The Financial Regulatory Authority (FINRA) recently revealed what it considers a "major problem" in a targeted investigation of crypto assets in retail communications by member firms. Interesting statistical headline. FINRA assessed nearly 70 percent of the retail communications it reviewed as potentially violating FINRA communication standards. The significant breakout rate is likely based on the newness and complexity of the crypto asset. It is unclear whether this figure is supported by regulators, who continue to take a cautious and critical approach to all crypto-related activities. One thing is clear. financial advisory firms should expect constant and robust oversight of crypto asset and service communications. In this article, we review FINRA's findings and discuss the key questions FINRA is asking to support firms' ongoing compliance and remediation efforts.
Important early results
FINRA listed the following issues and findings in its latest release:
- In communications, including mobile applications, do not separate crypto assets provided by Members through affiliates or other third parties, or products and services provided directly by Members.
- Misconceptions or implications that crypto-assets act as or are equivalent to cash.
- Other false or misleading statements or claims about crypto assets.
- Comparing crypto assets to other assets ( such as equity investments or cash) does not provide an accurate basis for comparing the characteristics and risks of those investments.
- A vague and confusing explanation of how crypto assets work and their main features and risks.
- Failure to provide an adequate basis for the valuation of crypto-assets by omitting a clear explanation of the issuance, holding, transfer or sale of crypto-assets.
- Misrepresenting that protections under federal securities laws or FINRA regulations apply to crypto assets.
- Misrepresentations about the extent to which certain crypto assets are protected under the SIPC or SIPA. [1]
We suspect that at least some of the misrepresentations and misleading/false statements made by FINRA may have been due to misunderstandings and misunderstandings. Crypto assets are still relatively new, often offer subtle features/use cases, and can be difficult to compare to other products available from traditional financial services firms. In fact, "crypto assets" include a wide range of digital assets, including stablecoins, fungible tokens (NFTs), bitcoins, and other cryptocurrencies. Each of these resources has unique characteristics and uses, which may not lead to universal communication. [2] These issues can complicate the ability of companies and financial advisors to translate understandable concepts into communications for retail investors. In addition, supervisory personnel involved in the review and approval process may not have sufficient familiarity and experience with cryptoassets to properly vet communications. Therefore, organizations should take steps to ensure that people with in-depth knowledge of crypto assets are involved in the development and review stages when preparing retail communications for crypto assets.
However, a focus on communication preparation may not be sufficient to overcome the subtle product differentiation, ongoing regulatory oversight, and risks associated with the implementation of key crypto-asset principles. Take, for example, FINRA's observation that some crypto assets were misidentified as cash equivalents. Some stablecoins (crypto assets whose value is often tied to a fiat currency such as the US dollar) appear to act as "cash equivalents". However, regulatory positions have evolved alongside accounting principles. For example, auction rate securities (ARS) are often classified as “cash equivalents” by leading accounting firms under applicable accounting standards. They weren't there yet [3] Later, after the ARS market fiasco, securities regulators penalized many brokerage firms for misclassifying ARS in client communications. [4] Firms should consider the value of using terms such as "cash equivalent" when discussing crypto assets and, if they choose to do so, establish processes to ensure they use such terminology to avoid future adoption. to become
Conduct practical evaluations of crypto asset communications
FINRA's notice also provides specific questions that firms can use when evaluating whether communication statements are accurate and presented in a fair and balanced manner. For example, a company should assess whether a particular crypto asset is offered by the company itself or its affiliates, and therefore corporate communications should clearly identify which entity offers each product or service.
Of interest for independent assessment is whether the SIPC is applicable to crypto assets traded by securities firms. The Securities Investor Protection Act does not define "security" to include "investment contracts" as a general matter. [5] Of course, the main reason crypto assets are considered "security" is that they include an "investment contract", which is still a matter of debate for many crypto assets. As a general rule, companies offering crypto assets should keep this in mind when disclosing SIPC coverage, especially when communicating with clients about account statements.
Finally, FINRA must take into account several considerations to ensure that disclosures about crypto assets are presented in a "fair and balanced" manner, as required by FINRA Rule 2210. Communications Regarding Crypto Assets:
In short, FINRA's update serves as a cautionary but informative piece of information for financial services firms as they increasingly consider how to incorporate crypto assets into their businesses. FINRA will continue to investigate crypto assets as new assets and products become available. Careful appointment and clear development of skilled people will be critical to managing the associated business and regulatory risks.
[1] https://www.finra.org/rules-guidance/guidance/targeted-examination-letters/sweep-update-jan2024
[2] FINRA defines "Crypto Assets" as assets issued or transferred "using distributed ledger or blockchain technology," including so-called "virtual currencies," "coins," and "tokens." : // www.finra. organization/rules-guideline/guideline/target-veteran-email/cryptoactive-communication
[3] "Securities at auction prices. short-term or long-term?" Stephen Taub, CFO.com, March 25, 2005.
[4] Testimony on Recent SEC Actions Relating to Securities Auction Rates, Before the US House Committee on Financial Services, Linda Chatman Thomsen, Director of the Division of Enforcement (September 18, 2008)
[5] 15 USC 78lll(14) (Definition of ``security'' under SIPA limits ``investment agreements to include investment agreements or certificates of interests or production shares or agreements to participate in mining or oil, gas or mineral leases (if any) or interest investments are subject to a registration statement with the Commission pursuant to the provisions of the Securities Act of 1933..”).