An Adviser's guide to cryptocurrency

 

Dealing with cryptocurrencies: advice, risks and regulation.

 

What are Cryptocurrencies?

Cryptocurrencies may have been “the future of money since 2009”, but digital currencies – like bitcoin, ripple and ethereum – are only now being enthusiastically embraced by the general public.

(Honestly, describing the current response as an embrace communicates neither the fervour, desperation nor contagious optimism that underpins the appeal of cryptocurrencies.)

Cryptocurrencies have always appealed to drug dealers, money-launderers and anarchists, but the growth and momentum of these virtual ‘investments’ is driving a frenzy of activity that is emboldening speculators, enriching traders and worrying regulators. On a daily basis, we are deluged by coverage, promotion, inspiring stories, trading releases and launches. 

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The ubiquity of these releases recently prompted Popular Science to publish this template to assist with the promotion of new players.

It was alarmingly credible.

Despite the clamouring for cryptocurrencies, few investors appreciate the fragility of their cryptocurrency-based wealth and the complexity and vulnerabilities of digital currencies.

In our view,  Cryptocurrencies seem to be 1850’s Ballarat in digital form – presenting the opportunity of obtain vast wealth without the need to labour.

Hope, however, can be the root cause of great tragedies.

 

Whether it’s a bubble or not will be determined by history, but it’s important to appreciate that the price of cryptocurrencies are more open to manipulation than most other investments.  

As unpopular as it may be, financial advisers should exercise both caution and scepticism in the face of investor frenzy.  

While there are practical limits to how real property prices can be ‘talked up’, and while most ‘pump and dump’ strategies are obvious to vigilant regulators, the price of cryptocurrencies can be shifted by a relatively small number of players.

Further, social media can magnify those shifts by several orders of magnitude. 

Combine these vulnerabilities with an absence of legislative controls, a lack of consistent regulation and disjointed regulatory responses and you can see some of the risks inherent in the widespread embrace of cryptocurrency investment.


The dramatic rise of digital token offerings saw the creation of hundreds of new virtual currencies, but experts say most of them have little to no value and some are outright examples of fraud. That’s due to the relative ease in conducting a token offering and the few regulatory checks.
— CNBC "Cryptocurrency trends" dated 7 December 2017

In a bear market, recommending caution seems unusual. We appreciate that others have conflicting views, but these are often driven by conflicting interests.

Before we advance too far it’s important to appreciate that reasonable concerns about some cryptocurrencies aren’t necessarily concerns about blockchain, (but even this disruptive technology is not without its critics).

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So what exactly is blockchain? We're glad you asked. For an excellent overview of Blockchain Technology read "What is Blockchain Technology? A Beginner's Guide"


 

cryptocurrencies and the slow regulatory creep 

In our opinion, while cryptocurrency is effectively unregulated, this ‘wild west’ environment will not long continue.

In Australia, Austrac has already begun to grapple with the regulation of cryptocurrencies and its use in money laundering, ransomware and financing terrorism.

ASIC, in the absence of regulatory authority over digital currencies, has focused on consumer education.

Even the ATO has made tentative steps into this arena.

Internationally, regulators are slowly moving towards mitigating or controlling the growth of cryptocurrencies, even as legislators start to grapple with the digital currencies’ immediate and long-term impact on fiat currencies.


Why are advisers considering them?

 (c) 2018 ifa.com.au. Results current at 21/01/2018

(c) 2018 ifa.com.au. Results current at 21/01/2018

IFA’s online survey suggests that few advisers are likely to recommend cryptocurrencies.

Anecdotal evidence, however, suggests that while advisers aren’t  recommending cryptocurrencies, they are considering them.

They're either being nudged in the direction of virtual currencies by client interest or being forced to try to temper their clients' speculative enthusiasm.

On this latter point, we understand that most advisers grappling with cryptocurrencies are doing so defensively.

They are either limiting themselves to warning clients that cryptocurrencies are speculative, unpredictable and complex or cautioning SMSF Trustees against inadequate diversification.

However, if cryptocurrencies continue to be seen as mainstream and effective investments, the pressure to recommend particular cryptocurrencies, and to create portfolios that incorporate digital currencies, is only likely to increase.

As often as advisers might warn clients not to chase performance, and despite their repeated warnings that past performance is not a reliable indicator of future performance, the lure of wealth and independence is often overwhelming.

Cryptocurrencies have displaced real-estate as the topic du jour at most BBQs and social events. As uber-drivers and neighbours advocate for them, financial planners should not be surprised that clients want a piece of the action

Even the mainstream press place inordinate focus on those who’ve made, or are in the process of making, fortunes in cryptocurrencies (or those successfully securing their financial independence through trading in digital currencies).

The opportunity is overwhelming. 

The data presented by Coindesk highlights the appeal for most investors; in an economic environment of low rates and low returns, investments that can double or quadruple in value over three months are irresistible, particularly when new opportunities will be plentiful.

 Data courtesy of Coindesk. The chart, data and presentation are available from Coindesk.com

Data courtesy of Coindesk. The chart, data and presentation are available from Coindesk.com

 Data courtesy of Coindesk. The chart, data and presentation are available from Coindesk.com

Data courtesy of Coindesk. The chart, data and presentation are available from Coindesk.com

Investors are not alone in their optimism.

Some advisers, focussed on these investment opportunities, and buoyed by the lack of red tape and regulation, have embraced digital currencies with the same enthusiasm as the more innovative international fund managers.


Financial Planning: What to consider

While there is a view that cryptocurrencies may have a place in client portfolios as ‘alternative investments’, others believe that any adviser reaching this position now, has probably missed the opportunity (and their failure to realise the investment opportunity is an indictment of the conservative advice industry).

In our view, financial advisers need to exercise a degree of caution.

While digital currencies are not ‘financial products’ and generally exempt from the single licensing, conduct and disclosure regime created by the Corporations Act, they are not entirely a ‘green fields’ opportunity for financial planners.

Remember, that s 961B(1) imposes an obligation on financial planners to "act in the best interests of the client in relation to the advice".

Notwithstanding that cryptocurrencies are not financial products, any adviser recommending them (either explicitly or explicitly) would need to demonstrate that their decision to do so was in the best interests of their client.

For products that are volatile, complex, opaque, unpredictable and exploitable, it would be difficult to meet this test, or satisfy the steps required by s961B(2), without significant effort.

Even if an adviser is confident that the possible returns will adequately address this obligation, they should be aware that, in some circumstances, digital currencies may be financial products.

Internationally, regulators like the FCA have taken this position with Cryptocurrency CFD and branded them as high risk investments. The SEC is similarly concerned. In our view, ASIC is likely to take a similar position to these regulators.

So, while cryptocurrencies may be essentially unregulated in Australia, ASIC are watching. It is not unreasonable to anticipate that ASIC may take the (correct) view that some Initial Coin Offerings (ICO) are, in fact, financial products.

A further complication is that cryptocurrencies may, in some cases, be “non-cash payment facilities” that are, subject to some exemptions, already regulated by ASIC.

As one financial services lawyer recently observed, “while often the NCP exemptions apply, some exchanges are offering NCP facilities without realising it.”

So, in our view, even if the bubble doesn’t burst, the smart money is on increased regulation.

We appreciate that there are inherent difficulties in regulating decentralised and anonymous services, but distribution, user access and investor activity can all be regulated, restricted and taxed.

In our opinion, if you are playing in this space, you need to ensure that you’re taking appropriate measures to mitigate the inherent risks of dealing with cryptocurrencies.        


Take outs

  • Cryptocurrencies are speculative, volatile, complex and opaque. They have specific risks and vulnerabilities that need to be carefully considered and addressed.
  • Past performance is not a reliable indicator of future performance.
  • The best interest duty applies even where you don’t actively recommend cryptocurrencies. If you consider them, integrate them into a portfolio or just execute your client’s instructions, you’ll need to demonstrate that you acted in your client’s best interests.
  • If you actively recommend cryptocurrencies (as alternative investments or derivatives) consider whether, and to what extent, you can demonstrate your compliance with the ‘safe harbour’ steps.
  • Where you are only executing client instructions (or reflecting client-initiated trades) consider whether you are adequately documenting the arrangement.
  • Review your PI Insurance to ascertain whether, and to what extent, it covers you for dealing in cryptocurrencies.   
  • Appreciate that while cryptocurrencies are not generally financial products, they may be. Review your processes accordingly.
  • Take the time to understand the taxation implications
  • Anticipate increased regulation of cryptocurrencies.
 

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