Finding Value and Managing Big Risks

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An employee selects the “Buy Bitcoin” option on a cryptocurrency automatic teller machine (ATM) … [+] during a demonstration at the Hong Kong Digital Asset Exchange Ltd. digital currency trading store. in Hong Kong, China on Thursday, June 24, 2021. Hong Kong Digital Asset Exchange is a cryptocurrency platform and is the first to combine online and physical exchange in Hong Kong. Photographer: Paul Yeung / Bloomberg

2021 Bloomberg Finance LP

By Erik Sherman

The good news for cryptocurrency is that El Salvador has decided to adopt it as legal tender and the Basel Committee on Banking Supervision has issued a proposal to allow banks to manage digital assets like Bitcoin.

The bad news for businesses? Many. When something is legal tender you must have a way to manage it, the banking proposal shows how unpredictable cryptocurrency values ​​are, a major crypto exchange is hit hard by countries that refuse to allow it to enter , and, as Tesla may well show in several days, when a company holds a crypto and the price drops, it can mean a negative balance sheet, even if the coin’s value rises again.

Cryptocurrencies are an interesting and developing intersection of finance and technology. But companies, even when exploring opportunities, must respect and manage risk. There are a lot of them going around with Bitcoin, Ethereum, and all the other coins and exchanges associated with them.

That’s the difference between fraud risk and structural risk, says Tal Lifshitz, Cryptocurrency, Digital Assets and Blockchain Group Co-Chair at Kozyak Tropin & Throckmorton. A business owner who is going to start selling crypto must obviously be fully aware of the inherent volatility and must decide whether to keep it or liquidate it immediately.

Bitcoin offers a prime example. According to data from the crypto exchange Coinbase, in 2015, Bitcoin prices were between $ 200 and $ 300 for a single coin. By April 13, 2021, it had climbed to $ 64,899. On June 22, during a sudden but brief spike, it fell below $ 30,000. On June 28 at 1:30 p.m., it’s almost $ 35,000. In the hour or the day or the week or the month to come? Who knows?

Individual investors could alternate between champagne and antacids. Societies, however, operate under rules that are not of their origin. If in El Salvador, if someone wanted to pay with Bitcoin, the company couldn’t say no. Cryptocurrency is official legal tender, which means it must be accepted.

LA LIBERTAD, EL SALVADOR – JUNE 16: A woman holds up a phone displaying a bitcoin wallet app in June … [+] December 16, 2021 in Chiltupan, El Salvador. Playa El Zonte has been named the Bitcoin Capital, around 500 families are promoting the use of cryptocurrency to help the economy of a place facing poverty issues. (Photo by Camilo Freedman / APHOTOGRAFIA / Getty Images)

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Now the company could immediately convert Bitcoin holdings into a national fiat currency, which in El Salvador’s case is the US dollar. But what if there is a sharp drop in value?

According to accounting rules, cryptocurrencies are considered intangible assets. A business records the value on its balance sheet upon acquisition. But in the event of depreciation such as a significant drop in value, the losses are entered in the balance sheet. But, as auditing, consulting and tax firm BDO International and other accounting firms have noted, these losses are currently not reversible. If the price does eventually go up, then the value is that low point, until the company sells the asset.

A company like Tesla, which acquired a significant stake in Bitcoin, could be forced to depreciate the value because it held the assets during the recent fall.

While El Salvador has welcomed the use of Bitcoin, at least other countries with a greater impact on international finance have pushed back cryptocurrency, either directly or indirectly through responses to exchanges.

Binance, the largest crypto exchange by volume, has been sidelined. Japan’s financial services agency warned the company on June 25, 2021 that it was not registered to do business in the country, as it had also done in 2018. On June 26, the Financial Conduct Authority from the United Kingdom warned the company’s subsidiary in the region. not to engage in regulated activities.

There are other exchanges, but such warnings to a large player indicate that the regulatory path is not yet easy. How to act in compliance when regulations are under development and still unknown?

You don’t, says Felix Shipkevich, a fintech and digital currencies lawyer and director of Shipkevich Attorneys at Law. Messy is a good word, but I think disorder can be a better word. It’s like trying to have 20-20 vision but weren’t there yet.

MIAMI, FLORIDA – JUNE 04: Jack Dorsey Creator, Co-Founder & President of Twitter & Co-Founder & … [+] CEO of Square on stage at the 2021 Bitcoin Convention, a cryptocurrency conference held at the Mana Convention Center in Wynwood on June 04, 2021 in Miami, Florida. (Photo by Joe Raedle / Getty Images)

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Banks, for example, would be allowed to hold cryptocurrency assets under the proposed Basel rule. But the details would make it all but difficult, with reserve requirements that would mean roughly a real dollar set aside for every dollar of Bitcoin value.

The regulation helps promote a chicken and egg problem. Until we see [major banks] allow their customers to hold cryptos, there will always be that regulatory ambiguity, says Shipkevich.

Businesses also need to know that their crypto assets are secure, which means they need to understand the digital wallets that contain them. If these crypto assets aren’t secure, if they’re in an unregulated entity, how do we know if they won’t be in their wallet someday? Thefts have occurred in cryptocurrencies on several occasions.

Beyond a basic level of security, it is necessary to understand the so-called smart contracts that can be attached to cryptocurrency transactions and to take actions based on events and conditions.

The company must ensure that the contract is public. But contracts are programs. They need to be public with the original source code, hopefully suitable for anyone to review, says James Cropcho, co-founder and CTO of Flipkick, which offers some crypto services to artists. Literally, there are smart contracts that you have no idea of ​​the code for.

When the code is there, someone has to be able to read it, which means getting help. But there is another problematic aspect, notes Cropcho. In the field of smart contracts, there is no court system and there are no courts, he says. It would take a Herculean effort to underestimate how much of a difference this turns out to be in practice. This is why auditors must play a big role, even if, frankly, the track record with this framework is far from dull.

Companies have made millions of dollars from cryptocurrencies. But some have also lost considerable sums. Any executives with their eyes on the financial prize had better look down every now and then to avoid the mud pits.

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