The digital assets landscape and the world of cryptocurrency investments are experiencing significant growth and success thus far in 2024. Before delving into the recent achievements of the industry, it’s essential to reflect on the past few years and the specific events that brought us to this point. Veterans in the digital asset arena recall these events as if they happened yesterday, and for newcomers, it’s important to understand that one of these incidents nearly undermined years of effort and credibility, putting the entire asset class on its heels.
Back in November of 2022, the digital asset world experienced a catastrophic event that, seemingly overnight, turned the entire industry upside down. The collapse of the once-dominate cryptocurrency exchange FTX triggered a market shock with immediate ripple effects across the entire industry. The subsequent period, often referred to as the crypto winter, became an exhausting cycle of legal battles and efforts to recover lost funds for both individual and institutional investors. The FTX Debacle deepened existing trust issues surrounding cryptocurrencies, it stifled innovation, and deterred new market entrants. It felt as though the reset button had been pressed, forcing the industry to start over in its quest to regain investor confidence and rebuild credibility in the cryptocurrency and blockchain ecosystem. While many events have shaped the present landscape, it is crucial to highlight this specific incident, as this era ignited a heightened focus on increased transparency, enhanced security measures, and stronger regulatory compliance.
Fast forward to January 10, 2024: Bitcoin (BTC) [1], the largest cryptocurrency by market capitalization, reached a significant milestone by gaining approval from the US Securities and Exchange Commission (SEC) to be listed and traded as an exchange-traded product (ETP). Spot bitcoin ETPs are the first ETPs that track the price of bitcoin by holding actual bitcoin as their underlying asset. This approval marks a historic moment, as all previous attempts to launch a spot bitcoin ETP had failed due to concerns over market manipulation and investor protection. The journey to this approval has been long and arduous, significantly aided by a pivotal decision on August 29, 2023. On that date, the US Court of Appeals for the District of Columbia Circuit granted a petition for review of a previously denied ETP application, ultimately overturning the SEC’s rejection. This decision paved the way for the SEC’s eventual approval, underscoring the growing acceptance and maturation of the cryptocurrency market.
Some may be confused about the difference between an ETP and an exchange-traded fund (ETF). It’s a common question. In short, ETFs are registered as investment companies under the Investment Company Act of 1940 and are considered the most common type of ETP dealing with securities. It’s crucial to remember that bitcoin is classified by regulators as a commodity, not a security. Because of bitcoin’s commodity status, these new investment products are ETPs, not ETFs. As a result, spot bitcoin ETPs adhere to a distinct registration process under the Securities Act of 1933 and Securities Exchange Act of 1934. This distinction means the spot bitcoin ETPs are not subject to the same regulatory requirements as mutual funds or ETFs.
Since its approval, bitcoin ETPs have garnered significant attention, rapidly accumulating assets and setting records for growth. They have surged in popularity, becoming the fastest growing exchange traded product in history. On June 4, 2024, bitcoin ETPs experienced significant inflows totaling $886.6 million, marking the second highest day of inflows since March 12, 2024. Fidelity Wise Origin Bitcoin Fund (FBTC) led the way, attracting $379 million, followed by BlackRock’s iShares Bitcoin Trust (IBIT), which drew in $274 million. As of June 14, 2024, U.S. spot bitcoin ETPs collectively hold 897,144 BTC, valued at $58.86 billion; the chart below breaks down the specific fund manager standings in more detail:
Source: Bitcoin Treasuries by BitBO – https://bitcointreasuries.com/us-etfs/
When Bitcoin, the largest cryptocurrency by market capitalization, received SEC approval in January, the next question on every crypto enthusiast’s mind was whether Ethereum (ETH), the second largest cryptocurrency by market capitalization, would be next. And if so, when? The crypto community received their answer on May 23, 2024, when the SEC approved the first US Ethereum ETPs. The decision came as a surprise amidst ongoing debates between the SEC and the US Commodity Futures Trading Commission (CFTC) over the classification of Ether and regulatory jurisdiction. The SEC uses the 1946 Howey test as a legal framework to determine if transactions involving Ether constitute investment contracts, whereas the CFTC classifies Ether as a commodity. This classification is crucial as it will profoundly influence the development of the entire ecosystem. For more on how these developments are part of broader legislative changes in the cryptocurrency landscape, see our detailed analysis on the current legislative landscape for cryptocurrency here. It’s evident that this recent decision is reshaping the landscape of crypto investment, indicating growing mainstream acceptance and increased investment in digital assets. Major asset managers, including BlackRock and Fidelity, are now preparing to introduce their Ethereum ETPs, pending regulatory approval. The chart below breaks down the specific funds set to hit the markets:
Although the approval of these bitcoin and Ether crypto products occurred within months of each other, the process for fund managers to get their specific funds on exchanges has varied significantly. Specifically, the bitcoin ETPs began trading just a day after the SEC’s approval because the applications were granted simultaneously. This expedited process resulted from proactive conversations between the SEC and fund managers long before a decision was made, allowing ample time for questions and feedback on application submissions. Conversely, the Ethereum ETP applications are still being processed, with modifications being made to exclude items such as staking – (staking refers to the process of actively participating in transaction validation on a proof-of-stake (PoS) blockchain network. It involves users (often referred to as validators) locking up a certain amount of cryptocurrency as collateral to support the network’s operations. In return for locking up their coins, validators have the opportunity to earn rewards, typically in the form of additional cryptocurrency, for validating and securing transactions on the network. Staking plays a crucial role in maintaining the security and integrity of PoS blockchain networks while providing incentives for participants to support the network’s functions). The timeline for these ETPs to go live and begin trading depends on how quickly the SEC and fund managers can navigate the necessary regulatory documentation. Irrespective of timing, if you had asked most people back in 2022 whether they thought we would reach this point so soon, the answer likely would have been a resounding no.
If you’ve followed along thus far, let’s conclude by examining the tax reporting and compliance obligations linked to these new investment products. Sponsors of the bitcoin ETPs have been vocal about their desire to be treated as grantor trusts for U.S. federal income tax purposes, which would exempt them from entity-level taxation. Currently, sponsors have obtained legal opinions supporting grantor trust classification. However, these legal opinions are not binding, as sponsors have disclosed that the IRS could still determine that a publicly traded partnership classification is more appropriate. If deemed grantor trusts, taxpayers with investments should proactively understand their tax reporting obligations and be aware of the required information to properly account for these transactions at tax time.
The mechanics of a grantor trust are generally straightforward: any income and expenses accounted for at the trust level are passed through to the shareholders holding a direct interest. If trust assets are sold to cover expenses, the proceeds are allocated to the shareholders, and a gain or loss on the transaction is calculated using the basis of the assets sold (i.e., bitcoin). On the surface, this seems simple – but it’s not quite that easy. These ETPs are likely to qualify for simplified tax reporting and meet a de minimis exception regarding the filing requirements and provision of Form 1099-B to shareholders. Therefore, shareholders should expect to receive a letter containing the information required to determine their tax reporting obligations. Taxpayers will need to calculate their own gains and losses based on the details provided in the letter. Depending on the number of transactions a taxpayer has during the tax year, these calculations can be extensive.
One final thought: It’s better to be proactive than reactive. Whether you already have investments in these products or are exploring the digital asset space, consulting with your accountant sooner rather than later can help prevent surprises during tax season.
If you need further guidance or have any questions on this topic, we are here to help. Please do not hesitate to reach out to discuss your specific situation.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.
[1] “Bitcoin” with a capital “B” is the Bitcoin protocol or network. Bitcoin with a lower case “b” is the currency or unit.
