May 9, 2018

Cryptocurrency: Regulation Nightmare or Investment Dream?

Have you heard of cryptocurrencies - the new and exciting digital currency that uses cryptography for security? In the past year, these currencies have gained major regulatory attention. As an advisor, you may be wondering how to cash in on these investments, but you may also be concerned with the regulatory impact.

While most people use trusted middlemen (such as banks) for their currency transactions, cryptocurrency allows consumers and suppliers to connect directly. You receive, send, and store value (like money), but unlike traditional money, it's completely digital.

Cryptocurrencies come in two forms, tokens and coins. The tokens and coins must be traded within an SEC-registered exchange and represent an investment or product/service and qualify as a "security" under US federal securities laws.

Cryptocurrency uses a new type of technology called Blockchain, which is a decentralized, distributed ledger technology (DLT). Blockchain tech guarantees a secure transfer every time, and allows you to see previous transactions, delivering an accurate record. Each transaction forms a "block" that is added to the previous blocks to form a "chain."

Each block is immutable, meaning that once it is created, it cannot be modified. The chain of blocks is replicated across the network. Think of it like a notebook, which publicly records all transactions and each user has an identical copy of the notebook. All user's notebooks are constantly compared to make sure they match. Since all the records are recorded digitally, it shows ownership of the account balances at any time.

Blockchain can be an advantage, but also a challenge to an advisor. Let's look at a comparison of both sides:

Advantages of cryptocurrencies and blockchain technology

• Eliminates "double spending" risk
• Removes the need for third parties (e.g. banks and credit card companies)
• Increases transactional trust with the permanent, public transactional record
• Decreases risk of tampering with or stealing of assets
• Increases smaller transaction speed, by removing third parties
• Decreases transaction cost
• Decreases error rates
• Immutable record of ownership that reflects current and past ownership
• Greater transparency

Challenges of cryptocurrency and blockchain technology

• Latency and scaling as the blockchain increases in size
• Correcting errors (If the chain is immutable, but contains an error, you must create an entirely new chain)
• Account security, as with any digital exchange
• The uncertainty of strict "securities" regulations
• Privacy concerns, as the balance is publicly visible

So, what do clients want to do with these blockchain cryptocurrencies? Well, they're using these digital currencies for securities offerings, broker-dealer transactions, hedge fund formation, and leveraging regulatory consultation on behalf of broker dealers and investment advisors. This is where it becomes cloudy for you as an advisor. Cryptocurrency has no intrinsic value and is not tied to a central bank, instead its traded-on cryptocurrency exchanges. There is, however, potential to trade in the digital world. There are various financial services that can be used to increase speed and lower costs of intellectual property. Cryptocurrency and the stock exchange are one example, blockchain could not only cut out brokers, but the stock exchange itself. The system could become decentralized, eliminating the central system required to bring supply and demand changes.

Many advisors consider this virtual trading of digital currency to be an unproven venture. Concerns dealing with criminality, cybersecurity, money transmission laws, fraud, and tax evasion can make an advisor skeptical. Also, how is a token or coin defined? Is it a security or a utility? The Securities and Exchange Commission (SEC) released a public statement in March, 2018, detailing the law on trading of cryptocurrencies and the considerations for investors using digital platforms for trading.

If utilizing cryptocurrencies for transactions and investments, is indeed a security, so federal and state laws will apply. If you are the issuing advisor, you must register the token exchange with the SEC and any resale must be compliant. As an advisor, if you choose to play in the digital world you must be aware of consumer fraud, personal and customer trading, suitability, and applicable disclosures.

Be aware of the inherit risks of allowing a client or even yourself, to do business in the digital world of cryptocurrency. As the advisor and financial liaison for your client, the decision to provide investment advice, advertise a digital currency or act in custody of an investment will fall to your discretion alone. You are responsible with making the decision to provide your clients with advice on the topic. Just be aware of the regulations that could impact you and your clients. In other words - keep your ducks in a row.

If you have questions about specific regulations and/or how they might apply to you and your business, please consult a licensed attorney in your jurisdiction.

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