Cryptocurrency is not an asset class for the faint‑hearted. In the past year, prices for some securities have fallen by more than half, several well‑known companies have gone under and the high‑profile scandal of the cryptocurrency exchange FTX is still unfolding.
The full extent of private and institutional investment losses (plus the ensuing industry ripple effect) is yet to be determined. However, the implosion of FTX will undoubtedly accelerate the introduction of digital asset regulation, which has already been mooted for some time. This is already being demonstrated in the UK, where His Majesty’s Treasury opened a consultation on 1 February 2023 titled ‘Future financial services regulatory regime for cryptoassets’.
Managed properly, regulation could buoy the confidence of new entrants to the market, particularly those who see an opportunity to buy in when the market is at a low. To that end, and with younger generations wielding increasing influence over investment direction, trustees can expect continued interest in the adoption of digital assets into portfolios.
Digital assets present particular issues for trustees: volatility, cybersecurity and the matter of how the assets are actually held. The question then arises as to how trustees are to administer this asset class while satisfying both their fiduciary duties and those imposed upon them by the relevant trust instrument when failure to do so can result in personal liability.
Get clued up
First, education is key. Trustees must have a good understanding of the digital asset ecosystem and the associated risk factors. Different types of asset will carry different degrees of risk; for instance, household name ‘coins’ might be considered lower risk than a non‑fungible token that has been hyped up via social media. If needed, one should take expert advice and document any research.
Who is in charge?
Custodianship of digital assets brings its own challenges. Setting aside the various trust structure options (such as holding the assets within an underlying company), how does one ensure ongoing safety and access?
Diligent trustees need to demonstrate consideration of the various options available. Will the assets be held directly? In a hot or cold wallet? Is that digital wallet secure? Would the engagement of a third‑party custodian mitigate that risk? If so, has consideration been given to the solvency of the relevant exchange or brokerage, how they will hold and manage the assets, and whether they are segregated? If not, the trust could find itself an unsecured creditor in the event of insolvency. Whatever is decided, clear directives will also need to be set out for passing account ownership or control and for the protection and provision of keys. Remember the saying, ‘not your keys, not
your coins’, where possession of private keys equates to control of digital assets.
Once those mechanisms are agreed upon, ongoing consideration will also need to be given to whether investment in digital assets remains in accordance with the relevant investment principles and objectives of the trust. Is there an exit strategy? Are predetermined criteria going to be set to dispose of the digital assets in order to limit potential losses?
Despite engaging with all of the above, a trustee may still find that assets have been misappropriated as relatively new technologies and the decentralised nature of digital assets create opportunities for scammers. If a trust falls victim to crypto fraud, the English and Welsh courts are, happily, at hand and have confirmed in a number of civil cases that crypto‑assets are 'property’ in the traditional sense, which means that the usual orders allowing one to trace and freeze assets are available. One can also apply for information orders that compel third parties such as exchanges to provide information and documentation that will help in identifying and pursuing wrongdoers. Despite recent hiccups, the digital economy continues to become more mainstream and, as a result, trustees are likely to have to engage with digital assets. Trustees must, therefore, be able to demonstrate that they have considered the particular risk profiles and seek professional advice at an early stage if required.
This article was previously featured in STEP Journal: The plugged-in trustee
For all questions regarding the topics raised in this article, please contact Amy Harvey or a member of our team.