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Research

KPMG report: ‘cryptoassets are now impossible to ignore’ but there are still challenges facing institutionalization

Quick Take

  • KPMG released a lengthy report in cooperation with Coinbase that details its view of cryptoassets
  • The Big Four firm notes that “cryptoassets are now impossible to ignore” because of their ability to reduce friction and inefficiencies
  • It lists key challenges facing institutionalization (regulatory compliance, forks, custody, accounting and tax implications)
  • Per KPMG, cryptocurrencies are not yet currencies but they can reduce friction and, by doing so, increase economic activity

KPMG says that it is focused on helping organizations build the infrastructure and capabilities required to scale crypto. The Big Four accounting firm is convinced that for cryptoassets to realize their potential, institutionalization is needed. In a recently issued report, the firm said: “We believe [institutionalization] is a necessary next step for crypto to create trust and scale.”

In the 42-page report, KPMG identifies the key challenges to the adoption of crypto in the global financial services ecosystem and introduces “KPMG’s Cryptoasset Framework” to help address them. The report was created with contribution from Coinbase plus insights and guidance from Fundstrat Global Advisors and Morgan Creek Digital.

KPMG notes that “cryptoassets are now impossible to ignore.” The firm believes that in 2017, crypto started competing against the traditional asset classes from an investment perspective. This development accelerated in 2018 as new financial vehicles entered the crypto space — security token platforms, stablecoins and more. Furthermore, KPMG pointed out that established financial services institutions are launching crypto products and services. However, it acknowledges that crypto is still dwarfed by the traditional asset markets with a size of more than $300 trillion globally. 

 

The case for crypto and institutionalization

While KPMG is convinced that there are real problems in the global financial services ecosystem that cryptoassets can address, there is still a gap between the use cases and development execution. According to the firm, there are more than 2,000 significant cryptoassets, yet many don’t actually have a functional product associated with them.

The report then lists some examples of important crypto use cases:

  • Bitcoin as a digital store of value
  • Ethereum as a means to raise funds
  • Litecoin as a P2P medium of exchange that is cheap and fast
  • Tokenization of traditional assets

Interestingly, the Big Four firm says that ”ICOs represent an important innovation, providing new pathways and more efficient flows for capital from a significantly wider group of investors.” The recurring theme of the report is that the staying power of cryptoassets will be defined by their ability to reduce friction and inefficiencies that currently exist within the global economy. Along these lines, the firm is bullish about the tokenized economy, which it says will likely be one of the more impactful innovations enabled by crypto.

One additional impediment to adoption is volatility, according to KPMG. It is widely quoted as a significant limitation although it will improve when crypto continues to mature. KPMG believes that the creation of stablecoins can also address the volatility problem (dozens of stablecoins have been introduced in 2018.)

 

 

Creating an open financial system

In this section, Coinbase explores crypto’s potential to:

  1. Bank the unbanked
  2. Help people in unstable countries hedge against devaluation of local currencies
  3. Make payments more efficient
  4. Create a global financial system with a model not controlled by any one country or company
  5. Democratize access to services

Coinbase believes crypto will mature in three stages:

  1. Investment/speculation (which the industry is currently in)
  2. Institutionalization
  3. Utility

Coinbase finds that unlike most other asset classes, crypto did not start with institutional adoption but rather with retail trading. The company notes that institutions have a different set of requirements than retail consumers and need to see a focus on compliance, transparency, and governance to comfortably use and transact with crypto.

 

Key challenges facing institutionalization

1. Compliance with regulations: Crypto businesses will need to clearly define their product offerings in order to navigate the evolving state and federal regulatory landscape.

2. Fork management and governance: Institutions can handle forks by chartering a governance committee to ensure consistency in decision making around whether to participate and where to invest to support the fork.

3. KYC and cryptoasset provenance: Fiat on ramps need to comply with existing banking regulations such as Anti Money Laundering (AML), Customer Identification (CIP), Know Your Customer (KYC), transaction monitoring, and other financial reporting requirements.

4. Secure storage and custody: Transactions are irreversible, which means that institutions must follow the best security practices to keep their cryptoassets safe. There is a dire need for qualified custodians that allows the safe storage of assets in a compliant manner.

5. Accounting and financial reporting: Neither the FASB nor the IASB have provided specific accounting guidance, which causes institutions to run into accounting issues.

6. Tax implications: Institutions need clear tax guidance. The only clear guidance from the IRS came in April 2014, which said that IRS will treat crypto as property. Every time a cryptocurrency is spent or exchanged, it is a taxable event according to the IRS.

Many key questions remain, including:

  • Are capital gains calculated by using last in, first out (LIFO) or first in, first out (FIFO)?
  • What are the tax implications of new phenomena such as forks?

 

KPMG’s Cryptoasset Framework

KPMG says that as adoption of crypto increases, organizations will need to prepare for a changed future. KPMG created a framework, which it says has already been applied successfully to several advanced crypto projects and businesses. The framework is designed to help a crypto business scale while addressing the key challenges.

 

Cryptoeconomics

To qualify as a currency in KPMG’s framework, cryptoassets must fulfill the 3 basic functions of money and function as a unit of account, store of value, and unit of exchange.

  1. Unit of account – many people believe cryptocurrencies are units of account
  2. Store of value – must be much more stable
  3. Medium of exchange – must have ubiquitous acceptance within a large enough jurisdiction

The report says that in order for cryptocurrencies to be usable currencies within the general economy, there is a chicken and egg type of problem that needs to be solved:

In order to be a medium of exchange, a crypto must be a store of value. In order to be a store of value, the speculative nature of crypto must dissipate. However, many creators of crypto seem quite happy with the steep appreciation their tokens have achieved. Until at least one crypto meets all three criteria, they cannot be considered full currencies.

While cryptocurrencies are not truly currencies today, they can reduce friction and thus increase economic activity. According to Constance Hunter, chief economist at KPMG, “some bubbles create lasting value because excess liquidity is pumped into ideas so innovative that they would not otherwise receive funding.”

Crypto designers consider three main features for tokens depending on the utility they want to achieve:

  1. Acquirability (some tokens need to be earned, and some can be both earned and bought)
  2. Transferability (sometimes it is advantageous to limit transferability outside of a closed system)
  3. Redeemability (must be decided if the crypto can be exchanged for government-issued fiat currency)

If all three features are enabled, a token is said by KPMG to be fully equipped.

The report concludes by saying that cryptoassets have the potential to increase trust via the immutability feature of the underlying blockchain technology where transaction and other records are unable to be changed. However, given the other limitations present today, this alone may not be sufficient to generate trust without also embracing institutionalization.

And so, the cryptocurrency ecosystem continues to build, while institutions continue to experiment.