Understanding the crypto crash – and what comes next

Cryptocurrencies remain a serious investment vehicle – albeit with many challenges for accountants

From a geeky fad dominated by rookie investors looking to turn a fast buck to a form of investment and finance teetering on the mainstream, the rise and fall of cryptocurrencies hit the buffers once again last month following a crypto crash, which saw half a trillion dollars wiped from the total market cap overnight.

Crypto has seen huge institutional adoption over the last 12 months, which has increased signs of correlation between crypto and equities, explain Ben Lee, a Partner at PKF Francis Clark and head of Blockchain and Cryptocurrency at the firm. “Increased interest rates have caused investors to consider less risky alternative investments and uncertainty around regulation in the US and other jurisdictions is also taking effect,” Lee says.

Crypto crash: investors get the jitters

However, the volatility sweeping the market since the start of the year – fuelled by inflation, rising interest rates and the war in Ukraine – has undoubtedly left investors jittery. The market crash in May can be directly attributed to the destabilisation of TerraUSD (UST), a stablecoin (that is a digital asset designed to maintain a stable valuation).

Some stablecoins are pegged to the price of another asset, for example USDC is pegged to the US dollar, and reserves of currency are kept by projects to maintain peg. Others such as UST are algorithmic stablecoins, where the value is maintained by code. “Certain transactions led to UST losing its peg to the dollar, so the team behind UST dumped approximately $3bn from their Bitcoin reserves to defend the peg,” Lee explains.

Crypto crash: there’s a longer-term view

But, crypto has been there before and the longer-term trends tell a very different story. At the end of 2017, the bitcoin price breached $20,000 promptly followed by crypto winter, a period of low prices that lasted almost 18 months, with prices dropping to $3,236 by the end of the year.

Bitcoin’s value is currently around $30,000. Last year in May, we witnessed a similar crash with value dropping from $58,000 at the start of the month, to $35,000 by the end (it would seem May is not a good month for crypto). In May 2020 it was $10,000. In May 2019 it was $6,000.

“Whilst these fluctuations may not be attractive to some investors, Lee likens adoption of digital assets to internet adoption in the 90s, when many considered the internet to be a fad. “I don’t believe this is the end for crypto, this is still the beginning.”

Regulators: could crypto be more conventional?

Today, wrangling between regulatory bodies and crypto organisations supports the suggestion that crypto is going mainstream as regulators seek to inject some centralized order into this seemingly unruly and rebellious world.

Financial services regulator the FCA last month hosted a two-day CryptoSprint event to explore how the evolving world of cryptoassets could be regulated in the UK. AAT-qualified Joe David is a “Crypto accountant” and Founder and Managing Director of Nephos Group and MYNA, a dedicated blockchain and cryptocurrency advisory firm: “Regulation is being discussed a lot. The FCA is considering many different use cases. It is likely that stablecoins – crypto pegged to a fiat currency – will be regulated first.”

With more and more countries legalizing cryptocurrency, and even some looking to follow El Salvador’s footsteps in making crypto legal tender, the rise and rise of crypto looks set to continue; analysts predicted last year that the cryptocurrency market would triple in size by 2030 at a valuation of around $5 trillion.

HMRC shuns the currency question

In the meantime, HMRC also published a detailed Cryptoassets Manual to guide people on how to file taxes on cryptocurrency. “The taxman does not view cryptocurrency as a form of currency which broadly speaking means that the movement of digital assets falls within capital gains tax, but where businesses are dealing entirely with digital assets, or individuals are highly engaged in this space, there are thousands of transactions to consider, to which the pooling rules need to be applied,” Lee explains.

Meanwhile, the huge pace of change across the industry means that legislation and guidance is struggling to keep pace. “Often the interaction between the legislation and economic activity can create a multitude of tax points over a series of transactions that can lead to complicated dry tax charges arising,” Lee warns. 

How to account for crypto? …It depends

However, the absence of accounting standards relating to digital assets remains something of a moot point. With over 18,000 different cryptocurrencies on the market, not all are the same, Lee says. “Some may be a store of value, such as bitcoin. Some such as Ethereum are considered a utility token, and some tokens may offer security.

“As a result, digital assets could be considered to be an intangible asset, stock, or financial asset, depending on what purpose the asset serves, and how it is being used.” An understanding of the underlying asset is imperative for ensuring correct accounting treatment, Lee says.

Felix Honigwachs, CEO of cryptocurrency exchange Xchange Monster, says: “In terms of classification of cryptocurrencies in accordance with IFRS (International Financial Reporting Standards), there is no clear definition. What will become very important is the disclosure thereof within the notes of the financial statements.”

Can accounting software cope?

Keeping records of transactions is a challenge in itself as modern accounting packages are built around currencies, and do not have the capabilities to incorporate digital asset transactions.

While there are many cloud-based crypto tools to monitor blockchain activity for tax purposes, it means a separate record of digital asset movements needs to be maintained outside of usual bookkeeping software and incorporated within the books as appropriate.

Auditors may need to change

Having to refer to existing standards presents a problem, says Rick Deacon, CEO or blockchain security expert Interlock. “Traditional accounting maintains and stores records in a centralised ledger based on a double-entry accounting system, where only the accountant has access, whereas blockchain relies on a decentralised system.

Blockchain may, therefore, mean auditors have to shift from an analytical capacity to more of a programming role.”

All, in all, more work is needed (and soon)

In a recent interview, Pauline Wallace, Executive Chair of the UK Endorsement Board, said Cryptocurrencies would be an area of focus over the next few years, as the board grapples to define how they are used and therefore how to account for them. “We are not aware of that many UK companies that hold significant portfolios of crypto currencies. Nonetheless, once you start thinking about how people are using them as a means of exchange then you realise how little accounting support there is for that type of thing,” Wallace said.

While crypto assets are by their very nature volatile, Honigwachs believes current market conditions do not reflect the substance of the industry. “Overall, an opportunity exists to buy well-priced crypto assets at a larger than average discount and benefit from substantial yields when the market turns. These assets should be well researched and validated against peer review and analyst reports. As with any asset class, diversification within one’s portfolio is very important and one’s risk profile and risk tolerance evaluated.”

Hope ahead for accountants (if they stay the course)

For accountants, blockchain offers many potential benefits, not least data reliability and financial statement audits, Deacon says. “Crypto currencies could make earnings a lot simpler to track when it comes to using the public distributed ledger that underpins a cryptocurrency. Everything is visible on the ledger, but you also need to track transaction fees, plus fluctuations in the currency’s value and this often trips people up.”

The biggest potential pitfalls hinge on the complexity and rapidly changing crypto environment, David says. “It’s tough to keep up. The lack of clear guidance is a challenge for accountants who are not fully immersed in the ecosystem.” 

AAT Comment offers news and opinion on the world of business and finance from the Association of Accounting Technicians.