A new day, a new article about cryptocurrency. Stories on volatility, service providers and regulatory challenges dominate the headlines. This is leading to increased interest from investors in all generations of wealth who are attracted to the potential of high returns.
According to the Journal of Financial Planning, nearly half of advisors surveyed in early 2021 said their clients have inquired about cryptocurrencies in the past six months. Organizations are at a crossroad. They struggle with how to handle the trading, operational and technological challenges without adding risk. Leveraging cryptocurrency as an investment option will be a substantial undertaking. A misstep can increase risk exponentially. Firms interested in adding crypto need to understand:
- How do you make your operations and technology ecosystem scalable?
- What will be the impact to the risk profile of your organization?
Approaching the challenges of cryptocurrency with a disciplined mindset, considering all impacts, will lead to improved investor outcomes. Not having a well-vetted strategy will impede success, lead to possible operating losses and impact returns.
What Is Driving the Hype?
Cryptocurrencies are causing a disruption in wealth management with adoption growing rapidly. Cardify found the average holder of crypto has an allocation of approximately 13%. An IN Research study showed that 79% of advisors plan to increase recommendations of cryptocurrency investments in the next year if they do not already recommend them.
The headlines have been dominated by the major swings in the value of some cryptocurrencies, which has led to large returns for some and significant losses for others. Some may look at cryptocurrency as the “next new thing”; however, there are perceived benefits to this emerging asset class. Early research has shown it is not correlated to other asset classes offering a source of diversification. Others look at cryptocurrency as speculative. These are some factors that have piqued the interest of wealth management clients.
Where Do Stablecoins Fit In?
Stablecoins are a cryptocurrency associated with a fiat currency, or a pool of assets. The intention is to maintain a more consistent value. They may not offer the same level of volatility as other cryptocurrencies; however, they are increasing in popularity with more conservative investors looking to include digital currencies in their portfolio.
Stablecoins have also garnered the attention of regulators. One of the largest cryptocurrencies, Tether, was banned by regulators in New York because of an overstatement of its U.S. dollar backing. Federal regulators have raised concerns on possible defaults based on issues with collateral and liquidity risk, leading to a greater risk than anticipated by investors. Long term, stablecoins would be most impacted by central bank digital currency (CBDC).
What Questions Do I Need to Answer?
Embarking on a new investment strategy starts with the need to address some fundamental questions. The Internal Revenue Service has already answered one, stating that cryptocurrency should be treated as property, clarifying gains/losses. That leaves firms to answer other questions in developing a business case.
- Should your firm offer cryptocurrency?
The answer may be obvious; however, firms still need to put thought into if, when and why they decide to invest in crypto. Consideration needs to be given to suitability for your target markets, fit within your core competencies and what products will be offered. Overlooking the simplest question impacts the foundation in moving forward.
- How do you navigate the evolving regulatory landscape?
A higher level of regulation is almost a certainty in the near term, requiring firms to address what has been mandated while developing an infrastructure to address what will come tomorrow. An area that firms will need to be proactive on is investor suitability. The level of risk associated with cryptocurrency requires some level of client vetting before allowing an investment.
- What changes need to be made to the advisor experience?
Any time you expand your investment offerings, there is an impact to your investment and client-facing teams. Ensuring the advisor desktop has the components to research, trade and report is a top concern when developing your strategy. Advisors need to be trained to assess client suitability and risk of the asset class. Despite the amount of information in the market, most advisors are not sure how best to leverage cryptocurrency. This inherently increases the risk to the firm.
- What operation and technology transformations need to occur?
Legacy systems need to be reconfigured to process cryptocurrency. Additional modifications to the ecosystem and standard operating procedures need to occur to reduce risk and maximize returns. Other considerations need to be made on liquidity sources and wallets/custody.
Where Do You Go From Here?
The adoption of cryptocurrencies is on the rise and will continue to emerge as a viable investment option. It is clearer that a higher level of governmental oversight is on the horizon complicating the decision on how to best incorporate cryptocurrency. The expectation should be, the way things look today, will not be how they are in the future. Conducting a thoughtful analysis is the first step in developing a clearly defined strategy that covers all the technical, operational, risk and compliance needs critical to moving forward.
Mike Tropeano, CFA, is senior director, Broadridge Consulting Services, wealth management practice