Investment in Bitcoin and other cryptocurrencies has exploded in the past few years so it’s no surprise that there is increasing interest in funds that trade in Bitcoin and newly launched Bitcoin futures contracts. However, these products have yet to enter the financial mainstream. Bitcoin’s well-known volatility and other factors have caused regulators and key market participants to maintain a cautious stance on cryptocurrency funds.
1. Performance Is Unpredictable
In 2017, Bitcoin started the year with a price of around $1,000, climbing to almost $20,000 by mid-December. According to Hedge Fund Research (HFR), hedge funds investing in cryptocurrencies finished 2017 with average returns around 3,000%.
So far, 2018 has been a different story. Bitcoin’s price has slumped to a little over $6,000 (as of this writing), and cryptocurrency hedge funds are struggling. For example, the Eurekahedge Crypto-Currency Hedge Fund Index was down 54.5% for the year as of September 30, 2018.
In early December 2017, both the Chicago Mercantile Exchange (CME) and CBOE Futures Exchange (CFE) introduced Bitcoin futures products. Recognizing the volatile nature of Bitcoin futures trading, the exchanges established extremely high initial margin rates and strict price fluctuation limits.
2. Hedge Funds Are Hesitant In Bitcoin Futures
A January 2018 international survey of commodity trading advisors (CTAs) by research firm BarclayHedge revealed lukewarm enthusiasm for Bitcoin futures contracts. Approximately 73% of CTAs — also known as Managed Futures Funds — didn’t “consider Bitcoin futures to be a valuable/useful addition to a diversified futures portfolio.” More than 80% said they had no plans to trade these contracts within the next six months.
The respondents cited several reasons for their reluctance, including high margins (30%), the newness of the futures market (31%), and the volatility of cryptocurrency (35%). Approximately one-third of respondents agreed with the statement that: “Cryptocurrencies are a bad idea and should not be encouraged.” Nevertheless, a significant portion of the respondents (more than 30%) believed that cryptocurrency futures contracts ultimately will be high volume and very successful.
Nine months later, Bitcoin futures have fallen far short of expectations. According to an October 24, 2018 article in Bloomberg Businessweek, the CME and CBOE, combined, traded only 9,000 contracts per day in 2018’s third quarter. That doesn’t necessarily mean Bitcoin futures are a failure. Average daily trading volume has been growing and, the authors note, their performance is in line with other successful products that took some time to get off the ground. The authors also observe that Bitcoin futures are quite expensive compared to other types of futures, requiring customers to post margin in excess of 40% of a trade’s value.
3. SEC Has Questions
The U.S. Securities and Exchange Commission (SEC) has also expressed concern about the many investor protection issues raised by cryptocurrency-related holdings. On January 18, 2018, the SEC released a staff letter to two trade groups representing fund managers interested in launching Bitcoin-based mutual funds and exchange-traded funds (ETFs). While the Commission acknowledged the many potential benefits of cryptocurrencies and related products, it also found “significant outstanding questions” about how funds holding substantial amounts of these products would satisfy the requirements of the Investment Company Act of 1940.
The letter poses dozens of questions, including:
- How would funds develop and implement policies and procedures to value, and in many cases “fair value,” cryptocurrency-related products?
- What steps would funds investing in cryptocurrencies or cryptocurrency-related products take to assure that they would have sufficiently liquid assets to meet redemptions daily?
- If a fund may take delivery of cryptocurrencies in settlement, what plans would it have in place to provide for the custody of the cryptocurrency?
According to the SEC, such questions must be addressed “before sponsors begin offering these funds to retail investors.”
4. The IRS Is Watching
Cryptocurrency investments raise several significant tax compliance issues — and the IRS is paying attention. For federal tax purposes, the IRS views cryptocurrency as property, rather than currency. That means investors must track their cost bases in cryptocurrency assets and report capital gain or loss when they sell or exchange those assets. (Note, however, that a Bitcoin “dealer” may recognize ordinary gains and losses.)
This tax treatment can be particularly burdensome for those who use cryptocurrency to purchase goods or services. Each purchase is treated as a sale or exchange of a capital asset, which can trigger gain or loss, depending on whether the cryptocurrency has increased or decreased in value. Suppose, for example, that you buy one Bitcoin for $1,000. A year later, when the price has risen to $8,000, you use the Bitcoin to purchase a designer sofa. According to the IRS, you have a taxable gain of $7,000.
5. FBAR Poses Another Challenge
It’s also critical to consider federal reporting requirements for offshore accounts. U.S. taxpayers with a financial interest in, or signature authority over, certain foreign accounts are required to report these accounts annually by filing Financial Crimes Enforcement Network (FinCEN) Form 114 – Report of Foreign Bank and Financial Accounts (FBAR). An FBAR is necessary if the aggregate value of foreign accounts exceeds $10,000 at any time during a calendar year. The civil penalty for noncompliance is severe – up to the greater of $124,588 (adjusted for inflation) or 50% of the account balance for willful failure to file.
Unfortunately, the IRS and FinCen have provided little guidance on the treatment of cryptocurrency for FBAR purposes. To be safe, it’s a good idea for cryptocurrency investors who meet the $10,000 threshold to file FBARs, particularly if the assets are held in a digital account hosted overseas — for example, on a “digital exchange” located outside the United States. There’s little downside to filing an unnecessary FBAR, but the consequences of failing to file an FBAR when required can be disastrous.
Potential Not Yet Realized
Cryptocurrency and related products have the potential to be lucrative but in light of their risks and investor protection concerns, these products may not be ready for prime time. Of course, this may change as they become more widely accepted, markets mature, and federal regulators provide more definitive guidance.
In the meantime, if you’re contemplating an investment in cryptocurrencies and/or bitcoin futures, contact your Untracht Early advisor to discuss potential tax and foreign account reporting and record-keeping obligations.