Over the past four years, Bitcoin and other cryptocurrencies have exploded in growth, acceptance and notoriety. Hedge funds and other alternative investment entities have begun launching new strategies to participate in this boom. Hedgeweek estimated that “there are now more than 800 active blockchain and crypto-asset focused funds” as of December 2020, and the market capitalization of digital assets has recently topped $2 trillion for the first time. As these assets become more widely accepted across the industry, alternative investment funds are continuing to explore how they can gain exposure to this space for their investors.
Direct vs Indirect Investing
There are two ways to gain exposure to cryptocurrencies and other digital assets: directly or indirectly. Direct investment involves owning Bitcoin, Ethereum, or other digital coins or tokens outright through a digital asset exchange or in private wallets. However, for fund managers who are hesitant about directly investing in cryptocurrencies, there are options to gain exposure to the space in a more traditional manner. Digital asset managers, such as Grayscale, provide access to a variety of digital assets in the form of single-asset investment trusts, publicly traded crypto-securities on the OTC markets, and digital asset-based mutual funds. Additionally, there are now publicly traded ETFs that provide exposure to blockchain technologies. A perhaps riskier but administratively easier way to gain exposure to the digital asset market would be investing in other private investment funds that are directly or indirectly investing in cryptocurrencies or tokens. From an audit and tax perspective, indirect investment provides multiple benefits that may outweigh the upside of owning digital assets outright.
Audit and Tax Considerations
Investment fund auditors are required to gain an understanding of and assess appropriateness of internal controls over financial reporting. If a fund directly owns digital assets or cryptocurrencies, the internal controls associated with maintaining a private wallet – buying, selling, transferring and safekeeping – can become burdensome and complicated. Maintaining a physical wallet itself involves safety protocols designed to protect and secure private keys and blockchain addresses, which are controls unique to this type of investment strategy.
Investing indirectly in digital assets shifts the burden of direct ownership to other asset managers. This can also alleviate financial and tax reporting complexities that are present with direct ownership. Fund auditors will generally need to confirm existence of assets with a third-party – typically a bank, broker or underlying investee fund manager. While this can be accomplished with direct investments, the anonymity of wallet ownership and absence of transparency around transactions can pose roadblocks to obtaining objective, third-party audit evidence.
From a tax perspective, indirectly investing in digital assets can provide advantages that direct ownership cannot provide, including the ability to accurately track gains and losses for tax reporting. Depending on the type of indirect investment, investors should receive traditional tax documents, such as 1099s or K-1s, which will accommodate tax return preparation. Additionally, indirect digital asset-related securities can be more easily transferred to estate beneficiaries than actual coins or tokens and, they can even be held in certain types of self-directed retirement accounts.
Risk appetite and risk mitigation strategies are important factors in making a decision to invest in digital assets. If you are interested in investing in cryptocurrencies or planning to launch a private fund with a digital asset strategy, please give us a call. Elliott Davis have been working with alternative investment funds for over 30 years.