The biggest regulatory question for advisors concerning digital assets today is: Are they securities or not?
Digital assets are still quite new, having only really burst into the mainstream over the past two to four years, while the central rules governing most financial advisors date back to World War II-era legislation like the Investment Advisers Act and the Securities Exchange Act. So today’s regulators, such as the U.S. Securities and Exchange Commission (SEC), have quite the job fitting the square peg of cryptocurrencies into the round hole of eight-decade-old laws.
I recently introduced readers of my newsletter columns to two different digital asset companies pushing into the registered investment advisor (RIA) market: Swan Bitcoin and HeightZero. Both of these companies have decided to narrow their focus to one or two types of cryptocurrencies, in part because they fear the regulatory scrutiny that may come when this big regulatory question is answered.
In Swan’s case, the company is focused solely on bitcoin.
“Many or most crypto assets have significant regulatory risk, particularly as it relates to being securities under U.S. law, but we think these problems are now solved for bitcoin,” said Andy Edstrom, the head of institutional investment at Swan Bitcoin. “We don’t think this question has been answered for most other digital assets, and they potentially pose problems for intermediaries like financial advisors.”
HeightZero, meanwhile, has decided to focus on both bitcoin and ether, but no other alternative coins (altcoins).
“As of right now, we want to be sure we’re listening to the SEC and making sure we’re doing everything we can to be compliant and keep our clients compliant,” said HeightZero founder A.J. Nary. “We don’t want to be in a position like Coinbase was when Ripple was declared a security, the SEC sued [Ripple], and [Coinbase] had to take the token off of its platform. If that happened to us, we would have to notify all our advisor clients that they were using a security. We want to protect our clients.”
Swan believes that ether is a security, however.
“The reality is that Ethereum isn’t really decentralized; the ownership is highly concentrated,” said Edstrom of the blockchain.”The proof-of-stake model they are moving to is inherently centralizing, because when you stake coins you end up getting more coins; thus, if you have more money, you make more money. So bitcoin is the only one we feel comfortable with.”
The great debate
At the heart of the debate are the SEC’s custody rules. If digital assets like cryptocurrencies are securities, then regulations require that they be held not by an advisor, but by qualified custodians. These rules are the reason financial advisors do not hold their clients’ assets but turn to companies like E*Trade, Schwab, BNY Mellon | Pershing and Fidelity to provide custody services.
Advisors and end-investors, for the most part, no longer hold stock certificates or paper bonds but a digital record of ownership for those investments, while the actual assets are held by a custodian on a centralized ledger within a central securities depository – and only qualified custodians are permitted to own the assets within this depository.
But digital assets, at heart, were invented to circumvent this system via a decentralized ledger and be “self-custodied.” By holding the cryptographic keys that enable me to access my cryptocurrency holdings, I am responsible for the safekeeping of those assets. They are also digital bearer assets – the person holding the keys is considered to be the owner of the assets.
What is a security, exactly?
The SEC defines a security as “the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.”
Under this definition, bitcoin does not meet the criteria for being called a security because there is no readily identifiable, centralized third-party enterprise.
Earlier this year, at the Aspen Security Forum, SEC Chair Gary Gensler made it clear that many tokens should be considered securities.
Why not both?
For the time being, the answer to our big regulatory question appears to be “both.” Some cryptocurrencies are not securities while others are, at least for the time being. The SEC seems comfortable with thinking of bitcoin itself as a commodity, not a security (a commodity being defined as either a tangible item or an item made to be bought and sold in commerce that is rightfully regulated by the Commodity Futures Trading Commission [CFTC] and not the SEC itself). And industry players like Height Zero feel pretty sure that the same can be said of ether – like bitcoin, it is a commodity.
But until greater regulatory clarity comes from the SEC and other federal policymakers, other altcoins should still be treated as if they were securities.
What if cryptos are securities?
In November 2020, the SEC solicited some guidelines from the financial industry to help determine whether advisors are working with a qualified digital asset custodian. A Dec. 6, 2020, response from the Open Economy Initiative noted that qualifications for digital assets should be based mainly on cybersecurity. A qualified digital custodian provides an offering ensuring secure key management and interoperability with different networks.
So as advisors begin to have more choice over where to custody clients’ digital assets, they should examine whether potential custody providers offer highly secure online custody services (hot wallets), offline services (cold storage) and potentially “deep cold” storage dividing custody recovery between different physical locations, which drastically reduces the chances of losing access to clients’ assets.
“Anyone who says they know what the SEC is going to do long term doesn’t really know what they are talking about,” said Nary. “I think it’s a good idea to take a very conservative approach to this space, especially if you are an SEC-registered advisor.”