What Financial Advisors Need to Know

With cryptocurrency markets hovering at a global market capitalization of over $1.7 trillion, financial advisors are likely to encounter some clients who already own crypto and others with questions about investing in digital assets. Unfortunately, uncertainties around current and future regulations could create a quandary for financial advisors when they discuss or recommend crypto investments.

Here is a look at what financial advisors need to know about the regulatory landscape for cryptocurrencies in the United States, in particular, how the U.S. Securities and Exchange Commission (SEC) regulates digital assets, what the future could look like for cryptocurrency regulation, and what it all means for financial advisors.

Key Takeaways

• Pervasive uncertainties around cryptocurrency regulations could raise compliance concerns for financial advisors.
• Advisors who want to provide clients with cryptocurrency exposure are likely better off limiting investments to SEC-registered securities, including the stocks of publicly traded cryptocurrency companies, trusts, and approved exchange-traded products (ETPs).
• It remains to be seen how cryptocurrency regulations might evolve, which could change the financial, legal, and ethical calculus for crypto advisory services.
• The SEC approved the first Bitcoin Spot ETFs in January 2024.

Understanding Crypto Regulations

Understanding regulations is crucial for financial advisors with clients planning to invest in cryptocurrency. The crypto space is rife with legal edge cases, and advisors have a fiduciary duty to act in the best interests of their clients, which means taking all reasonable steps to protect them from financial harm and legal problems. Educating clients about regulatory risks can help them steer clear of crypto practices that turn out to be scams, frauds, or market manipulation.

Understanding regulations can also improve the quality of investment analysis a financial advisor provides crypto clients. Regulations offer a framework for evaluating the legitimacy of their financial portfolio and potential returns on digital assets. A crypto product or company with significant legal and regulatory risks is unlikely to perform well in the long term and hold stable financial and monetary value.

Unfortunately, with so much regulation around the cryptocurrency market remaining unsettled, financial advisors might feel like they’re walking a compliance tightrope regarding crypto assets.

“There is no comprehensive federal regulation of any type of digital assets or cryptocurrency,” says V. Gerard Comizio, associate director of business law programs at American University’s Washington College of Law and author of “Virtual Currency Law: The Emerging Legal and Regulatory Framework.”

In the absence of forward-looking regulatory clarity on cryptocurrencies, financial advisors are put in the position of referring to retrospective precedent. Multiple financial regulators have developed existing regulations that may apply to crypto assets and allow them to be compared to traditional assets. Each regulator comes with its own focus, responsibilities, and jurisdiction.

Financial Regulators Affecting Crypto

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SEC’s Role in Crypto Regulations

While other agencies, such as the CFTC and FinCEN, play important roles in regulating crypto, the SEC has broad authority that gives it the power to influence judicial precedent and execute outcomes that make it the most consequential financial regulator for cryptocurrencies. These outcomes can stir uncertainty and fear in investors, potentially leading to sell-offs and a decline in crypto asset prices. This is particularly true if the agency targets major players in the industry or exposes fraudulent and manipulative practices.

The SEC has the authority to promulgate rules that govern the fair and orderly conduct of securities market participants, including digital currencies that meet the definition of securities, encompassing a significant portion of the cryptocurrency market. Crypto banks, exchanges, broker-dealers, investment advisors, and other entities that handle crypto assets would be breaking the law and opening themselves up to costly and potentially operationally ruinous legal trouble if they violated these rules, which are investigated and enforced by the SEC.

Among potential avenues of recourse, the SEC can seek penalties and cease-and-desist orders, bring civil enforcement actions, refer cases for criminal prosecution, and issue discovery requests to examine bookkeeping records against those who appear to be violating securities laws.

In court, the SEC cannot press criminal charges that extend to prison time, and it can only bring civil claims under lawsuits that seek monetary or injunctive relief. Injunctive relief could include ordering a crypto asset or company to discontinue a product or shut down entirely, potentially ending a valuable revenue stream or closing a business overnight.

Additionally, the SEC can issue guidance and interpretive statements that clarify its interpretation of existing securities regulations and move the needle in active judicial proceedings as an amicus curiae, meaning “friend of the court.” While these statements are not binding on courts, they can carry significant weight and influence the way courts interpret and apply the law, affecting securities regulations even in crypto-related cases not brought by the SEC.

SEC Crypto Rules

The SEC has taken a cautious approach when it comes to outlining new rules tailored specifically to cryptocurrency. Instead, it has left crypto regulation open to its own interpretation. The commission uses existing rules and relies on judicial precedents and legal interpretations of securities laws to bring charges against violators. These precedents provide guidance on how courts have applied the law in past cases and help shape the SEC’s enforcement approach to securities laws, record-keeping, fraud, manipulation, trading, and custodian violations.

In addition to these federal laws, the SEC may also enforce state securities laws if they are not inconsistent with federal law. State securities laws often complement federal law and provide additional protections for investors.

Here are some of the most relevant rules that govern the SEC’s approach:

• Securities Act of 1933 (Securities Act): The Securities Act regulates the issuance and sale of securities to the public, including registration requirements, anti-fraud provisions, and civil liability provisions.
• Securities Exchange Act of 1934 (Exchange Act): The Exchange Act regulates the trading of securities on exchanges and over-the-counter (OTC) markets, including anti-fraud provisions, insider trading prohibitions, and market manipulation rules.
• Investment Company Act of 1940 (Investment Company Act): The Investment Company Act regulates investment companies, such as mutual funds and hedge funds, including disclosure requirements, valuation standards, and investor protection provisions.
• Investment Advisers Act of 1940 (Advisers Act): The Advisers Act regulates investment advisers, who manage investment portfolios for clients, including registration requirements, fiduciary duties, and anti-fraud provisions.
• Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley Act): The Sarbanes-Oxley Act affected corporate ethics and enhanced corporate governance and accounting standards, including auditor independence requirements, financial reporting obligations, and corporate accountability provisions.
• Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act): The Dodd-Frank Act reformed the financial industry following the 2007–2008 financial crisis, and included increased regulatory oversight of financial institutions, consumer protection measures, and derivatives market regulation.

One area of keen interest to investors has been whether cryptocurrencies are classified as securities. Securities are a regulated market and subject to SEC rules and disclosure standards, creating extensive legal liability.

The SEC has not yet provided a definitive securities classification for all cryptocurrencies, opting to indicate generally that certain assets may or may not fall under the definition of securities.

“If it’s a commodity, then you’re going to have a different range of regulatory issues as an advisor in terms of registering with the CFTC,” says American University business law professor V. Gerard Comizio.

The SEC’s stance on the securities classifications of cryptocurrencies is based on the principles established in the Howey Test, a legal framework used to determine whether an asset is considered a security. By applying the Howey Test to cryptocurrencies, the SEC has determined that certain digital assets—such as those with clear ownership and control structures and where investor profit-taking depends on the efforts of others—may be considered securities.

The SEC has acknowledged that not all cryptocurrencies will meet the definition of securities. It has also stated that an asset with a utility function is less likely to be considered a security, as utility tokens are designed to be used within a blockchain’s ecosystem to grant rights or access to a product or service and not as an investment. For instance, LINK, the token for the Chainlink blockchain, is used for staking, blockchain payments, and granting access to products and services.

SEC Disclosure Standards

As part of its careful stance on cryptocurrency assets, the SEC has yet to introduce disclosure standards tailored specifically to crypto enterprises. In the commission’s view, there is no reason to create cryptocurrency-specific rules and regulations when the existing ones already cover these assets.

Corporate Governance

Cryptocurrency issuers, just like other investment issuers, must disclose their corporate governance practices, including the composition of their board of directors, executive compensation, and auditor independence in their filings. They must also provide financial information and statements, security ownership for owners and management, and much more. All of the requirements are listed on the SEC’s Form 10, “General Form for Registration of Securities.”

In addition to these general disclosure principles, advisors should look for crypto enterprises that disclose additional information specific to their business models and the crypto assets they offer. Such information could include the tokenomics of the asset, the security of the underlying blockchain, and the issuer’s plans for future updates or changes to the asset.

The SEC’s goal in imposing disclosure standards on crypto enterprises is to ensure investors can access the information they need to make informed investment decisions. Providing accurate and thorough information can help build investor confidence and promote the crypto industry’s growth.

More Guidance For Financial Advisors

SEC Crypto Investigations and Enforcement

The SEC has taken several notable actions in the cryptocurrency space in recent years. These actions have focused on a variety of individuals, issues, and products. These include unregistered securities offerings, fraud, insider trading, cybersecurity lapses, initial coin offerings (ICOs), NFT creators, and decentralized finance (DeFi) platforms.

By becoming familiar with the circumstances and outcomes of these actions, advisors can proactively address compliance requirements and minimize the risk of legal repercussions for their clients. Below are some notable SEC cases involving crypto assets and companies:

• SEC v. Centra Tech Inc. (April 2018): The SEC charged Centra Tech Inc., a purported financial services startup, with orchestrating a fraudulent ICO that raised over $32 million from investors. The SEC alleged that Centra Tech made numerous false and misleading statements about its products and services and that it failed to register its ICO with the SEC.
• SEC v. Kim Kardashian (October 2022): The SEC sued Kim Kardashian for promoting a cryptocurrency security on social media without disclosing that she had received a $250,000 payment for the promotion. The SEC’s action highlighted the importance of influencer disclosure in the cryptocurrency space.
• SEC v. Samuel Bankman-Fried (December 2022): The SEC charged Samuel Bankman-Fried, founder of the collapsed FTX cryptocurrency exchange, with orchestrating a scheme to defraud investors in FTX. The SEC alleged that Bankman-Fried misled investors about FTX’s financial condition and used investor funds to pay for personal expenses and other ventures. Bankman-Fried was found guilty on seven counts of fraud and conspiracy.
• SEC v. Coinbase Global Inc. (June 2023): The SEC charged Coinbase Global Inc., one of the largest cryptocurrency exchanges, alleging that Coinbase was operating as an unregistered securities exchange and broker and that it was failing to register its crypto assets as securities. The commission also alleged that Coinbase was making false and misleading statements about its compliance with securities laws.

Impact of SEC Crypto Actions

A series of agency actions must lead up to an SEC enforcement action, generally consisting of an investigation, an informal warning, a Wells notice, and a cease-and-desist order. The investigation could include issuing subpoenas to obtain documents and records and meeting with executives to discuss a company’s compliance with securities laws.

If the SEC’s investigation uncovers potential violations of securities laws, then it may issue a Wells notice to the crypto business. A Wells notice is a warning that the SEC is considering recommending an enforcement action against the company. This notice outlines the SEC’s allegations and gives the company an opportunity to respond before the SEC takes any further action.

An SEC enforcement action isn’t always a lawsuit pursuing civil charges, which are usually filed in federal court in New York or the District of Columbia. If the SEC determines that a crypto business has violated securities laws, it can alternatively issue a cease-and-desist order. A cease-and-desist order prohibits the company from engaging in the activity and may also require the company to take corrective action.

Some analysts argue that SEC enforcement actions can actually help legitimize the cryptocurrency industry by bringing it under the same regulatory framework as traditional financial markets. The overall impact of SEC enforcement actions on crypto prices is still unclear, but there have been several instances in which SEC actions have closely preceded stark changes in cryptocurrency prices.

In some cases, SEC enforcement actions have led to a decline or increase in crypto prices. For example, in January 2018, after the SEC charged Ripple Labs with selling unregistered securities, the price of XRP, Ripple’s native token, sharply dropped. But it doubled in price in November 2023, after Ripple won a partial victory in its case against the SEC after a court decided that XRP was a security when sold to institutional investors but not to the public on an exchange.

Navigating SEC Crypto Regulations

As the cryptocurrency landscape gains prominence, financial advisors will often have no choice but to work with clients who are interested in it. Some advisors may opt to steer clear of crypto altogether, and cryptocurrency platforms will struggle to comply with regulations. However, avoiding it altogether risks alienating clients seeking guidance in this rapidly growing realm.

“Advisors and firms can avoid crypto altogether, but that approach fails to properly serve clients who want exposure to this asset class,” says Ric Edelman, author of “The Truth About Crypto” and other personal finance books. “It also places advisors and firms at risk of losing assets under management (AUM)—and reputation—by failing to demonstrate to clients that they can rely on their advisors for up-to-date advice and investment opportunities.”

Alternative strategies exist that afford financial advisors the flexibility to navigate the crypto waters responsibly and effectively. For instance, shares of an SEC-approved fund that holds bitcoin can reduce the risks of the underlying asset while providing the exposure desired by investors.

There are several other examples, such as stocks issued by publicly traded companies engaged in the crypto industry, OTC-traded grantor trusts, crypto-themed stock exchange-traded funds (ETFs), Bitcoin and Ether futures ETFs, and crypto individual retirement accounts (IRAs).

The key takeaway is to do your due diligence. It’s going to be challenging to make sure you understand what financial products you’re dealing with, whether they’re securities, and as a result, what your regulatory obligations are going to be.

Regardless of the strategy, financial advisors open to working with investors in the asset class will need to balance their desire for exposure with the complexities and uncertainties surrounding its rapidly evolving regulatory landscape. By understanding the existing regulatory groundwork and staying up to date on the latest regulatory developments, advisors can:

• Better assess the pervasive risks of crypto investments
• Stay compliant with professional legal duties
• Help clients make informed decisions
• Maintain clients’ trust and confidence.

Other than looking to legal rulings for regulatory direction, advisors can consult with the SEC’s Investor Advocate, review the SEC’s investor alerts, and read the SEC’s guidance on digital assets.

The Investor Advocate provides information and assistance to investors about many topics, including the SEC’s views on cryptocurrencies. Investor alerts and guidance materials discuss potential scams, frauds, and legal interpretations.

Outlook for SEC Crypto Regulations

Crypto industry insiders yearn for a clearer picture of the SEC’s regulatory direction. Unfortunately, predicting the future of government regulations on virtual currencies remains a complex task at the SEC and beyond.

Under current laws, the SEC notably faces the challenge of proving that certain crypto tokens qualify as securities and should be regulated accordingly. However, the SEC’s authority to make such classifications has been called into question. A November 2023 court ruling vacated the SEC’s denial of Grayscale’s Bitcoin Spot ETF and ordered the Commission to re-review its proposal. This decision challenges the long-standing “Chevron deference” standard, which typically grants federal agencies significant leeway in their interpretations.

Because of the court order, the SEC took a step back and began accepting public input on cryptocurrency products like Bitcoin Spot ETFs. In January 2024, the Commission released approvals for 11 Bitcoin Spot ETFs. This approval, claimed by the SEC chair to not be a blanket for all crypto-related securities but rather an approval for products that meet specific conditions, still opens the gates for much more than Bitcoin Spot ETFs.

However, SEC chair Gary Gensler clarified in his statement concerning the approval, “… today’s Commission action is cabined to ETPs holding one non-security commodity, bitcoin. It should in no way signal the Commission’s willingness to approve listing standards for crypto asset securities. Nor does the approval signal anything about the Commission’s views as to the status of other crypto assets under the federal securities laws or about the current state of non-compliance of certain crypto asset market participants with the federal securities laws. As I’ve said in the past, and without prejudging any one crypto asset, the vast majority of crypto assets are investment contracts and thus subject to the federal securities laws.”

The agency is likely to keep its stance on cryptocurrencies, so there are likely more actions against issuers to be taken by the agency, but not necessarily any crypto-specific regulations issued by the SEC.

How Does the Howey Test Identify a Security?

The Howey Test considers four factors to determine whether an investment product is a security:

1. Investment of money: An investor must contribute money or other valuable assets to the enterprise.
2. Common enterprise: The investor’s profits are expected to be derived from the efforts of others rather than their own individual efforts.
3. Expectation of profits: The investor has a reasonable expectation of profits from the investment.
4. Investment in a security: The investment is in a common enterprise with a promoter or manager who controls the operation of the enterprise.

Does the SEC Classify Bitcoin and Ethereum as Securities?

In 2018, SEC Director of Corporate Finance William Hinman said the SEC does not consider Bitcoin or Ethereum securities. However, in 2021, SEC Chairman Gary Gensler said that the SEC is “taking a hard look” at whether Ether (ETH) is a security.

How Many Crypto Enforcement Actions Has the SEC Taken?

As of January 2024, the SEC has taken more than 130 actions related to crypto assets, including filing over 25 cease-and-desist orders against crypto executives and companies.

The Bottom Line

Financial advisors face a multitude of challenges when navigating SEC regulations on crypto, including complying with regulatory frameworks and interpreting and predicting case law involving securities registration, market manipulation prevention, disclosure, and other issues.

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Investopedia / Alice Morgan

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