Institutionalising digital assets is about the “Ts”
09 December 2022
It’s a story that any Netflix writer would be proud to pen – Ilya Lichtenstein and Heather Morgan conspired to launder the proceeds of 119,754 bitcoins ($4.5 billion at the time of their arrests) which were stolen from the Bitfinex platform. Doggedly pursued by the FBI and the US District Attorney’s office, the two were eventually arrested 6 years after the unauthorized transactions and now face up to 25 years in prison.
Closer to home, as it were, is the FTX bankruptcy which rocked the cryptocurrency sector only weeks ago. Likened to the cryptocurrencies Lehmen Brother’s collapse, the saga is set to have wide ranging effects for the sector. BlockFi, a crypto lender, has filed for bankruptcy due to significant exposure to the exchange. Cronos, the exchange token of Crypto.com, lost approximately a billion in value, partly due to the collapse. A host of other issues relating to withdrawal preventions, crypto fund losses, and more are continuing to plague the sector.
These are the sort of stories that make institutional investors run for hills when you bring up the dreaded “C” word. However, these stories only serve to reinforce the fundamental need to increase trust in the system through regulation, better governance, and through time. It’s yet to be seen whether FTX will cause the downfall of crypto. It does, however, serve as a warning sign to investors who are not partnering with trusted entities in this space.
Despite horror stories like the those above, digital assets are perhaps one of the most impactful developments within the global financial services ecosystem and have played a crucial role in the digitalisation of the industry. Crypto assets have, notably, evolved from a niche option to a viable and profitable, albeit volatile, investment choice in recent years – with the total market cap growing from $148.9 billion in October 2017 to $935.4 billion at the beginning of October 2022, peaking in November 2021 when total assets reached $2.9 trillion.
Figure 1: Total Crypto Market Cap
For Giorgio Medda, Azimut Group Chief Executive Officer and Global Head of Asset Management and Fintech, this increase in participation has largely stemmed from “overcoming the perception of crypto assets as something that is too difficult to understand, or in a worse case, something at the limits of legality.” Jean-Baptiste Graftieaux, Chief Executive Officer of Bitstamp, notes that a key aspect is trust. “Institutional clients want a trusted partner, meaning a regulated entity who can demonstrate those aspects that they have come to rely on – a robust internal control framework, a high level of security and integrity, and a robust compliance culture.”
Bitstamp’s Crypto Pulse survey shows that this level of trust is growing, despite the ‘crypto winter’; between Q1 and Q2 this year, there was a 10% increase among institutional investors looking to increase their exposure to the asset class. And while challenges remain, most are slowly but surely being overcome.
In fact, the latest data from BitStamp shows that institutional registrations on the platform increased by 57% in November compared to the previous month – even with FTX debacle in the limelight. Many have also continued to buy throughout the crypto winter given the sharp fall in coin valuations and the possibility of longer term profits.
Challenges still ahead but are being overcome
Much has been said regarding the challenges that crypto faces in terms of hampering the acceleration of institutional investment, from volatility to cybersecurity, sustainability to AML, fork management to regulatory obligations, as well as counterparty risk. However, as the asset class becomes further entrenched these challenges are beginning to be overcome.
While crypto is inherently a highly volatile asset class, this is no different from other high-risk investments such as venture capital or private equity. “Volatility is of course a risk, but it’s part of asset management,” says Olga Bogdanova, Head of Investment Counselling at Citi Private Bank Luxembourg. “What we’ve seen in this market cycle is that crypto assets are highly correlated, the move down has mirrored the broader equity market clearly showing that it’s a very high beta equity play.” Broader adoption could help in this regard by bringing a deeper market, possible diversification benefits and therefore lending credence to the narrative of crypto acting as a hedge.
The recent sell-off and thereafter the downfall of FTX are certainly challenging the trust of all investors, which will need to be rebuilt.
In fact, many of the challenges that crypto faces are not all that different from what the financial services industry traditionally deals with on a day-to-day basis. Cybersecurity remains a perpetual issue for the sector and with cryptocurrencies and blockchain comes the perceived lack of an agent of trust acting as an intermediary. That said, perhaps it is better to shift away from the trust narrative and rather towards one of confidence as researchers recently did? They proposed that blockchains rather act as confidence machines given the secure nature of the protocol itself replaces the need for trust between actors.
Many of the challenges faced are also due to current operational risk models in the traditional industry. “Fork management is a fantastic example,” says Bogdanova. “You need excellent data sources, you must be reactive, have appropriate internal controls and processes in order to manage the fork correctly to ensure it matches the required corporate actions, security settlement, and transfers.” For the private banking industry, the crypto side is not something that is inherently built into current operating systems and client servicing processes, making the managing of aspects such as forks far more complex and cumbersome.
We’re considering a type of ESG index or label on the crypto assets so that investors can select assets that have a better sustainability footprint.
Risk frameworks are currently also being challenged in the EU by the Markets in Crypto Assets regulation (MiCA). “MiCA will bring a level playing field to Europe, bringing a new standard in terms of compliance and risk management. It should also bring a higher level of trust in the ecosystem,” says Graftieaux. This should in turn trigger increased adoption of the assets from institutional clients, he notes, once again emphasising the trust aspect.
A key aspect hampering increased adoption by institutional investors is the negative perception regarding cryptocurrencies and sustainability. While the Ethereum Merge show the benefits of a proof-of-stake model compared to proof-of-work in this regard, the key issue remains how computing capabilities are powered to ensure maximum sustainability. However, this is already less of an issue than it is made out to be as 57% of energy used in crypto mining stems from renewable sources (hydro, wind, solar, nuclear, and geothermal with carbon offsets) according to a study by Roland Berger.
There are also a variety of initiatives being undertaken in order to embed ESG into the crypto ecosystem. “It’s early stage, but at Bitstamp we’re considering a type of ESG index or label on the crypto assets so that investors can select assets that have a better sustainability footprint,” says Graftieaux. While “Azimut has recently invested into Alps Blockchain and its mining company, which uses 100% hydro power for its computing power,” highlights Medda. There is no perfect answer, but akin to the traditional financial services ecosystem, positive steps are being made – from baskets of ESG crypto assets to the shift to proof of stake. Additionally, there is a distinction to be made between crypto in the US, Europe and APAC that is largely used for trading purposes, whereas in Africa, for instance, it’s USP is as a payment method. “Offering the unbanked access to e-commerce and payments infrastructure is a critical aspect of crypto in Africa, thereby also indirectly participating in the inclusion aspect of ESG,” emphasises Graftieaux.
Azimut has recently invested into Alps Blockchain and its mining company, which uses 100% hydro power for its computing power.
Ensuring crypto is a viable asset class for institutional investors
Looking back a decade, many saw crypto as a scam or some form of fraudulent activity. Today, however, it is clear there is an entire ecosystem at play, with use cases for various assets and companies backed PE and VCs building infrastructure around blockchains.
These assets, companies, and the infrastructure are fundamental in progressing the decentralized finance ecosystem, with crypto now used for payments, for NFTs, for smart contracts, settlement and many others. “Technological developments, as much as regulatory shifts, have seen crypto become increasingly more mainstream discussion point for both institutional investors and high-net worth individuals over the last five years,” explains Bogdanova, “but the recent sell-off and thereafter the downfall of FTX are certainly challenging the trust of all investors, which will need to be rebuilt.” Time is what clearly will tell.
A key steppingstone will be how crypto weathers the current high interest rate environment. “With interest rates rising, the opportunity costs rise as well,” notes Medda. “We need time to consider new trading evidence in order for correlation to be measured and to see how the system evolves,” he continues.
This will undoubtedly take some time before we can fully comprehend how the system evolves as higher rates set in, however what is clear is that institutional investors are slowly but surely wading in.