Crypto-investments – the alternative alternative

Published 1 Dec 2016

“…Bitcoin is the first of its kind in what is rapidly becoming a distinct asset class.”

So concluded ARK Invest and Coinbase in their comprehensive research white paper, Bitcoin: Ringing the Bell for a new Asset Class, issued earlier this year.

Whatever people say, innovation is always tricky to deal with and how and when to react to it, trickier still.  But evidence is growing of innovation having spawned an entirely new alternative asset class right before our very eyes.  Do we challenge or embrace?

The conceptual challenges of a virtual reality

In May 2008, a short paper, just 8 pages long, was published entitled Bitcoin:  A Peer-to-Peer Electronic Cash System.  The author of that paper, Satoshi Nakamoto, proposed the use of cryptographic techniques to establish and maintain a currency designed to operate entirely outside of the established financial system.  The true identity of the author (or authors) of that revolutionary paper has never been categorically established, but Bitcoin, the peer-to-peer currency, most certainly has been.  Around 16.5 million Bitcoin have now been issued, approaching 80% of the total supply possible under the governing algorithms.  With an exchange rate currently hovering around $700, the Bitcoin in circulation are capitalised at just over $10bn making it by far the most dominant cryptocurrency.

Quite apart from the technical challenges involved in understanding Bitcoin - challenges which require one to learn a whole new vocabulary of ‘mining’ and hashing’, ‘nodes and nonces’ - Bitcoin equally provokes a number of conceptual challenges.  First and foremost, ‘What exactly is it?’

It would seem that nobody is absolutely sure.

In the fiscal arena there are continuing issues surrounding classification.  In March 2014, the Internal Revenue Service (IRS) classified Bitcoin as ‘property’ for US federal tax purposes.  In September 2015, the Commodity Futures Trading Commission endorsed Bitcoin as a commodity for the purposes of the Commodity Exchange Act.  Just a month later, however, the European Court of Justice declared its hand confirming that Bitcoin exchange fell within the VAT exemption afforded to currency exchange (thereby suggesting the EU should treat Bitcoin as a currency).  In July 2016, evidence emerged suggesting that Russia was thinking along the same lines.

If tax authorities seem to be having trouble, the regulatory authorities are still chewing their pencils with a striking number of jurisdictions yet to declare their position.  

Bitcoin’s identity crisis now extends into the legal community and the courts as they also grapple with categorisation.  May 2014 saw the Dutch Courts confirming that, domestically, Bitcoin cannot be regarded as money under the Dutch Civil Code.  In the case of The State of Florida vs Espinoza, in July 2016, the Circuit Court in Florida threw out allegations that Bitcoin trading by Mr Espinoza constituted unauthorised money service business and money laundering, declaring, “Nothing in our frame of references allows us to accurately define or describe Bitcoin … Bitcoin has a long way to go before it is the equivalent of money”.  The Florida Court might have been assisted by the analysis of the UK’s Financial Markets Law Committee as, contemporaneously, they tackled the ‘Issues of Legal Uncertainty arising in the context of Virtual Currencies’, concluding that “there may be an argument for recognising the new reality of the digital world and extending the traditional legal categories so as to recognise virtual choses in possession as a new form of property”.  

And just in case there is a risk of universal consensus being reached surrounding the treatment of Bitcoin, Bitcoin is just one of a variety of unique life forms emerging from the primeval crypto-soup.  The emerging asset class, perhaps better characterised as ‘crypto-investment’, embraces not just a range of virtual currencies but also virtual value tokens, the most notable amongst which is Ether, a ‘cryptofuel’, designed as a payment system for the computational power required to run ‘smart contracts’ and with an exchange rate currently hovering around $12.

Curiouser and curiouser

By and large sophisticated investors are used to dealing with international diversity when it comes to taxation, regulation and legal treatment.  Some thrive on the resulting arbitrage.  A few even chase it.  Whilst Bitcoin’s existential predicaments might have encouraged some to steer away from cryptocurrencies as an asset class, it has certainly not deterred everyone.  Wherever there is established value and future prospect, there will also be an investment decision.

But what exactly is that future prospect?

In its VAT ruling, the European Court of Justice declared it to be “common ground that the ‘Bitcoin’ virtual currency has no other purpose than to be a means of payment”.  Whilst this may have been a convenient truth for the purposes of the VAT decision before the court, in reality – or, more accurately virtual reality – this conclusion was probably some way wide of the mark.

By dint of the blockchain technology - the ‘mini trust-engine’ under Bitcoin’s bonnet - the virtual currency is finding a wide range of uses entirely outside of pure value transactions.  The Bitcoin blockchain is a public, immutable, distributed ledger of transactions – a ‘spreadsheet’ open to examination by anyone.  Stick a little bit of Bitcoin to a physical asset and, by association, you get yourself an immutable chain of provenance - very useful for eradicating conflict diamonds from the market, providing the backbone of a property register in Honduras and even preventing data manipulation in clinical trials.

These types of innovative use cases will only further cultivate interest in Bitcoin, perhaps one day even eclipsing entirely Bitcoin’s original purpose as a transactional medium and as a store of value.  “Bitcoin’s obvious applications resemble those of fiat currencies and gold, while its potential lies outside the realm of any other asset class”, conclude ARK Invest and Coinbase in their white paper.

The crypto-investment landing site

Crypto-investments are, generally speaking, ownerless operations run on a de-centralised consensus basis unattached to any jurisdiction and with no macro-economic affiliations.  That’s all very well, but investment requires more grounded, terrestrial structures.  Where are the best landing sites for the investment proposition?

The case for Jersey is a strong one.  As a jurisdiction, it not only has a long history of innovation but an active digital initiative. Its small size, but expansive capabilities, guarantees legislative and regulatory processes that are nimble but robust.  A recent independent assessment of its AML/CFT regimes placed Jersey at the top of the class, evidence of its determination to build and retain a reputation as a top-ranking international finance centre.  Given these advantages, together with the distilled expertise, it is perhaps unsurprising that Jersey saw the establishment of the first ever regulated Bitcoin fund in 2014.

On 26 September 2016, and following last year’s Policy Statement by the Jersey Government, new Regulations came into force.  The accompanying Report confirmed the purpose of the Regulations, to create a “regulatory sandbox” for virtual currency exchange, “to allow innovation and creativity to flourish without unnecessary ‘red tape’”.

Innovation remains tricky to deal with, and how and when to react to it, trickier still.  But when it comes to alternative alternatives, the environment and the expertise are out there for those for those who care to look.

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