Financial advisers and digital assets – helping clients navigate the new world

In August 2022, 44% of Australian retail investors held cryptocurrency – its adoption was second only to shares. Since then, that figure will only have increased as the market has seen institutional investment, innovative product design e.g. exchange traded funds, and regulation designed at keeping consumers safe. Financial advisers are a crucial section of the financial services industry, offering clients personal advice on managing financial affairs.  As the rise of digital assets increases, and is increasingly financialising, there is more demand on financial advisers to offer sound advice to clients on the risks and benefits.  This article explores some of the key regulatory issues for financial advisers to keep in mind in exploring what is an exciting and promising market.

Authorisations territory – getting the basics right

Australia, and the global landscape has seen the entry of exchange traded funds (ETFs) which allows for exposure to bitcoin without the challenges of managing cryptocurrency private keys, etc. 

Financial advisers first need to understand whether they are operating under the right Australian financial services licence (AFSL) conditions to advise clients on these products.  Usually, this will be under a “Managed Investment Scheme – including Investor Directed Portfolio Service” authorisation.  Digital assets are wonderfully diverse, and outside this authorisation financial advisers may need to have authorisations to advise on non-cash payments (which many stablecoins may be used for), securities and derivatives. 

Further, as many digital asset issuers are commonly based offshore, or product issuers in Australia may not have tested their products to the extent one can expect in traditional financial services markets: understanding the provenance of the product is critical.  As Dr Bollen, ASIC’s lead of its digital assets team recently told a conference of digital assets professionals:

When did you last review the tokens that you list on your platform? When was the last time you reviewed the products and services that you are making available? How recently have you consulted with your lawyers about where the law currently sees the most current understanding based on cases over the last six months or so. If you haven't done that in the last four months you need to consider where you are.

Making sure that the financial adviser understands the product deeply, and the licensing which applies to it, is a critical first step in vetting a product for recommendation to clients.  This will only increase in 2025, with the widely anticipated augmentation of AFSLs to include a new “digital asset facility” authorisation.  It is a criminal and civil offence to offer financial services without the relevant AFSL authorisations, so financial advisers need to be prudent here.

Personal advice zone – understanding the commercial considerations

The landmark Quality of Advice Review (to which the Government responded on 7 December 2023) will see the Government introduce (perhaps as early as the end of 2024) a “modernised and flexible” best interests duty that will apply to all providers of personal advice. 

The Government decided not to expand the definition of “personal advice” i.e. financial advice which takes into account a customer’s personal circumstances, and to maintain the existing obligations to act in the best interests of the client and to prioritise the interests of the client in the event of a conflict.  Additionally, and sensibly, however, there will be distilled legislative guidance for scaled or limited scope advice or where the advice provider has limited, but relevant, information.  The ‘safe harbour’ steps will be removed.

The digital assets landscape is characterised by:

• Complexity: taking financial products, commodities, or real world assets, and representing them in digital format on technology, presents a range of legal, regulatory, operational and commercial complexity;
• Volatility: the swings in the major cryptocurrencies e.g. Bitcoin and Ether can pale in comparison to the swings in other digital assets.  When offering exposure to this asset class, or building financial products based on them e.g. a derivative where the collateral is Bitcoin, customers need to appreciate the market risk;
• Opportunity: digital assets can do many things which traditional products cannot.  Fractionalised ownership, smart contracts which execute on pre-set commands, easy secondary market activity, enhanced interactivity with customers or vastly more efficient transactions are some of the opportunities;
• Global nature: most large digital assets businesses are firmly global in nature, where issuers can be in one jurisdiction, while significant economic activity i.e. distribution and trading, occurs in another; and
• Regulatory & political development: mature economies around the world are building calibrated regulatory frameworks, largely based on existing licensing and guidance architecture.  Regulators are also increasingly enforcing breaches of the law in this space, and there is a heavy overlay of politicisation in the space as Governments react to the opportunities and threats presented.  A good example is the creation of central bank digital currencies, to assist central banks in financial assistance to their citizens (though with the caveat that financial assistance can be ‘programmed’, as it is digital, unlike fiat currency).

These factors variously present challenges for financial advisers seeking to meet their “best interests” obligations.  Another challenge is the depth of financial services regulatory expertise held by ancillary providers e.g. accounting, consulting, legal, tax, auditing, which can properly interrogate these assets for whether they are compliant with regulatory obligations e.g. PDS disclosure, etc.  The core foundations for financial advisers remain though – asking for the right information, documenting the needs of the client and preparing detailed statements or records of advice.  Many financial advisers are amending their processes now, as they come under additional pressure from clients to invest their money – which can be through their SMSF - in this space.

Insurance sector and compliance frameworks – hedging your risk

AFS licensees need to hold ‘adequate’ professional indemnity insurance covering themselves and their representatives.  Adequacy is determined by a range of factors, including the licensee’s liability for claims brought through AFCA, the nature, scale and complexity of the financial services business carried on by the licensee and its advisers, and the amount, scope and terms of the insurance cover.  Whereas many insurers were previously hesitant to cover digital assets, and it may not have been clear whether they fell within the insured’s AFS licence conditions, the market has changed in the last six months.  Ensuring that your broker is cognisant of the market you are advising clients on and that your activities are covered under your insurance policy is a must.  Without that cover, given the complexity in the sector and the potential for client losses, financial advisers run unnecessary risks.

The same can be said for risk and compliance frameworks.  Methodically understanding and putting in mitigants to protect against avoidable issues for advice businesses and their clients is a must in entering this space.  That might include:

• Training: financial advisers sell knowledge and experience. Without appropriately upskilling in digital assets, advisers create risk for their authorising AFSL and clients;
• Approved product list: as referenced above, undertaking thorough research on digital products e.g. Bitcoin ETFs, before placing them on approved product lists is critical.  The type of due diligence required will be distinguishable from that applied to traditional financial productions given the factors outlined above;
• Compliance: revising AML/CTF programs, client money handling policies, “best interest” policies and other policies which impact the giving of advice in relation to digital assets is a must.  So too is revising checklists for financial advisers in giving advice on these types of assets, which will be different to standard checklists.  They need to be nuanced, and carefully thought through to match the market. That is because the way in which digital assets are generated is different – they typically begin with a ‘white paper’ and code, not an information memorandum or product disclosure statement, which is often overlayed afterward.  Further, digital assets operate on one or more blockchains, for which there is no issuer like a large general insurer, bank or super fund.  The market certainly has creators of products, such as private equity funds converting their unit certificates to digital tokens to facilitate wider, more flexible and more efficient trading (and potentially synthetic secondary market activity with an AFSL market making authorisation), but often the market is dominated by broker / dealers and intermediaries trading in products where there is no ‘issuer’.  Bitcoin and Ether, the two dominant cryptocurrencies, are good examples. 
• Statements of advice: financial advisers are required to provide statements of advice, being a comprehensive document provided to a client, detailing the adviser’s financial recommendations based on the client’s individual circumstances, goals, and risk tolerance. It includes a summary of the client's current financial situation, specific investment and strategy recommendations, the rationale behind these suggestions, and any associated risks and fees. The SoA ensures transparency and helps clients make informed decisions by clearly outlining how the advice aligns with their objectives and the potential outcomes of following the proposed plan. Clearly, given the matters outlined above in this memorandum, the financial adviser recommending a client invest in a Bitcoin ETF, or private equity fund with exposure to digital assets, has new challenges in preparing sufficiently robust statements of advice. Where licensees revisit their standard statements of advice and calibrate them to prompt the financial adviser to consider various aspects of the assets, they will be doing themselves, the adviser and ultimately the clients a service.  (So too for those ETFs that assist financial advisers in this regard!)  That said, the Quality of Advice reforms may soon prompt licensees and advisers to adopt yet different processes for documenting advice, once the requirement for a statement of advice is removed and replaced with an alternative proposed ‘principles-based’ advice record requirement and adviser record-keeping obligations.

Opportunity ahead

Michael Saylor, the billionaire founder of Microstrategy, recently endorsed US Senator Cynthia Lummis’ proposed BITCOIN Act, which would compel the US Treasury to gradually accumulate 1 million BTC or almost 5% of the total supply of the cryptocurrency.

Thomas Jefferson purchased the Louisiana Territory for $15 million in 1803 and nearly doubled the size of the United States...Bitcoin is scarce, desirable digital property. It’s a great idea to trade a little bit of currency or paper for someplace that billions of people are gonna want to be in 100 years.

Whether or not that transpires – if former President Trump wins in November 2024 he has promised to create a digital assets advisory council to the President, and support this market – it is clear the demand for digital assets will continue.  Financial advisers responding to their clients’ instructions have a wonderful opportunity ahead of them, which requires them to study the map carefully and plan accordingly in order to avoid unnecessary risks.