Cryptocurrencies have exploded in popularity in recent years—even after major drops in 2022, when it neared $3 trillion, the total crypto market capitalization was still more than $1.7 trillion in January 2024.With more clients expressing interest or already investing in crypto, financial advisors are looking for best practices for this new asset class.
Conducting comprehensive due diligence means going beyond just looking at historical returns or projections.Advisors need to dive into the technology, security measures, liquidity, regulations, and other factors that impact the risk and return profile.Ongoing monitoring and adapting to new developments in the fast-evolving crypto space are also essential.
Key Takeaways
– Financial advisors’ fiduciary responsibilities extend to meticulously vetting crypto assets.
– Key due diligence areas include technical analysis, market dynamics, regulatory compliance, and security protocols.
– The job of financial advisors in this area is made more difficult since many crypto assets operate outside regulations from the U.S.Securities and Exchange Commission (SEC) and the U.S.Commodity Futures Trading Commission (CFTC).
– Real-world crypto failures highlight the need for enhanced due diligence, regulatory adherence, and investor education.
– Ongoing monitoring and education are crucial for navigating the risks and evolving regulations in the crypto sector.
Understanding Crypto Due Diligence
Financial advisors have a fiduciary responsibility to act in the best interests of their clients at all times.
This includes thoroughly vetting any investment products they recommend and fully understanding the risks and benefits for their clients.
Cryptocurrencies represent a new frontier that many advisors are just beginning to explore.Without proper due diligence, advisors could expose their clients to undue risk.
This involves thoroughly vetting and analyzing factors like the cryptocurrency’s underlying technology, development team, market changes, risk metrics, and security provisions.
Through due diligence, advisors can gain an in-depth understanding of a crypto asset and assess their applicability to their client’s
portfolios.Ongoing monitoring and adapting to new developments in the field are essential since events evolve quickly in the crypto sphere.
Additionally, regulatory compliance needs to be a central focus during due diligence.This task in the crypto space can be a problem because many crypto assets operate overseas or in other ways to avoid being regulated by the
U.S.Securities and Exchange Commission (SEC) and the U.S.Commodity Futures Trading Commission (CFTC).Yet the financial advisors themselves must adhere to all applicable regulations from bodies like the SEC, the Financial Industry Regulatory Authority (FINRA), and state agencies when considering crypto for clients.This ranges from disclosure requirements to custody procedures, licensing maintenance, transaction reporting, and more.
Rigorous due diligence processes demonstrate an advisor’s commitment to ethical conduct, risk management, and
fiduciary duty—upholding the highest standards of financial responsibility.This is critically important given the complexity, risks, and frequent regulatory shifts inherent to the cryptocurrency asset class.
Financial Responsibility in the Crypto Industry
Financial responsibility is the prudent management of monetary assets and transactions to ensure ethics, transparency, risk mitigation, and regulatory compliance.
This takes on greater importance in the cryptocurrency realm, given its historical
volatility, lack of investor protections, and a frequently shifting regulatory landscape.
For individuals investing in crypto, financial responsibility starts with only allocating disposable income that you are prepared to lose, given the asset class risk.Setting
stop losses, taking profits when prudent, and implementing security measures like multifactor wallet authentication and cold storage (putting assets offline) are also advised.Paying cryptocurrency-related taxes and adhering to reporting requirements are essential as well.
For financial advisors, financial responsibility means thoroughly vetting any crypto assets before making client recommendations through their due diligence processes.Portfolio allocations should match
client goals and risk tolerance.As with other types of alternative investments, the ongoing monitoring of crypto holdings, clear client communication, and keeping up with regulatory changes are critical, too.
Conducting Crypto Due Diligence
When conducting due diligence on crypto assets, advisors need to dig deep into the technical, financial, regulatory, and security aspects of a cryptocurrency.Proper due diligence takes considerable time and effort.However, it is the only way for advisors to fulfill their fiduciary duty when dealing with crypto assets.
Core Areas of Crypto Due Diligence
Here are the core areas that financial advisors need to cover in crypto due diligence:
– Assess the legitimacy and technical details: Advisors should review the cryptocurrency’s
white paper, development team, blockchainspecifications, and consensus protocol.Vetting the utility, security, and capabilities of the platform is essential.
– Analyze market dynamics and liquidity: Evaluate real-world adoption metrics, trading volume, volatility,
market capitalization, use cases, and historical returns.
Assess liquidity riskand the potential influence that changes in liquidity can have on crypto values.
– Review exchanges, platforms, and the custody of the crypto assets: Vet any crypto exchanges, wallets, custodial services, or trading platforms for security practices, insurance coverage, segregated asset storage, and regulatory compliance.
– Evaluate the cryptocurrency’s volatility, allocation, and risk modeling: Use risk analysis frameworks like
value at riskor modern portfolio theoryto model crypto asset volatility and how these relate to other parts of the client’s portfolio.Construct an appropriate allocation of crypto based on the client’s risk tolerance.
– Understand the regulatory landscape: Research legal classification, taxation policies, reporting requirements, investor protections, and other regulations applicable to the crypto asset in the relevant jurisdictions, then monitor for ongoing changes.Confirm that the platform is licensed or registered within its jurisdiction and that it is subject to real and frequent third-party financial audits.
– Look for transparency: More credible platforms are upfront about all fees, ensuring that there are no surprises for your client.A platform should maintain open communication, especially during market upheavals or technical challenges.
– Become a skeptic: Approach projects promising sky-high returns with great caution.
If the promoters of the crypto are promising excessively favorable returns, it warrants skepticism.A crypto’s promoters need not be fraudulent but can be taken away with their rhetoric and hopes.Many projects are nothing more than replicants of existing cryptocurrencies and blockchains with different names and terms—at the stage the industry is in, it is very rare for something new (and legitimate) to be introduced.
Additional Factors to Review for Crypto Assets
In addition to these core areas, advisors should pay attention to the evolving nature of the crypto industry and consider the following:
– Cybersecurity measures: Assess the cybersecurity measures employed by the crypto asset or project to safeguard against hacks, fraud, and unauthorized access.This includes evaluating the security protocols of both the blockchain and any associated platforms, exchanges, or wallets.
Platforms should deploy robust security measures, including two-factor authentication and end-to-end
encryption.
– Token governance and ownership structure: Examine the governance and ownership structure of the crypto asset to understand who holds decision-making power and how decisions are made and implemented.This helps assess the level of decentralization and the potential influence of major stakeholders.
– Community and developer engagement: Look into the ongoing interaction among the community, developers, and the project team.A strong, active engagement indicates a healthier ecosystem and support for future development.
– Competence and integrity: An evaluation to assess the competence and integrity of the team behind the crypto project is also crucial.A team that has no or questionable experience or credentials may not engineer a quality product.
– Long-term vision and road map: Review the long-term vision and road map of the crypto asset or project to gauge its ambition and feasibility, and the team’s commitment to achieving its outlined goals.
– Competitor analysis: Conduct a competitor analysis to understand the crypto asset’s positioning within the broader market and identify any unique selling points or advantages over similar projects—or the opposite: points that stand out as potential disadvantages.
– Third-party audits and reviews: Seek third-party audits and reviews of the crypto asset or project, which can provide an independent assessment of its technical, financial, and legal standing.
– The potential for integration and interoperability: Explore the potential for integration with existing systems and its interoperability with other blockchain platforms, which would provide more uses and a greater ability for others to adopt the crypto asset.
– Education and resources: Evaluate the availability of educational resources that the project provides to help investors and users understand the asset, its utility, and the technology behind it.
– Public and media perception: Monitor public and media perception, as it can significantly affect investor confidence and the market for crypto assets.
– Historical performance and resilience: Analyzing historical performance during varying market conditions and the asset’s resilience to past market downturns can shed light on its potential performance.
– Ethical considerations: Assess any ethical issues that might arise with the crypto asset or project, such as energy consumption, data privacy, and social impact.
Many crises in crypto have been brought about not by a problem within a platform or asset itself, but from misuse of client funds.Platforms associated with respected crypto entities or established financial institutions generally carry more credibility.
– Review token economics: Understand the underlying “tokenomics” to ensure the platform’s sustainability and long-term viability.How well does it trade? What is its trading volume? How is its liquidity? These should be easy to answer if the asset is worth investing in.If a platform or outlet deals with stablecoins or offers returns, ensure that it can do so.
– Stay updated: The crypto sector rapidly evolves, and projects and companies frequently refresh their services and tools.This might indicate a commitment to innovation, growth, or usability; however, it might also mean they are just trying to catch the next wave of crypto excitement.
Mitigating Crypto-Related Risks
As with any investment, crypto comes with the risk of loss.While the growth of cryptocurrencies presents potential opportunities, advisors need to be able to counsel clients about mitigating the substantial risks involved in crypto.
Some key crypto investment risks include market volatility, regulatory uncertainty, technological vulnerabilities, and liquidity issues.
Here’s a closer look at these risks and how advisors can help mitigate them:
– Market volatility: Cryptocurrencies are known for their significant price fluctuations over short periods.Advisors should educate clients on the volatile nature of crypto assets and encourage a long-term investment perspective.Diversifying assets can be a prudent strategy to mitigate the influence of volatility.As with other investments, advise clients to put no more into crypto than they are willing and able to lose.
– Technological vulnerabilities: Crypto assets depend on technology susceptible to hacking, fraud, and operational failures.Any crypto projects or assets should have robust security measures, and advisors should encourage clients to adopt secure wallets and exchanges to help mitigate these risks.The digital nature of cryptocurrencies thus makes them a target for
cyberattacks.
Utilizing secure and reputable platforms, employing multifactor authentication, and educating clients on best practices for digital security can help mitigate cybersecurity risks.
– Liquidity issues: The liquidity of a crypto asset can vary greatly depending on its market demand, trading volume, and the platform on which it is traded.
Advisors should assess the liquidity risk of crypto assets and advise clients accordingly, perhaps recommending assets with higher liquidity and established exchanges.
– Misinformation, scams, and lack of transparency: The crypto sector and the wider online world around it can often be opaque and filled with misinformation.
Conducting thorough due diligence, seeking transparent projects, and utilizing reputable sources for information are crucial steps to navigate through misinformation.The crypto space has been a fertile ground for various scams and fraudulent schemes.Ensuring thorough vetting of projects and educating clients on red flags associated with fraudulent activities can help mitigate these risks.
– Operational risks: Operational risks, including system failures or management incompetence, could adversely affect a crypto asset.Try to assess the operational robustness of crypto projects and the competence of their management teams.
Some of the operational risks of cryptocurrency projects include:
– Reputational risks: The reputation of a crypto asset or project can significantly affect its market value.Monitoring public and media perception and steering clear of projects with negative reputations can be prudent.
– Legal and tax implications: Understanding the legal and tax implications of crypto investments is essential.Advisors should seek to stay updated on changes in the legal and regulatory environment, as well as the tax obligations associated with crypto transactions.
– Smart contract risks:
Smart contractsautomate transactions on the blockchain but could have vulnerabilities or unintended consequences.
Assessing the quality and security of smart contracts is crucial.
Advisors have a fiduciary duty to provide well-informed guidance to clients on navigating these risks.By fostering a culture of education, transparency, and prudent risk management, advisors can help clients make informed decisions in the crypto domain, aligning their investments with their financial goals and risk tolerance.
Regulatory Framework and Compliance
The regulatory framework surrounding cryptocurrencies and the due diligence necessary for financial advisors can be complex because of the novel nature of these digital assets and the potential for regulatory changes.Here are the notable regulations and compliance essentials for individuals and businesses involved in crypto transactions, focused on the United States.
The U.S.is moving toward establishing a streamlined set of regulations for digital assets.The regulatory landscape involves various federal agencies, each with a unique mandate concerning cryptocurrencies:
– The
Financial Crimes Enforcement Network (FinCEN): Oversees digital assets concerning anti-money laundering (AML)and countering the financing of terrorism regulations.
– The SEC: Supervises the issuance and resale of digital assets deemed as securities.These can include the
crypto exchange-traded funds (ETFs)approved in January 2024, the stocks of crypto-mining companies, or even the cryptocurrencies themselves.
– The CFTC: Regulates digital assets that are classified as
commoditiesor used as derivatives.These can include futures and options contracts listed on crypto, such as Bitcoin or Ethereum.
Various jurisdictions worldwide are either enacting or on the verge of implementing regulatory systems for digital assets.These regulations aim to encourage a conducive environment for innovation, consumer protection, and sector growth while ensuring financial responsibility in the crypto sector.
Several federal laws may apply to crypto assets, depending on the nature of the asset:
– The
Bank Secrecy Act (BSA): Along with amendments to the USA Patriot Act and the Anti-Money Laundering Act, the BSA establishes a framework for preventing money laundering.
– The Commodity Exchange Act and Securities Exchange Act: These are relevant for the registration requirements for assets considered securities and commodities.
– The Responsible Financial Innovation Act: An initiative that creates the beginnings of a comprehensive regulatory framework for digital assets.
– U.S.
Department of the Treasuryand Internal Revenue Service (IRS)regulations: Newly proposed regulations touch on the sales or exchanges of digital assets, including cryptocurrencies, and relate to information-reporting requirements and the determination of the amount realized, basis, and backup withholding.
Compliance
Compliance is essential for mitigating the risks associated with crypto transactions.
Compliance Requirements
– Registration and compliance with the relevant regulatory bodies: Companies directly dealing with digital currencies must register with FinCEN, the SEC, and the CFTC, depending on the nature of the assets, and follow the relevant regulations.
– Assessing risk and AML programs: Regulated businesses should conduct risk assessments concerning money-laundering activities and implement AML programs proportional to their size and nature.
– Customer identification programs:
Know Your Client (KYC)is the term used for the standard practice in the U.S.
of verifying customer identities and legal status during onboarding and transactions to meet regulatory requirements.
Case Studies: Lessons Learned from Crypto Failures
The Collapse of FTX Exchange
The crash of the
FTX exchange was a significant event in the crypto industry that shed light on the importance of due diligence and financial responsibility.FTX was once a reputable name in the cryptocurrency exchange domain, known for facilitating crypto trading and derivative products.However, it faced a sudden collapse from mismanagement and fraudulent activities that quickly led in the fall of 2022 to a significant mismatch between its assets and liabilities.
Unlike traditional financial institutions where assets and liabilities are continuously audited, the FTX case exposed a gaping hole in the crypto sector’s self-regulation.The core issue was that the exchange was supposed to make money off slim fees from each transaction on the exchange while taking care to keep client assets safe.
Instead, those assets were put into risky investments, which meant that once clients called for their funds and those couldn’t be provided, its native token, FTT, collapsed in value.
Impact:
This failure affected not only the stakeholders of FTX but also sent a ripple of uncertainty through the crypto market.The collapse of FTX highlighted the need for enhanced financial compliance measures, better management practices, and the utilization of blockchain’s transparency feature to ensure continuous auditing of crypto firms to prevent such catastrophic events.
The collapse disrupted the crypto market and led to significant financial losses for investors.
The collapse brought attention to the regulatory shortcomings in the crypto industry, catalyzing discussions around creating more stringent regulations.
Former FTX CEO
Sam Bankman-Fried was convicted on Nov.2, 2023, on seven counts of fraud and conspiracy after his business partners, some of whom were close friends from his teen years, testified against him at trial.Once among the wealthiest people ever under age 30, he faces decades in prison.
The Bankruptcy of Genesis Lending Unit
Genesis was a well-regarded name in the crypto lending sector.However, it faced bankruptcy after not managing its liabilities following a freeze on withdrawals.After filing for bankruptcy in early 2023, its restructuring unit listed $43.8 billion owed to creditors.
This bankruptcy underscored the inherent risks associated with crypto lending platforms, especially in volatile market conditions.It also raised further concerns about the industry’s financial management practices and the need for stricter regulatory compliance within crypto lending platforms.
Impact:
– A significant financial loss for creditors
– A negative ripple effect for other entities in the crypto market
– The dispute between Genesis and crypto exchange
Geminiover a crypto lending product called Earn showcased the complex legal and financial intricacies in crypto lending agreements.
TerraUSD Crash
TerraUSD (UST), an algorithmic stablecoin, was designed to maintain a stable value by being pegged to the U.S.dollar.
However, it suffered a severe crash and deviated significantly from the dollar, dropping from $1 to $.35 in 2022.It regained its value by the spring of 2023.
The crash was triggered by a rapid sell-off on digital asset exchanges, which were not adequately buffered by the algorithmic mechanisms.The fallout was significant, leading to legal action and a loss of confidence in the stability of algorithmic
stablecoins.
The case underscored the challenges inherent in algorithmically stabilizing currencies and the need for continuous monitoring while managing crypto assets.Also highlighted was the importance of robust stabilization mechanisms and regulatory oversight to ensure the integrity and stability of crypto stablecoins.
Impact:
– The crash disrupted the wider stablecoin market, shaking investor confidence in crypto stablecoins.
– Legal action ensued against the project, further straining its resources and reputation.
– Investors and stakeholders suffered financial losses from the sudden decline in value.
What Are the Biggest Risks and Challenges with Crypto Investments?
Key risks include high volatility, liquidity constraints, cybersecurity threats, lack of investor protections, regulatory uncertainty, susceptibility to scams, and more.The lack of adoption of crypto tokens for real-world uses, the extreme price swings, and the speculative nature seen in crypto markets in the past present ongoing challenges.
How Can Individuals and Businesses Find Financially Responsible Crypto Outlets?
Ensuring financial responsibility in the crypto sector starts with education and awareness.Individuals and businesses should acquire a good understanding of blockchain technology and the specific cryptocurrencies in which they are investing.Regular financial audits can ensure transparency and financial health, while compliance with existing regulatory frameworks in the jurisdictions in which they operate is crucial to avoid legal complications.
What Are the Compliance Requirements for Those Involved in Crypto Transactions?
The compliance requirements for individuals and businesses involved in crypto transactions vary depending on the jurisdiction.
However, common requirements include following KYC and anti-money laundering and combatting the financing of terrorism (AML/CFT) regulations to prevent illegal activities.Tax compliance is also crucial, with individuals and businesses required to report and pay taxes on cryptocurrency profits in almost any jurisdiction.If a crypto asset is classified as a security, then securities compliance is necessary.Data protection compliance to ensure the protection and privacy of user data is also a crucial aspect of compliance in crypto transactions.
The Bottom Line
Cryptocurrency investments are still relatively new for many financial advisors.They have unique challenges that demand meticulous due diligence.The fiduciary responsibility of advisors extends to in-depth vetting of crypto assets so they can make informed recommendations to their clients.
Beyond analyzing historical returns, advisors should learn about the intricacies of blockchain technology, security protocols, market changes, liquidity, and an ever-evolving regulatory landscape.The aim is to ensure financial responsibility, risk management, and regulatory compliance in a sector known for its volatility and lack of investor protections.
Well-known fraud and conspiracy cases in the sector have created some valuable lessons—they should be used to develop a basis for essential practices that uphold integrity and foster trust..
