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2022 was a watershed year for cryptocurrencies, the burgeoning financial sector of digital currencies and associated products. And not in a good way.
For those who were late to the party, the ‘crypto crash’ of 2022 will be a painful reminder that what goes up can also come tumbling down; risk does indeed shadow returns, no matter how gravity defying those returns may appear in the moment.
It’s been a painful lesson for SMSF trustees who invested in cryptocurrencies, and a salient one for those who didn’t but may be considering dipping their toes in the crypto pool.
So what lessons can we take away from recent history? Read on to find out.
What is a cryptocurrency?
A cryptocurrency is a form of digital (or virtual) currency separate to physical (‘fiat’) currencies issued by central banks and treasuries of sovereign governments around the world.
It is digital in the sense that it is created through a computerised algorithmic process that involves the use of advance cryptographic techniques (hence ‘crypto’). Changes of ownership are recorded via chain-linked digital ‘blocks’, which once ‘written’ cannot be subsequently changed.
This ability to evidence and audit ownership changes without the need for government oversight was the impetus for the rapid growth of various cryptocurrencies, starting with Bitcoin in 2009.
Bitcoin was celebrated as a new frontier in ‘decentralised’ finance, theoretically giving users the ability to have a medium of financial exchange that was beyond the control of any government or monetary authority.
Since then, there has been a proliferation of products that collectively sit under the ‘crypto’ banner but vary widely in their risk and return characteristics.
As at March 2022, there were more than 9,000 crypto offerings, with a combined value that peaked at over US$800 billion during the year, before a prolonged correction in prices from May onward.
The cryptocurrency boom attracted investors, and speculators view crypto as an alternative asset class with potential for big capital gains, rather than as a means of exchange for products or services. For that reason, we’ll use the term ‘crypto asset’ rather than cryptocurrency from here on, as we believe it better captures the nature of these offerings today.
Types of crypto assets
As mentioned above, cryptocurrencies such as Bitcoin were the original crypto asset.
Other crypto assets that have emerged in more recent years include:
Non-fungible Tokens (NFTs)
NFTs are tokens that record ownership of a digital object on the blockchain. It might be a digital image or likeness of a real object, but the key characteristic is that each individual NFT is uniquely identifiable from every other.
NFTs are therefore considered ‘non-fungible’, as no tokens can be replaced by a similar one. Owning an NFT however does not of itself confer the holder any rights to the real object on which it may be based.
A stablecoin is a term for any crypto asset that aims to maintain a stable value relative to a reference asset, or collection of assets.
Stablecoins may try to maintain a close pricing relationship with a fiat currency (e.g. the US dollar, commodity (such as gold), or some other financial asset, such as bonds or share indices.
Various techniques are used to try and ‘peg’ the price of a stablecoin to its chosen reference asset, from backing the stablecoin 1-for-1 with a trusted, stable external asset such as US-government bonds, to using algorithms to manipulate the demand and supply of the stablecoin in question.
DeFi tokens are created through participating in various decentralised finance (hence ‘DeFi’) protocols.
These tokens are used within systems that seek to decentralise certain finance functions such as insurance, lending and exchanges, often by entities called decentralised autonomous organisations (DAOs).
DeFi is a relatively new entrant in the crypto asset world, and should be considered a ‘work in progress’ and treated accordingly.
Crypto as a store of wealth
Crypto assets have morphed from their original conception as digital alternatives to government-issued currency (such as Bitcoin) into something very different – a way of storing and increasing one’s financial wealth.
That transformation kicked off around 2017, as the price of Bitcoin exploded from around US $1,300 to hit around US $17,300 by mid-2019.
That level of price gain brought other cryptocurrency issuers onto the scene, with a resultant boom in products and prices driven by speculation.
As the recent price history of Bitcoin above attests, crypto assets should be viewed as high-risk investments.
If you (or members of your SMSF) are risk averse, crypto assets are unlikely to be a suitable investment for your fund.
That is not to say that crypto assets may not have a place in a well-diversified SMSF investment portfolio. They are best thought of as an alternative asset class with little or no correlation to traditional asset classes such as shares, property and bonds. They do however have some unique risks that you should understand (which we cover a little further on).
Can SMSFs hold crypto assets?
SMSFs are not prohibited from holding crypto assets, provided certain conditions are met.
The current view of the Australian Taxation Office (ATO) is that crypto assets are a legitimate form of investment for SMSFs provided that:
- They are allowed under the fund’s trust deed
- They comply with the fund’s investment strategy
- They comply with all relevant super legislation, just like any other SMSF investment must do. For example, SMSF crypto assets must be:
- Held in the fund’s name (not in the names of individual fund members)
- Valued according to ATO guidelines (explained later in this article)
For this reason, it is considered best practice if your SMSF’s trust deed is amended to specifically include crypto assets as a class or type of investment that might be held by the fund, together with their permissible allocations within your fund’s investment strategy.
The ATO only started including crypto assets in its SMSF statistics in 2018–19. The value of crypto assets held by SMSFs was roughly $1.5 billion in December 2022. That’s a relative drop in the ocean when considering total SMSF assets of $881 billion.
Interestingly, crypto asset holdings as a percentage of total assets is highest among SMSFs with lower balances, which indicates it may be most popular with younger members who have only recently established an SMSF.
Crypto holdings peak at 4% of assets for funds with less than $100,000 and 2.4% for funds with $100,000 to less than $200,000. Funds with between $500,000 and over $50 million have 0.3% or less in crypto.
How can my SMSF buy and sell cryptocurrencies?
To invest in crypto assets for your SMSF you will need a secure digital wallet – the online equivalent of a bank account in the crypto world. You will also most likely need the services of a crypto exchange, the crypto equivalent of an online brokerage.
There a two key types of crypto-asset wallets; hot wallets and cold wallets:
- Hot wallets are offered by most crypto asset exchanges and involve storing crypto assets in an online application. The upside is ease of setup, ease of use and access to a potentially greater range of crypto assets.
- Cold wallets hold crypto assets offline and do not rely on constant internet connectivity. Users receive a unique digital ‘key’ that allows them to access the wallet on whatever device it may be stored.
For their greater security features, cold wallets are generally considered more in line with the governance standards expected of trustees of a SMSF.
Like all SMSF investments, your SMSF crypto assets must be kept separate from your personal crypto assets.
Ideally, you should set up a single digital wallet for all your fund’s crypto-asset transactions to make record-keeping as simple and transparent as possible.
You can use the Australian dollars in your SMSF’s bank account to buy crypto assets. When you’re selling, crypto assets can be converted back to Australian dollars. It’s important to remember, though, that the proceeds of SMSF crypto-asset investments are just like any other superannuation investment. They can’t be accessed until fund members reach their preservation age.
The proceeds received from crypto-asset sales should be transferred to your SMSF’s bank account so you can declare any profit or loss you’ve made on any crypto-asset transactions as part of your fund’s annual reporting obligations to the ATO.
What are the tax implications of SMSF crypto-asset investments?
It’s a legal requirement for SMSFs to value their assets according to ATO guidelines as part of their annual reporting, and crypto assets are no different. They must be valued at their current market value as at close of trade on June 30 at the end of each financial year.
Crypto assets are also regarded as an asset for capital gains tax (CGT) purposes. If your fund makes a capital gain when selling a crypto asset, you will crystalise a CGT event and may have a resulting CGT obligation.
The CGT rate for SMSF assets that have been held for longer than 12 months is effectively 10%. This is a one-third discount on the full CGT rate of 15% for assets your fund has owned for less than 12 months.
However, if cryptocurrency assets are being used to fund the pensions of members in your SMSF, any capital gain on their sale may not be subject to CGT, where these members are 60 years of age or older.
The potential risks of SMSF crypto-asset investments
Crypto assets are not legal tender, even though they can be used to pay for goods and services if a seller is prepared to accept them. This means crypto assets do not have the backing of the Australian Government, unlike the Australian dollar, which is backed by the Reserve Bank and the Australian Government.
Investors are unlikely to receive government support if a crypto asset they hold ceases to exist for any reason.
Part of the allure of crypto assets has been the sense of freedom they once conveyed, in being financial instruments beyond the control of legislators and regulators of any country.
This deregulation zeitgeist did, however, come with a major downside; the loss of most investor protections built into modern financial systems.
So when cracks started to appear in crypto markets in 2022, starting with a South Korean-based stablecoin pair, Terra-Luna, there was nothing to prevent holders from suffering losses of up to 98% almost overnight.
Further collapses of cypto-related entities during 2022 included trading platform Voyager, Singapore-based crypto hedge fund Three Arrows Capital, crypto lender BlockFi and by far the biggest of them all, Bahama-based crypto exchange FTX. According to Reuters, FTX has about US$1 billion of client funds missing and unaccounted for.
Despite the billions in crypto-asset wealth wiped from investors since the start of last year, it is possible the space will continue to evolve.
But the lessons of 2022 should be heeded by SMSFs who either hold, or are considering holding, crypto assets. With high potential returns comes high actual risk; there is simply no such thing as high riskless returns.
For the most part, crypto assets do not generate cashflows the way ‘traditional’ assets do, such as dividends from shares and coupon payments from bonds.
Without these cashflows, the main factor driving the valuation of crypto assets will continue to be investor sentiment; in short, how much someone is willing to pay you for a crypto asset you own, based on their belief they can find someone else to sell it to at a higher price in future.
As 2022 demonstrated, sentiment can be a fickle beast.
For this reason, among others, it’s worth seeking independent financial advice with expertise in both SMSFs and crypto assets before committing your SMSF to investing in them.
The information contained in this article is general in nature. Nothing in this piece should be taken to be personal financial advice. Investing is by its very nature uncertain, and you should not consider anything contained within this piece to be a forecast of what may or may not occur in the future. Past performance is no indication of future performance.