CIARAN RYAN: Crypto arbitrage is very much in the news this [month] with the Financial Sector Conduct Authority, the FSCA, issuing a warning on Ovex, withdrawing it within hours, and following up with an apology the following day.
This has certainly put the regulatory reach of the FSCA under the spotlight, and perhaps it’s time to take a good hard look at the legality of crypto arbitrage in all its various forms. In addition to that, we thought it timely to look at the risks of arbitrage, and to look at the risks of trading with a particular exchange as well. To discuss this, we are joined by Wiehann Olivier, who is a partner and crypto specialist at Mazars.
Welcome back Wiehann. We’ve had you on Moneyweb Crypto before, but it’s good to have you back again. Arbitrage is as old as trading. It’s where you identify price differences in the same commodity on different markets, and seek to make a profit from that. For example, buying oranges cheaply in Limpopo and selling them at a higher price in Joburg would be one form of arbitrage, though you might call this straightforward trading.
But when it comes to financial assets like Bitcoin, you can often buy Bitcoin 3-4% cheaper on overseas exchanges, and then sell them on the local exchange in South Africa at a higher price. There’s nothing wrong with this, is there? What laws could you possibly be breaking, Wiehann?
WIEHANN OLIVIER: Ciaran, thanks so much for having me again. It’s a pleasure to be here and I’m happy to chat about anything crypto and regulation-related. But you are straight onto the topic of arbitrage. As you mentioned, arbitrage is as old as money itself, and trading itself. I think before we start with the process in regard to the laws and regulations applicable and how the process works, it’s probably best to explain what exactly arbitrage is. To understand that we need to take a step back, specifically referring to cryptocurrency arbitrage.
Back in the day a former colleague of mine did arbitrage in his own name where he essentially had to move cash from his South African bank account to his brother’s bank account in the United States, and move funds there to an exchange in the US, move the cryptocurrency back to South Africa, and then essentially liquidate the cryptocurrency for fiat currency. That whole process was quite a timeous process, but the arbitrage market was fairly big at that point and stage.
Subsequent to that, some of the overseas exchanges started to accept South African customers as well. There were some limitations with some of the exchanges. So there’s a limitation as to who you need to interact with, who you buy from and who you sell to – and the majority of the time with some of those exchanges it was limited to other individuals in your respective country.
But of course with the introduction of stablecoins, it was a complete game-changer. So for those individuals that don’t know what stablecoins are, they are a type of ERC-20 token, housed on the Ethereum blockchain and essentially backed by the US dollar. So you look at a TrueUSD or Tether, USDT, which is essentially a stablecoin that’s backed one to one by the US dollar.
You were referring to about a 3 or 4% difference.
The question is: why is there a market for it? Why are you able to utilise these differences in prices to make a profit?
I think for the investors to understand that, they need to understand cryptocurrency and how it’s valued. A lot of people don’t know this, but there’s no single Bitcoin price in the world. The price of Bitcoin is determined by the specific exchange in a specific country. So in South Africa itself we have several exchanges. The same in the US; there are several exchanges there, and the prices differ from exchange to exchange. And quite coincidentally cryptocurrency is slightly more expensive in South Africa than in the US.
The same applies to Nigeria as well, with the whole rigmarole that happened there with banks also saying that financial institutions such as banks can’t interact with virtual-asset service providers. That did cause a cryptocurrency such as BTC (Bitcoin) to trade at a premium of about 50%.
But I think coming back to understanding how the arbitrage market works, and how the transaction works, I thought it might be good to try and explain the manual process of arbitrage – and from there you can easily identify what the risks are.
If you are looking to arbitrage cryptocurrency, essentially what you do is you take your money from your bank account, you move that to a South African exchange. Once the money is deposited into the South African exchange, it’s reflected in your wallet. From there you usually go and purchase your stablecoin. Of course, once you have your stablecoin, you can transfer that out from your South African wallet to your overseas wallet. Now, once the cash or the stablecoin hits your overseas wallet, you can exchange your stablecoin for a cryptocurrency such as Bitcoin or Ethereum, and once you purchase that and you are happy with the process, and you’re happy with a price that you’re able to get on the South African exchange, you transfer the cryptocurrencies back to South Africa, and you liquidate that either for pure currency, or you take it back to a stablecoin to just mitigate any possible risks going forward. So that’s how the whole process works from an arbitrage perspective.
You can see it’s quite a tedious process and there’s a lot to look out for in terms of risks and timing. Therefore there are these virtual-asset service providers such as Ovex, which facilitate this whole transaction and also mitigate some of the investor’s risk to a certain extent.
Now, some of the laws or regulations that we need to look out for are things like foreign exchange control, money laundering, and looking at the regulations from a South African Reserve Bank and South African Revenue Service [Sars] perspective.
Among the other things that need to be taken into consideration when you want to do arbitrage are the foreign control in terms of the money that an individual is allowed to take out of the country during a specific period. Now, of course, you get your discretionary allowance. Each individual South African resident gets his or her discretionary allowance of R1 million to take out of the country. That needs to be reduced by holidays taken overseas, where you actually spend rands in another country, as well as if you are buying shares. Let’s say, for instance, you go to PSG and you buy foreign shares, that [allowance] needs to be decreased by that amount. But once that is utilised, you can move on to the foreign investment allowance, where you’re able to apply for a R10 million foreign investment allowance that you can utilise for cryptocurrency arbitrage as well.
CIARAN RYAN: Okay, you’ve got R1 million, which is your discretionary allowance. You don’t need any Reserve Bank approval for that. And then you have your foreign investment allowance, which is R10 million. You have to apply to get tax clearance from Sars for that. So you have purpose and you have R11 million, potentially, per year.
Let’s just take a little bit of a deeper dive into the risks of arbitrage. It’s often claimed to be low risk, but there are some risks involved. Maybe just talk about those. You’ve got exchange risk – you’re basically leaving your money in the hands of an exchange. So you’ve got to trust that exchange and the way that it looks after your money and the way it transacts.
But then you’ve also got other risks like foreign exchange. If the exchange rate changes, that can wipe out your arbitrage profit. You’ve got the crypto price exchange. If you’re arbitraging with Bitcoin, there’s a time delay in the time that you purchase the asset overseas and you ship it to South Africa; that can be an hour or so, maybe more, and the price can drop in that period of time again. So you do have some of these risks. Do you want to talk about that?
WIEHANN OLIVIER: Yes, sure. I think any investor who is looking to arbitrage with cryptocurrency needs to make sure that they understand the risk involved. If you think of it from an audit perspective – of course we take on clients as well – there’s a certain element of risk involved; but we perform procedures to mitigate that risk to an acceptable level, and investors need to do the same. They need to do their research, understand what they’re investing in and how to best mitigate those risks. So among the risks with these type of transactions is the security risk, as you mentioned.
Whether you’re doing arbitrage through a service provider or you are using an exchange to arbitrage with, there are two issues with the security.
There’s your own security, which is your user name, your password, and your second-factor authentication that you need to make sure is in place.
The second issue of security is the specific exchange or service-provider security. Of course there’s no possible way for you to assess that from your end. You have to look at track records. You need to look at something like expected credit risk. The perfect example of this is in the auditing profession, the financial reporting profession; we look at expected credit losses, where each and every type of financial asset has its certainty of risk, and we can quantify that risk.
So every asset – [even] the cash in your bank account – you need to assess the risk applicable there, no matter how low it is. There is the inherent risk of the Bitcoin or Ethereum price changing while the transaction is being facilitated. There’s liquidity risk, where possibly you won’t be able to exchange your stablecoin for Bitcoin, or maybe liquidate your Bitcoin back to a stablecoin, or maybe even liquidate your stablecoin to a fiat currency. As you mentioned, there’s exchange risk as well.
So when you use a stablecoin backed by a specific currency, you also have the issue that there could be a large increase or decrease in the price from a ZAR to a USD perspective. So there’s a fair amount of risk that needs to be taken into consideration. As I’ve mentioned, if you compare Bitcoin to Ethereum as well, there is that type of risk as well, but the same with stablecoin. You get stablecoins such as TrueUSD or Tether. There’s a reason why individuals prefer a specific stablecoin. It’s because of the risk involved, which is either/or. So there’s that risk as well.
But it boils down to the fact that these individuals need to make sure that once you invest in these type of investments, or you perform a specific process like arbitrage, you need to understand your risk.
And if you’re working with a virtual-asset service provider to facilitate that, you need to actually read through those terms and conditions to make sure that you understand the risk involved when you work with these service providers that perform arbitrage services.
CIARAN RYAN: Cryptocurrencies have been on a tear this year. Ethereum just in the last month has doubled, and the average price gain of altcoins in April was 47%. Bitcoin, by the way, in April went down 2%. That’s not a shocking drop, but it is a drop. People assume that these kind of gains will go on forever. There have been major bear markets in cryptos in the past, the last one being in 2018 – for Bitcoin anyway. People should probably study a little bit of history on this; would you agree with that? One of the key risks is price risk.
WIEHANN OLIVIER: Yes, one hundred percent. One of the big issues with cryptocurrency, of course, is the volatility involved. Now, I get asked the question a lot as to where to invest and what to invest in – be it from a general perspective or cryptocurrency perspective. Investors need to make sure that they understand what they’re investing in, once again, but also that all their other investments are intact.
You first need to look at things like long-term investments such as retirement – annuities, and through pension funds; retirement and annuity funds.
Then you look at your medium-term investments such as shares, which are a bit of a higher risk, but not as high as cryptocurrency.
And once you’re satisfied that your portfolio is in a position where you are able to take a higher risk, then you can start looking at things such as cryptocurrencies.
But once again it comes back to the principle of not forgetting about the volatility involved with cryptocurrency. These cryptocurrencies are extremely volatile. There are so many factors influencing the price of these cryptocurrencies, if you think about all the countries around the world, all the political views, the regulatory views that need to be taken into consideration that have an impact on the price of cryptocurrencies.
I think it was in [the] last month that [US President Joe] Biden announced certain tax implications for Bitcoin. That caused a large drop in the Bitcoin price. That was only for the US; it didn’t affect us in South Africa, but it affected Bitcoin pricewise.
Then you need to also consider that the market runs 24/7. So the market never closes. You can go to bed at night and wake up in the morning and your cryptocurrency investment portfolio might be 20% higher or 20% lower. I remember back in 2017 I woke up in the middle of the night to check cryptocurrency prices when we were experiencing that big boom.
The other thing that you need to take into consideration is that it is unregulated in most countries. So there are some of these regulations and bans that could possibly have an impact on cryptocurrency and cryptocurrency prices.
But it all boils down to what we’ve discussed previously in regard to when you are investing in cryptocurrency – to take perhaps a longer view and take a long-term stance if, say, you’re in it for five or 10 years or whatever, because it boils down not timing the market, it is actually time in the market.
And then just on cryptocurrencies like altcoins. In altcoins specifically, as you mentioned, we’ve seen a fairly large growth in altcoins of about 47%. Now, for investors who are looking to invest in cryptocurrencies such as these altcoins, you need to make sure that they understand what they are investing. Is it just a fly-by-night type of altcoin? There’s a major hype around it. You need to have a look at what sets this cryptocurrency apart from the rest. Is there added security? Are there lower transaction fees? Is there actually a use-case for this cryptocurrency? Sometimes it does raise a bit of concern for me, especially with individuals such as influencers trying to hype up a specific cryptocurrency without any cause or any real substance, because that creates an issue where certain assets could be inflated above a price, and then dumped just the next day.
There’s a possibility for those influencers to actually manipulate the market.
We’ve seen as well what a tweet from Elon Musk did to the Bitcoin price, what the comment of Elon Musk on Saturday Night Live did to the Dogecoin as well. So these type of things need to be watched as well.
But there are various techniques for analysing and assessing and predicting what the price of Bitcoin is going to be, or any cryptocurrency. But it is extremely difficult because of the volatility and because of the different elements involved. The golden rule always remains: never invest more than you’re willing to lose in the end.
CIARAN RYAN: Right. I think that’s a fairly good sort of baseline position – don’t invest in crypto unless you’re prepared to lose it.
When you’re evaluating a crypto provider or a crypto exchange, you as an auditor, what are the risk factors that you’re looking for? I mention this in particular in light of the recent starting of liquidation proceedings around the iCE3 exchange. If you look at their terms and conditions on their website, this is not something that the average person is going to go and dig into and ask what this actually means? If this goes down, what happens to my Bitcoin? Are these being held in trust on my behalf, or do they form part of the liquidated estate of the exchange if it goes bust? This is something that I think is going to come before the courts now in South Africa, but it is something that people need to start paying attention to. This is happening, of course, in an unregulated environment which is probably going to change quite soon when regulations do come in. But this is what you’re dealing with. A lot of these risks are unknown.
WIEHANN OLIVIER: Definitely. From an audit perspective, the things that that we tend to look at are the terms and conditions. Let me give you an example for terms and conditions. I’d even read the terms and conditions for myself in the contract. Before I invest in a cryptocurrency or make use of a specific service provider, I read the terms and conditions because you need to understand what your risks are. You need to understand exactly how they go about securing your funds.
Maybe I can touch on a couple of topics on the procedures that we go through to assess, first of all, the risks involved with a specific virtual-asset service provider, and then also things to look at from a security point of view. Some of the procedures we perform as an auditor are that we actually go to the CIPC [Companies and Intellectual Property Commission] to see the register of the Companies Act. We pull the information of a specific company, and the information such as the company and the company number is usually included in the terms and conditions. We have a look at the amount of directors and who the directors are.
A single director is not necessarily a bad thing, because we are dealing with a lot of startups where there’s a single director; but it always does raise a question and I usually like to meet the directors as well.
Unfortunately, we can’t look at the shareholders or the financial statements of the company. In the UK, for example, you’re able to do that. But in South Africa you can also have a look if they have actually appointed an auditor that is capable of looking after the company’s affairs. We do certain money-laundering procedures, but also make sure that these virtual-asset service providers also perform their own anti-money-laundering procedures and know-your-client procedures. We look at media coverage, where they market and how they market. And of course we speak to a lot of different people in the industry.
Again, it comes back to the terms and conditions, reading through those. How is your income being generated? Is it fixed? Is it variable? Is reference being made to some weird things such as bot trading, with no explanation? Is there something like cloud mining? A lot of the times the guys hide beyond these big words and most of the time it ends up being a scam as well.
Have a look at the company’s view on regulations, because I always ask myself what these companies are going to do when the industry is actually regulated. Are they going to jump around and try to make sure that they’re adhering to all the laws and regulations, or are they’re going to be left behind?
Now personally, one of the things that I also like to look at as well is the cryptocurrencies they’re dealing with. And if they are dealing with cryptocurrency, or the base of what the business is built on is using cryptocurrency, that uses ring signatures [a type of group signature] or mixers or something of that sort to allude to or hide transactions, it also is a bit of a red flag for me. But the main thing is, once again, that you need to understand what you’re investing in.
From an order point of view, our working standards telling us that we aren’t able to necessarily take on a client unless we understand the business and we understand the industry that they operate in. The same applies to investing. Why would you invest in something if you don’t understand it and don’t understand the sector itself?
If I knew nothing about cryptocurrencies and decided I’m going to take on a client, I could potentially cause more harm than good in that instance. The same applies to your investment as well. If you don’t know what you’re doing with a specific investment, you’re going to cause more financial harm to yourself than good.
Coming back to the security question, as you mentioned, these virtual-asset service providers and custodians hold your cryptocurrency in a fiduciary capacity.
There’s the age-old saying in the industry that if it’s not your keys, it’s not your coins, meaning if you aren’t the holder of the private key to the public key address, it’s probably not your coin.
And a lot of these exchanges and custodians actually either hold your coins in a public key address to which they’ve got the private key, or they hold your assets maybe with an external custodian. You need to understand what your risk is from that perspective.
It’s quite interesting how these exchanges actually mitigate those risks, and it raises a couple of questions in regard to iCE3X, as you mentioned, in the whole liquidation process. These exchanges actually make sure that only a certain percentage of the total funds is kept in hot wallets, for example, that have direct access to the internet and to the blockchain where a large portion is kept offline where there is no connection to the internet, so there’s no single point of failure. And they also apply multi-signatures as well, where there are maybe two or three signatures required to actually move funds out of a specific public-key address. So you need to make sure that those procedures are applied by the specific virtual-asset service provider.
That raises a question, of course, [about] iCE3X. There were a lot of funds that couldn’t be moved, and there was maybe just nothing left in the public key addresses. So it raises the question of was the error in the case of security issues, or was this actually fraud? I can’t imagine that any exchange that’s actually holding customer funds isn’t putting procedures in place to make sure that a certain portion of customer funds that don’t need to be liquid is kept in a safe and secure location. So that’s definitely one of the things to look out for when dealing with these virtual-asset service providers from a security point of view.
CIARAN RYAN: All right. I think a question that we get asked a lot at Moneyweb is: What are the reliable exchanges and service providers in the crypto space in South Africa?
I may be putting you on the spot, because you haven’t looked at them all; if people are left out of this they can complain to us. But give us your ideas, only the reliable ones.
WIEHANN OLIVIER: Sure. I’ve met a fair amount of people in the industry and we’ve been very fortunate at Mazars, as well, to be appointed auditor of some of these exchanges. So I can go through the list of the people that I’ve met, the institutions that I’ve dealt with, where I also invest, and of course my clients as well – which gives me a bit more of a warm, fuzzy feeling because I see the inner workings.
From an exchange point of view, some of the credible players in the game definitely have to be Luno, VALR, and AltCoinTrader, Richard de Sousa – you’ve had him on a couple of times also, a very knowledgeable guy.
And if you’re looking to invest in a ‘balanced portfolio’, the type of investment that you can definitely look at from a virtual-asset service provider perspective, is the likes of Revix and BitFund.
The nice thing, as well, is that they’ve got these balanced funds. So as soon as a specific altcoin starts running and there’s a significant increase, you get the upside to that as well. You don’t have to move around cryptocurrencies in your own capacity, keeping in the wallet and trying to get the upside as far as possible.
Then of course, from an arbitrage point of view, VALR of course has arbitrage, but Ovex as well. The work they are doing at Ovex is really phenomenal – a bunch of clever guys there with the products and service offering that they’ve got. More recently, I’ve also dealt with the guys at Xago – some really interesting concepts that they have on their end, and I think it’s really going to be a game-changer, especially for financial service providers. And then of course overseas as well, exchanges that I’ve personally dealt with and utilised are Kraken and Binance.
CIARAN RYAN: Right. And I think the one local company that you missed out was EC10, which does a portfolio-type investment. If you want to invest in the top 10 cryptos, you could do it through Revix, you can do it through EC10. They are slightly different products, but both very reputable.
WIEHANN OLIVIER: Definitely. And the thing that’s great about South Africa is we are really spoilt for choice here. If you come across a type of investment that you want to make, or a type of service or product that you want to buy, and you’re not getting that warm, fuzzy feeling, it’s only a Google away to try and find a credible virtual-asset service provider that has that good track record, that can render the same services that you perhaps need from your investment portfolio perspective.
CIARAN RYAN: All right, Wiehann, I fear we’re going to leave it there. Thanks so much for sharing your thoughts on that and giving us the rundown on how we assess the risk and the legality of the crypto space – which is a very, very Wild West pioneering type of area to be in. Thank you very much for that.