Digital assets can offer diversification and improved risk-adjusted returns to investment portfolios, while increasing levels of regulation have boosted confidence.
Family offices have traditionally prioritised wealth preservation via conservative investment strategies. However, digital assets now occupy a growing proportion of a well-balanced portfolio. With the value of cryptocurrencies increasing, interest among family offices in non-fungible tokens (NFTs), tokenised real world assets, stablecoins and decentralised financial products (DeFi) also remains high.
Opportunities for financial-based digital assets
There are several reasons for this shift towards a more adventurous investment strategy. First, a younger, more tech-savvy and entrepreneurial generation have become the key decision-makers. Digital assets also offer diversification and improved risk-adjusted returns, and the innovative appeal of blockchain technology generates an attractive narrative for investors looking to build a legacy. Lastly, more regulation has increased confidence in the asset class and the recent approval of certain US-listed spot bitcoin exchange traded funds has led to huge institutional interest, bringing digital assets further into the mainstream.
As well as holding digital assets directly, many family offices are allocating a portion of their new investments to funds that invest in specific digital assets or digital asset projects. The new bitcoin spot ETFs enable family offices to hold investments which track the performance of bitcoin without taking on the custody risks attaching to holding the asset itself, and it may soon be possible to invest indirectly through ETFs in other types of digital asset too.
Some family offices are making venture-style investments themselves in businesses which are developing the infrastructure around digital assets or new decentralised protocols; for example, in digital asset service providers, including exchanges, or software companies building products and services on the blockchain. In return for its investment, an investor might receive equity, or a combination of equity and tokens related to the underlying business or a protocol being developed by the business, thus further increasing its exposure to the digital asset class.
By investing directly or indirectly in service providers and other related infrastructure, family offices can promote and advance the ecosystem, creating the potential to make substantial gains and share in the anticipated growth of the sector, while mitigating their exposure to the volatility that accompanies investment in the underlying assets themselves.
Challenges and potential solutions
There is inevitably still some scepticism about investing in a sector where there remains so much uncertainty. A family office would be well-advised to establish an internal digital asset risk committee which is responsible for evaluating, approving and implementing the family office’s digital asset investments. When engaging experts, relevant expertise, experience, reputation, integrity, robust risk management controls and operational transparency should be key considerations.
Encouragingly, it seems that regulators have generally accepted that digital assets like cryptocurrencies are here to stay and so, rather than considering whether they should be outlawed or not, they are focusing now on striking a balance between developing the industry and protecting investors. It is essential for a family office to obtain comprehensive local and holistic advice on the multijurisdictional regulatory treatment of a digital asset investment strategy and the interplay of one regime with another.
Accurately valuing digital assets can be difficult due to their volatility and the absence of standardised valuation methodologies. Family offices should establish robust valuation frameworks and ensure that they have access to up-to-date and reliable market data. Family offices should work with their accountants to establish valuation processes and methods of financial reporting that enable investors to make informed decisions.
Different jurisdictions have different ways of treating digital assets and the gains derived from them for tax purposes. A similar approach to the regulatory analysis outlined above will need to be adopted for tax, with specialist local tax advice being obtained as well as a more holistic international perspective.
Concerns around data security necessitate the implementation of strong cyber security measures to ensure that both financial assets and personal information are adequately protected. Cloud-based systems, which offer enhanced security functionality, are increasingly popular to mitigate cyber threats.
It is not advisable to hold substantial amounts of cryptocurrency on exchanges or in “hot wallets” (mobile wallets which store cryptocurrency typically on a smart phone), as these can be hacked or compromised by a virus or malware. Instead, a form of “cold storage” wallet or vault should be used, which takes the cryptocurrency holding offline, thus reducing the risk of a hack. Most family offices retain a third-party specialist crypto custodian to hold their cryptocurrency and the relevant private keys. A service provider should have in place the most robust security systems currently available, require multiple layers of authentication from various internal stakeholders to execute any trade, and have insurance which covers the loss of the asset in the event of fraud or a cyber attack.
Sentimental digital assets
In reality, issues around more sentimental types of digital assets occupy advisers the most; in particular, rights to access digitally stored photographs, videos, emails and social media accounts in the event of the holder’s death or incapacity. These assets are often password-protected. It is worth having frank discussions with the owner of these assets upfront to ascertain how they might be accessed later without assistance from the holder. A balance will need to be struck between ensuring the preservation of security and the need for fiduciaries, personal representatives and family to access these digital assets later. Asset and password registers should be provided to trusted third parties and regularly maintained.
Digital assets have passed the point where they are merely a curiosity and now form a valuable component of a well-balanced and future-proofed portfolio. It is necessary to consider them in estate or portfolio planning and administration, and to come up with legally effective, tax-efficient, secure and practical strategies to ensure they can be held, transferred and passed from generation to generation safely and seamlessly. With forward-planning, sound professional advice and the use of financial management and custodian technologies, family offices can embrace digital assets with confidence and play an important role in the development of this exciting and fast-moving new world.
James Parker, partner, Norton Rose Fulbright LLP
