Risks and Key Considerations
Like all assets, cryptoassets are associated with various risks, and there are many important factors to consider before making an investment decision. However, because this is a relatively new asset class that is subject to rapid change and evolution, few investors are fully aware of all the potential pitfalls. Therefore, advisors working with clients who have—or would like to have—crypto holdings can add significant value by understanding these issues and discussing them with clients.
Regulation
At present, there are few unique rules or regulations that apply exclusively to cryptoassets—although some jurisdictions, such as the European Union, are in the process of creating such legislation and there are global efforts to more closely regulate stablecoins. In general, however, cryptoassets are simply subject to the same rules as any other asset class.
Importantly though, regulators continue to disagree about how to define—and, therefore, oversee—cryptoassets. As a result, the regulatory landscape is relatively complex.
What is Crypto from a Regulatory Perspective?
The Commodity Futures Trading Commission (CFTC) has been aggressive in asserting its authority over cryptocurrency. In 2015, it formally defined cryptocurrencies as a commodity, subject to the provisions of the U.S. Commodity Exchange Act (CEA) and supervision by the CFTC.18
In terms of enforcement, the agency has focused on issues like fraud and market manipulation—specifically, the manipulation of spot markets for the commodities (cryptocurrencies) that serve as the foundation for futures or swaps contracts. The CFTC has also levied fines on various companies for failing to register as exchanges or intermediaries in line with the CEA.
However, while the CFTC has asserted jurisdiction over cryptocurrencies as commodities, other agencies have taken a different approach.
In some cases, the SEC has defined certain tokens as securities, rather than commodities. It has brought actions against various crypto exchanges, crypto lenders, and other players for offering unregistered securities and, recently, has asserted that DeFi platforms—decentralized finance platforms, which offer a range of financial services, including cryptocurrency trading and lending—are offering securities and, as such, must be registered with and overseen by the SEC.19
The SEC has lately been more outspoken in its calls for greater oversight of the crypto industry and has worked closely with the CFTC on some actions. This suggests there may be more regulatory coordination between the two agencies in the future as they seek to exert greater authority over the space.
However, these are not the only two arms of government to have a stake in cryptocurrency rulemaking and enforcement. Other regulatory bodies, including the U.S. Treasury’s Office of Foreign Asset Control (OFAC) and Financial Crimes Enforcement Network (FinCEN), have also brought actions against various cryptocurrency firms on the basis that “convertible virtual currency” such as cryptocurrency can be defined as “currency” for regulatory purposes.
The Internal Revenue Service (IRS) also has a stake in defining and monitoring cryptoasset markets. The IRS has, for tax purposes, defined cryptocurrencies as “property,” which means that cryptocurrency owners incur tax liabilities on their crypto holdings in the same way as they do on other assets such as stocks or gold.
Among cryptocurrency owners, there is some confusion about the tax status of their holdings and what types of actions trigger tax liabilities. Per the IRS, multiple transactions, including selling cryptocurrency for U.S. dollars, exchanging one cryptocurrency for another, and even paying for goods or services with cryptocurrency, can all trigger a tax event, and tax authorities are becoming increasingly aggressive in their pursuit of crypto tax dodgers.
Unfortunately, calculating taxes owed can be quite complex, given the price volatility in crypto markets. Taxable value is based on capital gains or losses, which can be hard to track. As a result, some investors have faced unexpectedly large tax liabilities and had to sell their cryptoassets to cover them. Such forced selling can have a serious impact on an investor’s crypto strategy, meaning that tax planning must be a core part of crypto investing.
The SEC has lately been more outspoken in its calls for greater oversight of the crypto industry and has worked closely with the CFTC on some actions.
What Does This Mean for Investors?
As you can see, there is a degree of regulatory and tax complexity around cryptoassets. This has various implications that investors must keep in mind.
Perhaps most importantly, because regulatory conversations are ongoing, it is not at all clear how cryptoassets will be treated or regulated in the future.
China, for example, offers an object lesson. Originally highly supportive of cryptocurrencies, China’s government recently changed its stance, banning Bitcoin mining, declaring cryptocurrency transactions illegal, and cracking down on various blockchain operations in the country.20 China’s actions had an impact on Bitcoin’s price—and the price of other cryptocurrencies—and led to a limited reordering of the broader ecosystem. This is an important reminder that regulatory change has the potential to meaningfully impact crypto prices and accessibility and must be considered when evaluating crypto investments.
A second key consideration is that, again because of the ambiguity and disagreement about how cryptoassets should be overseen, many firms involved in the industry fall through the regulatory cracks.
Consider, for example, the expanding crypto lending industry. Besides the inherent risk of lending assets that are subject to significant price volatility (see discussion below), there are also important regulatory issues to consider when lending coins.21
Most crypto lenders offer collateralized loans backed by cryptocurrency. However, the industry is not regulated in the same way as the banks and brokerage firms that typically offer such products. Some lenders have, for example, admitted to pledging the same collateral for multiple loans—a practice notorious for its role in the 2007 mortgage collapse. Loans are also often packaged, sliced, and repackaged, meaning that it is not always easy to identify the extent of the risks involved in an individual product—again an issue that echoes problems that arose during the mortgage crisis.
While many crypto lenders are reputable and conservative, the relative lack of regulatory oversight means that there are also players that are taking much greater risks. Given the lack of consistency in standards, it is important to take care when selecting which firms to do business with. It is also important to fully understand the nature of the products purchased and the risks inherent in them.
The collapse of TerraUSD/Luna offers important lessons here.22 Stablecoins such as those offered by crypto project Terra are meant to be safe havens in the crypto universe. However, the collapse of both algorithmic stablecoin TerraUSD (UST) and its sister coin Luna (LUNA) have shown that there are no guarantees in unregulated investment spaces.23
Both UST and LUNA enjoyed significant growth over recent years. Demand for coins—particularly UST—was driven, in large part, by Anchor, a lending and borrowing protocol that offered returns as high as 20% on UST deposits.24 Eager investors purchased UST and deposited it with Anchor, earning returns of 20%. Returns were paid in stablecoins and were therefore, ostensibly, as good as dollars. However, when the value of UST and LUNA collapsed following a crisis of confidence, the institutions behind Anchor and Terra did not have sufficient reserves to defend the currencies. Those holding UST and LUNA have lost almost everything.25
This highlights the importance of fully understanding any products purchased and of remaining diversified across asset classes.
Volatility
Cryptocurrency markets are subject to significant price volatility, which can be far greater than the volatility of many other markets (see Figure 2). There are many reasons for this, including lower daily trading volumes and pricing discrepancies across trading platforms.
While many clients may comfortably tolerate this high degree of volatility, cryptoassets will not be suitable for all clients. Those approaching retirement, for example, may find it difficult to plan when parts of their portfolio are subject to major value spikes and dips.
Similarly, volatility can make cryptocurrency holdings challenging in a portfolio context. For example, when prices may swing by 50% or more in a quarter, this can create difficulties when rebalancing a portfolio. For this reason, some advisors and clients prefer to keep cryptocurrency holdings separate from the rest of their assets, but this approach is not without its problems—advisors may, for example, find it hard to levy fees for their role in managing a crypto portfolio that is ring fenced from other assets and subject to major price swings.
When working with clients who hold or wish to hold cryptocurrency, it is important to discuss the issues created by price volatility and to ensure that clients fully understand what this may mean for their portfolios.
WHEN PRICES MAY SWING BY
OR MORE IN A QUARTER, THIS CAN CREATE DIFFICULTIES WHEN REBALANCING A PORTFOLIO.
Diversification
As noted earlier, many investors see their cryptocurrency holdings as a form of “digital gold”—an inflation hedge and store of value for the long term. As such, many believe that cryptocurrency can serve as a valuable portfolio diversifier.
However, there is evidence of a growing correlation between cryptocurrency price moves and equity markets.26 Between 2017 and 2019, the correlation between Bitcoin’s U.S. dollar price and the S&P 500 Index was just 0.01. But between 2020 and 2021, this rose to 0.36. This 3,500% rise in correlation suggests that cryptocurrency prices are increasingly subject to the same drivers as stock prices. From a diversification perspective, this may mean that investors should rethink the role that crypto plays in their portfolios.
Security
As trading and investing have moved online, cybersecurity has become a growing issue. Hackers are often tempted by financial firms, which hold significant personal information about clients, as well as their assets. In the case of cryptocurrencies, however, digital securities issues are greatly amplified.
For a start, the preponderance of small and under-regulated players means that the level of crypto firms’ cybersecurity preparedness is uneven. Many crypto exchanges have been hit by hackers and, because of the way in which these entities are regulated, users have sometimes found that they have little to no legal recourse when seeking compensation for their losses.
More importantly, however, the role that cryptography plays in determining asset ownership and access puts extra responsibilities on investors.
When an investor loses the password for their online brokerage account, there is generally a simple way to regain access to the account. Regulated online brokers are subject to robust know your customer (KYC) requirements and can, therefore, provide access to accounts based on proof of identity.
For many cryptocurrency accounts, however, this is not the case. While some institutions offer accounts on a KYC basis and have robust recovery procedures, cryptocurrency is just as often held in crypto wallets that rely on PKC (see Box 3). In such cases, access is entirely contingent on the use of a cryptographic key. If that key is lost or stolen, users have no way to regain access to their accounts. Many Bitcoin wallet keys have been lost over the years and, as a result, many millions of dollars’ worth of Bitcoin is permanently locked out and will never be accessed, traded, or used.
It is, therefore, vitally important that investors fully understand how they access their crypto holdings and what options they have if they lose their keys or passwords.
18 Allen & Overy LLP. Cryptocurrency as a Commodity: The CFTC’s Regulatory Framework. 2020.
19 Paul Weiss. Chair Gensler Reaffirms Focus on Crypto Enforcement; SEC Brings Actions Against a DeFi Lender and a Crypto Exchange for Offering Unregistered Securities. August 11, 2021.
20 BBC. China declares all crypto-currency transactions illegal. September 24, 2021.
21 Barron’s. Lending Your Crypto Could Generate Attractive Yields. But How Safe Is It? December 12, 2021.
22 Financial Times. Terra Crisis Fans Regulatory Concerns Over $180bn Stablecoin Market. May 11, 2022.
23 Financial Times. Runtime Error: Stablecoin Not Found. May 10, 2022.
24 Financial Times. The Terra/Luna Hall of Shame. May 25, 2022.
25 Wall Street Journal TerraUSD Crash Led to Vanished Savings, Shattered Dreams. May 27, 2022.
26 IMF. Crypto Prices Move More in Sync With Stocks, Posing New Risks. January 11, 2022.
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