Family offices will need to update their thinking – and their technological capabilities – just as rapidly as they are changing their asset allocation strategies amid a digital assets boom. Here, we dig deep into this trend with a UHNW expert.

Moves by family offices to increase exposure to digital assets have important implications across tax, regulation and technology. Here, Marc L. Rinaldi, Partner at family office consultancy and tech advisory PKF O’Connor Davies, shares his views on the fast-changing landscape of digital assets and their impact on the family office sector. This piece forms part of this publication's new report "Technology Traps Wealth Managers Must Avoid 2022," published in partnership with EY, which is available for complimentary download now.

Top concerns for family offices on digital assets     
Often the first question clients ask is, “How will my use of digital assets impact my operating businesses and direct investment?” The second is, “How do I safeguard and invest in digital assets and decentralized finance and report on them when they are moving at breakneck speed?”

Family offices are also weighing future regulation and how likely the US government is to create a US dollar-based coin.

Understanding digital assets that include cryptocurrencies, stable coins, tokenization, and decentralized finance requires an understanding of how these products and services are changing the fundamentals of finance from investing and transacting to raising capital. 

Family office transformation      
Willingness to participate in this new economy is part of a broader digital transformation for family offices, whether they are introducing new digital business processes or finding new ways to manage investments and client interactions or exposing their portfolios to new asset classes. It is important, therefore, to grasp the main types of digital assets in circulation and their ownership responsibilities.  

Rinaldi believes family offices are at the start of a long period of adaptation into a different financial world. Right now, the broader economy is in the phase of establishing an alternative market to fiat currencies. Governments can’t stop printing money, so people are saying they are not going to rely on that source of historic value. The problem is that the alternative has been made into a supply and demand driven commodity.

Bitcoin may be displacing gold in the minds of some investors, who feel monetary policy has left fiat currencies debased, but bitcoin still sits in the speculative currency camp.

Wide-ranging disruption      
Rinaldi says clients are increasingly “dabbling” in trading cryptocurrencies and starting to invest in decentralized finance concepts or strategies. They are now starting to understand that software applications using blockchain technology, such as Ethereum, can help them create better supply change management or be put to other financial or commercial uses. Logistics, document management, accounting and record-keeping are other sectors that cryptocurrencies are being used.   

“When the ability to transact or function between the financial world and the document world is available and when those pieces can be connected, efficiencies are created, disruption happens and money can be made by creating a more cost-effective or better product,” he said.
 
A recent survey from Goldman Sachs suggests that at least 15 per cent of family offices worldwide are exposed to crypto and around half are interested in some near-term exposure. More families in recent times have also been using cryptocurrencies as a hedge against rising inflation.

The ultra-wealthy are also turning to stable coins as an alternative to fiat currencies when as foreign citizens they expect devaluation of their own currencies. Stable coins are virtual coins pegged to the US dollar, euro, yen, gold or other stable denominations backed by reserves. 

“Right now, from a tax perspective, digital assets are considered an intangible asset, which brings up all types of accounting issues,” Rinaldi says. “Every day, I get inquiries about digital assets whether concerning trading, investing, commercial integration or arbitrage,” he adds.

The building blocks     
The backbone of this flood of interest is decentralized finance, or DeFi, that is increasingly residing on a new crop of crypto blockchain technologies such as Ethereum, Solana and Cardano, to name a few.

These sophisticated protocols are creating their own “decentralized exchanges” that can accommodate all manner of financial transactions and functions normally performed by banks. 

Blockchain proponents see these platforms managing everything from retirement portfolios to insurance policies, delivered at a lower cost, with far lower exposure to fraud.

Tokenization: tax approach       
Rinaldi likens the tax implications of “minting” digital assets into tokenized ownership, that has lit up the art world, to owning IP, where the IP needs to be reviewed from an impairment perspective. He uses the analogy of a couple running an art business to demonstrate.

After using an NFT exchange to post and sell tokenized NFTs of their work and receiving payment in Ethereum, Rinaldi says the tax question became, at what price did they own the Ethereum?

“In their case, the currency price was $4,800. With Ethereum trading well below that today, they have lost more than 20 per cent of the value of what they received,” he explained. The advice was, think about selling the currency because you are going to have to pay tax on the whole amount.

“It was a practical piece of advice that you would not intuitively think about,” he said.

New investment considerations   
Opportunities have also arisen to trade crypto securities on a peer-to-peer basis rather than through exchanges such as Coinbase, Kraken or Binance. “There are still centralized crypto exchanges because of the need for coin custody,” Rinaldi points out. However, he suggests “DeFi will work around this and still allow excellent coin custody as a separate function.”

Another lure for those becoming comfortable in the digital space is gaining founder level access to Initial Coin Offerings (ICOs). These virtual offerings grant investors a stake in companies issuing new cryptocurrencies and the prospect of matching other lucrative coin offerings such as Ripple or Tether. “This is where families can really come into their own and where DeFi represents venture capital at its best,” Rinaldi suggested. “As most crypto companies are registered LLCs or C corps, a family would invest in these vehicles just as they would a normal private securities investment.”

Regulation of digital assets    
US regulation of cryptocurrencies is well underway for family offices dipping their toes in or looking to increase exposure. The market sense is that the SEC is trying to put these new digital asset classes into existing boxes, such as IPO issuances, private placements, brokers/dealers, investment managers, banks and lenders,” Rinaldi said of current Fed thinking, and their desire to put a lid on the exuberance and stay in control. 

More concerning for family offices deepening allocations is whether lawmakers will regulate the bigger family offices in the wake of the Archegos fallout. Rinaldi believes they will.

Is a US dollar coin on Its way?     
Developing a digital equivalent of the US dollar should allow the Federal Reserve to replace physical currency and improve the transparency and control of central accounting, and potentially introduce taxation at source, with implications for everyone.

The upside for investors is that fungibility and liquidity alongside fractionalized ownership should improve their ability to exchange assets and make them more liquid and available. 

"Equally, family offices, known for their patient capitalism, should have a smoother ride holding valuable illiquid assets on longer time horizons. Direct investment holdings are also on course to be digitized and therefore easier to exchange,” Rinaldi said.

Valuation and reporting of digital assets     
Investors can still apply classic valuation techniques to determine the value of digital assets, Rinaldi points out. Market supply and demand dynamics still largely determine the price of bitcoin and other cryptocurrencies, for example, and scarcity, value and global macroeconomics will continue to play their part.

The Takeaway  
The overall message for the family office is that while digital assets do present compelling use cases, investors will have to update their thinking – and technological capabilities – just as rapidly as they are changing their asset allocation strategies. 

About PKF O’Connor Davies Family Office     
PKF O’Connor Davies Family Office, a division of PKF O’Connor Davies LLP (PKFOD), has one of the most unique offerings in the industry, specifically meeting the needs of Ultra High Net Worth families and family offices.  We are recognized as a modern multi-family office alternative to the traditional MFO models and our innovative, multi-disciplinary team approach leverages the full resources of PKFOD and PKF International, delivering integrated, objective, conflict-free advice and the broadest set of services.

For any questions, please contact Marc Rinaldi, CPA, Partner at mrinaldi@pkfod.com.