- Recent events have highlighted the good, the bad and the ugly sides of cryptocurrencies, providing a cautionary tale for company governance, compliance, and disclosure
- Actions underway in the US and other markets to increase regulatory oversight to protect investors are viewed as positive
- Investors should engage with companies to understand the risks associated with cryptocurrencies
Cryptocurrencies or decentralised digital assets are not new to the market but are becoming increasingly mainstream. Companies accepting digital assets as payment include AT&T, Microsoft, Overstock, PayPal, and T-Mobile, with many more companies considering their potential. However, a decision by the Tesla board followed by market-moving tweets by its CEO Elon Musk thrust cryptocurrencies into the spotlight and along the way exposed the good, the bad and the ugly sides of digital assets.
Cryptocurrencies are a popular investment or form of payment for consumers for many reasons: lower fees, disintermediation, revenue-earning potential, low exposure to geopolitical currency fluctuations and the ease of international transactions. Cryptocurrencies also offer anonymity and are more accessible to those who can’t obtain traditional financial services. It is a growing industry, estimated to rise to $2.2bn by 2026, from $1.6bn in 2021.
Cryptocurrencies, unlike other financial assets, operate in a comparatively lawless environment with limited protection against fraud and manipulation. Put simply, cryptocurrencies are out of the control of governments and financial institutions with no global or standardised regulations. As cryptocurrencies become ubiquitous, more government action is being taken to protect consumers.
The elements that make cryptocurrencies attractive to consumers also make them highly susceptible to illegal activities including money laundering, fraud, malicious cyberattacks, organised crime and terrorism. Without protective measures in place companies and users may be exposed to legal, ethical, social and governance risks.
Cryptocurrency got its name because it uses encryption to verify transactions, via advanced coding for storing and transmitting cryptocurrency data between wallets, and to public ledgers providing security and safety. However, law enforcement and intelligence services are concerned that encryption makes fighting crime (such as drugs, terrorism, and fraud) tougher, and are using public policies or hacking techniques to prohibit and fight it. Developing ways around encryption can weaken everyone’s online security and privacy and is a risk to human rights.
Cryptocurrencies are highly volatile and vulnerable to manipulation, a point well illustrated by Bitcoin this year. In the first quarter, Bitcoin enjoyed a rise in the dollar per coin price stimulated by an announcement by Tesla that it had purchased $1.5bn in Bitcoin, and was considering accepting the digital asset brand as a form of payment for its products in the near future. Bitcoin’s rise in value was widely documented in the media, fuelled by Elon Musk’s tweets on the topic.
By May the Tesla CEO had changed his position on Bitcoin. In response Bitcoin dropped more than $30,000, briefly wiping out more than $500bn in value and erasing all the gains made since February. The volatility cascaded to other cryptocurrencies with Ethereum falling more than 40% in value and Dogecoin losing 45%. This prompted the US Securities and Exchange Commission to issue a warning regarding the volatility and speculative nature of digital assets. To Tesla’s credit, the company disclosed the volatility of Bitcoin and hence the risks to investors from the board’s decision.
Cryptocurrencies’ lack of physical form, reliance on technology and decentralised nature make them vulnerable to cybersecurity threats. According to Tesla these risks may subject the digital assets to the threat of security breaches, cyberattacks, malicious activities, human error, computer malfunction and technology obsolescence. These risks are real. A year after Bitcoin was created, a third of its trading platforms had been hacked and since 2011 there have been over 50 documented crypto hacking events with lost funds totalling over $2bn. There is no recourse for consumers and investors if this occurs. There are also complex financial, tax and legal considerations for companies accepting digital assets.
In its latest impact report, Tesla states that its “very existence is to accelerate the world’s transition to sustainable energy”. Few were surprised that environmental concerns were at the heart of Musk’s Twitter announcement that the company would suspend the use of Bitcoin for the purchase of electric vehicles from the manufacturer.
The events brought to light some ugly data regarding the energy consumption of cryptomining (the process of validating cryptocurrency transactions in return for fresh coin). Cryptomining requires significant computing power and therefore energy. The Cambridge Bitcoin Energy Consumption index estimates that Bitcoin miners account for roughly 0.3% of total global electricity consumption. This puts Bitcoin CO2 emissions on a par with countries such as Venezuela and Austria.
Cryptominers have been known to seek the lowest-priced energy, which is seldom the cleanest. Until recently, two-thirds of Bitcoin appeared to be mined in China using data centres reliant on coal-fired power generation. Cryptomining has also been associated with refiring idle coal plants and converting coal-fired plants to gas, continuing the reliance on fossil fuels for energy needs.
There are positive signs that the industry is striving to source cheap renewable energy and become more energy efficient. Musk tweeted in June that Tesla would resume allowing Bitcoin transactions when there is confirmation of reasonable (around 50%) clean energy use by cryptominers with a positive future trend. Some cryptocurrencies claim to already use less processing power and source a greater mix of renewable energy including hydroelectricity. Disclosure on the energy mix of these so-called “green” cryptocurrencies is limited, making it challenging to verify claims.
Our engagement expectations
Mitigating the impacts and risks of cryptocurrencies is critical. Companies have a responsibility and obligation to conduct robust due diligence and risk analysis, to incorporate sound governance practices and implement internal controls when deciding to invest or accept cryptocurrencies as a form of payment. We will be engaging with companies where cryptocurrency is a material consideration to encourage better practices such as:
- Alignment with the company’s business purpose and long-term strategy, including capital allocation
- Board-level understanding of the likelihood and impact of legal, ethical and cyber risks to the company
- Management undertakes robust due diligence of the target crypto business model, governance and technical attributes including the powering technology or blockchain
- Management is actively monitoring the evolving regulatory requirements and robustness of the company’s policies, procedures, controls, and capabilities
- There is clear disclosure of the environmental and social impacts from the digital assets owned.