Risks involved in trading and custody of digital assets

1. Introduction

This Digital Asset Risk Disclosure supplements and forms part of the contractual arrangements governing the relationship between Taurus and the Client and must be read in conjunction with the general terms and conditions of Taurus (the “GTC”), the custody regulations of Taurus (the “Custody Regulations”) and any other general or special terms of Taurus, as applicable. Taurus reserves the right to adjust and amend this Digital Asset Risk Disclosure at any time and to communicate such changes to the Client in accordance with the GTC.

This Digital Asset Risk Disclosure is separate from and in addition to the disclosure of risk factors by issuers, distributors, counterparties or other persons and financial services providers involved in the issuance, distribution, trading and other transactions relating to Digital Assets, as may in particular be contained in prospectuses, key information documents, white papers, fact sheets and other information sheets and which describe in more detail the risks associated with a particular Digital Asset or category of Digital Asset.

This document does not constitute nor purport to constitute exhaustive disclosure of all relevant risks or other relevant aspects in connection with Digital Assets or transactions in such assets, and may not serve, under any circumstances, as a substitute for professional advice by competent subject matter experts.

2. Reasons to invest in Digital Assets

The reasons for investing in Digital Assets are unique to each client. However, the following reasons can be cited among others:

  • Diversification: some Digital Assets, such as payment tokens, can show low correlation with traditional asset classes, and, as such, can bring diversification benefits in an overall portfolio context.
  • High risk / high return profile.
  • Belief in distributed ledger technologies: there is a consensus that distributed ledger technologies have a similar potential to that of the Internet 20 years ago.
  • Loss of confidence in the traditional monetary system.
  • Betting on the future: the future of Digital Assets is still largely unknown.

3. Key characteristics

Before investing, the Client should know some key elements related to Digital Assets. The elements presented below are only a part of them.

a. Distributed Ledger Technology

Distributed Ledger Technologies (″DLT″) refers to technologies that allow individual participants (nodes) within a system to propose, validate, and store operations in a synchronised dataset (″Ledger″) that is distributed across all nodes in the system securely. It typically exhibits the following characteristics:

  • Embedded consensus algorithm

    A distributed ledger includes a ″consensus algorithm″ that allows to add and replicate new entries in the database without any trusted third-party validation. In other words, none of the computers making the network needs to be trusted and the consensus algorithm makes sure that all the data entered is accurate.

  • Decentralised infrastructure

    A distributed ledger has no single point of failure, which means that if multiple computers participating in the network disappear, the network will continue to function as long as there is one computer.

  • Decentralised governance

    A distributed ledger has no single entity controlling the network or making the rules for the network. The rules are defined in the ″code″ running the distributed ledger.

  • Logically centralised

    A distributed ledger is logically centralised which means that every node sees the same state. It can be seen as a one global computer or thousands of dispersed computers that all see the same state.

Blockchain is a possible form of how data can be stored in such a system: operations (e.g. transactions) are organised in blocks, and a block is attached to the last previously created block. This allows operations and data to be stored without allowing them to be subsequently modified.

There are two main types of distributed ledgers:

  • Permissionless or public distributed ledgers

    Anybody, incl. private individuals, can participate in the network by installing the relevant version of the software. Examples are Bitcoin, Ethereum, Ripple etc.

  • Permissioned or private distributed ledgers

    Only people invited or accepted to join the network can do so – they need the permission of a trusted authority. Examples are hyperledger, R3 corda or other enterprise blockchain services.

b. Digital Assets

Digital Assets are digital representations of any types of assets, securities, rights, currencies or units of accounts registered on a distributed ledger such as a nlockchain. They include but are not limited to cryptocurrencies such as Bitcoin, Ethereum or Litecoin. They can also include securities such as classical shares or bonds registered on a distributed ledger (i.e. “tokenised securities” registered on a “securities ledger”).

From a regulatory perspective, according to FINMA guidelines for enquiries regarding the regulatory framework for initial coin offerings (“ICOs”) published on 16 February 2018, Digital Assets can be classified in four categories: payment tokens, utility tokens, asset/security tokens and hybrid tokens.

Digital Asset CategoryFINMA DefinitionMain Valuation DriversExamples
Payment tokens

Synonymous with cryptocurrencies and have no further functions or links to other development projects. Payment tokens may in some cases only develop the necessary functionality and become accepted as a means of payment over a period of time.

Supply and demand

Bitcoin, Ether, Tezos

Utility tokensTokens which are intended to provide digital access to an application or service.

Various

ICO token

Asset/ investment/ security tokensTokens representing assets such as participations in real physical underlying, companies, or earnings streams, or an entitlement to dividends or interest payments. In terms of their economic function, the tokens are analogous to equities, bonds or derivatives.

Share-like: similar to shares

Bond-like: similar to bonds

Tokenised shares of a private company in the form of a CMTA smart contract registered on the Ethereum public mainnet

Tokenised debt of a private company in in the form of a FA1.2 token registered on the Tezos public mainnet

The individual token classifications are not mutually exclusive. Asset/security and utility tokens can also be classified as payment tokens (referred to as hybrid tokens). In these cases, the requirements are cumulative; in other words, the tokens are deemed to be both securities and means of payment.

4. How to invest in Digital Assets?

Investors can buy themselves digital assets (for example through websites, crypto-currency exchanges, trading applications) or through selected banks and/or brokers.

5. Main risks

The following list highlights some of the main risks linked to digital assets, without being exhaustive:

Volatility risk

  • The value of Digital Assets is subject to high volatility, i.e. the price of Digital Assets may rapidly go down as well as up, on any given day, including on an intraday basis. Investments in Digital Assets are deemed highly speculative investments. The risk of substantial or total loss in purchasing or selling Digital Assets exists.
  • Market prices may be very volatile and sometimes differ materially from the fair value of a Company or an investment opportunity in the case of illiquid/low liquidity assets.
  • While the volatility of Digital Assets is high and varies significantly, changes and advances in technology, fraud, theft and cyber-attacks and regulatory changes, among others, may increase volatility further – elevating the potential of investment gains and losses. In addition, Digital Assets lack the historical track record of other currencies or commodities such as gold that could guide if current levels of volatility are typical or atypical.

Valuation risk Setting a value to Digital Assets can be difficult depending on which category is chosen and, in some cases, there may not be any proven valuation methods:

  • Payment tokens: the price of payment tokens depends on the supply and demand dynamics on a global level and does not rely on traditional valuation techniques used for securities (e.g., discounted cash flows), which can make it hard to provide an objective value to payment tokens.
  • Utility tokens: utility tokens represent a right to consume a service or a product in the future. There are no proven valuation methods. Some of the utility tokens that are being issued have no intrinsic value other than the possibility to use them to access or use a service/product that is to be developed by the issuer. There is no guarantee that the services/products will be successfully developed. At the time of writing, the Company is not planning to provide access to utility tokens.
  • Asset/security tokens: discounted cash-flow analysis + liquidity or illiquidity premium depending on i) maturity of company ii) trading venues. Asset tokens bear risks related to the underlying Company or asset in particular liquidity as many of the Companies raising funds are private Companies not listed in a stock market. See the Swiss Bankers Association standardized information booklet for further details on liquidity risks. Digital Assets only exist virtually on a computer network and have no physical equivalent. Establishing a value for Digital Assets is difficult as the value depends on the expectation and trust that Digital Assets can be used for future payment transactions (see valuation section above). Among others, persistent high volatility, changes and advances in technology, fraud, theft and cyber-attacks and regulatory changes may prevent the establishment of Digital Assets potentially rendering them worthless.

Liquidity risk

  • The market capitalisation of the digital assets industry is mainly led by Bitcoin, which represents more than 50% of the total market capitalisation. A significant position in any digital asset other than Bitcoin (and, depending on the case, including Bitcoin) may require several days or weeks to be unwinded with a possible negative effect on the price of the Digital Asset.
  • The market for the relevant Digital Assets may experience periods of decreased liquidity or even periods of illiquidity, hence under certain market conditions, it may be difficult or impossible to liquidate a position.
  • There is no guarantee that a private company will conduct an initial public offering or provide an alternative exit strategy for your invested capital.

Technology risk

  • Technology relating to Digital Assets is still at an early stage and best practices are still being determined and implemented. Digital Assets technology is likely to undergo significant changes in the future. Technological advances in cryptography, code breaking or quantum computing etc, may pose a risk to the security of Digital Assets. In addition, alternative technologies could be established, making some Digital Assets less relevant or obsolete.
  • The functioning of Digital Assets relies on open-source software (for unpermissioned distributed ledger). Developers may introduce weaknesses and programming errors into the open-source software or may stop developing the open-source software (potentially at a critical stage where a security update is required), keeping Digital Assets exposed to weaknesses, programming errors and threats of fraud, theft and cyber-attacks (see also ″Fraud, theft and cyber-attack risk″ below). Therefore Taurus does not provide any warranty that the services offered through the Taurus Platform will be uninterrupted or error-free.
  • Some Digital Assets networks have experienced a surge in the number of transactions over the last few years. An increasing number of transactions coupled with the inability to implement changes to Digital Assets technology may result in a slower processing time of Digital Assets transactions (potentially days to verify a transaction) and/or a substantial increase in Digital Assets transaction fees paid to so called ″miners″ (when relevant) for facilitating the processing of transactions.
  • Base layer transactions on a DLT or other distributed ledger are irreversible and final and the history of transactions is computationally impractical to modify. As a consequence, if the Client initiates or requests a transfer of Digital Assets using an incorrect distributed ledger address, it will be impossible to identify the recipient and reverse the defective transaction.
  • The Client should be aware that any purchase and sale of Digital Assets may be stored in a public distributed ledger and may therefore be visible to the public. Such decentralised public ledger is neither a property of nor under control of Taurus. Information available on the decentralised public ledger may be exploited or misused in unforeseen ways.

Hard fork risk

  • Since there is no central body (e.g. a central bank or a government agency) overseeing the development of technology relating to Digital Assets, the functioning of Digital Assets, as well as further improvements of such functioning (e.g. ability to increase number of transactions, reduce processing time, reduce transaction fees, implement security updates), relies on the collaboration and consensus of various stakeholders, among others, developers enhancing the open-source software related to a Digital Asset or so called ″miners″ facilitating the processing of transactions. Any disagreement among stakeholders may result in a split of the Digital Asset network into two or more incompatible versions (such an event called a ″hard fork″).
  • As a result, trading venues on which Digital Assets are traded may suspend (temporarily or indefinitely) the ability to trade a particular version of a Digital Asset. Consequently, the Investors in the Digital Asset may (i) not get exposure (indefinitely) to all versions following a hard fork and forego the value of one or more versions, or (ii) may get exposure to a version on a delayed basis (in which case that version might have lost a significant part or all of its value).
  • In addition, hard forks may result in instability of a Digital Asset version and hard forks or the threat of a potential hard fork may prevent the establishment of the corresponding Digital Asset as an accepted long-term medium of exchange.

Fraud, theft and cyber-attack risk

  • The particular characteristics of Digital Assets (e.g. only exist virtually on a computer network, transactions in Digital Assets are not reversible and are done anonymously) make it an attractive target for fraud, theft and cyber-attacks. Various tactics have been developed (or weaknesses identified) to steal Digital Assets or disrupt Digital Assets technology (to name a few: ″51% attack″ where an adversary may take control over Digital Assets technology by providing 51% of the computer power in the Digital Assets network or ″denial of service attack″ where an adversary attempts to make Digital Assets network resources unavailable by overwhelming it with service requests. This may result in significant waiting periods, network congestion and delays during which the Client may be precluded from disposing over the relevant Digital Assets while their value may fluctuate significantly or which may otherwise result in loss or damages).
  • Investors in any particular Digital Asset are directly exposed to fraud, theft and cyber-attacks: (i) Any high profile losses as a result of such events (e.g. bankruptcy of the then largest Digital Assets exchange Mt. Gox in February 2014) may raise scepticism over the long-term future of Digital Assets and may prevent the establishment of Digital Assets as an accepted long-term medium of exchange and may increase the volatility and illiquidity of Digital Assets; (ii) any loss resulting from fraud, theft and cyber-attacks relating to hedging party(ies) of the Issuer will be borne by the Investors.
  • Digital Assets are subject to a higher risk than usual of market abuse, market manipulation and insider dealing by market participants, due to a lack of regulation, supervision, market control and/or liquidity.

Legal, tax and regulatory risks

  • Risk of non-compliance or change of legal and regulatory framework: The legal, tax and regulatory framework governing Digital Assets in and outside of Switzerland is far from settled and continuously evolving. Existing laws and regulations, changes to the legal, tax and regulatory framework and related measures by regulators or other governmental authorities may affect the compliant issuance, domestic and international tradability and transferability or convertibility of the Client’s Digital Assets and may potentially result in a full or partial loss of units or reduction of value (including reduction to zero) thereof.
  • Any forthcoming regulatory actions may result in the illegality of some Digital Assets or the implementation of controls relating to the trading (and therefore liquidity) of Digital Assets. In addition, control mechanisms may increase Digital Assets transaction fees significantly (and therefore affecting the bid/offer spread of the Product). Investors should ensure that investing in any Digital Asset complies with their local regulation.

Supervision risk

  • As of today, Digital Assets do not have a function as and/or the full characteristics of a legal tender (even if some Digital Assets may be accepted for payment in certain countries or jurisdictions by public institutions) and are currently not supervised by any authority or institution such as a central bank.
  • Consequently, there is no authority or institution which may intervene in the Digital Assets market to stabilize the value of Digital Assets or prevent, mitigate or counter-attack irrational price developments of Digital Assets.

Operational risk

  • Sending Digital Assets to an incorrect and/or a wrong distributed ledger address leads to a total and irremediable loss of funds. Once a transaction is executed, it is impossible to cancel or reverse this transaction. As a consequence, users shall always check that a destination distributed ledger address is correct before to confirm a transaction.

Credit & counterparty risk

  • In the case of tokenized securities, the risk of default or bankruptcy of the underlying issuer is material in line with private equity and/or private debt investments.

Specific risks related to the custody of Digital Assets Among the digital assets class, the following points have to be outlined when it comes to custody of digital assets:

  • Owning a digital asset is equivalent to owning the private key (equivalent to a secret pin) that gives you access to it.
  • Losing this private key is equivalent to ever accessing those assets again. There is no central authority to contact to regenerate that key.
  • Having this private key stolen is equivalent to giving full access to the assets to the malicious person/entity.

It is therefore of utmost importance that clients back-up these private keys and store them securely.

In summary, it is highly recommended to only invest in Digital Assets the amounts the Client can afford to lose.

6. Adequacy of investment in digital assets with financial objectives

Investors willing to have exposure to digital assets should ensure their profile matches with the below characteristics of the asset class. Investors should seek advice from their investment advisors if they have any questions on the appropriateness of their profiles with the investment in digital assets, as well as to enhance their successful selection of opportunities within the asset class, according to their financial objectives and their risk tolerance.

Target clientsPrivate and Professional
Knowledge and experience

Intermediate and Expert

Ability to bear losses

Total loss of capital possible

Not recommended to clients with no loss of capital possible.

Total default or bankruptcy of Issuers possible.

Risk reward profileHigh risk
Investment objective

Diversification

General asset accumulation

Growth

Hedge against systemic risk

Investment horizon

Short term (for speculation purpose only)

Medium to long term