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Understanding Regulation on Cryptocurrency

Contrary to popular belief, there is more substantial regulatory clarity for cryptoassets than many advisors think.

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It has become nearly impossible for even the biggest skeptics to ignore cryptocurrency's spread, and that’s especially the case for financial advisors.

Even for advisors who today swear up and down that they will never touch cryptoassets, it still requires being educated on the subject for when clients inevitably ask about bitcoin headlines. And for those wondering how crypto would fit into their practice and client portfolios, there’s an important learning curve to climb for this still young area.

When it comes to that learning curve, many advisors identify regulatory clarity as the biggest area of concern. Registered Investment Advisors have a fiduciary responsibility to manage client assets with the utmost care and prudence. Being aware of the regulatory oversight and compliance requirements provides the baseline against which they make investment management and financial planning decisions.

In this column, I’ll touch on cryptoasset regulatory issues around the following:

  • Portfolio Management
  • Books and Records
  • Custody
  • Disclosures
  • Pricing

The Regulatory Backdrop

Unfortunately, regulation is a bit of a gray area, to say the least. U.S. financial regulators have been unable to come to a consensus when tasked with answering even two fundamental questions:

  1. What type of security should cryptoassets be classified as, if classified as a security at all?
  2. If categorized as a security, what regulatory body is responsible for oversight?

On the topic of bitcoin, the IRS treats it as property; the SEC views it as a nonsecurity; and the Commodity Futures Trading Commission views it as a commodity.

It’s easy to see why many advisors view the regulatory environment as opaque and ever-changing. When it comes to new and niche asset classes, advisors will often choose inaction to avoid adding unnecessary risk to their practice.

However, there has been recent guidance provided by the SEC, IRS, and Finra regarding what the future of cryptoasset regulation will look like.

The SEC and CFTC may be coming together to provide the investment community with more clarity on cryptoassets via the Eliminate Barriers to Innovation Act of 2021. Passed by the House of Representatives in April 2021 and now up for vote in the Senate, this act mandates the creation of a “crypto task force” whose sole purpose is to serve as general counsel to both commissions on how they should address the digital-assets market. The creation of a dedicated team would show commitment to the future development of the crypto economy and hopefully should result in clarification on whether cryptoassets are securities subject to SEC oversight or commodities supervised by the CFTC.

While the recent SEC/CFTC legislation framework offers a framework for a path forward, it follows on other efforts. In 2019, the IRS added to its previous 2014 commentary by publishing specifics on the tax implications of owning cryptoassets. (You can find a 2019 FAQ here.) The report shed light on important tax topics such as how it defines cryptocurrencies, determining their cost basis, the implications of a hard fork (such as what occurred to the Ethereum blockchain in the wake of The DAO’s 2016 hacking) gifts and donations, and more.

In July 2020, Finra released a notice encouraging investment firms to inform it of any activities involving cryptoassets, even if they are technically considered nonsecurities. While the regulatory notice was nothing substantial, the main point was this: At a minimum, Finra wants to be briefed on what advisors are doing in the cryptoassets space (if anything at all). If blind to how and if advisors access cryptoassets, Finra is hindered when attempting to update regulatory standards for brokerage firms and exchange markets.

The SEC has released commentary pertaining to cryptoassets on multiple occasions. In 2017, SEC chair Jay Clayton released a statement on cryptocurrencies, specifically saying that they are not securities and thus not within the SEC's jurisdiction. In February 2021, the SEC published a risk alert on cryptoassets, asserting that they “present unique risks to investors.” The alert specifically cited five areas of focus for investment advisors:

Portfolio Management

When approaching portfolio management, with cryptoassets, advisors need proper procedures in place to ensure they’re allocating assets efficiently and responsibly in alignment with client goals--just as they would with any investment.

In particular, that means advisors understanding where cryptoassets fit within a broader portfolio, ensuring that they perform thorough due diligence before investing, and specifying procedures for measuring and mitigating risk.

Books and Records

Regulators must make certain that advisors keep proper track of all transactions. The crypto market is always operating, highly liquid, and has no wash-sale rule, thus heightening the importance of frequent and accurate recordkeeping. To aid in this, advisors need to choose a customer relationship management software that facilitates reliable documentation of order executions, transactions, and client meeting notes.

Custody

As with all other securities, the appropriate regulators must be able to monitor for any unauthorized transactions, ensure suitable custody with qualified custodians, and verify proper storage of cryptoasset security protocols. Advisors are well aware of what the SEC considers to be a qualified custodian, and there are various firms, such as Anchorage--the first cryptocurrency company to receive a federal charter from the Office of the Comptroller of the Currency--that currently meet the traditional "qualified custody" requirements. Advisors also have the option to use state-chartered custodians, as long as they can explain the reason for that choice in the event of an audit. How advisors go about ensuring the security of private keys and the reliability of the software used to participate in the crypto markets is also critical. Without properly secured systems and security protocols, advisors would be putting client assets at high risk. To combat some of these risks, several crypto custodians now offer added insurance for client accounts.

Disclosures

Like for any investment vehicle, publicly facing content such as formal marketing materials, social-media posts about cryptoassets, or even advisors’ Form ADVs must be updated and is subject to regulation. These materials must include disclosures detailing the risks of investing in the asset class. Risks specific to the digital nature of cryptoassets are especially important to express to clients. Advisors can update their ADV and contact their errors and omissions provider about extending coverage to include cryptoassets.

Pricing

Selecting valuation methodologies becomes increasingly difficult when it comes to cryptoassets with 24/7 market operation and heightened volatility. How advisory fees are calculated can be greatly impacted by the advisor’s chosen valuation practice, thus justifying examination by external committees. This also calls into question quarterly billing in advance around such a volatile asset class.

There is more substantial regulatory clarity for cryptoassets than many advisors think. As it stands today, there is more than enough information in circulation for advisors to learn more and prepare their firms for potential SEC audits if they add crypto to their practice.

While regulatory concerns linger around investor protections and oversight, this is an area actively being working on, as evidenced by recent SEC communications. As always, abiding by the fiduciary standard will continue to be the benchmark by which advisors manage their practices. The RIA space is long overdue for specific guidance and regulations from the appropriate regulatory bodies. It is up to the SEC and CFTC to finally unite and assuage the investment community’s biggest concern and provide a clear regulatory landscape so that advisors can continue to make prudent investment management and planning decisions for clients when exploring this emerging asset class.

Tyrone Ross is the CEO and Co-founder of Onramp Invest and Founder of 401stc, a storytelling consultancy. He is a graduate of Seton Hall University, and was also a 2004 Olympic Trials qualifier in track and field in the 400 meters. He was recognized by Investment News 40 under 40 (2019), and WealthManagement.com as a top ten advisor set to change the industry in 2019. Financial Planning.com named him as one of 20 people who will change wealth management in 2020. He was recently named as Investopedia’s Top 100 financial advisors, and Think Advisor’s 2021 IA25: VIP’s Pushing Advisors Forward. The views expressed in this article do not necessarily reflect the views of Morningstar.