Article:

Cryptocurrency Funds: a new and easier way to invest in Digital Assets

07 September 2020

Geoff Rooney , Partner, Audit & Assurance |

This article was originally published 16 December 2019, and was updated on 7 September 2020.

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.

Yet, as quickly as cryptocurrencies have grown in popularity, so has our awareness of the numerous challenges and risks that individuals face when it comes to investing in these digital assets.

In this article, we discuss several key challenges for crypto investors today and the rise of cryptocurrency funds as an alternative to investing in digital assets.

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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. The ATO also announced cryptocurrency transactions undertaken by taxpayers would be one of their focuses as part of their data matching scheme.

In addition to this, if you are looking to invest in digital assets such as cryptocurrencies like Bitcoin, it is vital that you are aware of the rules and restrictions that apply. To find out more about investing in cryptocurrencies via an SMSF, please see the below resources or contact a Private Wealth adviser:

2. Risk of asset loss due to insufficient investor technical understanding and implementation

You don’t need to be a technology or blockchain expert to invest in crypto, however, investors in digital assets need to ensure they have the sufficient technical and financial knowledge to understand how to buy, sell, store and protect your cryptoassets safely (such as by encrypting their private keys).

A key consideration for to-be investors is how you will store your digital assets. While cold storage – offline wallets – are generally considered one of the safest methods for storing cryptoassets like Bitcoin, if the device is lost or destroyed, you can face difficulties in recovering your assets and lose them for good. However, if you choose to store your cryptoassets with an exchange, you will need to hand over the custody of your private keys which in essence is handing over the asset itself.

While there are several causes of cryptoassets loss such as storage device failure, human error, theft, seizure or robbery, two important risks to be aware of are:

  1. 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.
  2. Theft and/or loss of access information: as cryptocurrencies like Bitcoin are typically ‘anonymous’ in nature, there can be limited protections for investors in the circumstance of cryptocurrency theft or loss of access information.
    • Loss of mnemonic seed phrase – As your mnemonic seed phrase can be used to access your private key, everything must be secured including any wallets using passwords or PINs as the first line of access. Remember, ‘not your keys, not your coin’.
    • Loss of access (passwords) to a regulated Digital Asset Exchange – In Australia, the exchange acts as the custodian so your password is recoverable. However, if your password is stolen or someone else has access to it, they can access your account. Therefore, two-factor authentication should always be enabled when using a crypto exchange.

While many of these aforementioned issues and risks are unique to cryptoassets, all investments can involve a degree of risk, especially when conducting financial activity online. To learn more about operating safely online, see our Cyber Security insights.

3. Estate planning and succession

Similarly to other assets, there is a legal process that must be satisfied for the transfer of the ownership of cryptoassets like bitcoin, in the event of the original owner’s death.

However, the “ownership” of such assets depends on the ability to access the relevant digital wallet through the use of a private key or mnemonic seed phrase, rather than any traditional documents (such as title deeds). 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.

What can cryptoasset investors do?

As estate/succession planning is governed at a state level in Australia, you should speak to an expert about how you can ensure your digital assets can be securely and safely distributed should the unforeseen occur.

However, two options for investors are:

  • An offline backup of your digital wallet with details of access in a separate document addressed to your executor. These will need to be stored in a secure place that should only be identifiable by your executor and/or trusted persons, such as a spouse or next of kin.
  • Review of your current Will to ensure that your nominated executor is comfortable and has the technical understanding to deal with digital assets. You may also consider nominating a ‘digital executor’ to help manage your digital affairs. If you don’t currently have a Will, consider beginning the process of obtaining one.

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 Bitcoin 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 Bitcoin transaction – for example, buying and selling Bitcoin – it’s not always possible to verify who bought or sold the Bitcoin.

What does immutability mean and are all crypto blockchains considered immutable?

In the context of blockchain, immutability refers to the inability for the blockchain to be altered or changed after its creation. This means that no entity such as a company or government can manipulate or change the data stored on the blockchain resulting in a high level of data integrity and transparency.

Today, only Bitcoin has the network size and security that allows us to confidently say it’s immutable. Many other smaller blockchains have suffered ‘51% attacks’ – an attack on a blockchain where a single or group of entities has control of over 50 per cent of the hash power. These attackers have been successful in ‘overwriting’ several recent blocks to allow them to double-spend tokens. The smaller the blockchain (hash power) the cheaper it can be to attack.

This difficulty in verifying ownership of digital assets can raise several 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, some other challenges 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.

How we are helping to ensure the transparency of digital assets?

At BDO, we understand that one of the biggest challenges for investors considering investing in digital and crypto-assets is the lack of transparency about the quality of the assets.

To address this, our team of experts can provide a range of comprehensive audit and assurance services for blockchain and crypto/digital assets. Some of the services we can assist you with include:

  • Financial statement audits
  • Controls assurance reports
  • Anti-money laundering, counter-terrorism and fraud (AML/CTF) independent reviews
  • Accounting advice
  • Board governance support

In delivering these services, BDO also partners with Decentralised Capital, a specialist blockchain firm focused on developing institutional-grade digital assets and services.

To find out more or contact Tim Aman, Geoff Rooney or your local office.

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 because 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. 

Watch: How is Australia’s Financial Services industry using blockchain and distributed ledger technology to redesign value chains?

In this video, BDO Associate Director, Ryan Kris and Samuel Brooke from Block8 explore current blockchain and DLT trends and use cases in the Financial Services sector. Hear about the benefits of these emerging technologies, key decisions when integrating and deploying blockchain, and the top governance and risk considerations when delivering a solution as part of your digital strategy.

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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 DigitalX 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 how 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.

Disclaimer: The information contained in this article 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.

How BDO can help: Our Digital Asset Services

At BDO, our experts provide a range of specialist services for businesses and fintechs currently transacting with or planning to use cryptocurrencies as well as those developing products using crypto assets and blockchain technology.

Our Audit & Assurance Services for Digital Assets

  • Financial:
    • AML/CTF independent assurance and reviews
    • Process controls review and assurance reports
    • Financial Statement and external audit services
    • AFSL compliance engagements.
  • Asset Ownership:
    • Asset backing audits
    • Proof of ownership
    • Blockchain analysis for accurate and complete reporting data.
  • Smart Contracts:
    • Security audits for smart contract codebase
    • Reviews to identify and eliminate bugs and vulnerabilities
    • Pre and post-deployment analysis.

Our Advisory Services for Digital Assets

  • Strategy:
    • Services for discovery and capture of blockchain use cases
    • Digital product design, prototype and product build
    • Finance and capital raising to support new initiatives.
  • Security:
    • Cyber security health checks, security architecture and roadmaps
    • Threat risk assessment
    • Penetration testing and vulnerability assessment
    • Incident response planning.
  • Risk:
    • IT risk and control system audits
    • Risk management and assessments when using crypto
    • SOC2 reporting and internal control frameworks and development.

To find out more about our digital asset services and how we can best help you, see our blockchain services or contact your local advisor.