Cryptocurrency: The Good, the Bad, and the Ugly
By Justin Holmes, CPA, Senior Manager, Assurance Services, Alternative Investment Group
The cryptocurrency industry continues to mark milestone after milestone, with the most occurring in 2021. The industry is attracting all types of investors as retailers, traditional financial institutions, and large corporations all look to profit from the emerging trend of digital assets. The United States Securities and Exchange Commission (SEC) recently approved cryptocurrency exchange-traded funds (ETFs) to go live in the United States.
The SEC approval allows ETFs that track cryptocurrency derivatives, like Bitcoin futures contracts. It’s only a matter of time before the SEC approves ETFs to hold Bitcoin or other crypto assets directly. Crypto hedge funds also continue to grow, with assets under management reaching $3.8 billion USD in 2020 (up from $2 billion USD in 2019), and returns of approximately 128% (versus 30% in 20191). Bitcoin hit all-time price highs in April and November of 2021, with substantial volatility in between those highs. Throughout this year, some of the biggest breakthroughs for crypto have involved its cultural popularity. The industry and where it will go next is the subject of much focus and attention.
The industry isn’t without its challenges; for example, there has been much conversation about regulation. Lawmakers around the world are scrambling to establish laws and guidelines for cryptocurrency. Investors see regulation as a significant roadblock, while governments see it as a way to protect investors by making cryptocurrency safer and less appealing to criminals. The IRS and other taxing agencies also want to make sure investors report cryptocurrency assets when filing taxes. Many different agencies are trying to regulate an industry that is quickly evolving, which has proven difficult — and in the United States, it could mean each state operating under significantly different rules.
With the inflow of capital in the crypto industry there is, of course, an increased risk of fraud. The U.S. Attorney’s Office, Southern District of New York announced in September 2021 that the founder of a $90 million cryptocurrency hedge fund was sentenced to seven years in prison for securities fraud. The founder in this case managed two cryptocurrency funds based out of New York, which embezzled funds from investors and made unauthorized investments with client funds. The scheme ended when investor redemption requests couldn’t be fulfilled and the founder attempted to steal money from one of the funds. In total, approximately $54 million of investor assets was misappropriated. The founder of the two hedge funds was only 24 years old and had raised more than $90 million USD in capital. This case shows the importance of establishing a sound control environment with proper oversight to protect investor assets.
In the cryptocurrency world there are many risks that are similar to those that come with traditional hedge funds — but cryptocurrency also comes with additional risks relating to financial reporting and safeguarding assets. One added risk is the valuation of the assets. Due to the price volatility of many crypto assets, it’s easy to question the market price reliability. A valuation policy that is in accordance with generally accepted accounting principles, and that clearly specifies the time and exchange for which the digital asset is to be valued, would be necessary to avoid ambiguity and management bias. The difficulty in determining and validating the existence of the crypto assets adds another layer of risk. Traditional confirmation procedures may not be a viable way to verify the existence of these assets, which are generally held in digital “wallets” and not with a FINRA-regulated qualified custodian. Lastly, another challenge is determining if management has hired personnel and service providers with adequate expertise in crypto assets. The industry is evolving quickly and it’s important for organizations to have the resources to develop policies and procedures to mitigate risks. Establishing strong controls and proper oversight is important to creating a successful cryptocurrency fund.
Investors will continue to speculate on the future value of cryptocurrency, but there is limited history on which to base those predictions. Everyone is learning together and trying to keep up with the new risks and added regulation along the way. It’s an exciting time for cryptocurrency as it continues to expand and develop each day.