowledge of the crypto assets markets."

Instead of using these funds to purchase and trade crypto assets, defendants "misappropriated the majority of investor money to fund his [sic] unrelated real estate company and his [sic] extravagant lifestyle" through a Ponzi scheme. The SEC alleged that defendants violated federal securities laws in addition to seeking disgorgement of ill-gotten gain.

The SEC also has filed numerous other enforcement actions against companies involving unregistered crypto securities involving "pump and dump" schemes,⁹ "market manipulation" for crypto assets¹⁰ and "unregistered offerings" of crypto asset securities. "To date, the SEC has brought more than 100 enforcement actions involving digital assets, including ICOs [initial coin offerings], unregistered securities exchanges, and DeFi protocols."¹¹ In addition, the "CFTC has brought over 50 enforcement actions involving digital assets, including 23 matters in fiscal year 2021."¹²

As noted by the U.S. Department of Commerce:

"Continued and regular enforcement of applicable financial laws and regulations is a foundational principle of U.S. competitiveness in financial services, including digital assets."¹³

"Financial regulation and supervision must be equally applied to digital assets and their related products and services compared to similar traditional assets, products, and services."¹⁴

Even without the current enactment of formal U.S. regulation governing crypto markets, we can expect regulators such as the SEC, CFTC and others to continue to pursue aggressive enforcement actions to protect consumers and investors under existing traditional regulatory and statutory frameworks.

Firms and insurers working in this emerging marketplace for cryptocurrency and digital assets should continue to stay abreast of new legal developments in this space, and consider whether it makes sense to voluntarily comply with existing regulations that apply to borrowing, trading, lending and investing securities and commodities. Meanwhile, investors should proceed with caution when investing in this new and rapidly growing sector.

1 Fact Sheet: White House Releases First-Ever Comprehensive Framework for Responsible Development of Digital Assets (Sept. 16, 2022).

2 Edelman, Ric, "The Truth About Crypto," pp. 32-33 (2022)

3 BNY Mellon, "Digital Assets: From Fringe to Future" (October 2022).

4 U.S. Department of the Treasury, "Crypto Assets: Implications for Consumers, Investors, and Businesses" (September 2022).

5 Id. at p. 38.

6 Press release: "Lockton launches new digital asset custody insurance facility" (October 12, 2022).

7 Press release: "SEC Charges Kim Kardashian for Unlawfully Touting Crypto Security" (October 3, 2022).

8 Press release: "SEC Halts Crypto Asset-Related Fraud Victimizing Latino Investors" (October 3, 2022).

9 Press release: "Sparkster to Pay $35 Million to Harmed Investor Fund for Unregistered Crypto Asset Offering" (September 19, 2022).

10 Press release: "SEC Charges The Hydrogen Technology Corp. and Its Former CEO for Market Manipulation of Crypto Asset Securities" (September 28, 2022).

11 The Report of the Attorney General Pursuant to Section 5(b)(iii) of Executive Order 14067: The Role of Law Enforcement in Detecting, Investigating, and Prosecuting Criminal Activity Related to Digital Assets," p. 26 (September 6, 2022).

12 Id. at p. 28.

13 U.S. Department of Commerce Report, "Responsible Advancement of U.S. Competitiveness in Digital Assets" (September 2022).

14 Id.