The realities of cryptocurrencies for charities
Hardly a day goes by without a media reference to cryptoassets, whether in relation to the recent craze for non-fungible tokens, or “nifties” as they are currently referred to, or to entrepreneurs turned multimillionaires, or billionaires virtually overnight as a result of timely investment in cryptocurrency. The charity sector is not untouched by these technological leaps (Bitcoin was only launched in 2009) and increasingly trustees are wondering whether there are opportunities their charity could or should explore, and how they might go about this.
This article looks at some of the nuts and bolts of how cryptocurrencies work and some of the risks and challenges to be considered in any appraisal of whether a charity should dip its toe into these virtual waters.
HOW CRYPTOCURRENCIES WORK. Cryptocurrencies (a form of cryptoasset) are digital representations of value (otherwise known as “Exchange Tokens”) operating on a decentralised peer-to-peer network using blockchain. They are intended to be used as a means of payment or exchange but are not issued or backed by a central authority, making them more of a speculative investment.
Public but anonymous
Blockchains are usually public - but anonymous - ledgers of every transaction that has taken place on the cryptocurrency network. Computers, known as “nodes”, collectively operate the crypto network, verifying transactions by solving mathematical equations and all agreeing on the same version of events. Once a transaction is verified by the pool of nodes, it is added to the chain as a block. This means that no central authority such as a bank or government is required to verify, edit or reverse transactions.
The nodes on the network are rewarded for their work verifying transactions through small payments of crypto from the network. This process is known as “mining”. This is the “proof-of-work” method; the nodes prove they have done the verification work adding to the blockchain and then get rewarded with tokens.
To preserve value, most networks increase the difficulty of the mathematical equations making them harder and slower to solve over time and the rewards distributed to the miners decrease.
The “difficulty” at any given time is also dependent on the active computing power of the nodes. For example, in May 2021 a large portion of miners went offline in China, meaning there were fewer nodes in the mining pool and greater rewards available for remaining miners (the difficulty level fell and so mining rewards increased.
THE ENVIRONMENTAL IMPACT OF MINING. This is a valid concern. The power consumed by Bitcoin is equivalent to that of whole countries. Whilst this aspect of engagement with cryptoassets alone may be off-putting for charities, it can also add to volatility issues. The value of Bitcoin crashed after Tesla cited fossil fuel power consumption as the reason for halting the acceptance of Bitcoin for car purchases.
In response to increasing environmental concerns, Ethereum - a popular alternative to Bitcoin - is planning to change its mining protocol from the traditional “proof-of-work”, outlined above, to “proof-of-stake”, proposed as a greener alternative to mining.
It is a consensus mechanism whereby, firstly, a node operating on the network puts up a deposit of a certain amount of Ethereum. The network then selects a handful of nodes at random to verify a transaction and add to the blockchain. If a node validates a false or fraudulent transaction, which does not match the result from the other validating nodes, they will lose their deposit. In theory, this means that the Ethereum network will not need as many nodes all operating at the same time expending large amounts of energy.
Novel green solutions
Bitcoin is unlikely to pursue the ‘proof-of-stake’ protocol but instead plans to encourage node operators, particularly major rig operators, to run their machinery on renewable energy. Novel green solutions are also emerging such as using agricultural animal waste to power crypto mining rigs. The Ukraine, which has been a popular location for crypto mining operations, has already moved towards nuclear power plants, supported and encouraged by the Ukrainian government.
The result of these changing processes remains to be seen, but unless a greener alternative can be found, charities may find it difficult to balance the potential harm in association with cryptocurrency, against the benefits they seek to deliver.
THE VIABILITY OF CRYPTOCURRENCY AS A PAYMENT MECHANISM. As a payment mechanism, the principle of using cryptocurrency is viable, as the funds can be securely exchanged from one party to another without the need for a third party. This is one aspect which, over time, may assist charities working across international borders to move money to where it is needed without the significant cost of transfer and foreign exchange charges associated with traditional money transfers.
In June this year, El Salvador became the first country in the world to officially classify Bitcoin as legal tender. The rationale for this was reported as being to facilitate easier international payments and open up financial services for the large proportion of citizens without bank accounts. Whilst the world at large is unlikely to follow El Salvador’s lead, it is a good example of the potential use of Bitcoin and other cryptocurrencies.
However, the idea of using cryptocurrency as an everyday currency is not without its issues, including well documented price fluctuations. There are also risks over issues such as taxation and anti-money laundering compliance, as the source of funds is not as transparent as with fiat currencies (government issued currencies e.g. pounds, dollars etc) which require input and verification by traditional banks.
Fluid tax treatment
In the UK, trustees should also be aware that the tax treatment of cryptoassets remains fluid, with tax policy evolving as the sector develops. HM Revenue & Customs does not consider cryptoassets to be currency or money and its treatment of cryptoassets will depend on the nature and use of the token in question. More generally, cryptocurrencies remain unregulated by existing financial services regulation, albeit certain activities may trigger registration and ongoing anti-money laundering obligations for registered cryptoasset service providers.
ACCEPTING CRYPTOCURRENCY DONATIONS. Some charities in the UK, notably the RNLI (which receives Bitcoin under a pilot scheme) and the Children’s Heart Unit Fund, have already adapted to this form of giving, affording them access to a potentially vast pool of wealth (and arguably putting them ahead of their competitors). However, this is not a step to be taken lightly and charities need to understand the risks before taking any such decision, including a decision not to accept this sort of donation.
A major difficulty when accepting cryptocurrency payments or donations relates to Know Your Client (KYC) and anti-money laundering (AML) compliance. This remains a hot topic for debate and one which has not yet been resolved. For charities this means there may be residual concerns about potential association with proceeds of crime or with morally dubious donors.
Transactions are traceable
Whilst there is an assumption that cryptocurrency is anonymous, in fact most cryptocurrency (like Bitcoin) is pseudonymous, meaning that whilst the identity of the donor may be hidden, transactions can be traced to a given wallet address.
Whilst true anonymity might be regarded as an advantage for some philanthropists (rather than relying on the charity to keep their identity secret) this can be a significant issue for the charity if it later comes to light that the donor is associated with unsavoury activity or an industry contrary to the charity’s objectives.
AML compliance can often be satisfied via online “exchanges” where a third party acts as a bridge between cryptocurrency and “fiat” currency. However, if an organisation is accepting cryptocurrency directly from one wallet to their own wallet, the source of funds cannot be properly traced. Charities wishing to accept cryptocurrency will, therefore, need to carry out enhanced donor due diligence checks and risk assessment to minimise the risks.
THE RISK OF FRAUD OR LOSING CRYPTOCURRENCIES. The receipt of, use of and/or investment in cryptocurrency present several major risks, including: volatile price fluctuations, exchange and company network hacks, market manipulation, loss of private wallet keys and lack of regulation. Given the fiduciary duties which apply to charity trustees, it is unlikely, for example, that many charities will be jumping to invest in cryptocurrencies.
As with any other high risk asset, investment should only be considered with appropriate advice, including tax advice, and subject to all the usual principles when considering investments, including diversification.
Private wallet keys
If cryptocurrency is to be held in some way, the risks can be reduced by ensuring proper storage, limiting funds held in third party online exchanges, and doing proper due diligence on exchanges used. Crucially private wallet keys (digital passwords) need to be kept completely safe. If the private key is lost there is no “phone a friend” option - access to the assets will be lost.
Commentary suggests that cryptocurrency is increasingly viewed as secure albeit there are reported examples of cryptoassets, including Bitcoin, being hacked i.e. with Bitcoin stolen by gaining access to the owners’ digital wallets. As with other assets, there is a risk of fraud or cyber-attack and the usual principles of risk management would apply. Advice will need to be taken on how best to protect the charity.
BOTH SIGNIFICANT CHALLENGES AND OPPORTUNITIES. Whilst, as above, there remain significant challenges involved in receiving or otherwise making use of cryptocurrency and associated technologies, there are also significant opportunities to be explored and a vast pool of wealth to be considered.
Trustees need to keep all the usual considerations in mind, uppermost being the duty to safeguard the assets of the charity (including reputation) and to act only in its best interests. Any decisions need to be considered carefully, and documented so that the decision making process is clear should there be a challenge further down the line.
Fear of the unknown may be holding back many in the sector given the sheer complexity and new lexicon to be learned, but cryptocurrencies are unlikely to disappear in the foreseeable future. It is therefore worth starting to assimilate the available information and formulate a policy position in line with the charity’s policies on investments, donations and financial controls.
