Cryptocurrency Risks for Investment Advisors

By Jon Talamas

The world is going gaga over Bitcoin investing. That doesn’t mean you should. Caution is in order.

Cryptocurrencies are the investment equivalent of Instagram meal photos. Not only do they let investors brag about their cool portfolios to their friends, but they also can make them rich.

However, crypto assets aren’t just the latest financial fad. Their features appeal to thoughtful investors, too. Many see them as the currencies of the future. They like how one day they might reduce the power of central banks. They also like their use of blockchain technology to process and store transaction data on a decentralized basis. Finally, investors appreciate cryptoassets’ ability to appreciate in value...sometimes with head-snapping speed.

For instance, the price of a single Bitcoin, the leading cryptocurrency, was about $400 in 2016. It rocketed to $63,000 per coin in April of 2021, before swooning shortly after. As of this writing, Bitcoin was valued at $38,060. Although highly volatile, cryptoassets have often been viewed as the best performing financial asset of the past decade. Is it any wonder consumers are asking you about adding Bitcoin (or another cryptocurrency) to their investment portfolios?

How have you responded? Have you helped your clients get into this asset class, either as a pure commodity play or as part of an initial coin offering (ICO)? Or have you begged off for now? If the latter, then you’re in the RIA mainstream. According to a Bitwise survey, only 9.4% of advisors allocated client money into crypto assets in 2020. But this was a 49% increase from 6.3% in 2019.

As more consumers get interested in these novel instruments and as the infrastructure around them evolves, it’s inevitable more advisors will get involved. But it’s important to balance crypto’s growth potential with its speculative downsides. Just because clients want you to allocate Bitcoin into their portfolios doesn’t mean you must comply. After all, it’s your RIA license on the line.

Complicating matters is the fact that almost all RIA E&O policies do not cover crypto (including the NAPA Premier Errors & Omissions Insurance Program). Thus, if a client sustains a large loss after you do a crypto allocation and files a claim against you, your legal defense costs will come out of your own pocket.

The Basics of Cryptocurrency

Even though cryptoassets have taken the investment world by storm, they remain poorly understood. What are they exactly? They’re digital assets that consumers can use to buy goods and services. Purchase transactions are stored on a decentralized online ledger, with data encrypted to ensure security. The underlying technology is called Blockchain, which is highly regarded for being safe and reliable.

Being beyond the reach of government meddling is one of the perceived advantages of crypto assets. Unlike national currencies, many cryptocurrencies issue a limited number of units. For example, no more than 21 million Bitcoins can be issued. How do coins originate? Through a process called mining. This involves powerful computers doing calculations and processing transactions on the Blockchain ledger. By doing this work, the computers or “miners” earn a current unit or part of a unit. The electronic calculations are so intense it’s estimated cryptocurrency miners use as much electricity as entire countries.

Although Bitcoin has the largest share of the cryptocurrency market, thousands of other currencies are trading publicly. As new ones emerge, they use initial coin offerings (ICOs) to raise money. According to CoinMarketCap, the aggregate value of all cryptocurrencies in July of 2021 was $1.3 trillion. About $600 billion of this total was from Bitcoin.

When consumers buy cryptocurrencies, they store their value in a cryptocurrency wallet. This is a computer app that lets them receive or spend the currency. To enter a transaction in the Blockchain ledger, they need a “key” to allow them to enter it in the public ledger. Although the currency owner’s identity is tied to the key, it’s not linked to the transaction itself.

Although explaining digital currencies fully is beyond the scope of this article, here’s the important point: crypto assets are a novel way to buy things and invest money. Because they’re still relatively new, many unanswered questions remain for those who use them. That means careful due diligence is essential for advisors allocating client money into crypto or consumers buying cryptoassets for themselves.

Regulatory Uncertainty

Lack of regulatory clarity is a stumbling block for investment advisors interested in allocating client assets into cryptocurrencies. What’s the problem? U.S. financial regulators have been unable to agree on whether cryptoassets are a security and, if so, what kind. They also haven’t agreed on which regulatory authority should oversee the currencies should they be categorized as securities.

Despite their murky status, the IRS believes cryptocurrencies to be property, and the SEC considers them to be non-securities. Meanwhile, the Commodity Futures Trading Commission (CFTC) says cryptoassets are commodities.

But there’s good news. Efforts are underway to clear crypto’s regulatory fog. One important one is the Eliminate Barriers to Innovation Act of 2021, which passed the House of Representatives in April 2021. This law would create a task force to help the SEC and CFTC define cryptoassets from a regulatory standpoint. If passed, the measure will provide much-needed clarity to the crypto arena.

Despite the lack of clarity, RIA firms are not off the hook in terms of proper handling of Bitcoin and other digital currencies within their advisory practice. According to Tyrone Ross, CEO of Onramp Invest, RIAs remain under the jurisdiction of their regulatory agency when advising and working with clients regarding allocating their assets into digital assets. Even though cryptoassets aren’t considered securities yet, they can be considered as such during a regulatory audit in order to assure client safety. “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,” wrote Ross in his Morningstar article.

Cryptocurrency Risks

The riskiness of cryptoassets is evident in the fact that more than 90 percent of investment advisors shied away from recommending them in 2020. According to the Bitwise survey, regulatory concerns were the prime worry, with 54% of advisors citing them as the reason they’ve avoided them so far. Too much volatility was the second most cited concern, at 39%. Other crypto stumbling blocks included:

• Lack of valuation method (36% of advisors).
• No easily accessible crypto investment vehicle such as ETFs or mutual funds (37%).
• Lack of understanding (36%).
• Custodial concerns and fear of hacks (30%).

Compliance consultant RIA in a Box surfaced additional risk factors that should give you pause before putting your clients into cryptoassets. Among them are fears that:

• Charging traditional investment advisory fees may be difficult given crypto’s opaque valuation methods.
• Accurate and timely performance reporting may be difficult.
• A disruption such as a computer hack or theft might spark an “access-to-funds” liquidity crisis.
• The crypto marketplace lacks a consumer-protection framework or FDIC-type asset insurance.
• Cryptoassets may pose anti-money laundering compliance challenges.
• RIAs may face excess fee issues when they accept advisory fee payments via cryptocurrency.

Talking to Clients about Crypto

As digital assets get more media coverage, more clients will likely ask you about whether they should jump on the bandwagon. How should you answer them, given the risks just discussed? Here are some key points to make, courtesy of Capital Group:

• Cryptocurrencies have posted eye-popping results in recent years. However, it’s essential to remind clients that past performance does not guarantee future results. For clients who insist on shrugging off your guidance, advise them to limit their crypto investment to 1% or less of their portfolio to limit downside risk.
• Bitcoin is created using powerful computers that crunch algorithms. These machines devour electricity, which worsens global warming since coal continues to generate a large portion of global electricity. For environmentally-conscious clients, this feature alone may provide sufficient reason not to dabble in crypto.
• The future value of cryptocurrencies may plummet if world governments seek to make using digital coins harder. This is not an unlikely scenario since digital currencies seek to reduce or replace sovereign money. If that were to happen, governments would likely take steps to preserve their monetary policymaking power.
• Bitcoin is potentially an unsafe method of storing value. Owners can misplace or forget their access keys. If this happens, they will be out of luck since there’s no central authority that can restore their access.
• Consumers who buy cryptocurrencies forego the interest payments they’d normally receive for buying a sovereign currency. This means they can lose money just by holding the asset.
• Digital currencies may not be as good of a hedge against other asset classes as their proponents suggest. According to Capital Group currency analyst Jens Sondergaard, Bitcoin did not move in an opposite direction to stocks during the bear market of February and March 2020. “It remains an open question whether Bitcoin can act as a hedge,” Sondergaard said. “Investors should be careful assuming too much about how it will behave in various market environments.
• Document your conversations with clients regarding their views and your advice regarding cryptocurrencies. It will help clarify and support your viewpoint and create less future confusion between the client and yourself. Plus, it never hurts to have sound notes and email conversations in case an adverse crypto issue surfaces in the future.

Finally, if you’re still tempted to get into cryptocurrencies, consider the possibility of funding your own legal defense if an aggrieved client sues you. That’s because, as mentioned earlier, most investment-advisor E&O policies exclude cryptocurrency from coverage. It’s no accident insurers have elected not to cover crypto losses. They’ve determined that the potential losses are so high their existing E&O underwriting models can’t accommodate them. Keep this in mind before you enter—or expand your involvement with—the investment world’s latest darling.

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