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With Crypto, Advisors Need to Tread Carefully

Despite lack of formal guidance, advisors will face scrutiny.

Editor's Note
This article first appeared in the Q3 2022 issue of Morningstar Magazine. Jasmin Sethi is an associate director of policy research at Morningstar.

As interest in cryptocurrencies grows, many clients are seeking guidance from their financial advisors. But in an ever-evolving regulatory environment, and amid crypto’s recent crash, it can be hard for advisors to know what advice to offer that protects clients and fulfills their fiduciary responsibilities. Recent developments offer clues, but they’re not formal regulations. Instead, I call them “hooks”—guidance and precedents that, while not settled law, can mean that advisors will be under regulatory scrutiny. Recent hooks of note:

  • The U.S. Department of Labor’s guidance on 401(k) plans.
  • The SEC’s accounting bulletin asking for disclosure of the risks of being a custodian of crypto assets.
  • Registration of robo-advisors that recommend cryptocurrencies as legally recognized Registered Investment Advisors.

Labor’s 401(k) Guidance

In March, the U.S. Department of Labor issued a compliance release that identified five factors contributing to the risk of exposing 401(k) plan participants to direct investments in cryptocurrencies and related products. Shortly after, Fidelity announced that it was offering its 23,000 employer-sponsored 401(k) plans the option to allow participants to invest up to 20% of their retirement contributions in bitcoin.

While it is hard to imagine many plan sponsors taking Fidelity up on its offer, in light of the Department of Labor’s guidance, it raises a number of questions for fiduciaries, both those regulated by the Employee Retirement Income Security Act of 1974 and those who are not: Should crypto be part of a retirement portfolio? If so, how much? Should crypto be part of any investment portfolio?

The Department of Labor’s risk factors are a valuable framework for advisors to consider when counseling their clients, regardless of whether the client is in an account covered by Erisa or not. As such, we think it is useful to assess each factor with a Morningstar lens.

Crypto Is Speculative and Volatile

Cryptocurrencies are highly speculative and subject to extreme volatility. They are particularly hazardous for participants approaching retirement or those who elect to allocate a large portion of their accounts to them.

It Is Difficult for Plan Participants to Make Informed Decisions About Cryptocurrencies

Cryptocurrencies are a tempting opportunity for people trying to get rich quickly. They hear stories of people making large sums of money and hope to replicate that success, with little appreciation for the risks involved. Aside from the mere attractiveness of cryptocurrencies, clients are also less likely to have sufficient knowledge about these investments than they do about traditional asset classes. Evaluating cryptocurrency investments is difficult even for expert investors. Advisors must take the time to make sure their clients are fully informed about the asset and the risks involved instead of allowing them to naively accept the risks.

Custodial and Recordkeeping Concerns Abound

Because cryptocurrencies use digital wallets, as opposed to traditional trusts or custodial accounts, custodial and recordkeeping concerns are relevant, including the potential for hacking or theft. There are no protections through the Securities Investor Protection Corp. or the FDIC. Therefore, investments are not insured against hacking or theft unless the platform offers that service independently.

Self-custody is an option, but then crypto investors subject themselves to the possibility of losing their private key. Also, self-custody isn’t likely to be available as part of a 401(k) account. Further, when making a transfer, a slight mistake entering a wallet ID can result in the permanent loss of that crypto with no recourse to recover.

Cryptocurrency Valuations Are Not Reliable or Accurate

Valuation concerns regarding crypto assets stem from the lack of an academically substantiated model for cryptocurrencies, the potential for inconsistent accounting treatment, and differing reporting and data-integrity requirements. Because cryptocurrencies are still new, they lack the standardization required to adequately assess the quality of an investment opportunity. Without the means to accurately assess an investment, how confidently can advisors offer advice on it?

The Regulatory Environment Is Evolving

Currently, cryptocurrency investors do not benefit from regulatory protections from the SEC or the Financial Industry Regulatory Authority. Still, with the rising interest and attention on cryptocurrencies, it may not remain that way for long. Fiduciaries must analyze how emerging regulatory requirements surrounding cryptocurrencies in 401(k)s may apply to issuance, investments, trading, and other crypto activity. The Department of Labor explicitly warns that the sale of some cryptocurrencies could constitute the unlawful sale of securities in unregistered transactions. Advisors could expose themselves to liability and plan participants to risks of inadequate disclosures and a lack of protection.

Additionally, Finra warned that some cryptocurrencies were used in illegal activities and that because of such abuses, there is potential for law enforcement agencies to shut down or limit investors’ ability to use or trade specific cryptocurrencies—yet another level of risk that cannot be overlooked.

SEC’s Disclosure of Custodian Risks

Outside of 401(k)s, another way to invest in cryptocurrency is through an exchange-like platform that handles trading and custody. Exchanges such as Coinbase COIN can charge relatively lower fees and offer limited insurance coverage to protect against theft or hacking, but significant risks remain.

For example, Coinbase recently made clear in a 10-Q filing with the SEC that its customers could lose their crypto assets if Coinbase were to go bankrupt. (This can’t happen with securities like stocks because of the established processes under SIPC that would transfer the securities to another broker.) The risk of losing their assets is not new for crypto investors, but the disclosure is. The disclosure came because of new guidance in the SEC’s latest staff accounting bulletin that addressed accounting for entities that have obligations to safeguard platform users’ crypto assets. The bulletin called for increased disclosures about the unique technological, legal, and regulatory risks and uncertainties involved in this custodial relationship. As we mentioned above, self-custody is an option, but that requires technological savvy and isn’t realistic for most retail investors.

Advisors should be aware of their clients’ technological know-how and ensure that they understand all the risks involved with investing through an exchange—not just in the event of theft or key loss but also in bankruptcy and any other technological, legal, or regulatory challenges the exchange may face.

The Registration of Crypto Robos as RIAs

Investing through a robo-advisor like Makara or Titan is another option. Investors can invest in a diversified basket of cryptocurrencies through an entity that is registered with the SEC and take advantage of sophisticated algorithms that can tailor their portfolio to their goals while mitigating research burdens, adjusting to market conditions, and limiting fees. Because these robo-advisors are regulated, they must make disclosures about fees and conflicts of interest, enabling investors to make more-informed decisions.

Still, while this may be the least speculative route into crypto, it is not without its pitfalls. This option provides more protection than exchanges, but advisors still must be mindful of overallocating client assets to crypto, which could violate their fiduciary duties.

Also, while there are more protections with a robo-advisor, there is little clarity as to precisely what those protections are, particularly because the assets are in the custody of unregistered platforms such as Gemini.

Critical Role

Advising on crypto can feel like walking through a minefield. There are many factors to consider and varying risks for every investment pathway. It’s important for advisors to look at each client’s circumstances, risks, and wealth to determine proper allocations and be confident that they fully understand the risks of this asset class. That being said, crypto may be of interest and use to clients who wish to allocate a small portion of their portfolios at the appropriate level. Advisors have a critical role to play in helping clients make the right allocation decisions and decide the best way to invest—be it through a platform, robo-advisor, or, if available, their workplace 401(k).

Jasmin Sethi does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.