2021 Crypto Market Recap
The crypto market exploded in early 2021, with Bitcoin reaching an all-time high of $65k in mid-April, which was up from its $29K price at the beginning of 2021. This growth was fueled by a variety of converging factors.
Inflationary concerns have highlighted the need for solid investment options in order to store value. The general familiarity with crypto and blockchain has continued to expand and opening crypto investing accounts has become infinitely easier compared to previous years. According to a Gallup poll, 13% of U.S. investors between 18 and 49 own Bitcoin, up from 3% in 2018. Players in the space continue to grow infrastructure and energy to their teams to continue to add crypto to their balance sheets. Coinbase held its IPO on April 14, celebrities and business mogels like Elon Musk have continued to tweet about crypto, and the list of institutions that are investing into tokens/the blockchain ecosystem, including Tesla, MicroStrategy, Paypal, Square, Visa, Morgan Stanley, and many high-profile VC funds, has continued to grow.
Ethereum performed better than Bitcoin in 2021, starting the year at $731 and reaching all-time highs during November, up 532% as of November 3rd. The interest in ETH and other blockchains that support smart contracts, particularly in the DeFi, has continued to expand as these tokens continue to become a larger portion of the overall crypto market cap. With tons of future possibilities, DeFi has begun to cut out non-necessary middlemen, save time, and create more investment opportunities.
Smart contract protocols have made NFTs (non-fungible tokens) possible, and we really saw this industry boom in Q1 of 2021. Many of these NFTs were very popular at launch, and some have held popularity and others have dropped off. There is both a need and a want for these digital collectibles, especially as more people continue to spend time online and expand their digital identities. The trend of increasing money and time is only destined to grow from here. NBA Top Shot moments, CryptoPunks, digital art sold on Rarible and Open Sea, music, digital real-estate, and even tweets were sold as NFTs during 2021.
As many know, 2021 has also been flooded with both volatility and corrections. From $65k high in mid-April, Bitcoin dropped below $30k in mid-July, about a 54% decline. There were lots of factors contributing to the correction, which the crypto community is all familiar with by now. Government interest and involvement continues to be viewed as a key inhibitor to industry growth, with China again announcing it would be working to reduce bitcoin mining. While most governments are still trying to figure out how they can regulate crypto, at the same time these governments, including China, continue to work on their own central bank digital currency. According to the Atlantic Council, 81 countries, making up 90% of the world’s economy are in exploratory stages, with 5 countries in the Caribbean already launching and another 14 (including China) in pilot phases. El Salvador officially adopted bitcoin as legal tender. Mr. Musk also continued to stay busy on twitter, this time noting his concern over crypto mining energy consumption, although more than half the blockchains out there are proof of stake and don’t use energy like bitcoin mining.
Since its July low, bitcoin pricing has recovered, reaching new all-time highs in October. Reports noting large corporations like SpaceX, Facebook, the NBA, MLB, and Amazon and their continued acceptance or new work on crypto or crypto-related projects has bolstered confidence. Traditional hedge funds, wall street institutions, and some of the most prestigious venture funds are continuing to heavily invest in the space, and the first bitcoin futures ETF was approved and began trading in October, with several other crypto ETF products awaiting approval.
Taxes and Crypto
What has made cryptocurrencies so attractive is their decentralized and relatively unregulated nature. Combine that with an inherent anonymity that is nearly impossible to find elsewhere, and you have an asset that that appeals to both retail and institutional investors alike. These same features that make cryptocurrency so attractive to some are precisely what make it a challenge for regulators.
To date, we have seen very little guidance from tax regulators when it comes to cryptocurrency. The first glimmer of hope came with IRS Notice 2014–21 which addressed 16 questions and answers. While many of the items that were discussed in the notice were geared towards the casual retail investor, the most notable takeaway from this notice was that the IRS did not consider cryptocurrency to be a currency for tax purposes and instead treated it as personal property. Since 2014, the IRS has posted the original FAQs to their website and continued to update with more along the way. The latest piece of formal guidance came with Revenue Ruling 2019–24 which discussed the recognition of taxable income in the case of hard forks and airdrops.
While the guidance so far has been sparse, we have recently seen a refocus of attention from regulators around cryptocurrency. On September 13th, the House Ways and Means Committee proposed legislation that would change the way gains and losses are recognized on certain cryptocurrency transactions. In the absence of this proposed legislation, certain tax adjustments that apply to transactions involving securities do not apply to digital assets as they do not meet the definition of a security. The proposed legislation specifically targets the Wash Sale rule under Section 1091 and the Constructive Sale rule under Section 1259 to extend these sections to cover transactions involving digital assets. While this is not entirely surprising, it is certainly an unwelcomed development as investors in cryptocurrencies could benefit from tax losses at year end generated through these types of transactions.
The Biden administration recently released a report including proposed legislation which would effectively seek to classify stablecoin issuers as banks. Issuers would be required to be insured as depository institutions, they would be subject to federal oversight being required to meet certain risk management standards, and they would be required to comply with restrictions on commercial entity affiliation. While no action has yet been taken by Congress, the report indicates that certain U.S. financial oversight agencies like the SEC and the CFTC will take action to address concerns as they arise to the extent the issues fall within their respective jurisdictions even without new legislation.
As we keep up with changes from regulators, we continue to see our clients looking for reprieve wherever possible. For years, investment funds have been sensitive to Unrelated Business Taxable Income (UBTI) and Effectively Connected Income (ECI) which can be problematic for tax-exempt investors and non-US investors respectively. As we have received further guidance, it has become clear that these same issues would extend to investors in crypto funds, particularly when it comes to mining and staking activities.
Risks & Rewards
One of the unique aspects of the crypto market is that it is almost completely governed by code (smart contract). The usual characteristics of digital tokens such as their availability and transferability, are completely governed by a set of rules that have been transformed into a computer program. As such, once the transfer of digital tokens has occurred and has been processed on the blockchain, it is very difficult, if not outright impossible, to undo that transaction; such a process would require the consensus of 51% of the miners on the blockchain to revert back to a previous version of the blockchain that precedes the date of the transfer. Another option is to submit a reversal of the entry so both the original transaction and the reversal receive consensus by 51% of the miners. The parties that are part of the transaction also need to agree, which could be difficult if one of the parties does not want to reverse the transaction.
There are examples of individuals who mistakenly transferred a significant number of digital tokens to an incorrect address only to learn after the transaction was complete that the destination wallet address was mistyped, and their funds are irrevocably lost. The near immutability of the transfer of digital tokens is very attractive to malicious actors because once an unauthorized transfer of tokens is completed, the victims have very little recourse to recapture the lost tokens. Therefore, while the technology platform (blockchain) provides a secure method of conducting transactions, the actions by the parties involved can result in errors or unintended activities. It is paramount to implement effective cyber security controls associated with the processes and technology associated with digital transactions, including security for private keys and wallets used with digital tokens.