Digital Assets
Digital assets are assets that exist in digital form and are created, traded, and stored electronically. They are built on blockchain technology and represent a rapidly evolving asset class with significant regulatory uncertainty. Digital assets were added to the Series 65 exam outline effective June 12, 2023.
Blockchain Technology
A blockchain is a shared, immutable database (ledger) that records transactions across a network of computers. Key characteristics:
- Decentralized - no single entity controls the network
- Transparent - all transactions are publicly visible on the ledger
- Immutable - once recorded, transactions cannot be altered or deleted
- Consensus-based - transactions are validated by network participants (miners or validators)
Validation methods:
- Mining (proof of work) - computers solve complex mathematical problems to validate transactions and earn new tokens (e.g., Bitcoin)
- Staking (proof of stake) - validators lock up tokens as collateral to validate transactions and earn rewards (e.g., Ethereum post-merge)
Types of Digital Assets
| Type | Description | Example | Key Feature |
|---|---|---|---|
| Cryptocurrency | Digital currency used as medium of exchange or store of value | Bitcoin, Ethereum | Fungible; runs on blockchain |
| Stablecoin | Cryptocurrency pegged to a fiat currency, asset, or commodity | USDT (Tether), USDC | Designed to maintain stable value |
| Non-fungible token (NFT) | Unique digital token representing ownership of a specific asset | Digital art, collectibles | Non-fungible; each token is unique |
| Utility token | Token providing access to a product or service within a platform | Various decentralized finance (DeFi) tokens | Function-based, not primarily investment |
| Security token | Token representing ownership in a traditional asset (equity, debt, real estate) | Tokenized securities | Subject to securities regulation |
Cryptocurrency:
- Bitcoin (BTC) - the first and largest cryptocurrency by market capitalization
- Created in 2009 by pseudonymous Satoshi Nakamoto
- Limited supply - capped at 21 million coins (deflationary by design)
- Generally classified as a commodity by the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC), not a security
Stablecoins:
- Pegged to maintain a 1:1 value with a reference asset (typically the U.S. dollar)
- The Internal Revenue Service (IRS) does not consider any digital asset to be currency; only fiat currency backed by a government qualifies
- Used for trading, transfers, and as a bridge between crypto and fiat
Non-fungible tokens (NFTs):
- Each token is unique and cannot be exchanged on a 1:1 basis with another NFT
- Use smart contracts - self-executing contracts with terms written into code on the blockchain
- Central to the DeFi (decentralized finance) movement
The Howey Test: Security or Not?
The regulatory treatment of digital assets depends on how they function and are marketed. The Howey Test determines whether a digital asset is an investment contract (security). All four prongs must be met:
- Investment of money
- Common enterprise
- Reasonable expectation of profits
- Derived from the efforts of others
Think of it this way: If someone buys a token hoping the development team will build something that makes the token more valuable, that looks like a security. If someone buys a token just to use a service (like a subway token), it probably is not.
Exam Tip: Gotchas
- Labeling a token a "utility token" does not make it a non-security. The Securities and Exchange Commission (SEC) applies the Howey test to economic substance. If it was marketed with profit expectations driven by the team's efforts, it is a security.
- Bitcoin fails prong 4 (sufficiently decentralized, no central team), so it is classified as a commodity, not a security.
Regulatory Classification
| Regulator | Jurisdiction | Classification |
|---|---|---|
| SEC | Securities | Digital assets that meet the Howey test are securities; subject to registration and disclosure requirements |
| CFTC | Commodities | Bitcoin and certain other cryptocurrencies classified as commodities; CFTC regulates crypto derivatives (futures, options) |
| IRS | Taxation | All digital assets are treated as property (not currency); taxable events include sales, exchanges, and payments for goods/services |
| Financial Crimes Enforcement Network (FinCEN) | Anti-money laundering | Crypto exchanges must comply with Bank Secrecy Act (BSA) and anti-money laundering/know your customer (AML/KYC) requirements |
Exam Tip: Gotchas
- Bitcoin is generally classified as a commodity (regulated by the CFTC), NOT a security. However, many other digital tokens that meet the Howey test ARE securities subject to SEC regulation. The classification depends on how the asset functions, not what it is called.
IRS Tax Treatment
The Internal Revenue Service (IRS) treats all digital assets as property (not currency). Key tax rules:
- Every sale, exchange, or use of digital assets to purchase goods/services is a taxable event
- Capital gains/losses apply based on the difference between purchase price (cost basis) and sale price
- Standard capital gains rates apply: short-term (held 1 year or less) at ordinary income rates; long-term (held over 1 year) at 15% or 20%
- Receiving digital assets as payment for services is taxed as ordinary income at fair market value
- Mining and staking rewards are taxed as ordinary income when received
- Like-kind exchanges (Section 1031) do NOT apply to digital assets (only applies to real property)
Exam Tip: Gotchas
- The IRS does not classify any cryptocurrency as currency, even stablecoins pegged to the dollar. All digital assets are property for tax purposes. Every crypto-to-crypto swap is a taxable event.
Risks
| Risk | Detail |
|---|---|
| Volatility risk | Extreme price swings; Bitcoin has experienced drawdowns exceeding 70% |
| Regulatory risk | Evolving rules; assets classified as securities face registration requirements |
| Cybersecurity risk | Exchanges and wallets vulnerable to hacking, theft, and fraud |
| Liquidity risk | Smaller tokens may have thin markets; hard to sell at desired price |
| Technology risk | Smart contract bugs, protocol failures, blockchain forks |
| Custody risk | "Not your keys, not your coins" - loss of private keys means permanent loss of assets |
| Fraud risk | Scams, Ponzi schemes, and unregulated offerings are prevalent |
| No Federal Deposit Insurance Corporation (FDIC) or Securities Investor Protection Corporation (SIPC) protection | Digital assets held on exchanges are NOT insured by any government agency |
| Valuation difficulty | No earnings, dividends, or cash flows to anchor fundamental valuation |
Exam Tip: Gotchas
- Digital assets held on exchanges have NO FDIC or SIPC protection. If the exchange fails or is hacked, investors may lose their entire investment with no recourse.