Cryptocurrencies Held in Trusts

Take-Away: While a trustee’s investment in cryptocurrencies, like Bitcoins, is permissible under the Uniform Prudent Investment Rule, a trustee may want to ‘go real slow’ before holding cryptocurrencies in trust.

Background: Cryptocurrencies, like Bitcoins, is are receiving significant attention these days in the press and in Congress as part of the infrastructure legislation. For good reason. In 2020, the value of Bitcoins rose by over 300%, coming off a 92% increase in value in 2019. Bitcoins’ [which reflects roughly 50% of the outstanding cryptocurrencies- it is estimated that there are currently 8,500 cryptocurrencies!] algorithm is constructed to cap total supply at 21 million Bitcoin. Current price increases in Bitcoin reflect both a combination of increased demand for cryptocurrencies in general, and a falling supply that is available for Bitcoin. Digging a bit deeper there are some identifiable reasons for the increased demand for cryptocurrencies:

The macroeconomic reasons for owning Bitcoin intensified with the pandemic, and the ensuing concerns over future inflation caused by the enormous monetary and fiscal stimulus injected into the economy, caused many investors to view Bitcoins as an investment hedge against inflation in light of its limited supply;
The investment in cryptocurrencies is becoming in vogue with large institutional investors like Tesla and Blackrock, and some hedge fund managers all announcing that they invest in digital currency like Bitcoin, due to a more established infrastructure of the Bitcoin market with new regulatory guidance, and a growth in the derivatives market that allow for more hedging of cryptocurrency investments; and
Many traditional payment companies like Visa and MasterCard have announced plans to support cryptocurrencies, e.g. PayPal’s announced last fall that it will allow users to buy, sell and hold cryptocurrencies with the future plan to eventually permit users to pay merchants using cryptocurrencies, i.e. broader retail acceptance and use of cryptocurrencies as a form of money that impacts current demand.

In sum, there is an increased demand at a time when supply growth in cryptocurrencies is slowing. At the same time, investor-holding periods appear to be lengthening. Consequently, increased demand and falling supply supports the recent price increase of cryptocurrencies.

Bitcoin as an Investment: It would seem that a trustee’s investment in cryptocurrencies, like Bitcoin, would be permitted under the Prudent Investor Rule, despite their extreme volatility. Trustees are required to pursue an overall investment strategy that has risk and return objectives that are reasonably suited to the particular trust, taking into consideration tax consequences and the size and anticipated duration of the trust. However, each investment within that overall strategy is not viewed in isolation. Accordingly, while a Bitcoin investment might be very volatile when viewed in isolation, it is possible that it might still be an appropriate investment within the context of a much broader investment strategy engaged in by the trustee so long as the investment is designed to help achieve the trust’s overall strategic objectives.

Yet, while an investment by the trustee in cryptocurrency might not be a per se violation of the Prudent Investor Rule, there may still be some good reasons for a trustee to refrain from holding it as an investment in a trust at this time. Consider-

The volatility of investing in Bitcoin is about ten times that of investing in the S&P 500 over the past few years;
While Bitcoins might be the current dominant cryptocurrency at this time, and the longest standing, that lead-market position cannot be assumed to be perpetual, in light of over 8,500 competitors;
Competition is also coming from Stablecoins, which are digital currencies that are backed by traditional currencies, e.g. Facebook’s Libra. Central Bank currencies could reduce the demand for Bitcoin if they become wildly adopted; most Central Banks are currently exploring digital currencies, led by China;
Security issues remain a concern with the SEC rejecting all USBitcon ETF applications to date because of concerns about market manipulation and fraud, leading to the likelihood of some form of future regulation; and
Surprisingly environmental concerns could constrain wider adoption of cryptocurrencies in light of the enormous energy consumption associated with the cryptocurrency mining process. According to some estimates, the entire cryptocurrency system consumes more energy annually than the entire country of Argentina.

Cryptocurrencies Held in Trust: If a trustee is considering holding cryptocurrencies in trust, then-

The trustee must document all the facts and circumstances to support the conclusion that exposure to cryptocurrencies held in the trust is suitable to that trust and its particular objectives, thus satisfying the requirements of the Prudent Investor Rule. The strategy must be documented, and periodically revisited to confirm that holding cryptocurrency continues to be appropriate;
The trust instrument should expressly authorize the trustee to consider investing in digital assets and cryptocurrency, particularly if the settlor wants the trustee to retain a concentrated position in cryptocurrencies; an existing trust may have to be decanted or modified to authorize including cryptocurrencies as permissible investments;
If trust beneficiaries want the trustee to invest in cryptocurrencies, the trustee should ask for releases from the beneficiaries before investing in such volatile investments, and periodically confirm that such investments remain consistent with the beneficiaries wishes;
A trust may have to be formally divided into separate trusts if some beneficiaries do not want the trustee to invest in cryptocurrencies while other trust beneficiaries are willing to accept that investment risk; and
The best approach is to use a directed trust, where a trust director directs the trustee to hold cryptocurrencies, so that the trustee does not have any responsibility or liability for making that type of investment.

Conclusion: Cryptocurrency is a big business. Which is why the current infrastructure legislation before Congress contains extensive provisions that require the reporting of crypto-asset transactions by ‘brokers’ which is extremely broadly defined. In short, while it is possible for a trustee to invest in cryptocurrencies under the Prudent Investor Rule, despite the high level of volatility that goes along with that investment class great care and documentation will be required by the trustee that decides to make that investment. There are also several reasons why cryptocurrencies may not be a wise investment by a trustee at this juncture given concerns about security and the likelihood of future, unknown regulation by the SEC. Finally, if the trustee is willing to hold cryptocurrencies as part of the trust’s portfolio, it should protect itself as best it can with releases and if possible, insulate itself from liability with the use of a trust director.