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Financial Institutions—Crossing the Crypto Accounting Chasm

Dec. 3, 2021, 8:00 AM

The U.S. Securities and Exchange Commission’s approval of the first U.S. Bitcoin futures exchange-traded fund (ETF) marks a monumental shift in institutional and regulatory attitudes towards crypto.

In just two days, ProShares’ Bitcoin ETF topped $1 billion in assets. Approximately 10% of all Bitcoin ($125 billion) is now held in corporate treasuries, and 52% of institutional investors already report having exposure to crypto, according to a Fidelity survey

The debate about whether institutions are going to adopt crypto is over. The industry has crossed over from the early adopters to the early majority.

However, with various types of institutions adopting crypto there remain significant challenges around the regulatory and technical infrastructure required to meet the growing pressure from regulators and tax authorities. In other words, an accounting chasm remains between the technical capabilities of institutional adopters and the blockchain world with which they are increasingly engaging.

Where Are We in the Institutional Adoption Curve?

Geoffrey Moore’s technology adoption lifecycle serves as a useful model for charting the adoption of crypto. For those unfamiliar with the model, it is based on the classic bell curve distribution. It helps us visualize the adoption of new technologies over time: starting with a small handful of early adopters, moving through the massive mid-market, to eventually finding their way into the hands of even the most change-resistant consumers.

Regulation will play a fundamental role in the rate of institutional adoption. Larger, more regulated entities have more onerous compliance and regulatory monitoring, reporting, and oversight. This is why we saw strong early adoption by smaller funds and family offices. They are keen to take advantage of the exceptional investment returns and are also able to do so from a regulatory and compliance perspective.

Why Are Institutions and Corporates Adopting Crypto?

Broadly speaking, there are two primary use cases for institutions and corporates holding crypto: investment and wealth preservation, and payments and operations.

On the investment side, native crypto hedge funds and venture capital funds have the highest adoption levels, followed by traditional hedge funds, family offices, corporate treasuries, and finally pension and endowment funds, according to the Fidelity report. U.S. institutional adoption is behind Asia-Pacific and Europe, but the recent approval of ETFs should see take-up among U.S. firms grow rapidly.

On the payments and operations side, businesses such as Starbucks and Microsoft are now taking payments in crypto. Crypto-native businesses such as Binance are also choosing to pay their employees in crypto. And most substantially, El Salvador made Bitcoin legal tender.

This adoption is made possible by an ecosystem of businesses providing payments and custody infrastructure, such as Request Network, Bakkt, and Fireblocks.

Top Concerns for Institutions and Corporates

Despite this favorable picture and expected growth in institutional interest, challenges remain which serve as a barrier to greater adoption—in particular, around tax and accounting reporting. This is especially important given recent developments in the U.S. with the U.S. infrastructure bill, which controversially includes a provision that will place a greater tax reporting burden on institutions engaging with crypto and DeFi (decentralized finance) instruments.

Accounting and reporting infrastructure therefore is crucial for the next stage of digital adoption, as it helps market participants build trust with clients in the context of this increasing scrutiny. Accountability is essential in an industry that, to the average investor, appears shrouded in uncertainty.

Building this essential back-office infrastructure is crucial for the development of digital assets. In other words, bridging the gap between the blockchain and accounting systems by taking data from DeFi, digital asset custody records, over-the counter (OTC) crypto markets, and crypto exchanges, and turning it into auditable records for accounting, treasury, and tax filings.

Two-Fold Accounting Problem: Regulatory and Technical

The taxation of the types of crypto and gains derived will be jurisdiction-specific. What is currently also true, though, is that in many jurisdictions the tax treatment is not yet clear. This is the regulatory accounting challenge.

Regulatory

Tax authorities are now beginning to engage with the tax implications of crypto assets. Different authorities may take different approaches, and institutional stakeholders in the industry are keeping a close eye on these developments.

Financial institutions setting up new entities for their digital asset investments may consider many of the same tax issues when structuring and operating traditional hedge funds and family offices. However, there are also new forms of transactions that have no equivalent counterpart in traditional finance.

These new transaction types—including hard forks and airdrops—are specific to blockchain and programmable money. The tax characterization of these events may evolve from initial acquisition throughout the holding period until disposal.

Many crypto-friendly jurisdictions have also emerged, from both a regulatory and a tax perspective. The most recent Chinese crackdown saw a mass exodus of bitcoin mining businesses and a large move to the U.S.—now accounting for 35% of bitcoin mining computer power, or the “hash rate” (the speed at which a cryptocurrency miner operates). This goes to show that jurisdiction-based regulation will not decide whether institutions adopt crypto—it will decide where crypto businesses and institutions choose to set up their entities.

Many jurisdictions already have safe harbors in place to prevent traditional funds from paying tax in the location of the investment team, as a means of encouraging the development of their local investment management industries. A similar model could emerge for crypto-based funds and institutions.

Technical

Over the last 15 years, many finance teams and accounting firms have transferred their processes to accounting systems such as Xero, QuickBooks, and NetSuite. With a host of transactions now taking place on blockchains, institutions and corporates need to find ways to bridge the gap between their blockchain activity and their current accounting systems.

Institutions and corporates using DeFi protocols like Uniswap, SushiSwap, 0X, Compound, and Aave have the additional challenge of identifying these smart contracts and recognizing the kind of transaction happening—signing, wrapping, depositing, withdrawing, and more.

Where We Are Heading

The back-office infrastructure needed to identify and index needs to develop as the ecosystem grows, and as the scrutiny of the authorities increases.

Accountants, auditors, and fund administrators will need to educate themselves on crypto taxation and improve their technical infrastructure. If they want to service this rapidly growing market, they will need to embrace technology that bridges the accounting chasm between the blockchain and their current systems.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Antoine Scalia is CEO of Cryptio, institutional-grade accounting software.

The author may be contacted at hemant@cryptio.co; https://cryptio.co/