Why cryptocurrency is SMSF kryptonite
We are continuing to see the relentless pursuit of a volatile, high risk, overheated investment that has no underlying assets or government regulation to support the price.
As SMSF trustees start to chase higher returns in a low-interest rate economy, interest in investing in cryptocurrencies such as Bitcoin (BTC) is on the rise.
But with the BTC bubble hotly anticipated to burst, is cryptocurrency just SMSF kryptonite in disguise?
As many SMSF trustees (and their advisers!) don’t understand the mechanics of how cryptocurrency works, why are we continuing to see the relentless pursuit of a volatile, high risk, overheated investment that has no underlying assets or government regulation to support the price?
Part of the problem is the fraudulent legitimacy of cryptocurrency enmeshed in the use of the word “currency”.
The ATO has released a guidance paper on cryptocurrency that confirms that BTC (in particular) is neither money or foreign currency. Any comparison between cryptocurrencies and the dollar, euro or pound is therefore redundant.
One of the best definitions for cryptocurrencies is they are a new asset class that enable decentralised applications. These are electronic ledgers located in a decentralised system that’s continuously updated, open to everyone who uses it and those willing to download it.
In this sense, they are crypto assets, not cryptocurrencies because they serve a new form of software that allows payments without a trusted central party or bank. The technology that underpins this new software is called the blockchain.
With the ASX recently announcing the adoption of a blockchain or distributed ledger technology to replace CHESS, it’s safe to say that decentralised applications are here to stay.
Remember, too, that anyone can create a crypto asset, and BTC is just one of 1,400 crypto assets used to transact on decentralised ledgers. Other popular ones include Ethereum, Litecoin, Dash, Monero, ZCash, Ripple and YbCoin.
Then there are the failures.
The most noted collapse is The DAO which raised over $34 million in 2016 through crowdfunding that investors initially purchased by the truckload. When hackers found and exploited a vulnerability in the technology, they siphoned off one-third of The DAO’s funds resulting in traders dumping The DAO by the truckload.
There’s no doubt that the frequency and impact of cyber security incidents will continue to increase and adversely affect crypto assets.
Sole purpose test
Given that the original purpose of crypto assets isn’t for trading, is this an appropriate investment for an SMSF and should it pass the sole purpose test?
Of course, an SMSF trustee can invest in any asset allowed under SIS Act as long as it is permitted under the investment strategy and trust deed.
But a recent study from UTS Business School tracked illegal BTC use worldwide using data from 2009 to 2017. One-third of all BTC users are using it for illegal activity, with close to half of all transactions associated with buying and selling illegal goods and services, including drugs, weapons and pirated software.
Given the nefarious nature of BTC usage and their soaring value, one could ask: is there much difference between an SMSF trustee taking money out of their fund and going to the casino or racetrack – a big SMSF no-no!
While this conservative attitude may offend true BTC believers, it’s difficult to ignore billionaire investment guru Warren Buffet who said he would never invest in BTC or any other cryptocurrency and has predicted they’ll end badly.
Where an SMSF trustee decides to invest in BTC to trade and not just to hold the asset, the main risk is when identification of the other party in the transaction results in compliance breaches:
- Is it a related party transaction?
- Can contributions be accepted?
- Has the fund lent money or provided financial assistance to a member or relative?
- Has the fund borrowed money?
- Has there been a charge given over the assets of the fund?
As crypto assets are complex, they should to be reviewed in light of the SIS Act legislation, especially when SMSF trustees are chasing easy returns without an understanding of how they work.
A ‘wallet’ is required to be set up through an online crypto exchange to start trading in BTC. Depositing funds into the wallet allows trustees to buy and sell BTC, make payments, withdraw cash from ATMs and … hedge BTC against major currencies.
When an SMSF traditionally invests in derivatives, a separate derivative risk strategy is required under r13.15(1A) to 13.15(1G) SIS because there is a charge given over fund assets.
The exemptions traditionally available to an SMSF through r13.15(1A) to 13.15(1G) only apply to approved bodies (being domestic and foreign exchanges and clearing houses) to whom SMSF trustees may grant security in respect of certain derivatives listed in Sch 4 of SISR. The list doesn’t include BTC exchanges.
If a fund trades in derivative products using BTC, the fund will be in breach of r13.14 SIS. The reason is that a charge is given over fund assets (the wallet) to undertake hedging activities or make margin deposits to the exchange in BTC to eliminate counterparty risk.
SMSF auditors and advisors need to be aware that BTC exchanges are quickly developing sophisticated unregulated financial instruments, which will result in compliance breaches for SMSFs.
Death of the BTC wallet
One of the biggest headaches will be when an SMSF trustee dies. Typically, the private key and password to access the wallet are known and stored by the user who set it up. Documenting and sharing this information is critical; otherwise, in the event of death, the BTC will be lost because the wallet can’t be accessed.
It’s difficult to think of another asset (unless it’s in a tax haven) that is not recoverable when an SMSF trustee dies. To this extent, ensuring that the BTC wallet details are documented and stored securely should be considered BTC insurance.
Where the BTC is a material asset, the fund should document the fact that precautions have been put in place to securely pass on the BTC wallet details to other trustee/s or beneficiaries in the event of death.
If no such documentation exists, the SMSF auditor may consider qualifying part A of the audit report as fund assets are at risk.
Many safeguards protect BTC wallets against hackers and scammers, such as two-factor authentication and encryption.
But even the most alert and tech-savvy SMSF trustee can be taken in by scammers who can manipulate Google Search results and direct traffic to a fake, cloned BTC exchange website.
These are known as phishing scams, where a fake website mimics a legitimate website and steals a user’s account details when they try to log in.
In October 2016, the ACCC received 245 reports of BTC-related scams with losses totalling $92,000.
While the high-risk and volatile nature of crypto assets will stop SMSF advisors universally accepting this as a new investment class, it won’t stop SMSF trustees investing in them.
The original purpose of crypto assets is to make uncensored payments, not as an investment tool. Irrational returns on BTC will result in SMSF trustees taking further positions and investing in additional crypto assets for fear of missing out.
Additionally, the speed at which new financial products are appearing on BTC exchanges is concerning (such as the ability to hedge BTC) that will result in compliance breaches for SMSFs.
Some much-needed guidance from the ATO on the risks of investing in crypto assets and whether it’s a suitable asset for SMSFs is long overdue.
The one certainty? For as long as the BTC investment frenzy overtakes a reasoned and sensible approach to maintaining an SMSF for the sole purpose of providing retirement benefits to members, crypto assets will continue to be SMSF kryptonite.
By Shelley Banton, executive general manager, technical services, ASF Audits