From Dark Horse to Frontrunner: How Cryptocurrency Has Taken the Lead – and What That Means for Financial Services Firms
Cryptocurrency. Cryptoassets. Bitcoin. Blockchain. These terms have been thrown around, sometimes interchangeably, for years. Generally, the financial services market—and much of the general population—has been skeptical of digital assets thanks to its reputation as an anonymous backchannel for nefarious transactions. Despite this reputation and its severe volatility and occasional crashes, public interest has done everything but slow down. Now, thanks to Elon Musk and his company’s recent investment in this new asset class and the high-profile sale of one particularly expensive GIF, digital assets, or what we like to call cryptoassets, are no longer something financial services firms can ignore. Traditional lenders and wealth managers around the world are under pressure to provide access to this asset class as it becomes an accepted allocation within a diversified investment portfolio.
Not only do financial services firms need to familiarize themselves with these terms, but they need to start thinking about how—and when—they will offer these services to customers while managing the significant risks and ensuring compliance with regulations—which are not yet even fully developed!
What Do We Mean by “Cryptoassets?”
From Stablecoins to Bitcoin, there’s no shortage in variety of cryptocurrencies—and terms that accompany them—on the market. Before we can get into how banks can better serve customers in this new market, we need to define several key terms and how we’re using them here.
- Cryptoassets: Also referred to as cryptocurrency or digital assets, cryptoassets refers to this entirely new asset class as a whole. All the following terms fall under this larger umbrella.
- Stablecoins: Stablecoins and the Central Bank Digital Currency (CBDC) attempt to address the volatility of this asset class by tying the value of the digital token to an underlying asset based on fiat currencies—the US Dollar being a prime example—or even commodities.
- Privacy coins: This is most likely what people think of when they hear the term cryptocurrency. With Bitcoin as its most well-known example, the objective of privacy coins is to obfuscate transaction values and maintain the privacy of its transactors. Other examples include Ether—which is the cryptocurrency that sits on top of the blockchain network Ethereum—Monero and Dash.
- Non-fungible tokens (NFTs): A rapidly-growing asset category, NFTs represent unique or rare digital assets, including artwork, software code, one very famous GIF and more.
With these terms in mind, we can now look at the current ecosystem and what the role of banks has been so far in it.
How Is the Industry Providing Customer Access to Digital Assets?
Access to liquidity has been the starting point for the first digital currencies, with digital exchanges arising to enable access for early adopters particularly in the retail domain. Custody at this level is often provided for free with transaction costs driving revenue.
However, now mainstream retail and wealth management customers are also starting to demand access to all types of digital assets. As investment firms start to offer exposure, regulators are taking greater interest and starting to develop rules to govern the activity of all participants.
As the breadth and sophistication of investors grows, so too do the demands for security, transparency and scale. The largest banks have the skills and resources to build their own services including custody, while fee-based custody services are arising to serve the needs of other financial institutions.
While for retail investors today well-known exchanges provide both custody (usually via a wallet account) and transactional access, it is likely that banks may—smartly—wish to have separate or independent solutions for both these capabilities. For example, while it may be more efficient to use an exchange for transactional access, banks should consider keeping custody of the accounts separate with a more reliable partner to ensure that these accounts are secure.
In addition, banks seeking to enter the market have a binary decision to make regarding how they implement both custody and market access—either via a partner or by building all required functionality themselves. For transactional access, while it is technically feasible to integrate and transact directly with a distributed ledger system, in reality many banks will choose to gain access to multiple digital assets via exchanges. In addition, some banks—and non-banks—are manufacturing their own digital assets; Stablecoins are especially suited to regulated entities with strict obligations and much to lose from any breach or irregularity.
When it comes to custody, however, the secure management of digital assets differs from other traditional assets in that there is no independent registrar of ownership. Possession of the digital asset keys confers all rights necessary to transact. There are consequently significant risks and stringent technical requirements involved in digital asset custody, which takes the form of secure digital vault, depending on highly-secure and hardened networks and data storage, robust integration with exchanges and other banks to facilitate authorized transactions through to physical storage of the assets in which the keys are completely removed from networks of any description—so-called “cold storage” entirely eliminating any electronic access to the assets. Specialized custodians are already emerging, and banks now have the option of various forms of partnership to share risk and balance sheet liability.
How Can Banks Keep their Customers Safe—and Protect their Reputations?
As the exposure to crypto assets amongst retail consumers and other investors grows, so too do the risks.
Given the total financial loss possible in the event that asset keys are compromised, banks need to enhance the way they model risk. In the world of cryptoassets, cybersecurity is proving to be just as much of a financial risk to institutions as any other financial risk.
In addition, to mitigate the risk of inadvertently facilitating criminal activity, banks are shying away from direct crypto asset transfers between custodians. Transfers are largely limited to transactions in and out of fiat currency, where Know Your Customer (KYC) and anti-money laundering (AML) regulations can be more reliably enforced.
Regulators and central banks have been slow to react, however, leaving firms with a general lack of explicit guidance and oversight. In many jurisdictions, even legal precedent defining the status and treatment of digital assets is lacking.
This can be expected to change rapidly, though. The enormous sums being invested into these assets (not to mention profits being made!), the fragmentation and variable quality of services provided by exchanges, custodians and other market participants, the gaps in regulatory coverage and the potential of some types of assets to enable fraud and other criminal activity all contribute to the risk of widespread consumer and systemic financial impact, which will force a response from regulators.
We are seeing the first steps to rationalization and standardization, with three main areas of activity:
- Enabling access to liquidity: essentially, facilitating transactions; institutions may focus on specific digital asset types or provide more general services
- Provision of custody services – very often may be tied to the liquidity access, especially in retail or consumer-oriented services
- Investment management with direct exposure to digital assets or via intermediate instruments
It is only a matter of time before the forces of regulation, reliability and security force what is presently a semi-anarchic ecosystem to mature. In the meantime, banks need to focus on optimizing their security practices, providing rigorous protection of customers and bringing on high-quality services providers to help them navigate this complect field.
What Does the Future Hold?
Given the constraints and risks described above—and much to the chagrin of rebellious early adopters looking for the benefits of an independent, decentralized network—the functional landscape will continue to evolve to more closely resemble established markets with exchanges providing access to liquidity and custodians handling the post-trade environment.
Only the largest and most sophisticated entities will have the resources and skills to economically develop robust custody solutions of their own. For smaller banks, the practical options for entry into the market remain partnership with one or several service providers, which will become specialized by digital asset type.
As regulators seek to gain more control and streamline the increasingly converged and globally connected digital and physical economies, government approved “stable” digital assets will be introduced, backed by underlying fiat currencies while transactions themselves become more closely monitored, reported and more difficult to execute with criminal intent.
To guide them through this increasingly complex environment, financial services firms need a trusted partner to help them comply with local and global security regulations, protect their reputation and ultimately better serve their customers.
