Beyond Cryptocurrencies: Order and Progress For Digital Assets

The mood is clearly changing towards digital assets, in spite of—or perhaps because of—the frenzied market activity surrounding them. Once referred to as a bubble and infamously labeled by some a fraud, cryptocurrencies have created a fair amount of controversy while also whetting the appetite of eager investors. In 2017, they were completely banned by Nepal’s central bank, followed in 2018 by Pakistan’s central bank. And while other countries such as Bolivia, Ecuador and Kyrgyzstan remain strongly opposed to Bitcoin, cryptocurrencies are likely here to stay and, therefore, market players should be prepared. There’s plenty of work to do, and myriad issues with which to contend.

Inconsistent Regulatory  Framework

Digital assets pose a clear challenge to regulators around the globe, and the inconsistent regulatory framework needs to be addressed. Their censorship-resistant nature and suspicious roots in dark web activities have fueled major opposition from regulators. The market has evolved into an innovation incubator, however, so it seems likely that regulators will, in the short term, provide more clarity regarding the requirements and taxation of digital-asset trading activity.

Technical & business aspects key to investment strategy

The mastery of the technical and business aspects of digital assets is crucial to drive investment strategy. A cryptocurrency won’t survive if it’s not absolutely dedicated to its purpose, meaning that no alternative can be used to complete the same function or acquire the service. For example, Ether, the cryptocurrency based on the Ethereum protocol, is required for users to leverage the Ethereum infrastructure, which has a specific added value linked to its smart contract capability. Hence, the adoption of Ether is strongly correlated to the value of the Ethereum infrastructure. Too often, the market is plagued by amateurish investors that rely solely on growth market value to make investment decisions. In the highly illiquid and opaque side of the Initial Coin Offering (ICO) market, this approach can quickly turn investors into victims of market manipulation.

Diversification & market value growth

While the market has long been dominated by Bitcoin in both market value and trading volume, the situation is quite different today, with the diversification of digital-asset instruments and growth of market value. In 2014, Bitcoin represented 87% of the digital-asset market value at US$8.1 billion; it now accounts for only 34% at around US$120 billion. Ether is ranked in second place with 14% of market value at US$48 billion. In fact, the liquidity available on these two leading cryptocurrencies is now on par with those of traditional equities listed on Nasdaq like Salesforce, Intel, etc. In addition, a vast number of digital assets have emerged as Altcoins, alternative cryptocurrencies that followed the launch of Bitcoin, and asset-backed tokens, which represent significant investment and hedging opportunities. In the first six months of 2018 alone, the funds raised through ICOs reached US$13.7 billion. As of August, the overall digital market value was estimated to be around US$350 billion, but a selloff in early September would cut that down by roughly 47%.

Crypto funds struggling with expansion

While the number of funds dedicated to digital assets has increased significantly in recent years, the lack of regulatory certainty, coupled with the often-amateurish operations of funds, has limited the ability to tap into funding from institutional investors. Today, despite interest from asset managers, crypto funds mostly rely on high-net-worth (HNW) individuals and family offices for investment. In fact, if we analyze the assets under management in crypto funds expressed in Bitcoin, it is now equivalent to its January 2016 value (see Figure 1), as numerous investors cashed out during the astonishing growth of 2017. The market has yet to rebound to its peak of December 2016.

Greater participation from institutional investors will require clarification from regulators and the development of market solutions to address institutional investors’ concerns, e.g., custody. Also, a professionalization of the market will be needed for growth, its reputation has been tarnished by financially unskilled crypto-fund managers. Opimas estimates that only around 20 out of 400 crypto funds can meet institutional investor requirements.

Figure 1. AuM of Crypto funds is still below its peak of December 2016

Source: Opimas analysis

Institutional money holds off—for now

There is a lot of discussion in the press and at industry conferences about the growing appetite of institutional investors for digital assets. This has not yet translated into increased activity in the market, however. It is often claimed that this is primarily due to the lack of regulatory clarity. This explanation is not sufficient, as CME Group and Cboe Global Markets Bitcoin future contracts represent a viable route to gain exposure to the crypto market without fear of being confronted by potential regulatory issues. The aggregated volume of open interest on both exchanges, however, has not seen the kind of growth one would expect if significant institutional money was pouring in. From 16 January to 10 August of 2018, the aggregated value of Bitcoin futures open interest on both exchanges increased from BTC11,611 to BTC18,697, accounting for only an additional US$50 million of exposure.

Regulation is not the sole factor preventing institutional investor participation in the digital asset market. The dearth of expertise and understanding of the asset is also a limiting factor, especially when coupled with narrow support from traditional service providers in the capital markets industry.

Market structure is still heterogeneous

A number of exchanges have emerged to aggregate and facilitate trading of this new breed of asset class and are flourishing. Today, the market is dominated by pure crypto exchanges that account for 69% of trading volume, indicating that many investors are now mostly trading within the digital asset realm. Fiat vs. cryptocurrency exchanges only account for 6% of trading volume. 

However, numerous solutions provided are, in fact, half-backed, meaning that they leverage established technological approaches and apply them to a new type of protocol and infrastructure.  First, after a number of hacking scandals, the market moved away from online exchange platforms’ crypto “hot wallet” storage solutions. Now, the relevance of the centralized exchange model is being questioned and some market participants regard a decentralized exchange model as the potential next step in the evolution of the digital asset market.

In addition, there is significant activity being conducted over the counter (OTC) and, therefore, can go unreported. Nevertheless, while the situation might differ from one digital asset to another, a close analysis of the blockchain record of transaction does not point in the direction of a massive reliance on OTC trading, which actually seems to be aligned with exchange-reported volume.

Hot FinTech space answers market need

Given that cryptocurrencies are mostly a technological play, it is not surprising that a burgeoning FinTech ecosystem is quickly taking shape around them. Numerous start-ups have emerged to answer market needs and regulatory concerns in every step of the value chain.  We see companies providing blockchain transaction record analysis to facilitate Know Your Customer/Anti-Money Laundering (KYC/AML) compliance requirements; hardware/software tools to ensure the safekeeping of private keys and digital wallets; and crypto-fund administration, regulatory and tax reporting solutions, etc. Yet not all solutions have passed stringent, operational due diligence analysis, though they are working on providing the relevant systems to meet new market requirements.

It is also worth pointing out that a number of these FinTech start-ups are evolving to become regulated financial entities to facilitate regulatory compliance and ensure the durability of their business models.

FIs must move beyond PR announcements  

In the past year, many traditional financial institutions have made announcements, typically forward-looking, about their crypto strategy. One such company is Goldman Sachs, which announced in early May 2018 that it would launch a cryptocurrency trading desk, allowing clients to trade bitcoin as a non-deliverable forward, though bank executives have not yet set a timetable for the operation. In many cases, crypto-related announcements from firms are more a communications move rather than a strategic plan tied to implementation phases.  If the digital asset market is to mature and include traditional institutional players, then it’s time to move away from PR to implementation.

There are numerous revenue opportunities in the digital asset space that will allow traditional financial institutions to leverage their existing competencies and build partnerships with relevant FinTech companies.

Each type of market player, from exchanges to broker/dealers to custodians, should consider developing services for the emerging digital asset market. Custodians are the financial institutions that have the most to win—or lose. The digital asset market represents a paradigm shift in the provision of safekeeping and custody services. This situation is well understood by Nomura, which in May 2018 launched Komainu, a venture with Ledger and Global Advisor Holdings to provide institutional-grade digital asset custody services.

Within the value chain, mastering these elements will open up significant opportunities beyond just the financial markets as securing sensitive data in myriad industries has become the holy grail of our time. The recent scandals involving 87 million Facebook users whose personally identifiable information was improperly provided to political consultancy Cambridge Analytica and the 380,000 British Airways clients whose credit card information was stolen clearly point towards an increased need for improved data protection solutions.

And unlike the current approach taken by financial institutions to gain experience with blockchain technology through industry consortia and reliance on private blockchains, the digital asset market offers the opportunity to acquire expertise in a live environment.

The combined and collaborative efforts of regulators, FinTech companies and financial institutions can more readily steer "Ordem e Progresso"—Order and Progress—in the digital asset market.

© OPIMAS, 2018. All Rights Reserved.