By Eyal Beigman,  Head of Quantitative Research, Lukka, Inc
By Eyal Beigman, Head of Quantitative Research, Lukka, Inc

Solving the Fair Value challenge for Level 1 and Level 2 Crypto Assets

One new question on the 2019 tax return has created a buzz:  “At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”  After 5 years of IRS silence on crypto issues, that’s a big question to ask from the perspective of the crypto community.

First Published: e-Forex Magazine 93 / Blockchain and CryptoCurrencies / January 2020

One new question on the 2019 tax return has created a buzz:  “At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”  After 5 years of IRS silence on crypto issues, that’s a big question to ask from the perspective of the crypto community.   It’s easy to answer yes or no, but the number of questions surrounding the answer is what gives people pause -- the most notable of which is how you calculate fair value when you give or receive virtual currency in exchange for something else.  

Putting the Spotlight on Fair Market value

The IRS’s recent guidance on virtual currency mentions fair market value (FMV) no less than 29 times, but provides little guidance outside of certain easy cases.  So, why is establishing FMV so critical? What does it mean, and what are the challenges in determining FMV in the crypto ecosystem? FMV is critical from a tax perspective because it determines the proceeds that are potentially subject to tax.  FMV also determines tax basis, which functions as a reduction in potential tax.  

To define FMV, the IRS offered the following standard in Revenue Ruling 59-60: “the prices of stocks which are traded in volume in a free and active market by informed persons best reflect the consensus of the investing public” In other words, the informed consensus of opinion of the investing public lies at the heart of the value and fairness determinations. It is fair if there is agreement on the basis on which to exchange value.

Cryptocurrencies, blockchain technology, and other developments have provided investors with unprecedented mobility of capital and expansion of global markets.  No single market is the central aggregator and disseminator of crypto pricing information, which has diluted the consensus building aspect of the market.

With a weakened consensus building mechanism, it becomes a very complex task to identify the fair market value of a crypto asset for financial and tax reporting.  The IRS guidelines for crypto assets fall short of designating the kind of markets from where prices should be sourced. In integrated markets, however, sourcing prices is less of an issue, because price differences between markets are instantaneously arbitraged. Moreover, in most asset classes a designated market exists. 

Without one, the most prominent market is used to source price information. Similarly in financial reporting, GAAP and IFRS standards assume a designated principal market from which authoritative price information could be sourced. When there is no prominent market, the most advantageous market for the reporting entity should be consulted. 

The challenges of a fragmented market

If establishing fair market value works so easily in other asset classes, why is it such a challenge in the crypto asset ecosystem? Deep fragmentation, global reach, and high mobility have created a universe where trading occurs on hundreds of active exchanges around the world, crossing national borders, geographic regions, and economic systems. 

In this universe, there are neither designations nor any clear notion of prominence or advantage. Moreover, low barriers to entry and a lack of regulation in many places may perpetuate this state well into the future. Underlying the differences in prices is genuine diversity of price and value across markets, reflecting real disparity in location and jurisdiction under which these markets operate as much as they reflect asymmetry of information, structural noise, and structural differences. These differences are real and cannot be arbitraged. 

As the level of IRS scrutiny increases, the need for greater clarity regarding Fair Market Value is dire. 

Cryptocurrencies
 

A dynamic adaptation

While building solid market consensus today is difficult, defining a reasonable notion of fair value is still achievable. The two key requirements of useful financial information, as outlined in Concepts Statement #8 and applied to fair value determination in FAS 157, are reliability and relevance. Reliability, or faithful representation, looks at the quality and verifiability of the data. The reliability requirement is satisfied by markets that operate with transparent processes and public data. Applying this standard, most exchanges with a public API would qualify.

Relevance typically relates to information that drives investment decisions, which equates to the actual attainability of a price, accessible markets and liquidity. Sourcing prices from the principal or most prominent market meets the relevance requirement for most asset classes. However, the structure, fragmentation and sheer diversity of crypto markets makes sourcing pricing from a single source and meeting the reliability requirement impossible. The Lukka approach to fair value pricing in the crypto world breaks from static designation of the principal market in favor of a dynamic one. 

Rather than seek the impossible single principal market,  Lukka uses a dynamic designation that shifts from one market to another based on the data quality, activity volume and freshness of the price information offered by the market. Thus, under the Lukka Prime methodology, we can wake up with Binance as the principal market, see it shift to Bitstamp over breakfast, move to Gemini by lunch time, over to Coinbase in the late afternoon, jump to Kraken by dinner time, and bounce back to Binance overnight. 

Seeing the bigger picture

The new IRS guidance validates the need to establish a proven methodology to determine FMV in the challenging crypto market. Yet, so much more is at stake. Crypto assets have the potential to improve our global financial system for billions of people, but without investors being able to trust that an asset’s price is fair, the crypto asset market will never reach its potential.