CRYPTOCURRENCY: WHAT ADVISERS NEED TO KNOW

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7 February 2023

The skyrocketing value of cryptocurrency has made it a popular trading instrument, but is this emerging investment market safe?

The prospective returns look extremely tempting, yet crypto assets are very high risk and still largely unregulated. If a client approached you about investing, would you be able to provide the right advice?

For those of you yet to dip your toes into these opaque waters, we’ve put together a beginners guide to bring you up to speed.

Let’s start with the pros

Crypto assets are underpinned by cryptography (secure communications) and based on a network that is distributed across a large number of computers, making them nearly impossible to counterfeit or double-spend.

Generally, they are not issued by any central authority, so theoretically, they are immune to government interference or manipulation and this decentralised system means they do not collapse at a single point of failure.

As they offer cheaper and faster money transfers, some experts believe cryptocurrency is going to disrupt many industries, including finance and the law. Bitcoin, which has been available to the public since 2009, remains the most widely traded, but there are numerous other incarnations in which investors can make significant returns if they trade wisely.

Despite the known risks, there has been a major leap in the prices of cryptocurrency and the total market capitalisation now stands at more than $1 trillion.

Now the cons

The price volatility of crypto assets remains a significant issue. There have been high investor losses due to scams, hacks and bugs, whilst the technical complexity of usage and storage can be a major hazard for beginners. Market manipulation is thought to be a substantial problem and some exchanges have been accused of influencing prices or deliberately trading against customers.

Likewise, the current legal status of cryptocurrency has implications for daily use and trading. In June 2019, the Financial Action Taskforce recommended crypto wire transfers should be subject to its Travel Rule, which requires anti-money laundering compliance. Whilst the regulatory status of these assets remains so unclear, there is a chance that a sudden crackdown could make them difficult to sell or cause a market-wide price drop.

User error, however, remains one of the biggest risks to investors. There is no way to reverse or cancel a crypto transaction after it has been sent. To put this into context, it is thought around a fifth of all Bitcoins are now inaccessible due to a loss of passwords or incorrect sending addresses.

Many users rely on exchanges or other third parties to store their assets, yet theft is a real possibility, as there remain very few protections against deceptive or unethical management. A bug or deliberate attempt to exploit these automated platforms could also cause the loss of an entire investment.

The FCA’s position

UK crypto firms must be regulated by the FCA for AML purposes and must comply with the anti-money laundering regulations.

Any investment product that references crypto assets is likely to fall within the FCA’s powers and in an attempt to clarify the assets themselves, the regulator has created a framework, based on structure and use. There are two types of tokens that fall inside its remit, both of which provide rights such as, ownership position, repayment of a specific sum of money or entitlement to a share in future profits. They are:

• Security tokens: These are crypto assets, excluding e-money, that amount to a ‘specified investment’ under a Regulated Activities Order.
• E-money tokens: Any asset that meets the definition of e-money, as per the Electronic Money Regulations, falls within its perimeters.

Tokens that do not fit into either of the two categories above are likely to be unregulated. This includes Bitcoin, Litecoin and equivalents, along with utility tokens used to access a specific product or service using a DLT platform (distributed ledger technology).

Another important point to note is that the FCA’s powers do not cover how crypto firms conduct business and it is not responsible for making sure they protect assets.

Key considerations before investing

The UK Cryptoasset Taskforce believes certain types of crypto asset have the potential to deliver benefits, for example, when used as an innovative capital raising tool or an intermediary step for international money transfers. However, they are considered very high risk, speculative investments and harnessing their potential requires effective action.

UK customers are being increasingly targeted by scammers who manipulate software to distort prices and returns. They convince people to buy non-existent crypto assets, then close the account suddenly and refuse to give any money back. The scams are becoming ever more sophisticated – some involve regulated activities, whilst others may clone a genuine firm to garner credibility or offer realistic returns in an effort to seem legitimate.

Be careful if you are advising on crypto assets. Consider the business and whether the asset is suitable, know who you are dealing with and always check a firm’s contact details with those held on the FCA register. If you can, try to understand what drives the company’s profits and what factors are affecting its returns.

The regulator operates a warning list of known firms operating without authorisation, but even if a company isn’t on it, you could still be dealing with a scammer. Check them out with multiple sources, such as Companies House and be wary of anyone contacting you out of the blue.

If you would like more information about the regulation in place to protect crypto investors, visit: https://www.fca.org.uk/consumers/cryptoassets or contact us on (0161) 521 8641 or email: info@b-compliant.co.uk