With official interest rates hovering at an all-time low of 0.25%, it’s not surprising that many SMSF trustees are turning to riskier investments to try to generate better returns. While these investments are allowed by the SMSF legislation, there are several factors that need to be considered before investing.
What is a Derivative?
A derivative investment is a contract that enables the investor to purchase or sell a set number of shares or commodities for a specific price at a predetermined date. While this means that investors are exchanging contracts rather than buying and selling physical assets, there is always an underlying asset attached to the contract.
There are two (2) types of options traded on the Australian Stock Exchange (ASX):
- Call option – gives the taker the right, but not the obligation, to buy the underlying shares
- Put option – gives the taker the right, but not the obligation, to sell the underlying shares While the taker is not obligated to exercise the option, they may decide to sell the option before the contract expires, or they can let the contract lapse and forego the option premium.
Like with all investments, it needs to be allowed by the SMSF’s Trust Deed and Investment Strategy. The fund should also have a Derivatives Risk Statement or DRS in place to further confirm the trustees are aware of all risks involved and ensure the Fund remains compliant.
Over the Counter Derivatives
Over the counter derivatives (OTCs) trade through decentralised dealer networks monitored and regulated by ASIC. These service providers are issued with an Australian Financial Services License (AFSL) and provide access for SMSF trustees to trade in derivatives and financial products such as contracts for difference (CFD), binary options and margin foreign exchange. One advantage of OTCs is that they are more flexible than derivatives traded on an exchange because they can be customised to meet the individual needs of each party.
Always check the ASIC registries to confirm your chosen broker has a current AFSL before investing.
Contracts for Difference
A CFD provides the investor with an opportunity to profit from price movement without owning the underlying asset. CFDs are synthetic financial products (or derivatives) which are tradable through OTC providers on stock indices, stock options, currencies and futures contracts. The CFD price is calculated by the asset’s movement between the entry and exit price, with the investor not required to own the underlying assets. Essentially, a contract exists between two parties, typically described as the buyer and seller.
The appeal of CFDs is that SMSF trustees only need to put up a small deposit to hold a trading position. There are no restrictions regarding the timing of the entry or exit and no time limits regarding the duration of the contract. Once a CFD position is opened by buying a CFD (going long) or selling a CFD (going short), it remains in place until closed out.
While CFDs can seem attractive, they are not standardised, every CFD provider has their own terms and conditions, which can quickly lead to compliance issues for SMSF trustees if they are not clearly understood.
Risk of CFDs
To put it simply, CFDs are very similar to gambling; the potential to make large returns is there for those that understand the complexities however there is always the risk to make potentially unlimited losses.
Specifically, the type of risks associated with trading CFD’s include:
- Investment risk – the risk of markets moving against the CFD trade
- Counterparty risk – the risk of the CFD providers or another party failing to fulfil their obligations
- Client money risk – the risk of losing some or all of your money held by the CFD provider
- Liquidity, gapping and execution risks –market conditions and trading mechanics may result in unfulfilled trades at the expected time or price
Due to the speeds at which the CFD market can move, CFDs should not be viewed as a “set and forget” investment – trustees must actively monitor and manage their investments.
ASIC has provided a warning for SMSF trustees due to increased trading activity in derivative investments and CFDs in the current volatile markets created by COVID-19. They have found that some investors are engaging in short term trading strategies, unsuccessfully attempting to time price trends. Even market professionals find it hard to ‘time’ the market in a turbulent environment, and the risk of significant losses is a common challenge. For SMSF trustees to attempt the same is incredibly risky, and likely to lead to massive losses – losses that could not happen at a worse time for many funds during COVID-19. Trustees who chase quick profits by playing the market over the short term have traditionally performed poorly – even in relatively stable, less volatile market conditions.
Cryptocurrency, the current buzzword investment of the decade, is a digital currency using encryption to regulate the generation of units of currency and verify the transfer of funds. It is ‘a virtual currency that essentially operates as online cash’ and as a ‘crypto-currency, designed to reinvent the way that money works’.
Crypto operates through a decentralised peer-to-peer payments network and in electronic ledgers that are continuously updated, open to everyone who uses it and those willing to download it. As the payments system operates independently of a central bank and is not under the control of a central authority, the value of crypto is ‘not derived from gold or government fiat, but from the value that people assign it’.
While crypto does not earn income, investors only receive a return after they are sold at a higher than original price. Other factors that influence the price includes:
- Its popularity at a given time (demand vs supply)
- How easy it is to trade or use it
- The perceived value of the currency
- Its underlying blockchain technology
While Bitcoin is the most popular and well known of the cryptocurrencies, there are many more in existence, each with their own appeal and valuation.
The ATO has shown concern where SMSF trustees have invested in crypto. They issued two (2) taxation determinations in 2014, TD 2014/25 and TD 2014/26 which clarified that bitcoin and cryptocurrencies like bitcoin are not money, but capital gains tax (CGT) assets. Where a fund transacts in crypto, SMSF trustees and members need to be aware of the tax consequences as well as price volatility, which can impact returns. SMSFs involved in acquiring or disposing of cryptocurrency must keep records concerning their transactions as it could give rise to a CGT event.
While the risks of trading crypto are mainly related to price volatility, it is considered a high-risk and speculative investment that is subject to changes in market sentiment. As an unregulated market, there are questions about the susceptibility of error and hacking (such as Mt Gox) with little possibility of preventing technical glitches or human error. Crypto can also be affected by forks or discontinuation, which sees investors switching to a new chain and no longer using the old one, or where both new and old chains are maintained and compete for dominance and branding. Examples of these include Ethereum vs Ethereum Classix, Bitcoin vs Bitcoin Cash and Bitcoin Cash vs Bitcoin SV.
Once purchased, cryptocurrency then needs to be stored in a wallet, which is a software program that enables investors to store, send and receive digital currencies. As each crypto has a different address type, holding multiple cryptos may mean that numerous wallets are required if the wallet chosen cannot support several digital currencies.
Initial Coin Offerings
There are new cryptos promoted and sold through initial coin offerings (ICOs) every day. An ICO is raising capital by offering a new cryptocurrency to the market. Under a capital raising banner, promoters sell “tokens” to investors who pay with legal tender or other cryptos such as BTC or Ethereum. These are particularly risky as are not regulated; do not provide investors with an ownership stake in the company and are prone to scams and securities law violations. The most common scam is known as the “pump and dump”, where scammer talks up the value of an ICO to generate interest, then “dumps” the coins for a profit
SMSF Cryptocurrecy Compliance
As with all investments, you will need to confirm your SMSF Deed and Investment Strategy allow for any investments in cryptocurrency. The investment strategy should also mention other risks concerning the secure storage of the hot or cold wallet and private keys.
As with any SMSF investment, all SMSF assets must be kept separate from any money and assets that are held personally. The easiest way to ensure this is for the exchange account and wallet are held in the name of the SMSF trustee as trustee for the fund.
Difficulties arise where the where reports and statements from the exchange show that the wallet is held in the name of the trustees personally and your SMSF auditor may have no choice but to qualify their audit reports.
The Fund must use its own bank account directly to buy and sell cryptocurrency at all times to ensure compliance and avoid falling foul of the Acquisition From a Related Party regulations.
One of the biggest issues with crypto will be when an SMSF trustee passes away – particularly if it is the trustee who set up the crypto wallet as access is generally limited to this one user. If the access is lost then the entire investment is not recoverable and unable to be passed on as part of a Death Benefit Payment. Ensuring that the wallet details are documented and stored securely should be considered a form of cryptocurrency insurance. The fund should document the fact that wallet details will be securely provided to other trustees or beneficiaries in the event of death.
High-risk investments are possible within an SMSF, but you need to understand the risks and make sure the correct documentation is in place before proceeding. We always recommend speaking to us before investing to ensure all compliance guidelines are in place.
How your SMSF Accoutant can manage and advise
If you want to investigate some new investment strategies for your SMSF, please feel free to give us a call on 1300 392 544 or get in touch online to arrange a time to meet so that we can discuss your SMSF in more detail.