Since its inception over 10 years ago, Bitcoin has grown to become the leading cryptocurrency worldwide and even a household name. As a result, a growing number of Australian individuals and businesses have begun to look into how they can invest safely and securely in digital assets like Bitcoin to take advantage of its rapid growth and revolutionary potential.
Want to find out more about Bitcoin and blockchain? Read our article here first.
Yet, as quickly as cryptocurrencies have grown in popularity, so have our awareness of the numerous challenges and risks that individuals face when it comes to investing in these digital assets.
What are some of the biggest challenges facing cryptocurrency investors?
1. Changing regulatory understanding and approaches
While Australian regulators have taken a cautious stance when it comes to the use of Bitcoin and other cryptocurrencies, the dynamic landscape means further regulatory changes will need to occur. As crypto tech continues to advance and evolve rapidly, regulators will need to navigate new challenges and scenarios, and individual and business investors will need to keep on top of both technological changes, and new compliance requirements.
Guidance has been released by the Australian Tax Office (ATO) that articulates digital assets tax treatment and record-keeping requirements. This is a complex area, further burdened by the anonymity of digital assets, as well as different rules and legislation cross-borders.
Furthermore, the ATO also announced cryptocurrency transactions undertaken by taxpayers would be one of their focuses as part of their data matching scheme.
2. Risk of asset loss due to insufficient investor technical understanding and implementation
Cryptocurrency ownership often requires a degree of technical knowledge to understand how to buy, sell, store or transact it safely. Many would-be investors are deterred from investing in digital assets, as they are at greater risk of losing their digital assets, due to insufficient understanding of the infrastructure of blockchain, or technical capability to safely use and protect their digital assets (such as by encrypting their private keys). Moreover, ownership of any digital asset like bitcoin is accompanied by unique risks including:
- Hacking: while the bitcoin blockchain is highly secure, digital wallets used for holding cryptocurrencies as well as the exchanges for transactions have been susceptible to hacking. There has been over US$4b hacked in 2019 which is more than 100% increase on the prior year.
- Loss or stolen currency or passwords: given bitcoins anonymous nature and ownership structure, there is limited protection for investors from governments or institutions when digital assets or passwords are lost or stolen. The Wall Street Journal suggests 20 per cent of all existing bitcoins have been lost.
3. Estate planning and succession
Unlike other assets where there are legal processes to transfer asset ownership in the case of death or sudden death, these processes don’t exist for bitcoin. This is because bitcoin ownership is dependent on the ability of the investor to access their bitcoin wallet through the use of a private key rather than ‘documented’ ownership. Therefore, if the investor dies without communicating to their beneficiary how to access the bitcoin wallet, there is no way the beneficiary can take ownership of the bitcoin - meaning it’s ‘lost’ forever.
4. Audit Procedure
Individual and institutional investors investing directly in cryptocurrencies may face significant risks when it comes to correctly accounting for and reporting on their digital assets.
While blockchain transactions are renowned for their immutability – once recorded they can’t be modified - this transactional transparency doesn’t always extend to ownership. While an auditor can see evidence of any blockchain transaction - for example, buying and selling bitcoin - it’s not always possible to verify who bought or sold the bitcoin. This difficulty in verifying ownership of digital assets can raise a number of issues for auditors including difficulties detecting fraud, illegal transactions, misrepresented financials or failures to identify transactions between related parties. Finally, while we’ve focused on the aforementioned issues, there are also some other challenges that can arise for cryptocurrency investors, such as:
- Ensuring Investment Mandate satisfaction
- Exchange and counterparty licencing and due diligence
- Exchange liquidity and fee review
- Order funding and transfer limit review
- De-banking risk and insurance access
- Dealing with forks and airdrops
As a result, many individual and institutional investors have been looking for new avenues that allow them to invest in digital assets while mitigating the aforementioned risks. One of these avenues is through cryptocurrency funds.
What is a cryptocurrency fund?
Generally speaking, there are two main types of cryptocurrency funds - cryptocurrency index funds or exchange-traded funds (ETF), and cryptocurrency hedge funds.
Cryptocurrency ETFs and index funds are similar in nature to any other ETF or index fund, and as a result, are becoming a choice of investors looking to break into the cryptocurrency market. Much of this is due to the fact that investors do not need to purchase and manage the currency directly in it. Instead, the investor can purchase shares in an ETF that invests in digital assets or tracks the digital market. This not only reduces some of the risks and complexities of investing in digital assets but also provides investors with an investment mechanism that is familiar and has low barriers to entry. Also, in the case of funds that invest in multiple digital assets, such as a range of cryptocurrencies, there is an additional benefit for investors who wish to have a broader exposure. Typically these passive funds have lower fees than actively managed hedge funds.
Similarly, investing in a cryptocurrency hedge fund is similar to investing in a traditional hedge fund. Unlike a cryptocurrency ETF that tracks the performance of a currency or asset, cryptocurrency hedge funds tend to invest in specific assets. For more risk-averse this can be a popular choice as the investor does not need to be well versed in cryptocurrency trends and activities as a team of experts manage the investments. However, because new investors must meet minimum investment requirements and they are considered less flexible and liquid than a cryptocurrency ETF, barrier to entry is high.
One of the companies innovating in this space is DigitalX, who after recognising a growing interest in accessing bitcoin from people who haven’t traditionally considered investing in digital assets, recently launched their own Bitcoin Fund. This fund is similar in style to an index or ETF as it is designed to track the Bitcoin price, providing investors with exposure to Bitcoin but through a familiar investment mechanism.
Want to read more about why investors are interested in Bitcoin and how it’s different from other cryptocurrencies? See our article here.
Why could this be a better alternative for investing in Bitcoin or other cryptocurrencies for some investors?
DigitalX’s bitcoin fund can allow investors to gain exposure to bitcoin with reduced risks and complexity for individuals or businesses who do not have the technical or compliance expertise to navigate the complex crypto environment. This opens the doors for sophisticated investors - such as family offices and high net-worth individuals - who may be interested in digital asset investing but not the specific skills or resources to safely and securely buy and sell bitcoin.
As described on their website, some of the issues and administrative burdens cryptocurrency funds like Digital X aim to assist investors with are:
- Knowledge and experience with the various exchanges available to purchase bitcoin
- The requirement to sign up and provide personal and corporate details to those exchanges before being able to purchase bitcoin
- Transferring cash to the exchange and complying with various transfer limit restrictions
- Executing orders at the best price
- Storing the bitcoin and associated key and seed using a secure wallet procedure
- The process for transferring bitcoin back into an exchange account and selling the bitcoin
- Understanding the taxation and audit procedures for their holdings
Overall, Bitcoin and cryptocurrency funds have the potential to transform the way in which invest in digital assets as well as open the doors for new investors who are interested in cryptocurrency investing but deterred by the complexity and compliance requirements. However, as with any investment, it’s important to note there are still risks, particularly within a rapidly changing environment with strict legislative requirements.
BDO is excited to be part of this emerging technology - working with DigitalX to provide Audit and Assurance services across their operating model to provide additional trust and transparency in their offering.
For any questions or if you would like to know more about bitcoin and blockchain technologies, please contact us.
Disclaimer: The information contained in this letter is purely factual in nature and does not take into account your personal objectives, financial situation or needs. The information is objectively ascertainable and, therefore, does not constitute financial product advice. If you require personal advice that takes into account your particular objective, financial situation or needs, you should consult us in our licensed capacity.