Cryptocurrency Assets: Investment and Regulatory Risks that Investors and Financial Professionals Should Know.

Cryptocurrency is a type of digital asset that uses cryptography for security. Cryptography secures communication and information through complex codes, ensuring transaction authenticity, integrity, and confidentiality. By leveraging cryptographic techniques, cryptocurrencies ensure secure peer-to-peer transactions without the need for intermediaries like banks.

Cryptocurrencies typically have two defining features: their reliance on blockchain technology and operations on decentralized networks. A blockchain is a distributed ledger that records all transactions across a network of computers, ensuring transparency and immutability. Each block in the chain contains a list of transactions, and once a block is added to the chain, it cannot be altered without consensus from the network.

Decentralized networks play a critical role in the functioning of cryptocurrencies. Unlike traditional financial systems where banks or central authorities manage transactions, decentralized networks distribute control across all participants in the system, referred to as nodes. This structure eliminates the need for a central authority, allowing users to conduct peer-to-peer transactions directly. Transactions are verified and recorded on a shared ledger accessible to all nodes, ensuring transparency and reducing reliance on third-party intermediaries. The network’s security and integrity are maintained through consensus mechanisms, where participants agree on the validity of transactions. Enthusiasts of cryptocurrencies argue that this decentralized structure enhances the resilience and trustworthiness of cryptocurrencies, shielding them from governmental interference and making them a groundbreaking alternative to traditional currencies.

Bitcoin, created in 2009 by an anonymous individual or group known as Satoshi Nakamoto, was the first cryptocurrency and it is perhaps most established and well known today. It introduced the concept of a decentralized digital currency and paved the way for the development of thousands of other cryptocurrencies, collectively known as altcoins. Some of the most well-known altcoins include Ethereum, Litecoin, and Ripple (XRP).

Evolving Regulatory Approach to Crypto Assets

The Securities and Exchange Commission (SEC) has historically been reluctant to approve Bitcoin-based exchange-traded products (ETPs) due to concerns over market integrity and investor protection. A central issue cited in its denials has been the risk of market manipulation, given that a significant portion of the cryptocurrency trading occurred on unregulated platforms that lacked robust oversight. In its disapprovals, the SEC also emphasized the absence of comprehensive surveillance-sharing agreements with a regulated market of significant size, which it deemed necessary to detect and deter fraudulent and manipulative practices. Until April 2022, the Commission denied every proposal to list any Bitcoin-based exchange-traded products.

Despite its initial reluctance to approve Bitcoin ETPs, in April 2022, the SEC approved NYSE Arca’s proposal to list the Teucrium Bitcoin Futures Fund, followed by its approval of Nasdaq’s proposal to list the Valkyrie XBTO Bitcoin Futures Fund in May 2022. For both products, the listing exchanges had established surveillance-sharing agreements with the Chicago Mercantile Exchange (CME), which the SEC determined satisfied its "significant market" test, ensuring that sufficient oversight mechanisms were in place to detect and deter fraud or manipulation in the underlying Bitcoin futures market. However, in both orders, the SEC was careful to clarify that these approvals did not signal imminent approval for Bitcoin ETPs that directly track the cryptocurrency. The Commission’s position reflected its continued caution regarding the risks of manipulation and market integrity in the broader Bitcoin spot market, which remains largely unregulated.

As telegraphed, the SEC continued to deny the listing and trading of spot bitcoin exchange-traded product shares and, in June 2022, despite the overwhelming public support, the SEC rejected the proposal by Grayscale to list the shares of the Grayscale Bitcoin Trust (GBT) – a spot bitcoin ETP – on the NYSE Arca, stating that the proposal was not adequately "designed to prevent fraudulent and manipulative acts and practices" and did not satisfy the significant market test, a key standard for approval. This decision mirrored the SEC's stance on every other proposed Bitcoin exchange-traded product up to that point. In response, Grayscale petitioned for a review of the SEC’s decision, marking the beginning of a legal challenge that would later result in the U.S. Court of Appeals for the District of Columbia vacating the SEC’s disapproval.

In August 2023, in Grayscale Investments, LLC v. Securities and Exchange Commission, No. 22-1142, 82 F.4th 1239 (D.C. Cir. 2023), the court held that the SEC's decision to deny the listing of the Grayscale Bitcoin Trust as a spot Bitcoin exchange-traded product was arbitrary and capricious.

The court’s analysis centered on the SEC’s inconsistent treatment of similar cases. Grayscale demonstrated that its proposed spot Bitcoin ETP was materially similar or identical to two Bitcoin futures ETPs that the SEC had recently approved—namely, the Teucrium and Valkyrie products. Both types of ETPs derive their value from Bitcoin’s market price, and the futures ETPs hold contracts directly tied to the spot market. Despite these similarities, the SEC failed to provide a rational explanation for why it approved the futures ETPs but denied Grayscale’s application. This inconsistency violated a fundamental principle of administrative law, which requires agencies to treat like cases alike. The court vacated the SEC's rejection of the Grayscale ETP application, prompting its reassessment as well as of similar previously denied applications.

In January 2024, following the court decision and its reexamination of the issue, the SEC approved the listing and trading of several spot Bitcoin exchange-traded products (ETPs), including the Grayscale Bitcoin Trust, marking a significant shift in its regulatory approach.

Cryptocurrency Investment Risks

The SEC approvals demonstrate that digital assets are increasingly being integrated into the broader financial system and highlight the growing acceptance of Bitcoin and other crypto assets as a legitimate investment vehicle and an asset class. However, while investors are now afforded access to these regulated products, it is important to reiterate that cryptocurrencies such as Bitcoin and Bitcoin-based ETPs may present significant risks to retail investors. Regulatory agencies such as the SEC and the Financial Industry Regulatory Authority (FINRA) have frequently emphasized these risks, urging caution and advocating for greater investor education and transparency.

One of the most prominent risks associated with cryptocurrencies is extreme price volatility. Prices can fluctuate dramatically due to speculation, market sentiment, regulatory developments, and even misinformation. Unlike traditional securities, cryptocurrencies often lack intrinsic value, making their valuation subject to unpredictable market forces. This volatility can result in significant financial losses, particularly for retail investors who may not have the risk tolerance or diversification strategies necessary to mitigate these swings.

Fraudulent offerings and scams further complicate the cryptocurrency landscape. The rise of initial coin offerings (ICOs), fake tokens, and deceptive investment schemes has drawn significant attention from the SEC, frequently bringing enforcement actions against bad actors. Many of these fraudulent schemes exploit retail investors' limited knowledge and lure them with promises of high returns and low risks. Consequently, conducting thorough due diligence becomes crucial for anyone considering cryptocurrency investments.

Cybersecurity risks compound the challenges faced by retail investors. Cryptocurrency exchanges and wallets are frequent targets for hackers, and the decentralized nature of cryptocurrencies means that stolen assets are often unrecoverable. Unlike traditional banking systems, which offer deposit insurance and fraud protections, the cryptocurrency ecosystem provides limited, if any, safety nets. This makes the security of platforms and wallets critical, yet it remains an area of significant vulnerability.

Operational risks related to cryptocurrency exchanges further heighten investor vulnerability. Many exchanges operate without the safeguards found in traditional securities markets. Failures such as platform outages, liquidity crises, or outright insolvency can leave investors unable to access or liquidate their holdings. High-profile collapses, like that of FTX, underscore the systemic risks posed by poorly managed platforms, making it clear that retail investors must approach such exchanges and investments in cryptocurrencies cautiously.

Cryptocurrency Regulatory Risks

Financial professionals recommending cryptocurrency investments to their clients must be acutely aware of their regulatory responsibilities under securities laws and FINRA rules. These responsibilities encompass understanding the products they recommend, evaluating the risks and suitability of those products for their clients, and ensuring that recommendations align with their financial objectives and risk tolerances.

Financial professionals must conduct reasonable due diligence to understand the products they recommend. This obligation applies to securities like ETPs that derive their value from Bitcoin and/or other cryptocurrencies and digital asset-related products. Given the unique characteristics and risks associated with these assets, financial professionals need to comprehensively understand cryptocurrency risks, how cryptocurrencies function, and many other factors that influence their value.

For instance, financial professionals should understand the levels of volatility inherent to cryptocurrencies, the lack of intrinsic value in many tokens, and the regulatory uncertainty surrounding these assets. Additionally, financial professionals should understand the operational risks associated with cryptocurrency exchanges and wallets, including cybersecurity vulnerabilities and potential platform failures.

In line with their obligations to ensure compliance with anti-fraud and disclosure requirements under the federal securities laws, Reg BI and FINRA rules, financial professionals have a duty to disclose material risks associated with cryptocurrency investments to their clients. Failure to adequately disclose those risks, or making misleading statements about the potential returns of cryptocurrency investments, can lead to enforcement actions by regulatory agencies or civil lawsuits by the aggrieved investors.

Similarly, recommending cryptocurrency investments that are not in line with a client's objectives and risk tolerance can result in investigations and disciplinary actions by regulatory authorities. The SEC and FINRA have both taken enforcement actions against financial professionals who failed to uphold their obligations when recommending cryptocurrency investments to clients. Indeed, in recent years, there have been several high-profile cases where financial professionals faced fines, suspensions, or other penalties for recommending inappropriate cryptocurrency investments. These cases underscore the importance of providing sound investment advice and ensuring clients are fully informed about the risks involved.

The cryptocurrency market continues to evolve rapidly, creating both opportunities and challenges for investors and financial professionals. While digital assets offer new possibilities for portfolio diversification, they also present significant risks that must be carefully navigated. For financial professionals, understanding the regulatory landscape and adhering to compliance requirements is essential to avoid legal and disciplinary consequences. By conducting thorough due diligence, ensuring suitability for clients, and remaining informed of regulatory developments, professionals can mitigate these risks and provide sound investment advice.

For those seeking further guidance on navigating the complexities of cryptocurrency investments and compliance with securities laws, or if you or someone you know has suffered financial losses from crypto investments, consulting with an experienced attorney is highly recommended. AMW Law, PLLC offers legal services to help investors and financial professionals understand their options for potential recovery, or regulatory obligations and protect their practice from potential liabilities.