As a fairly nascent asset class, digital assets face a number of challenges as they grow in popularity. Although much effort has gone into strengthening and legitimising the market, there’s still work to be done
Digital assets have been a mainstay of conference agendas and webinar discussions for some time now, with the constantly evolving field providing plenty of talking points for market participants across the industry.
It can be difficult to keep up with everything going on around digital assets. With an emerging market come emerging risks, prompting, of course, new regulations.
On the brighter side, there’s also an increasing number of rewards being reaped from those breaking into the space.
Rewards: use cases and focuses
Digital assets are an emerging asset class that has truly captured the public imagination, with several gaining a reputation outside the financial industry and breaking into the mainstream. Art-based NFTs, for example, and various cryptocurrencies, have become household names; even if someone has no interest in the field, they’ll likely have seen celebrity endorsements or overheard conversations about the next ‘next big thing’.
Despite their fame (or notoriety), the scope of potential for digital assets is far greater than most people envisage.
Even those in the industry are often oblivious to innovative new use cases, partly due to the sheer speed that the field is developing.
“The most current use cases at the moment are cryptocurrencies, decentralised finance (DeFi) and non- fungible tokens,” explains Andy Schmidt, global lead for banking at CGI. “These are the bright objects of the digital assets realm that are garnering a great deal of attention.”
Tokenisation is also a focal point, with Zodia Custody CEO Julian Sawyer predicting that institutions will “expand the use case away from only investing in tokenised assets to developing their own, particularly around private funds and securities as well as public funds.” According to Adrien Treccani, founder and CEO of Metaco, up to 10 per cent of financial assets will be tokenised by 2030 — a figure that will only continue to rise from there.
Considering the benefits of security tokenisation, Irfan Ahmad, head of digital asset commercialisation for APAC and MENA at State Street, cites new market settlement solutions, operational efficiencies and enhanced liquidity as major draws for participants. More broadly, he names underlying data transparency, enhanced speed and liquidity, broader distribution and more tailored portfolios as just a handful of the ways that digital assets could improve efficiencies in the financial system. “We see digital assets as one of the most transformational forces affecting our industry in the years to come,” he asserts.
In the banking industry, “we’re still coming up to speed on how to leverage and serve digital assets because there are so many alternatives that exist,” Schmidt says. “The most promising use cases are relatively mundane, and tend to rely on blockchain.” These include central bank digital currencies (CBDCs), which have seen considerable interest from central banks across the world in recent years; smart contracts, which can self-execute when the terms of an agreement are met and reduce a firm’s paper-based activities; and digital identity, the potential of which is being explored by industries across the board.
Risks: overcome
Although there are still points of concern in the digital asset space, the industry has solved several risk issues over recent years. While a large part of this is down to the creation and updating of regulatory requirements, other initiatives have been developed and implemented to help participants overcome key barriers to entry, technical problems and more.
Although they can be seen as a risk in themselves, Sawyer suggests that “digital assets have great potential to reduce the number of risks across financial services.”
He reports that “a significant number of institutions are increasing their exposure to the asset class,” something he puts this down to infrastructure development, and the use of over-the-counter trading, digital asset prime brokerage and native custody solutions over complete reliance on exchanges.
“Banks are looking at services that could wrap around [digital assets], like managing the tax implications for their digital currency clients,” Schmidt adds. A key service around digital assets is, of course, custody. As Treccani puts it, “it underpins all the business use cases being developed across the industry.”
Regulation: present and future
It’s well known that a long-standing point of concern in the digital asset sphere has been its lack of regulation. Whether it’s around the development, trading or promotion of products, highly volatile markets that offer little or no protection to those participating in them are unlikely to really be taken seriously in the industry, particularly when held up against established asset classes and markets.
“The biggest aspect to unlocking institutional innovation will be the implementation of clear regulation and legislation,” Sawyer affirms. This will “allow banks, asset managers and more to build the future of digital assets.”
In the UK, the Financial Conduct Authority released rules around marketing digital assets, ensuring that potential clients are aware of the risks associated with cryptocurrencies. “This is a standard test for any other investment type,” CGI’s Schmidt says, and works to bring digital assets under the same level of control that traditional assets are subject to. So far, “progress has been made by adopting a simple approach,” he comments.
“Applying regulations that govern what digital assets most closely resemble and then filling in the gaps as necessary” is an effective strategy, he says, and one that helps regulators towards their goal of market transparency.
Brand new regulation is seen in the Markets in Crypto- Assets Regulation (MiCA), a regulatory framework designed to protect investors, maintain financial stability, facilitate innovation and build trust in crypto-assets. After going live in June 2023, ESMA is currently running a consultation process to determine the successes and challenges of the regulation.
While crypto-assets that are categorised as financial instruments have often operated under existing regulations in the EU, many others have been left out in the cold. In its March 2023 publication, the European Parliament highlights the fact that “at present, there are no rules, other than those in respect of anti-money laundering, for the provision of services related to such unregulated crypto-assets.”
In response to this issue, a number of jurisdictions began to implement their own rules and regulations. Yet while this may have resolved some issues in the short term, an absence of overall regulation for the European Union didn’t help to increase confidence in crypto-assets. Additionally, operating across borders became increasingly confusing and convoluted.
With MiCA now in place, the EU has a harmonised regulatory framework across jurisdictions — in theory.
But there are still some regions that are ahead with their infrastructure development; Switzerland, for example, “has taken a very proactive approach”, Treccani reports. By ensuring clarity to the market through regulations, laws and guidelines, “the market can operate in a sound and safe manner”. Germany, too, has gone the extra mile, implementing the Electronic Securities Act and building a legal framework for security tokens.
In the US, the Financial Innovations and Technology for the 21st Century Act and the Responsible Financial Innovation Act divide regulatory oversight responsibilities, including consumer protection, legal compliance and required disclosures, between the Commodity Futures Trading Commission and the Securities and Exchange Commission.
urisdictions are generally keen to improve the clarity and strength of their digital asset regulations, but in terms of actual implementation, there’s still a long way to go. Opinions vary greatly on how regulation should be structured and enforced, and to what degree such digital assets should be overseen. In several regions, there isn’t even agreement on how they should be categorised.
Sawyer highlights the importance of firms engaging with regulators in the jurisdictions they enter “to build out the framework that banks and financial institutions need for better, safer custody”. Bringing the digital assets sphere under control will require a group effort, with collaboration across the industry required to ensure a system that works to the benefit of all participants.
“Regulation is good for everyone in digital assets,” Sawyer explains. “It brings more clearly defined markets and a more robust infrastructure for market participants to operate in.” As digital assets have “gone into the mainstream,” financial institutions now have dedicated teams to meet client demand, and “regulators are well aware of the role they must play,” he adds.
Progress is certainly being made, but is it happening fast enough to keep up with an industry that’s always racing to the next thing? Sawyer warns that “protracted discussions without implementation pose a risk of creating a ceiling in the digital asset space,” affirming that “even the most innovative and future-gazing institutions can only go so far without a framework of regulation to work within.” If regulators don’t start to catch up with digital asset technology, the transparent and safe markets that participants are looking for will remain unrealised.
Risks remain
Although progress has been made around the regulation and use of digital assets, “risks have been reduced rather than overcome,” Schmidt clarifies. The market is not yet as stable as other asset classes, and the industry continues to grapple with a number of problems that are, as of yet, far from resolved.
There’s hope ahead — as Integral’s chief strategy officer and head of business development, Sanjay Madgavkar, explains, “If we look at the historic evolution of other asset classes, we have seen that they have dealt with challenges in the past via regulatory and technology solutions”. Digital assets just need time to mature, so that they can rectify fragmentation and credit solution difficulties.
Considering where the industry should be placing its focus, the Commodity Futures Trading Commission (CFTC) outlines four broad risk categories in the digital assets space: operational, cybersecurity, market and fraud.
Perhaps the most obvious risk around a number of digital assets is their extreme volatility. Cryptocurrencies are known for their meteoric rises and crashing falls, with many becoming ‘dead coins’ due to abandonment, scams or a lack of liquidity. These peaks and troughs can be brought about by miniscule events; a prominent investor’s passing comment on social media can spark major market movement.
Due to just how new digital assets are, particularly when compared to their established traditional counterparts, the CFTC warns that it can be difficult to predict how they will react to different market conditions. There’s no precedent to base predictions on, and a lack of track records means that projections tend to be heavily reliant on speculation.
The CFTC’s first entry under its cybersecurity risks header is the bleak affirmation that “most new projects fail”. Alongside the broadly covered cases of exchanges like FTX failing, and frequent mentions of a ‘crypto winter’ throughout 2022, it’s no surprise that confidence waned. Exchange insolvency “is a key concern for clients” following this string of events, Zodia’s Sawyer reports, and is an issue that the firm is actively targeting by introducing insolvency protection measures and ensuring that client assets are never mixed.
One of the biggest challenges that the digital asset space faces is reputational. The general public are far more aware of failures and fads than innovative use cases, and without further education on what digital assets can actually do, improving existing processes and solving longstanding problems, hesitancy around engagement is likely to continue. “After the recent disruption in the digital assets markets following the FTX collapse, financial institutions are tentative about trading in markets they aren’t familiar with,” confirms Integral’s Madgavkar.
There is change in the air, though: “Public perception of digital assets is beginning to shift,” says Waqar Chaudry, executive director for digital assets, financing and securities services at Standard Chartered. This is down to a combination of increased regulation and the sector’s work to “curb illegal activity”, he explains.
Worries have also been somewhat allayed by institutional investors’ and financial institutions’ engagement with digital assets, according to Rohan Khoja, senior data consultant at Delta Capita, “helping to legitimise the industry and provide greater confidence to retail investors”.
Safety and security
Due to their digital nature, the risk of cyber attacks is a central concern for digital asset issuers, custodians and clients alike. The use of hot and cold storage and wallets is going some way to remedy this issue, but there are pros and cons to every method. Hot wallets allow for easy access but their connection to the internet leaves them vulnerable to cyber attacks. Cold wallets are far more secure, but are more complicated to use and tend to be more expensive. There’s no perfect solution, and the complexities of the storage process can hold investors back from engaging.
There’s been a lot of publicity around digital asset fraud. It’s become so commonplace that it’s often easy to spot—if you’re on Instagram, you’ve either seen someone’s account hacked to promote some crypto scam or you’ve been hacked yourself.
However, others are more complex and sit on a bigger scale. Industry bodies are regularly posting warnings of the latest fraud and scam cases; between increasingly sophisticated attacks and shaky regulation, investor hesitancy persists.
Next steps
State Street’s Ahmad adds that ensuring interoperability will be key as the digital asset space continues to develop: “This will allow participants to build scalable solutions and have unlimited options for partnerships and collaborations” he says, but warns that “this will require a lot of stars to align”.
“A collaborative effort involving regulators, industry stakeholders, and policymakers is crucial,” says Delta Capita’s Khoja, highlighting market transparency, privacy, data protection and environmental impact as particular areas that the industry should focus on.
Integral’s Madgavkar brings attention back to the technology underpinning the asset class: “Regulation is a central pillar in shaping market infrastructure, but it shouldn’t be thought of as the only tool.” To ensure safety and stability, technology solutions must be broadly adopted alongside regulation, market infrastructure improvements and execution advancements, he says.
As the digital asset sphere continues to develop at speed, firms may feel that the race to innovate and create new products is on — but there can be no race if the track isn’t laid down first. The industry must collaborate to ensure there’s a robust framework in place to support this asset class, and to allow it to make the most of the opportunities that digital assets can bring.
