Market Solutions, Volume 33, Number 2

Attorneys Sean Coughlin and Christopher Vaughan recently authored the article, Crypto ETFs: Suitability and Supervision, in the Financial Markets Association (FMA) June 2024 Market Solutions Newsletter.

To learn more information about the FMA, click here

See below for the full article.

Crypto ETFs: Suitability and Supervision

Three weeks ago, the SEC shocked the financial world by approving eight spot Ether ETFs simultaneously.1 These approvals marked a drastic policy shift from what investors have come to expect from the regulator, as industry experts predicted that the Ether ETFs would likely face at least a delay, if not a whole- sale rejection.2

With twelve spot Bitcoin ETFs already available to the investing public, and eight more Ether ETFs on the way, Financial Advisors will undoubtedly face questions from some of their more crypto-curious clients about the economic upsides, and inherent risks, of adding these ETFs to their portfolios. These new opportunities for investors will also create new potential headaches for both investment advisors and broker-dealers offering these products on their platforms. This article outlines the requirements to which advisors must adhere when recommending these new products, as well as the steps financial firms should take to properly offer, manage, and supervise Cryptocurrency ETFs.

A. Suitability

Perhaps the first question a financial professional must ask before considering recommending cryptocurrency ETFs for their retail clients is the extent to which these products are appropriate for those customers. This concern is reflected by FINRA Rule 2111, also known as the Suitability rule. The Suitability rule requires a financial professional to have a reasonable basis to believe a trans- action or investment strategy is suitable for their customers. The financial professional must believe that the investment is suitable through reasonable diligence on both the investment product (Crypto ETF) and the client’s investment profile.

The share price for Bitcoin ETFs now, and Ether ETFs in the future, reflect the current spot market price of Bitcoin and Ether themselves. While Bitcoin has recently become less volatile than many stocks in the S&P 5003, all crypto- currencies are susceptible to black swan events and market pivots that simply do not exist in the traditional stock market. Additionally, the price of Ether, which is inherently far more volatile than Bitcoin and traditional equities, is further exposed to fluctuations related to blockchain upgrades, large sales by the Ethereum foundation to fund developer work, and other factors that the average investor almost certainly has failed to consider in their decision to add the corresponding ETF to their portfolio.

While there is no requirement that financial professionals become experts in the stock or investment vehicles they recommend, the cryptocurrency markets introduce an entirely new set of downside risks to which even the most veteran of Wall Street brokers are unaccustomed. Therefore, financial professionals will need to do their due diligence on the causes of crypto volatility before they can make an adequate assessment as to the suitability of Bitcoin and Ether ETFs for their client’s portfolios. Otherwise, they may find themselves under cross-examination from Claimant’s counsel in front of a FINRA Arbitration panel, attempting to explain a client’s investment they recommended without fully understanding.

B. Supervision Requirements for Broker-Dealers

Cryptocurrency ETFs also cause new supervision concerns for the financial firms recommending the purchase of Crypto ETFs. Under FINRA Rule 3110, firms are required to establish and maintain a system to supervise the activities of their associates that is reasonably designed to achieve compliance with applicable securities laws and regulations. These systems typically include automated software which flag unusual trading patterns or potential conflicts of interests for advisors who may be recommending these ETFs. However, given that the vast majority of cryptocurrency trading takes place via anonymous (or at least pseudonymous) wallets, Broker-Dealers will likely need to be on high alert for any advisors they suspect may attempt to exploit that aspect of crypto custody to use their clients for their own financial gain.

Further, while it may be the financial professional’s responsibility to perform their own due diligence prior to recommending a Cryptocurrency ETF to clients, it is equally the firms’ responsibility to ensure that their Advisors are properly trained. Under FINRA Rule 1250, Broker-Dealers are required to provide continuing education for their registered personnel so that their advisors may remain knowledgeable about the products they handle, which in this case extends to Cryptocurrency ETFs. For this requirement, it may be prudent for Broker-Dealers to consider hiring cryptocurrency experts to offer these trainings, due to the highly specialized nature of the crypto markets.

Finally, under SEC Rule 206(4)-7 of the Investment Advisers Act of 1940, Broker-Dealers are required to establish written policies and procedures designed to prevent violations of securities laws. Given the new volatility and liquidity issues introduced by cryptocurrency ETFs, all Broker-Dealers offering these products will likely need to draft new policies specifically addressing the offering and solicitation of these vehicles. Further, given that cryptocurrency trading can sometimes lend itself to quick decisions and short holding periods, financial firms must put forth their best efforts to ensure that these new policies actually align and comport with the realities of crypto trading practices. It is likely that these policies will need to be adapted to the cryptocurrency markets as they evolve, but an immediate baseline must be put in place if financial firms hope to avoid SEC and FINRA scrutiny in their offering of Crypto- currency ETFs to retail investors.

C. Conclusion

Undoubtedly, the prospect of Cryptocurrency ETFs, and the potential returns they offer retail investors, are exciting and novel. However, while the assets underlying these new products may be a departure from the norm in securities markets, the rules surrounding them remain the same. Investment Advisors and the Broker-Dealers who employ them, therefore, must plan and act accordingly in their offering and solicitation of Crypto ETFs.

  1. Spot crypto ETFs buy cryptocurrencies and securitize them. On the retail side, Investors buy and sell shares of the ETFs as needed, as they would for any other ETF. A spot bitcoin ETF tracks the current price of bitcoin and is backed by actual bitcoin holdings, while a spot ether ETF does the same thing for ether.


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