2022 – The year that nodes died? - PKF Francis Clark
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2022 – The year that nodes died?

By David Manning – Manager, Blockchain & Crypto Team

While the title might seem dramatic, it is certainly the sentiment you will find across the array of forums which are full of disappointed, angry and confused “investors”, some of whom have suffered heavy losses as these projects have lost value over the last five months.

Acknowledging that crypto in general has taken a big hit since the beginning of 2022 with BTC down 53%, ETH down 68% and SOL down 78% being some of the more widely traded currencies, it is hard to argue that many tokens have taken a harder hit than Node based tokens, with STRNGR* down 99%, THOR down 92%, DRIP down 89% at the time of writing this.

If you are reading this, you may already be aware of what these projects are and how they work. The concept behind nodes was not new. A node was purchased for a certain number of specific tokens, which would reward you a passive income each day in a native token specific to the project. The majority of the purchase proceeds seem to be used to reward existing node holders. The initial cost of the node is a sunken cost which cannot be recouped, at the time of writing, a node has no resale value and cannot be traded on the second hand market.

Can you can spot the issue with these projects? The number of new nodes has to be exponentially higher than the number of existing nodes in order that the original nodes can be rewarded. As these projects have progressed there has been a typical pattern of significant growth while large numbers of investors have bought into the project in the hope of longer term passive income, then as the number of new nodes could no longer reward the existing nodes, the price then begins to fall, quite rapidly to the point that the developers of these projects usually try to extend the life by cutting rewards and making the reward system more sustainable. Inevitably though, over time, these reduced rewards are not sufficient to sustain the project and the price continues to fall.

Those investors who bought into the projects early, compounded rewards into new nodes and took full advantage of the rapidly increasing price, will likely have done well. Returning on their investments by covering their initial costs and enjoying passive income streams even as the overall price falls. Investors who were unlucky with their timing might have bought nodes on the downturn, compounding rewards in additional nodes to receive a larger piece of a smaller pie. Those who have compounded throughout the process and have not withdrawn any of their rewards to fiat are left with potentially significant costs of buying into these projects with little or nothing to show. Frustrations are understandable.

Lets not forget that the developers or these projects are rewarded by maintenance fees which are required every month to run a node, due for payment regardless of the falling price of the underlying token of their project. While the rewards have decreased for investors, the developers have seen ever increasing income from the number of nodes that has grown from the outset. Circa 415,000 STRNGR nodes each paying a maintenance fee generates million in fees every single month or the developers.

Focussing on STRNGR, things went from bad to worse on 19th May when the developers, addressing the sustainability issues which in their defence they had to do, capped rewards on their original nodes (The newer entangled nodes already had a lifetime cap). The existing nodes, overnight had a lifetime cap of 20 STRNGR. Any nodes that had already received the full 20 expired instantly, ignoring the fact that many of them will have paid their maintenance fees well in advance of this date. The reality set in that the majority of investors in the protocol would never return on their initial investment. You can see why there is so much anger and confusion on the forums over this. While many hoped for enduring benefit albeit at a lower value, this was brought to a sudden halt.

Working through the numbers and the costs associated with maintaining a version 2 node over its life (266 days) when taking into consideration the potential rewards, it is clear that even when combining the ability to pay associated gas fees across all nodes within their entangled system, there is no longer a profit for owning a node. In fact, should you chose to compound half of the 20 tokens received into a new node to replace the expiring node, you would actually make a loss on each investment. The price would have to increase significantly before there is even a point of breakeven.

So why would anyone choose to buy a node now?

Well it isn’t entirely Armageddon. In Quarter 3 of 2022 we are expecting the release of the Strong Chain which we are told by the marketing team is being developed. Their own blockchain. While it is not clear how this will work in practice, the potential upside for participants could be huge so many are unwilling to let their investments in the project die. Could this be the opportunity to recoup the losses incurred by owning nodes? If the token price does recover to its earlier highs then any tokens held outside of the protocol could be worth considerably higher than they are now. Is it worth running nodes in the hope that prices will increase during the period of ownership? That would be down to appetite to risk and personal choice.

The Tax Situation

So how does the income and costs work for node projects?

Although there is no legislation to specifically covering nodes-as-a-service (the term “node” is interchangeable in this space) at the point of writing rewards from nodes are taxed as miscellaneous income in the same way that staking and mining income is recognised.

HMRC’s guidance on Miscellaneous income allows “reasonable expenses” to be offset against the income received. Arguably the maintenance costs of running nodes and the gas fees associated with the maintenance costs are deductible expenses. So too are gas fees associated with the formation of a node. Costs for withdrawing and claiming tokens are transactional in nature and cannot be offset.

The actual cost of the node has been widely disputed from the outset among tax and accountancy professionals. There is a clear case for the capital treatment of certain nodes however there is also reasonable argument that these costs are expenses and can be deducted from the income received. The two different treatments have a huge impact on the overall tax position of an investor regardless of the falling price over the period of ownership.

Many also formed companies to hold their nodes due to the tax planning opportunity this created which, although at the start could have been a sensible choice, may not be the most tax efficient way to structure things going forward.

If you are in any doubt about how things stand for you and your individual circumstances, please don’t hesitate to get in touch.

*STRNGR was formed in April 2022 replacing STRONG
** For transparency purposes. the author of this article holds investments in a range of node protocols.
*** The purpose of this article is for information only and is not to be considered financial advice.

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