How financial advisors can protect clients and themselves from crypto risk

The bankruptcy case of cryptocurrency exchange FTX and a burgeoning debate about the regulation of digital coins give financial advisors ample compliance-related reasons for caution.

In a panel at Financial Planning's INVEST: Cryptocurrency for Advisors conference, three experts explained how planners can adapt those valid concerns into fiduciary advice that protects themselves and clients from the very real risk of losses and legal cases, all while helping interested customers to learn about and potentially invest in a compelling asset class.

Cryptocurrency "doesn't fit squarely or very nicely into the securities laws, the currency and commodity laws, or really anything that we have presently in terms of regulation," Jon-Jorge Aras, the chair of securities litigation at the Warren Law Group, told the conference on Monday. That's the current state of affairs, even though digital assets touch all three areas and the Securities and Exchange Commission as well as FINRA have said that they're "looking at crypto as a security," Aras said. 

"Investment advisors are going to have a fiduciary duty to their client, and they can be put in a very difficult position if there's huge, hemorrhaging losses in a portfolio," he said. "There's a lot of warranted skepticism. That being said, an investment advisor and a financial advisor can counsel their clients on crypto assets. It just needs to be done in the same way that any other type of disclosure would be made regarding something as simple as a mutual fund." 

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Advisors face a dilemma around the complexity of the appeal of the asset class and uncertainty about the government's regulation of it, agreed Intellivest Securities CEO Dan Kolber. His firm raises capital for companies involved in cryptocurrency and blockchain, and Kolber is also of counsel at Warren Law. Kolber brought up the example of President Joe Biden's executive order on cryptocurrency in March and guidance from the Labor Department about the use of the asset class in 401(k) accounts.

The Labor Department came "as close to prohibition as you could make it without prohibiting" the recommendation of a crypto investment in a 401(k) plan, because it pledged to "investigate any plan that holds crypto," Kolber said. At the same time, Kolber said he had been observing with interest how agencies have responded to Biden's request earlier this year for policy recommendations about crypto.

"Not a single one of them were willing to draw a line in the sand, almost to a report, to a person," Kolber said. "They're as F.O.M.O. — as afraid of missing out — as anybody is. They don't want to be looked on as foolish. So, as a result, they're leaving the door open, and they're being so cautious that it's my prediction that it's going to be at least a year or two before all of this is sorted out."

In the interim, advisors struggling with whether to trust that exchanges such as FTX, Coinbase, Binance or others have the reserves necessary to stay in business for the long term can take a simple step, according to Aras. Assets on an exchange are "really in the hands of a third party," he noted, pointing out that investors would then become creditors in a bankruptcy case in the event of a firm's demise — assuming that anything is left to claim. The FTX saga offers a cautionary tale and a solid rationale for advisors to educate themselves about storage and custody of cryptoassets, Aras said.

"We've done cases like this at the firm, where we represent individuals that are just creditors to a bankruptcy. It is not a great place to be," Aras said. "Juxtaposing that with cold storage — meaning that you put it on your own USB device or you store it yourself — that asset is yours. It's stored, and you could put it online pretty much at any time. And I think, without a doubt, given the current environment that we're in, that is the quote unquote safer way of approaching handling and custody and crypto."

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Unfamiliarity with certain terms and concepts need not scare advisors away from the topic in general, Kolber said, noting there's a risk of overcomplicating the topic. He recommended the CFP Board's new guide to cryptocurrency recommendations as a resource.

"You're not going to have to read code or understand code, but you're going to have to understand the risk of investing in something," he said. "These issues are going to be resolved sooner or later. They have to be. They're going to be. That's the good news. And, in the meantime, you look at the cases, go to conferences like this and simply use common sense."

The simple need to learn and make clients aware of the risks stood out as a key lesson from the panel to moderator Adam Blumberg, the founder of digital and alternative asset education firm Interaxis.

"One of the important takeaways for me is that both of you, repeatedly, have said, 'Err on the side of being conservative, err on the side of more disclosures,' which seems overtly conservative," Blumberg said. "And yet you're both saying, 'crypto's here to stay,' and you're kind of pro. You're not saying it's going away, which I think is an interesting dichotomy."