7 minute read 8 Oct 2021
IT guy launching his first mining rig for cryptocurrency

Three key cryptocurrency trends family offices should be aware of

Authors
Alexander Hayward

EY UK&I Family Office Market Leader; Senior Manager; Private Client Tax, Ernst & Young LLP

Enhancing long-term success of family businesses. Focused on family governance, office set-up and review. Over 10 years of research-led consulting. Avid scuba diver. Trustee of a refugee charity.

David Bowen

EY UK&I Family Office Advisory Services Leader; Partner, Private Client Services, Ernst & Young LLP

Family office professional. Advises complex and wealthy families on family office design, transformation, operation and institutionalization. Keen Bristol rugby supporter and youth rugby coach.

7 minute read 8 Oct 2021
Related topics Blockchain Family enterprise

More family offices are making crypto assets part of their investment strategy. But embracing the crypto economy also brings risk.

In brief
  • Family offices must bear three trends in mind when dealing with cryptocurrency. Online as well as offline fraud can present a significant risk. 
  • Stricter Anti-Money Laundering (AML) and Know Your Client (KYC) regulations are placing increasingly heavy red tape demands on family offices.
  • Family offices can be faced with challenges, and sometimes unwelcome revelations, due to inconsistencies between tax regimes globally.

In response to a series of high-profile cases involving cryptocurrencies, many family offices and owners have taken steps to review the opportunities and risks that this potential asset class offers. This article identifies three emerging trends that family offices need to consider when reassessing the role cryptocurrencies should play in their immediate and long-term strategies. It concludes with a list of common misconceptions that family offices should be aware of.

Family offices and cryptocurrencies: A rapidly changing relationship

A number of family offices have enjoyed a profitable relationship with cryptocurrencies over many years and they are becoming increasingly popular among family office managers. A recent Goldman Sachs survey of more than 150 family offices worldwide showed that 15% of respondents have already invested in cryptocurrencies. Another 45% are interested in following the same route to – among other reasons – “hedge against higher inflation, prolonged low rates and other macroeconomic developments against a backdrop of unprecedented global monetary and fiscal stimulus.”

One reason for the growing popularity of cryptocurrencies among family offices is that they offer an alternative to their traditional way of doing business. Historically, any activities undertaken by owners, executives or operating businesses aligned with a clearly defined, interconnected and centralized financial and regulatory model. Cryptocurrencies have decentralized this established model, allowing players inside the family office to interact autonomously with the cryptocurrency ecosystem in multiple different ways without the obligation to follow traditional procedures and patterns. In short: the old rules no longer apply.

To stay in control of the changes and risks that these dynamics are driving, family offices need to be aware of three key trends.

Trend 1: Family offices are particularly vulnerable to fraudsters – online and offline

The growing number of people involved in the world’s rapidly expanding crypto economy, combined with its increasingly decentralized structure, is presenting new opportunities for online criminals – and family offices are high on their target list, as the public nature of blockchain has allowed criminals to screen for and focus attacks, based on the size of wallets.

The UK’s National Crime Agency (NCA) lists the most common forms of cybercrimes as: hacking, including social media accounts and email passwords; phishing, which involves bogus emails asking for security information and personal details; malicious software, including ransomware; and distributed denial of service attacks against websites, often accompanied by extortion threats.

A significant majority of family offices surveyed by EY in 2021 had suffered a cyber breach as a result of these activities. It’s also alarming that an equally high number of respondents had no breach response plan in place. But more encouragingly, a growing number of family office clients are looking beyond the established priorities of structuring deals and confirming valuations. They are asking for support in reviewing the security credentials of any party involved in a deal before initiating transactions. In some cases, family offices are also seeking guidance on tracing stolen crypto assets.

As a minimum, family offices should undergo a formal risk assessment every year to assess fraud and risks, and ensure controls are in place to mitigate them. Importantly, a risk assessment should pay equal attention to online and offline fraud. This is because any gaps or weaknesses in online security infrastructures act as a gateway to traditional forms of fraud. That is because the emergence of the crypto economy has left in place the three factors that invariably lead to fraud: opportunity, motive and weak protection. The fraudsters’ tried and tested tactics of impersonation, misrepresentation and “smash and grab” are alive and well in both the online world and in the physical world.

Trend 2: Regulations governing cryptocurrencies are becoming increasingly heavy and complex 

A key reason for the rise in fraud cases is weak regulation. The use of crypto assets has flourished in the form of a weakly regulated, decentralized form of finance. The lack of regulation also allowed the number of fraud cases to rise. But this is beginning to change. Although tighter checks and balances are welcome, changes to the regulatory landscape are imposing increasingly heavy burdens. 

The requirements associated with Anti-Money Laundering (AML) and Know Your Client (KYC) regulations are placing particularly heavy procedural demands on family offices overseeing a portfolio of crypto assets, as well as the companies that hold these assets. 

Regulators are starting to ask for increasingly extensive historical records on crypto assets. There is a general assumption among asset holders that these records are either stored on blockchain or within the cryptocurrency exchanges. But this is not always the case. Sometimes the historic information is difficult to extract. In other cases, it was never stored in the first place. Overall, the level of regulatory risk continues to rise. To complicate matters, there are significant inconsistencies between advanced and less advanced jurisdictions, where rogue traders are free to operate in unregulated environments.

This is having an impact on trading platforms. Recently, for example, some trading platforms have started to ask for higher levels of KYC information disclosure before allowing customers to remove any cap on withdrawals from their accounts. 

The changing regulatory landscape is also having an impact on new relationships that family offices develop with advisors and banks. Family offices trying to open new accounts are advised to develop KYC packs that cover areas such as transaction histories, proof of ownership of their crypto assets, and a review of previous ownership of these assets. 

Trend 3: Each jurisdiction’s approach to taxing crypto assets can often conflict and overlap 

Conflicts and overlaps between the tax regimes in different countries can present family offices with challenges – and, sometimes, unpleasant surprises. They should pay particular attention to detail in the following areas:

The situs of the asset

The wallet used to hold the crypto assets, the exchange, the servers and the Ultimate Beneficial Owner (UBO) can be located in different places. In the UK, if the token represents an underlying asset, the crypto asset – in other words, the token – will be located where that underlying asset is located. But be aware that if there is no underlying asset, the situs of the crypto asset will follow the tax residency of the beneficial owner. There is no common agreement on the taxation of crypto assets, so conflicting jurisdictions may stake a claim to take precedent.

Record-keeping

The blockchain technology that underpins crypto assets has led some family offices to believe that record-keeping is automatic. However, experience shows that this is not always the case. Exchanges do not retain the records required, nor do they always provide a comprehensive view on the following points: 

Activity that generated the asset 
  • Mining – competitive activity to settle a transaction on a blockchain
  • Staking – buying tokens to become an active validator part of the network 
  • Airdrops – free distribution of crypto to select wallets 
  • Forking – a change in protocol in the blockchain
Type of coin
  • Exchange tokens – grant unit or means of payment for goods or services
  • Utility tokens – grant access to goods and services 
  • Security tokens – grant an interest or right in a business
  • Stablecoins – grant value pegged to an underlying asset (e.g., US dollars, gold and oil)

Losses and theft 

Family offices should consider three factors governing the taxation of lost or stolen crypto assets in the UK.

Firstly, Her Majesty’s Revenue & Customs (HMRC) does not consider theft to be a disposal because the original owner still owns the stolen asset and has a right to recover it. This means victims of theft cannot claim a loss for capital gains tax.

Secondly, individuals who enter a contract to acquire tokens but do not receive them may not be able to claim a capital loss.

Thirdly, individuals who contract to acquire tokens and actually receive them may be able to make a negligible value claim to HMRC if those tokens become worthless. If the tokens are worthless when acquired, then a negligible value claim won’t be allowed. This will not affect the ability of the individual to dispose of the tokens by other means to crystallize the capital loss.

Finally: Five common misconceptions family offices should be aware of

Family offices need to pay attention to the following misconceptions:

  1. Crypto asset-to-crypto asset transactions are not taxable. Crypto assets are only taxable when they have been cashed out. 
  2. Crypto asset thefts are treated as losses.
  3. The term “blockchain” implies a level of security that is not always as robust as might be assumed.
  4. All crypto assets should be treated the same way as bitcoin.
  5. Records of all transactions are kept online and will be easily accessible. 

Summary

In one respect, at least, the brave new world of crypto assets is no different to the traditional world of investing: the higher the potential returns, the higher the possible risks. While the crypto economy has proved fertile ground for some, this article identifies three emerging risk areas and several misconceptions that all family offices should take into account.

About this article

Authors
Alexander Hayward

EY UK&I Family Office Market Leader; Senior Manager; Private Client Tax, Ernst & Young LLP

Enhancing long-term success of family businesses. Focused on family governance, office set-up and review. Over 10 years of research-led consulting. Avid scuba diver. Trustee of a refugee charity.

David Bowen

EY UK&I Family Office Advisory Services Leader; Partner, Private Client Services, Ernst & Young LLP

Family office professional. Advises complex and wealthy families on family office design, transformation, operation and institutionalization. Keen Bristol rugby supporter and youth rugby coach.

Related topics Blockchain Family enterprise