Morningstar - Q3 2022 - 17

Dispatches
With Crypto, Advisors
Need to Tread Carefully
Despite lack of formal
guidance, advisors will
face scrutiny.
Jasmin Sethi
POLICY
As interest in cryptocurrencies grows,1
While it is hard to imagine many plan
sponsors taking Fidelity up on its offer, in light
of Labor's guidance, it raises a number of
questions for fiduciaries-both those regulated
by the Employee Retirement Income
Security Act of 1974 and those who are not:
Should crypto be part of a retirement portfolio?
If so, how much? Should crypto be part
of any investment portfolio?
The Department of Labor's risk factors are a
valuable framework for advisors to consider when
counseling their clients, regardless of whether
the client is in an account covered by Erisa
or not. As such, we think it is useful to assess
each factor with a Morningstar lens.
many
clients are seeking guidance from their financial
advisors. But in an ever-evolving regulatory
environment, and amid crypto's recent crash, it
can be hard for advisors to know what
advice to offer that protects clients and fulfills
their fiduciary responsibilities. Recent
developments offer clues, but they're not formal
regulations. Instead, I call them hooks-guidance
and precedents that, while not settled law,
can mean that advisors will be under regulatory
scrutiny. Recent hooks of note:
gThe U.S. Department of Labor's guidance on
401(k) plans.
gThe SEC's accounting bulletin asking for disclosure
of the risks of being a custodian of crypto assets.
gRegistration of robo-advisors that recommend
cryptocurrencies as legally recognized Registered
Investment Advisors.
Labor's 401(k) Guidance
In March, the Department of Labor issued
a compliance release that identified five
factors contributing to the risk of exposing 401(k)
plan participants to direct investments
in cryptocurrencies and related products.
Shortly after, Fidelity announced that it was
offering its 23,000 employer-sponsored
401(k) plans the option to allow participants
to invest up to 20% of their retirement
contributions in bitcoin.
gCrypto Is Speculative and Volatile
Cryptocurrencies are highly speculative and
subject to extreme volatility. They are particularly
hazardous for participants approaching
retirement or those who elect to allocate a large
portion of their accounts to them.
gIt Is Difficult for Plan Participants to Make Informed
Decisions About Cryptocurrencies
Cryptocurrencies are a tempting opportunity for
people trying to get rich quickly. They hear
stories of people making large sums of money
and hope to replicate that success, with little
appreciation for the risks involved. Aside
from the mere attractiveness of cryptocurrencies,
clients are also less likely to have sufficient
knowledge about these investments than they
do about traditional asset classes. Evaluating
cryptocurrency investments is difficult even
for expert investors. Advisors must take the time
to make sure their clients are fully informed
about the asset and the risks involved instead of
allowing them to naively accept the risks.
gCustodial and Recordkeeping Concerns Abound
Because cryptocurrencies use digital wallets,
as opposed to traditional trusts or custodial
accounts, custodial and recordkeeping concerns
are relevant, including the potential for
hacking or theft. There are no protections through
the Securities Investor Protection Corp. or
1 Business Wire, " KuCoin's 'Into the Cryptoverse Report' Reveals 27% of U.S. Adults Invested in Cryptocurrencies, " May 26, 2022.
morningstar.com/products/magazine
17
the FDIC. Therefore, investments are not insured
against hacking or theft unless the platform
offers that service independently.
Self-custody is an option, but then crypto
investors subject themselves to the possibility of
losing their private key. Also, self-custody
isn't likely to be available as part of a 401(k)
account. Further, when making a transfer, a slight
mistake entering a wallet ID can result
in the permanent loss of that crypto with no
recourse to recover.
gCryptocurrency Valuations Are Not Reliable
or Accurate
Valuation concerns regarding crypto assets
stem from the lack of an academically
substantiated model for cryptocurrencies, the
potential for inconsistent accounting treatment,
and differing reporting and data-integrity
requirements. Because cryptocurrencies are
still new, they lack the standardization
required to adequately assess the quality of
an investment opportunity. Without the means
to accurately assess an investment, how
confidently can advisors offer advice on it?
gThe Regulatory Environment Is Evolving
Currently, cryptocurrency investors do not
benefit from regulatory protections from the SEC
or the Financial Industry Regulatory Authority.
Still, with the rising interest and attention to
cryptocurrencies, it may not remain that
way for long. Fiduciaries must analyze how
emerging regulatory requirements surrounding
cryptocurrencies in 401(k)s may apply to
issuance, investments, trading, and other crypto
activity. The Labor Department explicitly
warns that the sale of some cryptocurrencies
could constitute the unlawful sale of securities
in unregistered transactions. Advisors could
expose themselves to liability and plan
participants to risks of inadequate disclosures
and a lack of protection.
Additionally, Finra warned that some
cryptocurrencies were used in illegal activities
and that because of such abuses, there is

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