Deciphering Digital Assets
Digital Assets in 2024
Globally, the financial industry finds itself at a major inflection point with the deepening and unstoppable integration of digital assets, including cryptoassets, into traditional finance systems. After a dormant period for cryptoassets following the 2021 crypto market euphoria, sentiment is once again returning, with the price of Bitcoin, a bellwether for the interest toward digital assets, surging past its all-time high along with a raft of institutions now increasing their exposure to cryptoassets.
In particular, the approval of 11 spot Bitcoin exchange-traded funds (ETFs) by US regulators in January 2024 has, for the first time, laid a clear path to institutional adoption of cryptoassets. Asset manager BlackRock has stated it is in early-stage talks with wealth funds and pension funds over deploying capital into its spot Bitcoin ETF.
The approval of the spot Bitcoin ETFs in the US perhaps represents a changing regulatory stance toward cryptoassets, which for several years has been shrouded in uncertainty, confusion, and scepticism following several cataclysmic events in the cryptoasset space this decade. For example, the collapse of the Terra Luna network in May 2022, which was the third-largest crypto ecosystem at the time, saw US$50 billion in investor funds wiped out. In addition, the collapse of the FTX crypto exchange in November 2022 sparked further mistrust, underscoring the need for more stringent regulatory frameworks.
US regulators have found it difficult to classify and regulate cryptoassets, with several different regulatory bodies, such as the SEC and CFTC, at loggerheads over defining cryptoassets as a security or other classifications. The EU’s Markets-in Crypto-assets regulation has since entered into force, becoming the first comprehensive regulatory framework globally designed to govern the provision and issuance of services related to cryptoassets.
The UK is comparatively behind in its cryptoassets regulatory journey. Cryptoassets are generally still unregulated in the UK, with cryptoasset service providers required to ‘register’ with the FCA rather than obtain authorisation, leaving them subject to existing and generic anti-money laundering and counter-terrorist financing regulations. There is a distinction between being registered and authorised. While providing a mark of credibility, registration means that consumers will not get protection from the Financial Services and Compensation Scheme in the event something goes wrong.
UK regulators have outlined plans to make the regulations more widely applicable and more stringent, with authorisation likely to be required in the near future. There is no question that the inherently volatile and open-source nature of cryptoassets calls for more nuanced and dynamic regulatory oversight than the traditional finance world is typically used to, with institutional and retail investors equally facing significant market risks. It is important for brokers seeking exposure to cryptoassets to stay attuned to the evolving regulatory landscape and consider how they may be affected by new requirements.
From a structural standpoint, brokers and indeed financial institutions are still deciphering what increased participation in the cryptoasset space may look like as they seek to stay relevant to the demands of their clients. The crypto world is structurally different from the traditional finance realm in terms of trading and infrastructure, largely due to the blockchain technology that underpins it, as well as its origins in the retail world.
For example, there is a lack of standardised access to crypto platforms, with mismatches in the large number of cryptoasset exchanges and a limited number of market makers and liquidity providers.
Fragmentation is also commonplace within the cryptoasset industry, with liquidity often needing to be sourced from a plethora of centralised and decentralised exchanges in order to fill large institutional orders at the expense of order execution quality. The opacity of some decentralised exchanges means regulatory reporting functionalities are often lacking.
In many ways, these uncertainties and bottlenecks are providing early opportunities for specialised crypto prime brokerage services and APIs, which can provide a much-needed systematic and standardised approach to crypto trade execution and data management. This, along with education, will be the key to truly opening the door to institutional adoption of cryptoassets.
Brokers may also be considering not only how to harbour cryptoassets themselves but also how to leverage the revolutionary technology that underpins cryptoassets in order to achieve trade settlement and operational efficiencies. For example, the use of blockchain presents a new paradigm when it comes to settling transactions, providing almost immediate, cross-border settlement capabilities that are protected by immutable and highly securitised blockchain code.
In addition, the application of blockchain to traditional securities is becoming increasingly apparent with the emergence of tokenisation and ‘digital’ assets. Tokenisation involves creating digital tokens to represent real-world assets, with ownership tracked and stored on a digital ledger. The FCA and Bank of England are currently overseeing a 19-firm digital asset sandbox which will explore use cases for blockchain and tokenisation in the financial services industry. Lloyds Banking Group has also given backing to Fnality International, a blockchain-based wholesale payments firm which orchestrated the world’s first live transactions that digitally represent funds held at a central bank.
By and large, the entire traditional finance industry is on a long maturity journey when it comes to integrating cryptoassets. In comparison to traditional finance systems, the crypto industry is still ‘a baby’ with many structural and regulatory challenges yet to be overcome. Nevertheless, the financial services sector is undoubtedly taking on a more proactive and open stance toward digital assets, with the potential of cryptoassets and the blockchain of which they are comprised starting to be fully realised.
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