What Financial Advisors Need to Know

With cryptocurrency markets hovering at a global market capitalization of over $1.3 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.

Let’s look at what financial advisors need to know about the regulatory landscape for cryptocurrencies in the United States. We’ll consider 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 who want to stay compliant with securities laws while offering clients the most complete advice for their financial lives in the 21st century.

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 their clients’ best interests, which means taking all reasonable steps to protect their clients 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 that a financial advisor provides to 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 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 when it comes to 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 analogized to traditional assets. Each regulator comes with its own focus, responsibilities, and jurisdiction.

Financial Regulators Affecting Crypto

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, particularly 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, which encompasses 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 over how courts interpret and apply the law, affecting securities regulations even in crypto-related cases not brought by the SEC.

In sum, the SEC’s regulatory authority comprises discretion over financial securities, active enforcement, focus on investor protection, and leadership in regulatory discussions on financial markets.

SEC Crypto Rules

The SEC has taken a cautious approach when it comes to outlining new rules tailored specifically to cryptocurrency. Instead, the SEC has left crypto regulation open to interpretation through enforcement of existing rules, charging crypto issuers and companies for securities laws, record-keeping, fraud, manipulation, trading, and custodian violations under federal acts and judicial codes that have already been enshrined in civil law. Here are some of the most relevant:

• 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, including increased regulatory oversight of financial institutions, consumer protection measures, and derivatives market regulation.

The SEC relies on judicial precedents and legal interpretations of securities laws in enforcing these laws and bringing charges against violators. These charges provide guidance on how courts have applied the law in past cases and help shape the SEC’s enforcement approach.

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.

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.

“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. 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. The SEC has also said that an asset with a utility function is less likely to be considered a security, as utility tokens are used for a purpose other than investment, such as to pay for goods or services. For instance, Bitcoin, the most well-established cryptocurrency recognized by its trading ticker BTC, has been considered a commodity due to its decentralized nature and lack of a clear promoter or issuer.

SEC Disclosure Standards

As part of its careful stance on cryptocurrency assets, the SEC also has yet to finalize disclosure standards tailored specifically to crypto enterprises. However, the SEC has outlined general disclosure principles that apply to all issuers, including those that offer crypto assets. Here are some key disclosure standards that the SEC expects crypto enterprises to follow:

Description of the Business

Issuers must provide a clear and concise description of their business, including their products, services, and target markets. The description should include a detailed explanation of how crypto assets are used in the business and the risks associated with these assets.

Risk Factors

Issuers must disclose all material risks associated with their business, including those specific to crypto assets. These risk disclaimers should mention technology, market volatility, regulatory uncertainty, and cybersecurity.

Financial Statements

Issuers must provide audited financial statements prepared in accordance with generally accepted accounting principles (GAAP) or other applicable accounting standards. Financial statements help investors understand the issuer’s financial condition and performance.

Management Discussion and Analysis (MD&A)

Issuers must provide an MD&A that discusses the issuer’s financial condition, results of operations, and liquidity. An MD&A should include a discussion of the issuer’s plans for future growth and how crypto assets will play a role in those plans.

Corporate Governance

Issuers must disclose their corporate governance practices, including the composition of their board of directors, executive compensation, and auditor independence. Governance practices help investors assess the issuer’s commitment to transparency and accountability.

In addition to these general disclosure principles, the SEC may also require crypto enterprises to 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 that investors have access to the information they need to make informed investment decisions. Providing accurate and thorough information can help to build investor confidence and promote the growth of the crypto industry.

SEC Crypto Investigations and Enforcement

The SEC has taken a number of notable actions in the cryptocurrency space in recent years. These actions have focused on a variety of individuals, issues, and products, including unregistered securities offerings, fraud, insider trading, cybersecurity lapses, initial coin offerings (ICOs), and decentralized finance (DeFi) platforms. The SEC has not yet brought enforcement actions against non-fungible tokens (NFTs).

By becoming familiar with the circumstances 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.
• 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 SEC also alleged that Coinbase was making false and misleading statements about its compliance with securities laws. The lawsuit is ongoing, and Coinbase has denied the allegations.

Impact of SEC Crypto Actions

A series of agency actions must lead up to an SEC enforcement action, 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 the SEC may issue an informal warning letter or a Wells notice to the crypto business. A Wells notice is a formal warning that the SEC is considering recommending an enforcement action against the company. The Wells notice will outline the SEC’s allegations and give 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 illegal activity and may also require the company to take corrective action.

In September 2022, the SEC sent a Wells notice to the largest crypto exchange, Binance, indicating that the SEC is considering recommending an enforcement action against the cryptocurrency exchange. The SEC’s concerns reportedly center around Binance’s failure to register as a broker-dealer and its alleged role in facilitating market manipulation. Binance has denied any wrongdoing and has said that it is cooperating with the SEC’s investigation.

That same month, Coinbase, another major crypto exchange, said the SEC had privately threatened to sue the company for offering the Coinbase Lend program as an unregistered security. Coinbase later announced it would discontinue the release of the Lend program.

In March 2023, the SEC issued a Wells notice to Coinbase, raising concerns about the potential listing of unregistered securities and the legality of its staking service. The notice indicated the SEC’s consideration of potential enforcement actions against Coinbase, potentially leading to fines, disgorgement of profits, and registration requirements. Coinbase initially denied any wrongdoing and cooperated with the SEC’s investigation, but was later sued by the SEC in June 2023.

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 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. Similarly, in July 2022, after the SEC charged cryptocurrency lender BlockFi with failing to register its interest-earning accounts as securities, the price of Bitcoin declined.

Navigating SEC Crypto Regulations

As the cryptocurrency landscape continues to gain prominence, financial advisors will often have no choice but to work with clients who are interested in investing in crypto. While some advisors may opt to steer clear of crypto altogether, and cryptocurrency platforms will struggle to comply with regulations, this approach 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. One strategy, Edelman says, is to “provide clients with crypto exposure, but limit those investments to SEC-registered securities.”

These securities need not directly deal in the asset, and could instead provide indirect exposure to crypto. Edelman points to an array of examples, like stocks of 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).

“No compliance officer can legitimately object to the use of products like these,” Edelman says. “Crypto might be speculative, but an ETF that invests in publicly traded stocks of companies engaged in blockchain technology can hardly be called impermissible.”

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, and 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 July 2023 court ruling declared that Ripple’s XRP token is not a security, contradicting the SEC’s stance. This decision challenges the long-standing “Chevron deference” standard, which typically grants federal agencies significant leeway in their interpretations.

The ongoing legal wrangling in courts for explicit crypto regulatory leadership highlights the limitations of the current regulatory framework and political economy. More comprehensive changes are likely to require new legislation and moving away from a piecemeal regulatory approach. For example, the Biden administration’s March 2022 executive order called for a “whole-of-government” approach to regulating digital assets.

However, Congress has been gridlocked in its views of crypto, rendering such legislation and centralized coordination largely improbable. Members of Congress hold diverse views on cryptocurrencies, ranging from strong support to staunch skepticism and a lack of urgency. Crypto laws and regulations have become entangled with partisan politics, with Democrats and Republicans often holding opposing views on the appropriate approach.

Additionally, the industry has invested heavily in lobbying efforts, and the technical complexity of cryptocurrencies and blockchain technology poses a challenge for lawmakers. Crypto lobbyists seeking to influence legislation in the industry’s favor have fomented conflicting pressure between insider interests and constituents. Lawmakers may lack the expertise to fully grasp the nuances of these technologies and fear legislative risks setting off unintended consequences.

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.