- An introduction to Crypto
- November 8, 2017
Interest in cryptocurrencies has grown significantly since the inception of bitcoin in 2009. Cryptocurrencies are widely regarded as the next evolution in financial services technology. They offer the promise of increased speed and accuracy in payment processing; greater access for the unbanked; and a detachment from centralised monetary policy. Trading in cryptocurrency has historically been dominated by speculators which has contributed to notorious price volatility. Institutional investors are starting to take note as this asset class matures and gains mainstream acceptance.
The increasing trading and applications of cryptocurrencies have given rise to a number of legal and tax issues. Many of these are yet to be satisfactorily resolved and regulators around the globe have thus far struggled to keep pace with the challenges posed by these rapid advancements in technology. Change is however sure to come and it is therefore important for investors and coin issuers alike to be properly versed on the implications as they arise.
First there was bitcoin….
Bitcoin is the first cryptocurrency to have been developed. It was originally introduced as a whitepaper in October 2008 by an anonymous person (or group of persons) going by the name Satoshi Nakamoto. The bitcoin blockchain is comprised of a series of blocks which record transactions between different addresses. The entire blockchain can be downloaded from the internet and any interested party may study it as they wish. It is possible to see how much bitcoin is held within each address, though there is no way of knowing exactly who controls each address. Bitcoins can only be moved from one address to another by authorising a transaction with a private key. These private keys are often printed by holders of bitcoin on a piece of paper or electronically stored on a thumb drive or a hardware wallet. This is known as the cold storage of bitcoin and may be compared to the 'hot wallet' that is created by opening an account with an exchange.
One of the conceptual underpinnings of bitcoin is that the value of the currency is not to be devalued by simply generating more coin. There will only ever be 21 million bitcoin unlike other fiat currencies which can be devalued by government monetary policy. Bitcoin transactions are not processed by a single entity – it is designed to be decentralised putting it further out of reach of any single regulatory or government authority. Independent parties compete to process transactions on the blockchain. This is the process of 'mining' whereby racks of computer services compete to be the first to solve a cryptographic puzzle and receive a block reward. This method of validation is known as 'proof of work' and can take hours rather than seconds to complete. It is only theoretically possible for any group of persons to rewrite the blockchain and undo past transactions given the amount of computational power which is required. This makes the blockchain accurate and highly resistant to internal fraud.
The dominance of bitcoin has been gradually slipping over the past few years as different cryptocurrencies have been developed. The second most valuable cryptocurrency by total market capitalisation is ethereum. A powerful feature of ethereum is the ability to deploy 'smart contracts' on its blockchain. The ethereum blockchain is able to perform computational functions which simply can't be done on the bitcoin blockchain. The real world applications of this technology are immense. It is able to bring together payments with a computational cause and effect; including linking with physical devices which can be instructed to perform a function once a transaction in ether has been confirmed. Another key feature of ethereum is that it is moving towards 'proof of stake' as the mode of confirming transactions. This will enable must faster validation as it relies on achieving consensus through a process of wagering rather than work.
There are now over 1,000 different types of cryptocurrencies. Many of these are not actually currencies in the true sense, and are instead tokens which grant usage, governance or other rights. A good example of this is the golem network token. Golem describes itself as a market for spare computing power. Users are able to rent out their idle computer processing power in exchange for golem tokens. The golem protocol brings together all this computing power to perform tasks (such as a CGI animation) in a manner which is an alternative to centralised cloud computer services. Anyone can buy golem tokens through a cryptocurrency exchange but, speculation aside, the real value of these tokens will increase if there is customer demand for the underlying product.
A murky history….
The anonymity of cryptocurrencies has made this the payment method of choice for criminals and dark web users. This anonymity can be further enhanced by 'tumblers' which causes a mixing of cryptographic funds to further obfuscate the original source and the addresses which may be involved in a transaction.
Perhaps the most famous example of this is the Silk Road which was an online marketplace for the trade of illicit drugs and weapons. When it was shut down in 2013, the FBI seized a total of 144,000 bitcoins from the site's founder. These bitcoins were later auctioned by the US Marshals Service as the proceeds of crime. More recently victims of the WannaCry ransomware attack were instructed to make payment in bitcoin to unlock their computers.
There have been some high profile cases of cryptocurrency exchanges being hacked resulting in significant losses. The Tokyo based Mt Gox exchange was the world's largest bitcoin exchange at the time it was hacked in 2014. Approximately 850,000 bitcoins were stolen which led to the exchange declaring bankruptcy. The Hong Kong based exchange Bitfinex was also hacked in 2016 losing over USD 70m of digital currency. Ethereum suffered a big setback in 2016 when ether raised by the Decentralised Ambiguous Organisation (DAO) was hacked. The DAO was established to sponsor the developments of applications to be run on the Ethereum blockchain. The transactions appropriating the funds raised by the DAO were reversed by a change to the Ethereum blockchain. Not all of the Ethereum miners agreed to the change in the blockchain (known as a hard fork) and it was effectively split into Etheruem and Ethereum Classic.
A frontier asset
The colourful history of bitcoin and other cryptocurrencies is one of the main reasons why this is still regarded as a frontier asset class. There is evidence that this is changing. There is an increasing amount of institutional investor interest and growing public awareness. It used to be the case that purchasing bitcoin required a level of computer proficiency beyond most people – generating a wallet address required downloading the blockchain and a cryptocurrency escrow provider was often used as a party to purchase transaction to prevent fraud. Now it is as simple as opening an account with one of the exchanges that will accept transfers of fiat currency.
Bitcoin has the highest level of vendor acceptance but it is still extremely low by comparison with fiat currencies. It is still many years away from being a substitute for the currency we use today. Most of the interest in cryptocurrency has come from speculators. This is a point made by the US Financial Regulatory Authority in their investor alert which carries the not-so-subtle title:_ “Bitcoin: More than a Bit Risky”._
Cryptocurrencies are renowned for extreme volatility and erratic private movements which has a lot to do with the heavy trading by speculators. The price of ether increased over 3,000% in the first half of 2017. Recently a flash crash which occurred on the GDAX exchange in which the price of ether plunged from US$320 to US$0.10 in less than a second due to a multi million dollar sell order being placed. The price of bitcoin is by comparison now fairly stable. It is akin to reserve cryptocurrency and is also used to price other cryptocurrencies. This creates a baseline level of demand and has contributed to bitcoin being seen as a store of value by investors.
Rise of the Initial Coin Offering
The rising popularity of cryptocurrency is evidenced by a rapid increase in 'initial coin offerings' (ICO). This is a funding structure whereby a new blockchain venture issues its own token to investors as opposed to traditional shares or debt. These ICOs are often structured as an exchange of ether or bitcoin for a pre-determined amount of the new token, but new and novel pricing mechanisms are starting to emerge. This includes the price discovery mechanism in the EOS ICO in which investors simply transferred ether for an unknown quantity of the EOS token. This ICO is one of the largest in history and raised USD 185m during the initial five day crowdsale.
The economic motivation behind participating in an ICO is slightly different from the purchase of debt or equity in a new venture. Investors will only realise an economic return if there is demand for the token itself which can come in the form of fevered speculation or from a real word business case. One of the reasons why the price of ether is said to have risen in recent times is the demand for investors purchasing ether to invest into ICOs.
Regulatory and tax considerations
State of cryptocurrencies
The regulatory status of bitcoin and other cryptocurrencies varies from country to country. The regulatory response tends towards a middling position – cryptocurrencies are generally not considered to be legal tender though it is also not illegal to conduct transactions using this form of payment.
The establishment and mining of cryptocurrency does not appear to run afoul of the right retained by the state to produce currency such as that found in Article 1 of the US Constitution, or existing counterfeiting laws. The US now publicly recognises a distinction between: 'convertible decentralized cryptocurrency' as opposed to currency plain and simple. A more cynical analysis would see this as an acknowledgement that the cat is well and truly out of the bag. The globally decentralized nature of cryptocurrencies makes it very difficult for these to be regulated out of existence by the unilateral action of one government alone.
The growing awareness and vendor acceptance of cryptocurrencies is leading to increased analysis of these issues by central banks and regulators. There are early signs that the pendulum seems to be swinging towards cryptocurrencies being brought within the regulatory mainstream. Earlier this year the Government of Japan amended the Banking Act to recognise bitcoin as legal tender. This brings with it a host of regulatory and compliance issues for cryptocurrency exchanges including money laundering and know your customer requirements. The desire to tackle money laundering is one of the reasons why Russia is considering recognising cryptocurrencies as a legitimate financial instrument with new regulations targeted for 2018.
The general consensus position has been that a cryptocurrency token is not a 'security' for securities law purposes. This is particularly true for utility tokens which provide a network usage right, as compared to those which enable a share in the profits of the coin issuer. ICOs have to date been being conducted with comparatively light informational disclosures and none of the investor protection mechanisms which are common for a standard IPO or debt issue. The US SEC and the MAS in Singapore have however both recently stated that the issue of a token may come within existing securities law. Chinese regulators have also indicated an intention to regulate ICOs.
The trend toward government intervention is an investor protection response. There are many risks and information asymmetries for an investor participating in an ICO. It is common for sponsors to pre-mine a significant amount of the tokens which are issued and retain these as part of their incentive. Outside of a self-imposed escrow mechanism, there is nothing the sponsor of an ICO embarking on a pump-and-dump once the token is listed on a public cryptocurrency exchange (which can happen within days of an ICO). There is also the potential for price manipulation and trading on asymmetric information in a manner which would be insider trading if the tokens were securities.
In the immediate wake of the statements made by the US, Singapore and Chinese authorities, issuers are now starting to exclude investors from these jurisdictions participating in an ICO. There are a number of methods which are used. These include the creation of investor whitelists (some of which require proof of identification documentation) and geoblocking participants from these countries during the ICO itself. Issuers are also changing the features of their tokens so that they are less likely to be considered securities. Many of the large cryptocurrency exchanges are based in the US and they will not list a token for trading if in their view it is a security. An inability to list on major exchanges hampers liquidity and consequently the price of the token itself.
Income tax issues
There are a significant number of tax issues associated with the trading of cryptocurrencies. The United States Internal Revenue Service (IRS) issued guidance in 2014 addressing the treatment of cryptocurrency for US federal tax purposes. Cryptocurrency is considered “property” under the Internal Revenue Code, therefore transactions involving cryptocurrency have potential income tax, capital gains, and employment tax implications as well as possible information reporting obligations.
The IRS guidance highlights the following potential issues:
• A taxpayer who receives cryptocurrency as payment for goods or services must include the fair market value of the cryptocurrency in his or her gross income.
• Cryptocurrency will have a basis equal to the fair market value of the currency on the date of receipt. Therefore, upon a future exchange of the cryptocurrency for other property, the taxpayer may have a taxable gain or loss. The character of the gain or loss, and thus the rate at which it is taxed, depends on whether the taxpayer held such cryptocurrency as a capital asset (e.g. as an investment) or as inventory or other property held mainly for sale to customers, which is not considered a capital asset.
• A taxpayer who “mines” cryptocurrency will include the fair market value of such mined currency in his or her gross income. If such mining constitutes a trade or business, the net earnings resulting from the mining activities may constitute self-employment income, subject to the self-employment tax. Similarly, cryptocurrency paid by an employer will be considered wages for employment tax purposes.
• All IRS information reporting requirements related to property ownership, transfer, receipt, etc. apply to virtual currencies just as otherwise required for other property.
• Penalties can potentially be incurred, including accuracy-related penalties and penalties for failure to timely or correctly report cryptocurrency transactions when require. However, relief may be available if such failures are shown to be due to reasonable cause.
A broadly similar position applies in the United Kingdom. Businesses that accept payment in cryptocurrencies are subject to corporate tax and income tax in the same manner as if the amount was paid in fiat currency. Capital gains taxes are chargeable if an individual makes a gains on the disposal of cryptocurrencies. Similarly, companies are liable to pay corporate tax on trading gains.
The position of traders who are not subject to a worldwide basis of taxation also requires close analysis. A trader who is based in Singapore may be able to take a position that their frequent trades are not subject to local taxation as capital gains. This argument is potentially open given the current administrative position of the IRAS in relation to share trading gains made by individuals. If however they choose to buy and sell cryptocurrency on a Hong Kong based exchange, will the territorial basis of taxation in apply to subject any gains to profits tax? A comprehensive double tax agreement is not in place between Singapore and Hong Kong and so there is no ability for the trader to assert they do not have a permanent establishment in Hong Kong and are not subject to tax on that basis.
In addition to the taxation of gains realised by traders, there is also the question about the application of withholding tax to cryptocurrency lending transactions. Many cryptocurrency exchanges enable the lending of cryptocurrency on a short term basis. This is essentially peer-to-peer lending though little – if anything – is known about the party or parties to whom the currency is lent. It is facilitated by the exchange which will automatically liquidate the position of the borrower if there is an adverse price event through the equivalent of a margin call. It is not clear in these lending structures who is the withholding agent and even the source of the interest income that is derived. The taxation character of “airdropped” tokens which are issued for no consideration and the proceeds of coin sharing remain to be considered.