What is cryptocurrency?
A cryptocurrency coin is stored in a software or hardware wallet. On a basic level, inside the wallet is an address made up of 26 alphanumerical case sensitive characters. This is the address used for sending and receiving cryptocurrency – akin to a bank account from which funds are deposited and withdrawn. Along with the address is also a ‘key’ made up of several characters. This is like a PIN, albeit longer, and allows access to the funds in the wallet.
Investing in cryptocurrencies
In the light of increased adoption of cryptocurrencies by both institutional and retail investors alike, together with the move by various governments and financial watchdogs starting to introduce regulation of them , it is worth considering at this juncture how investors actually gain exposure to cryptocurrencies, or indeed purchase the asset directly.
This article will focus on bitcoin as it has the largest market capitalisation ($902 billion as of October 2021) and is arguably the most easily traded of the cryptocurrencies currently in circulation. At the time of writing, it is estimated that there are more than 12,000 different types of cryptocurrency available for investors to trade.
Bitcoin
Bitcoin is created (or mined) using a string of numbers and letters in the form of an encrypted code. The technology is known as blockchain, a type of database that structures data in ‘blocks’ which are ‘chained’ together in an irreversible timeline when implemented in a decentralized way. Each block is given an exact timestamp at the moment it is added to the chain and becomes a permanent part of the timeline once it has been filed. Bitcoin is an attractive investment to many because of its decentralised nature, i.e. the data is not stored in a single location or controlled by a single entity but rather by separate individuals across different countries and territories. If one user tampers with the any block of transactions, the other sources can cross-reference each other and pinpoint the incorrect information. Some investors also value the fact that unlike fiat currency, bitcoin has a fixed cap supply and is neither regulated by a government nor central bank, and therefore it is not subject to currency controls or inflation thus can be viewed as a hedge against Bank of England monetary policy.
Investment strategies
There are several ways to invest in bitcoin, either directly or indirectly. The most common way to buy actual coins (or fractional shares of a coin) is to purchase them on a cryptocurrency exchange such as Coinbase or Binance and hold the coins/shares in a wallet as described above. In recent years, however, it has been possible to gain exposure to bitcoin in other ways.
Investing in cryptocurrency exchanges or buying shares in large multinational companies like Tesla that hold bitcoin as part of their investment strategy (and accept them as payment for goods and services) is one obvious way to invest in bitcoin indirectly without purchasing the coins. This helps to limit exposure to any bitcoin price volatility, although it does mean that an investor will only benefit from appreciation in bitcoin value through the performance of a company’s shares on the stock market. As an alternative, investing in companies that are involved in the underlying blockchain technology could be another way of benefiting from the rise in value of bitcoin and other cryptocurrencies without being exposed to the fluctuations in price.
Perhaps of more interest to investors wishing to add bitcoin to their portfolio but without the risks of owning the asset outright is the possibility of investing in funds that invest in bitcoin, companies that are involved with bitcoin or blockchain technology, and the emergence of specific bitcoin funds. In respect of the latter, while not a new invention—Greyscale Bitcoin Trust incepted on 25th September 2013—new bitcoin (and other cryptocurrency) funds are coming to the market frequently and giving investors a greater choice. Currently, regulators in the US and the UK are reluctant to approve bitcoin exchange traded funds, citing concerns about the highly speculative nature of cryptocurrencies and instead choosing to regulate exchanges and brokers. However, this position is likely to change soon and open yet another opportunity for investors who wish to trade in bitcoin but are put off by the risks of investing directly and are looking for regulated cryptocurrency products.
Finally, a form of financial derivate known as an option is an alternative method of investing in bitcoin that does not involve directly purchasing coins and the risks posed by holding the asset. Options allow investors to take a speculative position (up or down) on the future price of bitcoin. If an investor believes that the market price will increase, they can buy a ‘call option’ and hope that the value of bitcoin rises above the ‘strike price’ at which they will make a profit. In the event that the market price falls, the investor simply allows the contract to expire and only loses the premium paid to open the trade. It should be noted, however, that in January 2021 the Financial Conduct Authority (‘FCA’) banned the sale of cryptocurrency derivatives to retail investors as it considers them too risky for consumers and have the potential to cause serious harm in the form of sudden and unexpected losses.
Governmental Perspective
On 07 September 2021, El Salvador became the first country in the world to accept Bitcoin as legal tender. The International Monetary Fund said at the time: ‘Some countries may be tempted by a shortcut: adopting crypto-assets as national currencies. Many are indeed secure, easy to access, and cheap to transact. We believe, however, in most cases risks and costs outweigh potential benefits'.
Later that same month, China issued a wholesale ban on all cryptocurrency transactions and mining. Conversely, the US Federal Reserve Chairman recently confirmed that the US government has no plans to ban the buying and selling of cryptocurrencies. With different jurisdictions adopting differing approaches to cryptocurrencies there seems is no sign of any international consensus on the future of cryptocurrencies. Given the banned sale of cryptocurrency derivative contracts by the FCA to retail investors and China’s recent ban on all cryptocurrency transactions, the regulation of digital assets will be incremental and on a country-by-country basis, with many investors left at a disadvantage due to the lack of regulation either because they are unable to trade or are trading in an unregulated asset.
Regulation
Whilst cryptocurrencies continue to grow in both numbers and acceptance, there is no clear international regulatory framework, or consensus as to how they should be treated. For example, the US Securities and Exchange Commission treats cryptocurrency as a security with cryptocurrency exchanges falling under the Bank Secrecy Act. These exchanges are required to comply with anti-money laundering and anti-terrorism legislation. In the UK, cryptocurrency is treated as property with cryptocurrency exchanges required to register with the FCA. The regulator has therefore introduced cryptocurrency specific requirements relating to Know Your Customer, anti-money laundering and combating the financing of terrorism.
What is clear is that financial regulators recognise that the trading of cryptocurrencies needs to be regulated, and with the growth and acceptance of cryptocurrencies, there is clearly a need for regulatory certainty, to not only protect both investors and their investment managers, but also provide them with a clear framework within which to trade.
Potential claims impact
As companies look to diversity their assets and seek new ways of generating investment income, more may decide to follow in the footsteps of companies like Tesla and invest in cryptocurrency.
Like any financial asset, care needs to be taken in protecting and storing the asset. If an organisation holds cryptocurrency as part of its portfolio of assets and fails to implement adequate measures to protect it, we could potentially see not only shareholder derivate claims in negligence for failing to take adequate security measures, but also in relation to the disclosures made regarding both security measures and the actual levels of investment made in cryptocurrency. This is in addition to potential cyber-related risks arising from attacks on either the organisation itself, the relevant cryptocurrency exchange, or storage providers.
Until there is regulatory certainty, investors and their advisers / managers are potentially open not only to what Sir Jon Cunliffe (Bank of England’s Deputy Governor for Financial Stability) referred to as the risks associated with the price volatility of investing in crypto, but also not knowing whether investments made in cryptocurrency will suddenly fall foul of new regulations. New regulation, depending upon its scope and nature, may either positively or negatively impact the price of cryptocurrencies, thereby not only exposing investors to price volatility, but also their managers and advisors to regulatory investigation and sanction.
Any organisation investing in cryptocurrencies should not only be mindful of potential claims by shareholders / investors in relation to the protection of their crypto investments, but more importantly for their decisions to invest in cryptocurrencies in the first place where there is no regulatory framework and such investments are vulnerable to price fluctuations. For insurers, they will be well served in being mindful of such claims emanating and to potential material impact on applicable policies within the financial lines suite, including commercial D&O and FI PI and D&O policies as well as potential ‘silent cyber’ implications on such covers. Clearly, investigations costs and defence costs exposure is of potential immediate concern but also damages/settlements will inevitably play into the adjustment process.
