About the author: Franz Bergmueller is chief executive officer of SEBA Bank, a digital-assets bank.
Digital assets are at an inflection point. Institutional engagement with the asset class is reaching unprecedented levels. That development may seem strange in light of the significant downturn we’ve seen in the crypto markets, but this bear market is unlike any that we’ve seen before.
Institutional players are now looking long-term when it comes to digital assets, despite the short-term volatility. This summer has seen leading asset managers including Abrdn, Blackrock, and Charles Schwab invest in digital-asset offerings. These developments are representative of a broader trend, with a wide spectrum of investors clamoring for access to the sector. According to a PwC report earlier this year, more than a third of traditional hedge funds now invest in digital assets, nearly double the figure from a year earlier.
This year has also seen the collapse of a number of centralized-finance companies. Known as CeFi, these are relatively traditional financial firms that specialize in digital assets. Many are lightly regulated, if at all. Prominent failures have also fundamentally reshaped the go-to-market strategy for many investors. Lending platforms Celsius, Voyager and Vauld have all declared bankruptcy with little clarity for customers on what will happen to their assets. Investors looking to participate in the space are now seeking transparency, asset security and deposit protection.
Demand is here, led by a new understanding that this is a volatile asset class. However, the industry needs to address a number of key concerns in order to enable institutional investors to operate with confidence in the sector and unlock the next phase of growth.
We can start by learning from the CeFi wipeout. The collapse of a number of CeFi platforms offers a stark warning to investors. While these platforms mimicked traditional banks, albeit on the blockchain, the lack of supervision or regulation governing their practices meant their business model was never going to be sustainable. As soon as there was significant market turbulence, the model unraveled, and it became clear that some platforms didn’t have sufficient deposits to support withdrawals from clients.
Their failings offer a warning that there needs to be a clear set of rules of the road in place for institutional investors to engage with digital assets at scale. The world’s largest asset managers simply won’t engage in markets where basic financial requirements are not met, or supervised effectively. To encourage such companies to engage with digital assets, regulatory authorities need to put in place liquidity and capital requirements. They need to impose standardized deposit protections for investors and monitor them effectively.
Many investors still have not received funds they had deposited with bankrupt CeFi platforms. The fledgling legal and regulatory frameworks on digital assets in many jurisdictions means that it is not clear when they will receive funds, or even how much they will be entitled to. Regulation must address these issues.
A number of jurisdictions have led on digital asset regulation: Switzerland and Singapore have two of the most well-established frameworks, providing clear rules for operators to engage with confidence in the sector. These jurisdictions are now being joined by other states keen to unlock the burgeoning growth and innovation being cultivated in the sector.
In June the EU agreed on a landmark regulatory bill on digital assets. The “Markets in Crypto Assets” harmonizes rules on digital assets and infrastructure across the 27 member states and provides power to the European Securities and Markets Authority to ban or restrict crypto platforms that fail to sufficiently protect investors. This will help to ensure that large institutional players can invest in the digital asset sector with confidence.
Other leading financial centers are watching the EU’s plans. Notably, President Biden’s executive order on crypto has compelled U.S. regulatory agencies to work together to develop a comprehensive, overarching framework for the asset class. Similarly, the U.K. has stated its intent to become a global digital asset hub, with the Treasury announcing that it would develop a regulatory framework and introduce a “financial market infrastructure sandbox” to enable firms to innovate in the sector.
States would be better off collaborating as they develop regulation. Doing so would avoid recreating existing frictions in our financial infrastructure. This regulation should consider the fallout from the CeFi meltdown and mandate greater transparency, as well as strict capital and liquidity requirements for operators.
The final piece of the institutional jigsaw lies in security. Over $2.4 billion in funds has been hacked or exploited in the crypto industry since January. Investors need institutional-grade infrastructure in order to mitigate the risk of their assets being compromised.
Considerable debate has focused on the merits of particular key-management technologies for institutions. Investors should look beyond technology when evaluating counterparties. Regular independent reporting on custody solutions should be considered an essential security requirement, while deposit insurance can also guarantee reimbursement in the event of compromise.
As shown by the CeFi collapse, regulators also need to require companies to segregate assets on their balance sheets. The assets of investors who use counterparties without segregation are at risk in the event of financial collapse.
It is clear that institutional engagement with digital assets is entering a new phase of growth. Initial moves to develop clear regulation and the availability of mature institutional-grade infrastructure are combining to encourage investors to participate with greater confidence in the sector. Digital assets and their associated infrastructure will play a key role in the future of financial services. With a blueprint for institutional adoption now in place, it is up to investors to make sure they do not risk being left behind.
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