Bitcoin and other Cryptocurrencies
With recent developments in the regulatory, legal, and compliance landscape surrounding Bitcoin and a spot Bitcoin ETF (i.e., an ETF backed by physical Bitcoins. If the value of the digital coins backing the ETF rises, the value of the investment will generally be expected to increase), some investment advisers may be considering how to potentially integrate Bitcoin (and/or other types of cryptocurrencies) into client portfolios. This Alert is intended to provide an update on the regulatory landscape and inform advisers how to fulfill their compliance and fiduciary obligations should they determine to integrate Bitcoin (specifically, the current GBTC (see below) and/or anticipated ETFs that will invest in Bitcoin or other types of cryptocurrencies) into client portfolios or assist a client with a requested purchase thereof. Please Note: This Alert is not, and does not serve as, an endorsement of Bitcoin, or any other cryptocurrency. Advisers must separately educate their investment professionals and clients about cryptocurrencies prior to integrating crypto into client portfolios or assisting with a client directed purchase.
Summary
Bitcoin is considered to be speculative. The SEC has been aggressively reviewing cryptocurrency investments during examinations. Depending upon the scope of an adviser’s assistance with/use of crypto (employing same as a courtesy/client directed accommodation vs. utilizing same as an asset class in client portfolios) both applicable clear and conspicuous ADV disclosure, and a separate Acknowledgment executed by the client, are strongly encouraged-we continue to assist our clients with such disclosures/acknowledgements.
Regulatory Landscape
On August 29, 2023, the United States Court of Appeals of the D.C. Circuit ruled in favor of Grayscale Investments in Grayscale’s lawsuit against the SEC for denying the company’s application to convert its Grayscale Bitcoin Trust (GBTC) into a spot Bitcoin ETF. The Court’s ruling vacated an order by the SEC denying Grayscale’s spot Bitcoin ETF application and requires the SEC to consider the application anew.
The ruling could have far-reaching implications for other spot Bitcoin ETF applications. As of August 30, 2023, the SEC is considering 14 spot Bitcoin ETF applications, including applications from financial behemoths like BlackRock, WisdomTree, and Invesco, to name a few. Analysts have predicted that odds of spot Bitcoin ETF approval are 75% in 2023 and 95% in 2024. With the imminent approval of a spot Bitcoin ETF, investment advisers could determine to consider adding a Bitcoin ETF to client portfolios. However, doing so comes with compliance implications, and it is critical for advisers to conduct appropriate due diligence to confirm that such integration is reasonable and suitable for clients.
Compliance Program
Investment advisers registered at the federal and state level are required to maintain a robust compliance program. Advisers who want to integrate a Bitcoin (or other type of crypto) ETF should update their policies and procedures to address the unique risks and challenges that Bitcoin presents, including:
- Suitability – prior to proactively (vs. only per client request/direction) purchasing a Bitcoin ETF for clients, advisers should confirm that these assets are suitable for the client. Bitcoin is historically (and notoriously) volatile, and advisers should assess whether an investment in Bitcoin (or any other type of cryptocurrency) is consistent with a client’s suitability, long-term objectives, and risk tolerance.
- Disclosures and Acknowledgements – advisers should request that clients execute an Acknowledgement which, among other disclosures, makes clear that cryptocurrencies are considered to be speculative investment, and that unlike conventional currencies issued by a monetary authority, currently, cryptocurrencies are generally not controlled or regulated, and their price is determined by the supply and demand of their market. Additionally, those advisers who are considering proactively incorporating crypto into client portfolios should amend their Brochure (i.e., Form ADV Part 2A) to include language that similarly describes the risks associated with Bitcoin and how the adviser can integrate crypto into a client’s portfolio (i.e., on a discretionary/non-discretionary basis, or at specific client direction). Stark & Stark can assist with preparing the acknowledgement and appropriate ADV disclosure language.
Fiduciary Duty
Registered investment advisers are fiduciaries and are required to act in the best interests of their clients. As such, comes the responsibility to:
- Conduct thorough due diligence, including understanding bitcoin’s market dynamics, its correlation with other assets, and the technology behind it;
- Educate clients so that they can better understand both the risks and potential rewards of investing in Bitcoin (or any other cryptocurrencies); and,
- Disclose the fees associated with such an investment (i.e., both the underlying investment’s fees and the adviser’s fee).
Conclusion
The D.C. Circuit’s ruling on Grayscale’s spot ETF application, and the SEC’s currently anticipated approval of a spot ETF, reflects Bitcoin’s growing legitimacy as an asset (however, as indicated above, this Alert is not, and should not be construed in any manner whatsoever as, an endorsement of Bitcoin or any other cryptocurrency investment). However, integrating Bitcoin into client portfolios comes with compliance obligations. By adhering to a robust compliance framework, keeping abreast of regulatory changes, and educating themselves and clients on the both the risks and benefits of Bitcoin, advisers can seek to harness the potential of Bitcoin while fulfilling their fiduciary and compliance obligations.
