About the Author: Franz Bergmuller is Managing Director of SEBA Bank, a digital asset bank.
Digital assets are at an inflection point. Institutional commitment to the asset class is reaching unprecedented levels. This development may seem odd in light of the significant downturn we have seen in the crypto markets, but this bear market is unlike any we have seen before.
Institutional players are now looking long-term when it comes to digital assets, despite short-term volatility. This summer, leading asset managers including Abrdn, Blackrock and Charles Schwab invested in digital asset offerings. These developments are representative of a broader trend, with a wide range 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 the previous year.
This year also saw the collapse of a number of centralized finance companies. Known as CeFi, these are relatively traditional financial firms specializing in digital assets. Many are poorly regulated, if at all. Significant failures have also fundamentally reshaped many investors’ go-to-market strategy. Lending platforms Celsius, Voyager and Vauld have all filed for bankruptcy with little clarity for customers on what will happen to their assets. Investors who want to participate in the space are now looking for transparency, security of assets and protection of deposits.
The demand is there, driven by a new understanding that this is a volatile asset class. However, the industry needs to address a number of key concerns in order for institutional investors to operate with confidence in the sector and unlock the next phase of growth.
We can start with learn from CeFi erasure. 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 oversight or regulation governing their practices meant that their business model was never going to be sustainable. As soon as there was significant turbulence in the market, the model broke down and it became clear that some platforms did not have enough deposits to support customer withdrawals.
Their failures offer a warning that there needs to be a clear set of rules of conduct in place for institutional investors to engage with large-scale digital assets. The world’s largest asset managers simply will not engage in markets where basic financial requirements are not met or effectively supervised. To encourage these companies to engage in digital assets, regulators should put in place liquidity and capital requirements. They must impose standardized deposit protections for investors and monitor them effectively.
Many investors have still not received the funds they deposited with failed CeFi platforms. Emerging digital asset legal and regulatory frameworks in many jurisdictions mean it is unclear when they will receive funds, or even how much they will be entitled to. The regulations must answer these questions.
A number of jurisdictions have taken the lead in regulating digital assets: Switzerland and Singapore have two of the most established frameworks, providing clear rules for operators to confidently engage in the sector. These jurisdictions are now joined by other states eager to unlock the booming growth and innovation cultivated in the sector.
In June, the EU passed a landmark regulatory bill on digital assets. “Crypto Asset Markets” harmonises rules on digital assets and infrastructure across 27 member states and empowers the European Securities and Markets Authority to ban or restrict crypto platforms that do not sufficiently protect Investors. This will help ensure that large institutional players can invest with confidence in the digital asset sector.
Other major financial centers are monitoring EU plans. Notably, President Biden’s executive order on crypto has compelled US regulatory agencies to work together to develop a comprehensive, all-encompassing framework for the asset class. Similarly, the UK has declared its intention to become a global hub for digital assets, with the Treasury announcing that it will develop a regulatory framework and introduce a “financial market infrastructure sandbox” to enable companies to innovate in the sector.
States had better collaborate as they develop regulations. This would avoid recreating existing frictions in our financial infrastructure. This regulation should take into account the fallout from the collapse of the CeFi and impose greater transparency, as well as strict capital and liquidity requirements for operators.
The final piece of the institutional puzzle is security. Over $2.4 billion in funds have been hacked or exploited in the crypto industry since January. Investors need institutional-grade infrastructure to mitigate the risk of their assets being compromised.
Considerable debate has focused on the merits of certain key management technologies for institutions. Investors should look beyond technology when evaluating counterparties. Regular independent reporting on custody solutions should be considered a key security requirement, while deposit insurance can also guarantee reimbursement in the event of a compromise.
As the collapse of the CeFi shows, regulators must also force companies to segregate assets on their balance sheets. The assets of investors who use non-segregated counterparties are at risk in the event of financial failure.
It is clear that the institutional commitment to digital assets is entering a new phase of growth. Early steps to develop clear regulation and the availability of mature, institutional-grade infrastructure combine 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 an institutional adoption plan now in place, it’s up to investors to make sure they don’t risk being left behind.
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