11 minute read
The Crypto Revolution
Th e Crypto Revolution
When they are, some key concepts and decisions become vital.
BY CAL MOSTELLA
LURED BY MULTI-MILLION-DOLLAR WINDfalls, more and more media companies are dipping their toes into the non-fungible tokens (NFTs) market. It involves a conversion of treasured content images into tokenized digital assets for auctioning on the blockchain.
Treasurers and CFOs are frantically evaluating how accepting, paying and holding cryptocurrencies can (or should) be managed for not only NFT transactions, but other forms of revenue generation as well.
The accounting, controls and risks surrounding cryptos are vastly different from the familiar fiat currencies. And there are very specific decisions that need to be made when cryptocurrency is incorporated into a company’s operations.
THE OVERALL LANDSCAPE
Before delving into those decisions and related issues, let’s step back for a big-picture perspective on cryptocurrencies. As you are probably aware, debates over the impact of crypto on the economy and society are passionate, to say the least. Governments, banks, billionaire entrepreneurs and Main Street investors have espoused a variety of opinions. Some of them are completely opposed to crypto transactions, while others hold ever-evolving views.
As of July 2021, the total market cap for all cryptocurrencies was $1.43 trillion, up 59% compared to
January but down 58% compared to its peak in May 2021. The dramatic volatility was driven by coinciding regulatory announcements: China banned banks from offering crypto services and cracked down on crypto mining operations. (Crypto mining is the process of gathering cryptocurrency as a reward for work that’s been completed.) Unfortunately, this followed news that
Tesla would no longer accept crypto due to sustainability concerns over mining processes. No wonder finance leaders are approaching crypto with such consternation and hand wringing.
One of the biggest concerns relates to compliance with anti-money laundering (AML) and know-your-customer (KYC) requirements. Cryptocurrencies have a propensity for anonymity and lack of regulation, which make them attractive for money launderers. Fortunately, governments are cracking down on crypto exchanges to curb cybercrime, and top exchanges are proactively taking various measures to ensure AML and KYC compliance.
The U.S. made cryptocurrency exchanges subject to AML and KYC requirements back in 2019, when regulators defined them as money-services businesses.
Popular exchanges Gemini and Coinbase require complete KYC procedure, submitting official documents and personally identifiable
information (PII). Coinbase goes further by incorporating biometric facial recognition and liveness detection to authenticate users.
Because of that, companies that transact with crypto currencies have wisely designed onboarding processes or engaged trusted third parties to determine the source of any crypto they receive or disburse. This helps to ensure they aren’t sanctioned or restricted. There are many crypto service providers that help ensure sales channels comply with AML and KYC requirements. Today, there are more than 11,000 different cryptocurrencies and growing. Each crypto serves a unique purpose or functionality for its underlying blockchain. Some digital currencies, like stablecoins, are tied to fiat currencies to reduce volatility and facilitate quick and cheap value transfer, while others offer incremental innovations from the original crypto currency, Bitcoin. The top Bitcoin alternative is Ether (used on the blockchain Ethereum), which is essentially a programmable cryptocurrency that enables decentralized applications and smart contracts. (See sidebar more info on smart contracts.) Still, many more cryptos are speculative or even PR stunts, chasing those massive returns.
In the end, they’re all vying to achieve mainstream adoption. It’s challenging to know which cryptocurrencies will survive long term – even Bitcoin isn’t a sure winner. In its whitepaper, ”Blockchain and the Decentralized Revolution,” J.P. Morgan predicts that the underlying blockchain technology is likely here to stay whether Bitcoin survives or not. J.P. Morgan goes further to offer this snarky assessment, “Bitcoin is to the blockchain as America Online was to the internet.”
Generally, companies accepting crypto use it in three different ways: for indirect point of sale (POS), direct acceptance or a hybrid of both.
USING INDIRECT POS
The most accessible and straightforward use case is indirect POS. Many companies use service providers like BitPay, Bakkt, Flexa, Coinbase, PayPal and Bitnet to accept crypto at the point of sale. These solutions usually offer hosted checkout, payment buttons, invoicing and other e-commerce integrations. For example, BitPay displays the invoice via QR code to the customer, who then uses a wallet app to pay the invoice at a locked-in exchange rate. Next, BitPay converts the customer’s payment into the company’s local currency, then initiates a bank settlement for the next business day. In this scenario, crypto is just another payment rail like Visa/Mastercard or American Express. It allows customers more payment options and helps the businesses cater to the much-desired, digital-savvy customer. Another bonus is that processing fees for crypto are 1-2.5% lower than traditional credit card processing. The indirect POS approach also avoids the complex accounting and tax entanglements of holding and managing cryptocurrencies.
When choosing a third party, it’s essential to perform careful due diligence to ensure a vendor’s resilience and a positive customer experience. It is also vital to understand the
THE GROWING CRYPTO RATIONALE
THE BLOCKCHAIN, WHICH CRYPTOCURRENCIES ARE BUILT UPON, HAS TREMENDOUS value. It increases trust, security, transparency and the traceability of data shared across a business network. The cost savings and efficiencies that it delivers are transforming how companies conduct business today and in the future.
For example, blockchain smart contracts are revolutionizing financial products because they run when predetermined conditions are met, automating the execution of agreements without an intermediary’s costly involvement in facilitating, verifying and enforcing the contract. Speaking of intermediaries, J.P. Morgan estimates that over $10 billion in costs can be avoided by simplifying the correspondent banking structure with blockchain technology.
As the use cases for blockchain expand, the value and efficacy of cryptocurrencies will evolve and stabilize. In a recent speech to Congress, Federal Reserve chairman Jerome Powell said, “You wouldn’t need stablecoins, you wouldn’t need cryptocurrencies if you had a digital U.S. currency. I think that’s one of the stronger arguments in its favor.” As one can imagine, a digital currency backed by the U.S. government would be a gamechanger for the blockchain. Ready or not, like it or not, blockchain and cryptocurrencies are reshaping the future of money.
When you consider the transformative power of the blockchain, the amount of cryptocurrency in circulation and the highly desired, tech-savvy customer represented, it would be unwise to dismiss a business opportunity simply because it involves accepting and managing cryptocurrencies.
A recently released whitepaper by Deloitte, “Corporates Using Crypto,” claims many clients and vendors want to engage by using crypto, which means companies need to position themselves to meet that demand.
Although this is new territory for most corporate treasuries, large corporations are stepping into it successfully. Microsoft, Whole Foods, Starbucks, Home Depot, Rakuten and Twitch have all been accepting crypto as a form of payment for some time now, according to a Yahoo! Finance article by Andrew Lisa.
transparency and accuracy of conversions and to provide adequate data for the substantial record- keeping requirements.
Unfortunately, the indirect approach doesn’t work for every use case. Many smart contracts provide for commissions on the secondary sales of digital assets. Most POS solutions don’t accommodate these transactions, which require companies to accept cryptocurrencies directly.
DIRECT ACCEPTANCE
There are several concepts to understand before diving into the many considerations surrounding the direct acceptance of cryptocurrencies. First and foremost, direct acceptance requires a digital wallet structure.
Digital wallets store the public and private keys that allow a company to send, receive and spend cryptocurrencies. When a company collects cryptocurrency revenue directly, they store its location in their digital wallet and use it to make transactions or exchange for other cryptos or fiat currencies.
These digital wallets can be a physical device, similar to a USB drive, that runs a wallet app, often referred to as a “cold wallet.” The wallet can also take the form of a program, app or online website, known as a “hot wallet.”
Cold wallets are not connected to the internet and are therefore considered more secure.
On the other hand, hot wallets are accessible online, making them more convenient but also more vulnerable to hacking. These wallets don’t store the currency but act as an interface with the blockchain. The information stored on the wallet only points to your cash’s location on the blockchain.
It is necessary to have a digital wallet to protect your company’s digital assets, but choosing the proper wallet structure is fundamental to successful cryptocurrency management.
Digital asset transfers are authorized using a private key, and managing these keys is a new and critical responsibility in blockchain environments. Most digital wallets and wallet providers are single-signature login. For corporations, these configurations put too much control in the hands of a single user and would undoubtedly cause a treasurer concern and lead to many restless nights.
Most institutional users adopt a multi-signature structure where hot wallets are used as operational accounts. Much like bank transactions that require multiple written signatures, multiple keys can help alleviate some of the control risk surrounding digital wallets. This configuration is called “multisig,” and you can choose how many keys are required to open the vault as well as the minimum number of keys needed to unlock it.
For example, you could require that two out of a possible three signatures is required, or three out of five, and so on. Although this configuration distributes the risk and decision-making for a digital vault, it also has a few drawbacks. If you lose most wallets in a multisig account and the seed phrases for these wallets, you lose access to the whole vault.
Therefore, it is essential to design some redundancy into the configuration. Some popular multisig service providers with key management services include Blockstream, Casa and Unchained Capital.
CURRENCY CONUNDRUMS
When considering the type of wallet and configuration that is best for their purposes, treasurers and CFOs must decide how they plan to manage their cryptocurrency. Does the company hold crypto on its balance sheet or trade immediately for fiat currencies? Do they use crypto for expenditures or only as a means of collection?
There are a multitude of accounting and tax considerations to weigh before making those decisions. In general, crypto is considered an intangible asset that is adjusted for value impairment, not appreciation. Essentially, that means writing down the value to its lowest point each reporting period.
Due to crypto volatility, it will probably require additional disclosures when the current market value of crypto significantly exceeds the intangible asset value on the balance sheet. To further complicate matters, for tax purposes, the use of crypto for receiving or making payments may be treated as a barter transaction triggering a gain or loss on the underlying asset used in the transaction.
Your wallet structure must allow for segregating tranches of crypto to make these calculations possible. Consult with your accounting policy team to fully understand and identify all the accounting and tax nuances so that you can design processes to support the detailed tracking required. Due to these complexities, regularly exchanging crypto for stable coins or fiat currencies is a commonly recommended strategy.
Digital currencies and the blockchain are changing the future of money and how we conduct business. As with any transformative technology and marketplace, there are significant opportunities but also many risks and challenges. Incorporating cryptocurrenies into your operation is a complex undertaking. But, with thoughtful planning and careful due diligence, it can be done.
Start with creating an implementation plan that defines your objectives and addresses the considerations for the approach (indirect, direct or a hybrid) that works best for your company. Keep in mind, you can always start with a small pilot program to test the new processes and solution providers, then expand your offerings as your operation stabilizes and gains more confidence.
Cal Mostella is vice president and treasurer at WarnerMedia. He can be reached at cal.mostella@warnermedia.com.
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