Compliance Considerations for Cryptocurrency

*Estimated Read Time: 4 1/2 minutes

With the rise of cryptocurrencies and Initial Coin Offerings (ICO’s), the industry has its ears perked at the prospect of something “new.” For decades, the investment advisory space has been occupied by traditional investment strategies, consisting of some asset allocation mix of stocks, bonds, mutual funds, ETFs, and the occasional private placement investment that offers attractive returns in exchange for limited liquidity for accredited investors. Perhaps for high net worth investors, an occassional non-securities investment recommendation has created additional opportunities for diversification outside of traditional investment strategies. Therefore, it makes perfect sense that both market professionals and investors are interested to hear more about cryptocurrency. The questions that advisers can expect from their clients surrounding these offerings are generally similar to the questions received on traditional investment products. 

“What are the risks?”

“Can I make money?”

“Is this the next big thing?”

“How is cryptocurrency tied to the market?”

And then, the most common question of all…”Should I…?”

Here are a couple of perspectives.

The Client Perspective

From a client protection standpoint, it’s important that clients know that Initial Coin Offerings are not registered with the SEC. So, investors do not necessarily benefit from the protections provided by SEC Regulatory Guidelines. It is therefore advisable that advisors make this statement a consistent part of their discussion with clients when this subject arises. Another downside for investor protection is the fact that the transfer of cryptocurrencies may span across the borders of multiple nations, with virtually no regulations in place to provide tracking for the transfer of the currency. For any client that ever became hesitant at the prospect of an international wire transfer, the prospect of buying and selling cryptocurrency may be an immediate red flag.

The Firm’s Perspective

From the perspective of investment advisers and compliance officers, there is plenty of room for regulatory agencies to assume authority in matters regarding this topic. This gray area revolves around the following idea: Although  cryptocurrency has not been officially classified as a “security” by the SEC, firms are still under the jurisdiction of their regulatory agency, which may choose to hold the recommendation or transaction involving a cryptocurrency to the standards of any other security. In other words, cryptocurrency can be treated as a security in a regulatory audit if the regulator deems it necessary to classify it as such for the protection of the investor. The level of regulatory uncertainty present in this determination may lead more cautious compliance officers to steer advisers away from cryptocurrency recommendations altogether (Check out XYPN’s perspective on Bitcoin).

Financial advisors are expected to provide opinions and guidance on both securities and non-securities investments. It is imperative, however, that advisers make sure to thoroughly document each conversation held with clients regarding cryptocurrency, as well as make sure to be well-versed in cryptography in case a regulator wants to question the merits of the conversation. It’s impossible to justify an in-depth conversation with a client if the adviser doesn’t genuinely understand the topic of the discussion. Therefore, the safest policy is for advisers to take more of an "educational" role than a role in which they will make specific recommendations in the conversation.

From a compliance standpoint and for the aforementioned reasons, advisers should be hesitant in recommending the use of crytopcurrency for the purposes of either transactions or investments. Why? There are still substantial enough legal concerns regarding an "unregulated" currency that many should consider whether or not it's worth the risk of a recommendation. Although the IRS has ruled that cryptocurrency is treated as a "property" for the purposes of capital gains taxation, there is not yet a completely clear picture on how the SEC and/or state regulatory agencies will evaluate suitability in an audit or exam.

The Road Less Traveled

Inevitably, some advisers are going to feel that the value outweighs the compliance risks as it pertains to diving head first into Initial Coin Offerings and cryptocurrency recommendations. If so, there are a few items that advisers can consider in order to minimize the potential compliance pitfalls.

1. Know/adjust compliance documents - The purpose of the ADV is to provide a public-facing document that describes the firm and discloses risks associated with the adviser’s recommendations. Although cryptocurrencies are not considered securities, it is important to review the current risks that are associated with investment strategies and securities as placed in the ADV, so that the adviser can use that language to “translate” how these items may be applicable to cryptocurrencies. If nothing else, the adviser will want to be able to make this translation for a regulator should the issue arise. Also, placing a few lines in the compliance manual that discuss ongoing supervision and suitability metrics for clients to whom recommendations are made may be advisable.
2. Learn everything there is to know about cryptocurrencies - As previously mentioned, advisers can’t make recommendations surrounding topics that they do not understand. Due to the nature of these assets, the landscape in terms of liquidity, value, and use of the asset could change drastically in a short period of time. Therefore, advisers would be wise not only to learn the history and basics of the assets, but also commit sufficient time to ongoing education and research to stay abreast of rapid changes that may occur. As always, document the educational process, as well as how that impacts any recommendations that are made.
3. Stay in your niche - With new and exciting topics in the industry, it’s easy for advisers to become sidetracked with the possibility of a new and cutting edge niche. Perhaps business is slow, and there appears to be an opportunity with cryptocurrencies. In consideration of the previous point, maybe the time that it takes to become sufficiently educated and then properly educate clients on these assets is underestimated, and valuable time is taken from the adviser’s target client within their niche. This is an important consideration, because a compliance program that has been built to service a particular “type” of client can be negatively impacted by a miscalculated focus on a separate and insufficiently defined new item.
4. Reach out to your regulators - Advisers aren’t fond of this point, but the value of gaining the regulator’s perspective on anything outside of the ordinary cannot be overstated. There is no substitute for reaching out to the agency that will execute the firm’s audit to find out what types of items they may want prepared as it pertains to a specific subset of the firm’s business activities. Chances are, with something of this nature, the response provided will be somewhat ambiguous. However, by documenting the date, time, and method of contact, the firm shows awareness of their compliance responsibilitie, and competence as it pertains to investor protection through their compliance program.

About the Author:

Scott is a licensed Securities Principal with experience in both RIA and broker-dealer compliance. He began his financial services career in 2006 as a Registered Representative with E*Trade Financial in Alpharetta, GA. He has also worked with J.P. Morgan Private Banking in Chicago, IL and with Wells Fargo Advisors in Chapel Hill, NC.

Scott’s most recent role before joining Team XYPN was as Compliance Officer of Carolinas Investment Consulting, in Charlotte NC. He’s a graduate of The University of North Carolina at Chapel Hill and holds FINRA Series 63, 65, 24, 4 and 53 Licenses.

Scott lives in Charlotte NC with his wife Meredith, and their two Sons Tyson and Jackson. In his free time, Scott enjoys watching sports, exercising, and operating the charitable organization he created upon his father’s passing.

You can connect with him on LinkedIn.