Evolution of Digital Assets in Financial Services
By Glen Lee:
Few creations in the financial services industry have captured the imagination of the global investment industry, as have digital assets and cryptocurrencies over the past decade. With the maturation of the global digital finance industry picking up speed, this article sets out to take a deep dive into the factors driving development and interest in the field. We explore regional banks’ different approaches to adopting the new digital asset class and take a closer look at some of the risks, obstacles, and potential solutions that could further drive widespread acceptance of digital currencies in Asia, and across the world.
Growth of Digital Assets and Cryptocurrencies
[Figure 1: Investment in crypto driven by institutional clients | Source: BCG]
Over the past few years, cryptocurrencies have seen a rapid increase in investment, primarily driven by growing interest from institutional clients. As shown in Figure 1, invested capital per deal had risen from USD$5M in 2015 to USD$20M in Q1 and Q2 2020 (RHS axis). Total invested capital (LHS axis) has also been on an upward trend, reflecting a broader trend of professionalization in the cryptocurrency industry.
Several factors have contributed to this momentum. Firstly, the introduction of new investment vehicles such as initial coin offerings (ICOs), which are similar to Initial Public Offerings in the context of cryptocurrencies, means that regulators and large retail banks have become more involved in the industry as a whole. Other investment options such as illiquid funds with venture capital, highly liquid hedge funds, and market-based investment opportunities have also become increasingly mainstream investment options. Driven by the growing involvement of regulators and retail banks in digital assets through these investment vehicles, public perception of the safety of digital currencies as an asset class has in turn also significantly improved; today, despite their significant volatility, cryptocurrencies are seen as significantly safer compared to a few years ago.
Secondly, investors have become increasingly familiar with other uses and applications of blockchain, such as in settlement processes and smart contracts; indirectly, this widespread acceptance of these technologies have also contributed to investors’ confidence in cryptocurrencies. Thirdly, investors view cryptocurrency as a diversification strategy in their investment to hedge against other asset classes, as cryptocurrencies are perceived as one of the least correlated assets to stocks and bonds.
Evolution of digital assets and cryptocurrencies in global asset management
Amid the boom in digital assets and cryptocurrencies, more clients have been seeking ways to invest in them. The growing demand has pushed more asset management firms into digital assets, with top asset managers now beginning to explore cryptocurrency strategies, and derivative variants and researching tax implications, and fiduciary duties involving digital assets.
In the U.S., for instance, Morgan Stanley’s wealth division opened three Bitcoin funds to clients in March 2021, and J.P. Morgan opened six cryptocurrency funds in August 2021. Other banks, such as Goldman Sachs, have also been looking to offer cryptocurrency funds to their clients. Similarly n Europe, Swiss bank UBS is exploring equity strategies that would benefit from the rise of blockchain technology, and Citi is devising digital asset funds for its clients.
Changing asset management landscape in Asia
Similar trends have been observed in Asia. Amid growing demand from clients, Asian banks have begun expanding their offering of cryptocurrency and digital assets management services. This trend became especially evident after the cryptocurrency market reached an all-time high of USD $3T in total value in November 2021.
In Singapore, DBS Bank boasts SGD $600M ($446 million) of digital AUM as of end-October 2021 with Singapore Exchange Ltd. taking a 10% stake in the digital exchange. Specifically, the DBS Digital Exchange platform enables clients to trade in four crypto-assets (Bitcoin, Bitcoin Cash, Ethereum, Ripple) against the Singapore dollar, Hong Kong dollar, Japanese Yen, and U.S. dollar. According to the head of SC Ventures, Standard Charted recently partnered with blockchain-based asset management companies to establish a virtual asset brokerage and exchange platform. Likewise, in South Korea, top banks such as Woori Bank, Shinhan Bank, NongHyup Bank, and KB Kookmin Bank are all building crypto-asset services.
In India, United is planning to expand its banking services to include cryptocurrency products. Collaborating with Cashaa, a cryptocurrency banking service provider, United has established a joint venture named UNICAS to offer both online cryptocurrency banking services and walk-in services for 34 physical branches in northern India. Through UNICAS, customers would be able to buy Bitcoin, Ethereum, and Ripple by paying in cash or directly from their accounts. According to Cointelegraph, United is even devising mechanisms to allow customers to take out loans against cryptocurrencies.
Reputational risks of cryptocurrencies
Despite the rise in the adoption of digital assets, cryptocurrencies pose reputational risks to banks due to their uncertainty and volatility. In particular, some believe major benchmark cryptocurrencies such as bitcoin have no inherent value. According to a representative of a North American major global wealth business bank, it is difficult to evaluate such assets. He adds, “it’s very hard for us to put it on the shelf or to offer advice”. Hence, vouching for the management of crypto-assets at the industry’s current stage of development may put the banks’ reputation at stake. The hacking of major US Twitter accounts in July 2020 due to a Bitcoin scam further tarnished the reputation of cryptocurrencies, adding to the uncertainty surrounding the legitimacy of digital assets.
Another issue banks need to address is digital assets’ inherent volatility. "Banks don't necessarily want to hold crypto on their balance sheet … they just want to make crypto offerings available to their clients, but [the Basel Committee's rules proposal] still underscores this narrative that crypto is a very risky product, it needs to be treated with caution", said Andrew Gilder, the Asia-Pacific banking and capital markets leader at Ernst & Young. In light of the rapid and unexpected collapse of Luna and TerraUSD in May 2022, the risks surrounding the instability of crypto assets were further brought to light, spurring regulators in South Korea and the U.S. to crank up the heat on investigations into the causes behind the collapse. In particular, TerraUSD, a so-called algorithmic stablecoin, was meant to maintain a $1 peg. However, a huge sell-off of UST led to hyperinflation of Luna, resulting in a spiral of diminishing both UST and Luna.
[Figure 2: Volatility of Digital assets | Source: S&P Global]
Taking a closer look at other benchmark digital currencies, we see that they tell a similar story. The price of Bitcoin slid 48.44% since its peak (Figure 2) at April 2021 according to the S&P Bitcoin Index. The S&P Cryptocurrency MegaCap Index, which covers the two most popular cryptocurrencies, Bitcoin and Ethereum, also demonstrated volatility beyond the comfort level of most banks. Hence, due to the volatile and speculative nature of cryptocurrencies, some financial services leaders remain skeptical of taking on cryptocurrency as an asset class for their banks.
Regulatory concerns among regulators and banks
Regulations have been imposed by different governments to monitor cryptocurrencies. In January 2020, the Monetary Authority of Singapore (MAS) introduced new legislation named the ‘Payment Services Act (PSA)’ to regulate the cryptocurrency and digital assets industry. PSA outlines ‘digital payment tokens’ as a digital representation of value that is expressed as a unit that can be accepted by the public as payment and can be transferred, stored, or traded electronically. Under this definition, intermediaries that trade digital payment tokens need to adhere to customer due diligence, conduct regular account reviews, make risk assessments and mitigation, report suspicious transactions, and more.
In Thailand, the Thai Securities and Exchange Commission (SEC) is also taking measures to regulate the trading or exchange of digital assets. According to the Thai SEC, the trading or exchange of digital assets must be done by licensed operators (digital asset exchange, digital asset broker, and digital asset dealer).
As illustrated by Singapore and Thailand, regulations are at a nascent stage of development, and regulators and governments across Asia do not yet have a cohesive stance on digital assets. With changing regulations, banks need to constantly adapt to comply with these changes, which can add to the costs and processes on the banks’ part. Therefore, many banks are concerned with complying with the changing regulations and managing assets accordingly.
Another important issue that banks need to navigate is tracing the transaction of funds. This is essential for them to complete their due diligence processes to maintain the legality of their transactions, not involving any illicit trade, criminal activities, and tax evasion.
Solutions to regulatory concerns and verification issues
In terms of regulatory compliance, banks can start to develop guidelines addressing them. First, respective banks should research current regulations in different regions, then conduct gap analysis, outlining the difference between current regulatory requirements and changes). Second, banks can develop risk management diagnostics for respective cryptocurrency activities or services they aim to offer. Third, banks can create risk management software solutions for their transactions or trades.
In terms of the due diligence process, banks can rely on ‘Know Your Transaction (KYT)’ services, which allow banks to track all transactions with blockchain technology (Figure 3). Currently, the ‘Know Your Customer(KYC) program is in place to check the reliability of customers with proofs such as government identification, proof of employment, and credit references. Since KYC only verifies the transactor, there is a limitation in detecting illegal transactions. However, the KYT service saves the history of exchanges and payments, provides data regarding the previous patterns of behavior associated with criminal activity, and notifies the bank when those patterns occur.
[Figure 3: KYT checkpoints to verify and trace transactions | Source: BCG]
All in all, the growth in cryptocurrencies and digital assets is changing the landscape of banks across the world. While this evolution takes place, it seems that the reputational risks associated with crypto need to be addressed. Furthermore, while concerns remain over the issue of complying with changing regulations, banks can aim to mitigate regulatory concerns by creating their respective guidelines and implementing KYT services.