On December 11, 2017, Securities and Exchange Commission (“SEC”) Commissioner Jay Clayton, issued a public statement in regards to cryptocurrencies and initial coin offerings. This latest public statement from the SEC follows previous investor alerts issued by the agency including alerts issued on July 23, 2013, May 7, 2014, and on July 25, 2017. However, even since Chairman Clayton’s recent public statement, the level of interest and media buzz related to Bitcoin and other cryptocurrencies and initial coin offerings continues to escalate. This recent escalation of general public interest has also placed registered investment adviser (“RIA”) firms in a challenging position as they attempt to respond to a surge of client inquiries on the topic.
Note: RIA in a Box LLC is not a law firm and does not provide legal advice. We strongly advise that all RIA firms with questions related to cryptocurrencies, initial coin offerings, and other related subjects consult with a qualified securities attorney as the regulatory and legal framework continues to evolve.
As RIA compliance consultants, we advise all RIA firms to exercise great caution as it relates to cryptocurrencies such as Bitcoin and others. In particular, Chairman Clayton recently stated the following as part of his December 11, 2017 public statement:
On cryptocurrencies, I want to emphasize two points. First, while there are cryptocurrencies that do not appear to be securities, simply calling something a “currency” or a currency-based product does not mean that it is not a security. Before launching a cryptocurrency or a product with its value tied to one or more cryptocurrencies, its promoters must either (1) be able to demonstrate that the currency or product is not a security or (2) comply with applicable registration and other requirements under our securities laws. Second, brokers, dealers and other market participants that allow for payments in cryptocurrencies, allow customers to purchase cryptocurrencies on margin, or otherwise use cryptocurrencies to facilitate securities transactions should exercise particular caution, including ensuring that their cryptocurrency activities are not undermining their anti-money laundering and know-your-customer obligations. As I have stated previously, these market participants should treat payments and other transactions made in cryptocurrency as if cash were being handed from one party to the other.
Chairman Clayton also further states:
It has been asserted that cryptocurrencies are not securities and that the offer and sale of cryptocurrencies are beyond the SEC’s jurisdiction. Whether that assertion proves correct with respect to any digital asset that is labeled as a cryptocurrency will depend on the characteristics and use of that particular asset. In any event, it is clear that, just as the SEC has a sharp focus on how U.S. dollar, euro and Japanese yen transactions affect our securities markets, we have the same interests and responsibilities with respect to cryptocurrencies. This extends, for example, to securities firms and other market participants that allow payments to be made in cryptocurrencies, set up structures to invest in or hold cryptocurrencies, or extend credit to customers to purchase or hold cryptocurrencies.
In a previous investor alert issued by the SEC on July 23, 2013, the agency also expressed concern that the use of virtual currencies could create the risk of ponzi and other-related schemes:
We are concerned that the rising use of virtual currencies in the global marketplace may entice fraudsters to lure investors into Ponzi and other schemes in which these currencies are used to facilitate fraudulent, or simply fabricated, investments or transactions. the fraud may also involve an unregistered offering or trading platform. These schemes often promise high returns for getting in on the ground floor of a growing Internet phenomenon.
Source: Coindesk as of December 26, 2017.
Despite the significant risks, some RIA firms may feel they have the proper knowledge and expertise to advise on cryptocurrencies. When considering whether to provide such advice, there are a number of potential regulatory concerns to consider including:
- Regardless of whether a cryptocurrency is an actual “security” or not, it appears to be a highly speculative investment given its high level of volatility and is likely not a suitable investment for most clients
- Given its highly speculative nature, there could be a complete loss of client funds
- Charging traditional investment advisory fees may be challenging given the difficult nature in accurately valuing cryptocurrency on a daily basis from a reliable third party source
- Providing accurate and timely reporting may prove problematic
- There may be illiquidity risks and other “access to funds” considerations in the event of any type of disruption, lockout, shutdown, hack, or theft
- There are no consumer protections and no availability of Federal Deposit Insurance Corporation (“FDIC”) insurance
- There may be potential custody rule issues for the adviser to address
- There may be potential anti-money laundering (“AML”) issues for the adviser to address
- There may be potential excess fee issues related to accepting advisory fee payments via cryptocurrency
- Even if not deemed to be a “security”, there may be other regulatory considerations such as those related to private (e.g. unregistered) offerings and Commodities Futures Trading Commission (“CTFC”) regulations for advisers to consider
In addition, RIA firms should also review professional liability or errors and omissions insurance coverage as providing advice related to cryptocurrencies may not be covered by the policy.
While some RIA firms may feel business pressures to offer clients guidance and access as it relates to cryptocurrencies, advisers need to carefully consider if the potential upside outweighs the significant risks. As more guidance is provided at the federal and state regulatory levels, we will continue to provide new and updated commentary as it relates to Bitcoin and other new and emerging cryptocurrencies.
RIA in a Box LLC is not a law firm, investment advisory firm, or CPA firm. RIA in a Box LLC does not provide legal advice or opinions to any party or client. You should always consult your relevant regulatory authorities or legal counsel if applicable.