Investment Products

Crypto: Risks Abound

By: Micah Hauptman, Director of Investor Protection

The market for cryptocurrencies and crypto-related assets has experienced explosive growth in recent years. While investor interest in these assets seems to increase as the prices of crypto assets grow and shrink as the prices of crypto assets fall, the interest isn’t likely to be going away anytime soon.

Accordingly, financial professionals are increasingly being asked about investing in crypto assets and they are increasingly saying that they expect to recommend these assets to clients in the future. For example, according to a Cerulli survey, 80% of advisors surveyed said that clients of all ages have asked them about cryptocurrencies. While just 10% are using it because of client requests, 45% of advisors say they expect to use crypto in the future in response to client requests.

In addition to increasing investor interest in crypto, there’s also growing competitive pressure within the market as more firms, including traditional securities firms, are offering access to crypto-related assets to retail investors. At a certain point, firms and financial professionals are likely to ask themselves, “Investors seem to want crypto, other firms are offering it, maybe I should too?”

However, because of the unique risks that are inherent in the crypto market, firms should consider the following very carefully before doing so. Among other concerns, crypto-related assets:

  • Can be speculative and volatile investments, with prices that can swing wildly and crash without warning – this volatility can be particularly devastating for investors who are approaching retirement;
  • It can be extraordinarily difficult, even for expert investors, to separate the facts from the hype with regard to crypto assets;
  • Crypto-related assets are not held like traditional assets in trust or custodial accounts, which can expose them to heightened risk of fraud, theft and loss – FTX’s recent failure illustrated these risks and the harms that can flow from them;
  • Crypto-related assets raise valuation issues because they may not be subject to traditional, empirically-validated valuation methodologies;
  • Crypto-related assets may be unregistered or otherwise offered by or through providers who are operating outside of or not complying with existing regulatory frameworks; and
  • Crypto-related assets may be subject to additional regulation, which may evolve in unpredictable ways.

Recognizing these unique risks, it is important for financial professionals who recommend or advise investors to include crypto-related assets in investors’ portfolios to fully understand the implications of doing so. Principally, recommending crypto-related investments raises the potential for them to violate their standards or conduct,[1] specifically their care obligation under Regulation Best Interest (Reg BI), if they are a broker, and their Duty of Care under the Investment Advisers Act, if they are a registered investment adviser.

When an investor is being recommended a security:

  • Reg BI requires a broker-dealer to exercise reasonable diligence, care, and skill to, among other things, to have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks, rewards, and costs associated with the recommendation.;
  • Similarly, the Investment Advisers Act fiduciary duty requires to adviser to have a reasonable belief that the advice it provides is in the best interest of the client based on the client’s objectives. The formation of a reasonable belief would involve considering, for example, whether investments are recommended only to those clients who can and are willing to tolerate the risks of those investments and for whom the potential benefits may justify the risks.

With all of this in mind, here are some potential fact patterns regarding the recommendation of crypto-related assets that would likely raise concerns under Reg BI or the Investment Adviser’s Act fiduciary standards of care:

  • If a financial professional recommends crypto to an investor despite the investor not having an appropriate risk tolerance of risk capacity for crypto. In other words, if either the investor would not be personally comfortable with the risk of losing a significant or even the total amount of their investment or they can’t objectively absorb the risk of losing a significant or the total amount of their investment, it would raise serious questions about whether the financial professional complied with their standard of care when recommending that the investor invest in crypto-related investments.
  • If a financial professional recommends a larger allocation than is prudent for the investor, subjecting the investor to significant losses they can’t absorb.
  • If a financial professional recommends a particular crypto-related asset without understanding that specific asset, its features, and its potential risks/rewards relative to other crypto-related assets that are reasonably available
  • If the financial professional recommends a particular crypto-related asset without considering the costs associated with investing in that crypto-asset relative to other reasonably available assets.
  • If the financial professional does not custody the crypto-related assets prudently, subjecting the investor’s investment to enhanced risk of theft/loss.
  • If the financial professional isn’t clear about if or how they will monitor the crypto-related asset and as a result, the investor’s asset allocation (and portfolio risk) changes significantly because of volatility of that asset and changes in exposure to that asset.

As you can see, there are many risks regarding recommending crypto to retail investors and financial professionals must tread carefully. If they don’t, they may expose clients to significant harm and expose themselves to significant legal liability for doing so.

Update Dec. 1, 2022: On November 30, 2022 the Certified Financial Planner Board of Standards (CFP® Board) published a Notice to CFP® Professionals regarding financial advice about cryptocurrency-related assets. Consistent with this blog’s analysis regarding recommendations and advice by broker-dealers and investment advisers about crypto-related assets, the CFP® Board Notice highlights the need for CFP® Professionals to undertake careful analysis when providing financial advice about crypto-related assets in order to comply with the CFP® Board’s Code and Standards, including the Fiduciary Duty and the Duty of Competence. In full disclosure, I am a member of the CFP® Board’s Standards Resource Commission, which helped to develop the Notice.

[1] As a primary matter, Reg BI only applies when there’s a securities transaction that’s recommended. To the extent that a broker recommends a crypto-related asset that is not considered a security, then Reg BI would not apply (notably, key regulators have indicated that most crypto-related assets are securities). However, because an adviser’s fiduciary duty applies to the entire advisory relationship and portfolio, an adviser’s fiduciary duty would apply if they provide advice to invest in a crypto-related asset, regardless of whether the asset is a security or not.