Alternative Investment

Cryptocurrencies: Where We’ve Been and Where We’re Going

In Q1 2022, we sat down with industry experts to get their take on the institutionalization of cryptocurrencies. Since then, the crypto market has gone from emerging to exploding. Entirely new asset classes and transactions have given way to hundreds of new blockchains. Dozens of countries now accept Bitcoin. And celebrities have made tidy sums for endorsements in Superbowl ads.

We’ve entered a new era, one where some institutional investors are eagerly putting money to work in the crypto space, while others are still wary of it. As 2022 winds down, this relatively new arena continues to raise questions: What’s driving the expansion and adoption of digital assets? How are investors feeling about crypto now? What challenges and opportunities lay ahead for fund managers?

To help you stay current, we’ve reflected on our 2020 Q&A with industry experts, highlighting those topics still very much in the forefront of this ever-evolving market. We’ve also added new topics to consider.

Q: How are fund assets stored and protected? What kind of infrastructure exists to keep them safe and help fund managers sleep at night?

A: Managing the risk of crypto asset storage used to involve safeguarding secret keys and implementing multiuser transaction approval to manage risk. While these methods are still critical in self-custody scenarios, the addition of mainstream exchanges and platforms for cryptocurrency trading and storage have changed the game. Using a third-party custodian carries inherent risks, requiring fund managers to evaluate their custody options carefully.

Q: One big concern among institutional investors is audit and tax. How are you dealing with that?

A: Solid reporting on crypto transactions throughout the year is key, just one of many reasons to partner with an experienced fund administrator. We’re seeing several common reporting challenges, including:

• Properly reporting staking and DeFi income streams
• Internal transfer of assets between wallets
• Increased numbers of NAV break periods
• Tracking illiquid investments in side pockets, in-kind contributions and withdrawals
• Depositing assets onto DeFi platforms

While the accounting professionals require quality books and records to provide assurance and compliance services, the regulatory environment may provide even greater challenges. The tax rules around crypto are especially nebulous, and tax professionals are still hoping for better guidance from the IRS. After all, the last time the agency officially addressed crypto was back in 2014. As the regulatory framework improves, the potential compliance risks decrease. So it’s reasonable to believe the institutionalization of crypto will only accelerate.

Q: How do you see crypto banking looking in the future?

A: The vast majority of global financial transactions are already electronic, but they can be slow and expensive in traditional finance. With the rise of decentralized finance and adoption of stablecoins, it’s increasingly easy to send crypto assets anywhere in the world. Consumers can do it from the privacy of their own homes, outside traditional banking hours and without a cut to the bank or credit card company.

Still, we need more clarity from banks and governments before blockchain-based currencies can be widely adopted. Even now though, we’re seeing a dramatic increase in investors subscribing to funds using cryptocurrencies – most often with stablecoins – to avoid the hassle and cost of initiating a wire transfer. It’s important to note, however, that so-called “stablecoins” are not necessarily stable. Recent years have seen multiple stablecoin implosions, with billions of dollars’ worth of value evaporating in just a few hours.

Q: What are some of the tax pressure points faced by fund managers when it comes to both traditional and nontraditional cryptocurrencies?

A: There are a few tax challenges native to this space: the lack of official guidance from the IRS, the need for complex structuring, and a struggle to maintain the books and records. Besides writing your local senator or congressman, we can’t do much about the IRS. But as fund advisors gain experience in this space, it’s becoming easier to structure a fund to allow access to different tokens or to shield investor groups from certain activities. Again, we can’t overstate the importance of good recordkeeping, particularly for strategies that the fund administrator isn’t intimately familiar with.

Q: How do you think different factors like the pandemic, oil prices, inflation and unstable governments have affected the crypto markets?

A: We’ve seen a sharp decline in crypto assets, starting at the end of Q4 2021, coinciding with major disruption of the traditional financial markets. Some used to think that inflation would add value to scarce assets like cryptocurrency, but the opposite seems to be true. Then again, the devaluing of risky assets during periods of recession is common, so it may still be too soon to come to any conclusions. As crypto becomes more institutionalized, we’ll be paying close attention to see how the markets react.

For more information on the topics covered in this summary or Richey May’s alternative investment services, contact Business Development Partner  Steve Vlasak.