Commercial – Crypto & NFTs
What are the biggest investment opportunities in digital – and how can clients decide on the best entry point for them?
When investing it is important to learn about the investment. There are thousands of different types of digital currencies and assets, and each has its own characteristics. Most are not legally backed by anything at all. Therefore, clients should understand the characteristics of the digital asset being acquired. If investing as part of a corporate strategy, then prior to starting to invest a client should conduct a risk assessment of the new investment and adopt policies, procedures and internal controls to mitigate risks. This should include an analysis of the best entry and exit points for the investment.
Crypto can be a volatile market: how do you advise your clients to mitigate risk when trading in digital currencies?
Because by their nature digital currencies employ decentralised control, clients cannot yet rely on a robust regulatory scheme to impose controls on this $2 trillion+ industry. Consequently, customers must assume their own control to ensure that they are protected in conducting trading in digital currencies.
Most importantly, clients should conduct their own due diligence in engaging in this activity. What does that mean? First, ensure that the exchanges or virtual asset service providers (VASPs) with whom the client is doing business are properly licensed, if required. Although the industry itself is not regulated, much of the activity being conducted by the exchanges and VASPs may require some type of license – in particular a money service business/money transmission license. Such license is issued at a state level so the client should ensure that the counter party has the appropriate license. In addition, registration of money services businesses should also be registered with the Financial Crimes Enforcement Network (FinCEN), the U.S.’s financial crimes regulator.
Secondly, clients should try to engage in these activities through their bank or broker-dealer. Because these entities are regulated and have significant internal controls, clients can better rely upon these institutions when investing in unregulated digital assets. While the bank or broker-dealer will not engage in the activity directly, it is likely they will use vendors (exchanges and VASPs that they have vetted through their vendor selection process. It is important to note that cryptocurrency and digital assets will not be covered by government deposit or securities insurance even if purchased through a bank or broker-dealer.
Be aware of the fraud risks with digital assets, which are not limited to hacking risks. Other risks include the possibility of insiders misappropriating cryptocurrency and digital assets, especially where control of those assets, through keys or otherwise, are in control of only one or a few persons. Lastly, clients should stay alert with regulatory developments. It is anticipated that regulation will likely be implemented in the near future with respect to digital assets. New regulation can affect the viability of some digital assets.
“It is important to note that cryptocurrency and digital assets will not be covered by government deposit or securities insurance even if purchased through a bank or broker-dealer”
How is your jurisdiction managing the legal challenges of NFTs: for instance, taxation on purchases, IP, ownership and theft?
Florida has a general sales tax on purchases but has not specifically pronounced itself with respect to the sales tax applying to purchases of NFTs. The laws are broad enough, however, to apply to such purchases. Therefore, if the sales activity rises to a level of more than casual, then it is likely that such sales will generate a sales tax.
In August 2022, Florida had the first ever sale of a house as an NFT. The seller transferred the ownership to the house into a limited liability company (LLC) and then “minted” the LLC into an NFT and the property rights are to be stored on the blockchain. The house was paid for in cryptocurrency.
Florida’s CS/HB 273 comes into effect on 1st January 2023. This act creates a new definition for “virtual currency” as “a medium of exchange in electronic or digital format that is not currency.” The definition specifically excludes virtual currency that is “issued by or on behalf of a publisher and used solely within an online game, game platform, or family of games sold by the same publisher or offered on the same game platform” or “[u]sed exclusively as part of a consumer affinity or rewards program and can be applied solely as payment for purchases with the issuer or other designated merchants but cannot be converted into or redeemed for currency or another medium of exchange.” CS/HB 273 also indicates that only those persons acting as an intermediary in a “virtual currency” transaction require a money services business license in the State of Florida. Previous to the passage of this legislation, it was unclear whether a person engaging in trading of “virtual currency” for their own account would be deemed to be a money transmitter, and recent court rulings had indicated that two-party transactions would be subject to MSB registration. This legislation provides clarity on this issue.
Florida further has the Florida Fiduciary Access to Digital Assets Act, which aims to regulate the manner in which a fiduciary acting under a decedent’s will, trust or power of attorney can access digital assets. The Act allows users to indicate their intent with respect to their digital assets after incapacity or death. Such intent can be expressed in their will, trust, power of attorney or through the platforms they use directly. If a direction is not explicitly stated then a fiduciary will not have control or access to a client’s digital assets.
Top Tips
Exploring digital asset investments
- If the digital assets are part of a company’s investment portfolio:
- Learn about the digital asset – not all digital assets are the same.
- Conduct a risk assessment of the asset to be purchased – it is essential to understand the product and the risks.
- Implement internal controls to manage the risks.
- Recognise there is a need to commit to technology to support this investment and ensure that the persons managing these investments are capable. There needs to be the correct and sufficient resources.
- Manage cyber security risks, including managing custody, approval processes for transactions, and addressing other vulnerabilities that may be inherent to the specific type of asset.
- Consider using the company’s bank or licensed broker-dealer for the purchase and custody of the assets.
- Conduct due diligence on the parties involved: ensure entities have proper licenses.
- Conduct public record searches on the parties involved to confirm that there are no outstanding or historical claims that may cause concern.
- Stay alert to regulatory developments.
- Analyse the tax implications.
- Consider an incremental approach. Start on a limited basis and expand once the risks are recognised and managed: digital assets are potentially high risk, high reward.
