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Understanding Cryptocurrency Risks and Opportunities

INSIGHT ARTICLE  | 

Cryptocurrency is gaining traction with investors for many reasons, including its nontraditional structure and potential for significant returns on investments. While many are aware of more common currencies, several potential investors do not know the wide variety of assets and how they work. Before investing, you must understand the unpredictable nature of various types of cryptocurrency, as well as potential security, regulatory, accounting and tax issues.   Investors in cryptocurrencies do not enjoy the same legal and regulatory protections that are common in other currency and financial transactions and it is critical that investors consider the evolving risks in this area.

What are cryptocurrencies?

Cryptocurrencies are a new asset class that allows one user to transfer a “coin” to another using both encryption and digital ledger, or blockchain, technology. More than 1,100 cryptocurrencies are currently available; the best known is Bitcoin. Not all of these currencies are alike, and most have a specific purpose. For example, while Bitcoin is often compared to gold, Ethereum allows for smart contracts. Monero is built on highly anonymized transactions and Civic is designed to provide government identity data.

Cryptocurrencies are becoming increasingly popular with investors as they are highly volatile and in some cases appreciating rapidly. For instance, in November 2016 bitcoin was trading at about $700. By November 2017, it was trading at nearly $7,000.

Most currencies have a theoretically limited supply, which is one of the reasons the price has appreciated rapidly to date for some.

Cryptocurrency transactions are executed via blockchain technology, in which the transaction sending a coin from one person to another is placed in a virtual “block,” and that block is then broadcast to participating parties on a blockchain network. These parties are called “miners,” and they are paid a commission to ensure that the transactions are valid.

Once the transactions are validated, the block is added to a “chain,” providing a transparent record of the transaction. A transaction in which a cryptocurrency is tendered is typically completed in 10 to 15 minutes. In that sense, it is more comparable to a banking transaction than a credit card transaction, which takes place in seconds.

A large, complex cryptocurrency marketplace has evolved, consisting of currencies, exchanges for trading, financial and legal advisors, venture capitalists and hedge funds, market-makers and market researchers, and offline methods for storing the currencies known as “cold storage.”  At this time, these marketplaces are subject to no or only limited regulation.

Regulatory status

Bitcoin was designed, and other cryptocurrencies followed, around the idea of an ecosystem where no one entity is in charge. Changing functions in Bitcoin requires consensus among miners to agree, rather than a monetary authority to make policy.

This makes cryptocurrencies more difficult to regulate than traditional currency or financial products, though we expect to see increasing regulation from jurisdictions around the world.  The SEC, CTFC and other regulatory bodies are currently in the process of transforming the rules to support this new asset class. Recent statements by SEC Chairman Jay Clayton, among others suggest that this process is set to continue.    

As the scope and volume of regulation increases, we expect to see prices fluctuate in response.  Therefore, a key risk of investing in cryptocurrencies today is that that new regulation could greatly impact that value of your investment.

Currently, the most enforced area of cryptocurrencies is in ICOs. The SEC has taken an active approach to making sure ICOs follow standard securities offering processes. Additionally, it is actively looking for Ponzi schemes in this space as well as other fraud. Even though we see regular action against frauds in the ICO space, this is by no means an assurance that every ICO is following U.S. law.

In keeping with increased regulation and investor interest, we are seeing traditional financial products being developed that offer investors exposure to cryptocurrencies.  These products include exchange traded funds (ETFs) and other derivatives traded on national exchanges like the CBOE and CME.  The SEC has recently voiced significant concern with some of these products and the future for these offerings is unclear.

Operational security

With respect to operational security, cryptocurrency presents several important risks to consider. First is the fact that all transactions in the cryptocurrency space are final and cannot be reversed.

  • For example, if you transfer coins to the wrong account, or “wallet,” they are gone—you cannot get them back
  • If you are running a trading operation and an unscrupulous trader moves coins into his own wallet and not the corporate wallet, there is little you can do to get them back
  • If an exchange that you are trading on gets hacked or you lose your username or password, your coins are lost
  • If you are storing your coins on a laptop and a hacker breaks in and steals them, they are gone as well

For all these reasons, security in this space is extremely important. Therefore, you must balance the currencies you keep on an exchange, on your local computers and in cold storage. There are good security options available on the exchanges, but it’s incumbent on the participant to utilize them. They are not required or automatically available.

The same is true if you keep these coins on your computer. They are vulnerable to hacking if you do not take adequate precautions.

Therefore, consider keeping coins offline, in cold storage. This is especially advisable if you are a buy-and-hold trader. More active traders might miss out on opportunities by keeping their coins in cold storage. Cold storage typically uses a USB key-like device to store the private keys that allow you to send currency.

As noted above, new offerings are emerging that combine cryptocurrency exposure with more traditional financial products (like options or ETFs). Since no actual cryptocurrency is traded these operational risks will be less applicable. As more new products are created in this space, it will be important for investors to evaluate the particular risks before making an investment.

Accounting issues

Just as with regulations, there are few established accounting guidelines for cryptocurrencies. Many regulatory bodies have yet to define what a cryptocurrency is. Is it a financial instrument? Cash equivalent? Intangible asset?

Regarding ICOs, there are questions about how issuers and recipients should treat these transactions for accounting purposes. Are they issuing equity in a company or should it have liability treatment? Or is it a prepaid asset or intangible asset to the recipient and deferred revenue for the issuer? There are no definitive answers yet.

Top tax issues

With regard to taxation, there are many uncertainties with cryptocurrencies. However, the IRS has issued some guidance. Most importantly, cryptocurrencies are taxed like property, not currencies. This generally leads to standard capital gains and losses, which requires painstakingly detailed record keeping of every individual transaction.

Final thoughts

Just as with any new and disruptive technology, the ecosystem around cryptocurrencies is evolving fast. If this is an area that you are interested in investing in, you shouldn’t only be drawn by the appreciation and volatility. Understanding how cryptocurrencies work, their purpose and how the ecosystem works around it is important before making an investment.

The information and opinions contained herein are for informational purposes only. This is not a solicitation to offer investment advice or services in any jurisdiction where to do so would be unlawful. All opinions expressed are as of the date of publication and subject to change.  This piece and the analysis it contains are not for trading or investing purposes. RSM US LLP and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information.

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