Cryptocurrencies, digital assets, and digitization of existing assets represent the next massive shift in the evolution of money and, more generally, value; these technologies could potentially create the next multi-trillion-dollar opportunity set. But we’re not there yet. So, how do we get there? And why should the FX industry embrace the rise of cryptocurrencies and digital assets? And furthermore, where do the underlying technologies, blockchain and distributed ledger technology (DLT), fit in? This article focuses on the key challenges to institutional uptake and proposed solutions for mainstream adoption. Although sell side was first out the gate in researching and experimenting in crypto and blockchain, buy side is critical to driving the trading and investing growth in the space.
Across all industries, it is becoming clear that data is value and data is also money. Just as email revolutionized the frictionless movement of information, cryptocurrencies and blockchain technology is set to do the same for digital money and value; this will accelerate in the years come. Buckle up, industry incumbents.
David vs Goliath?
January 3rd, 2009 – a very important date in crypto world, the date Satoshi Nakamoto (an anonymous person or group) released the Bitcoin protocol to the world. 11 years later and some cryptocurrencies remain shrouded in mystery and, often, misinformation and hype.
The current cryptocurrency market total market cap is approximately $230 billion and the daily turnover in the top crypto (bitcoin) is about $36 million. Bitcoin is about 67.3% of total market cap and remains the dominant cryptocurrency since its inception. Over 2000 coins have launched in the past decade, though the vast majority represent a graveyard of hopes, experiments gone wrong, and in some cases, outright scams, some of which are (rightly so) being prosecuted.
In contrast, the latest BIS Triennial Central Bank Survey (April 2019) states daily global FX markets turnover rose to $6.6 trillion, up from $5.1 trillion three years earlier. The US dollar retained its dominant currency status, being on one side of 88% of all trades and FX Swaps, its use as the preferred instrument to manage funding liquidity and currency risk represents 49% of that volume.
Key challenges to crypto and proposed solutions for mainstream adoption
Challenge 1: Global common taxonomy and need for education
Common terminology, standards, and best practices are critical to advancing an industry. The FX and derivative markets have FIX Protocol, ISDA, and some industry and regulatory bodies which have aligned on taxonomy and standards.
This is just beginning to happen in the cryptocurrency markets. But it’s not easy. How do you define and differentiate virtual currencies, cryptocurrencies, tokens, and digital assets? And what are stablecoins and central bank digital currencies (CBDCs)? This new asset class requires coordination, technical standards, business standards, and legal and regulatory clarity, further increasing the complexity.
For example, the FIX Trading Community has had a long-standing working group focused on digital currencies and standardization of codes for trading. And ISO is working on developing technical standards for blockchain under ISO/TC307 for blockchains and distributed ledgers. The standards bodies ISDA, ANNA, XBRL are all reviewing and incorporating possible crypto taxonomy and standard for crypto, which is a positive direction for the development of the industry.
In addition, regulatory bodies like Switzerland’s FINMA, Singapore’s MAS, and UK’s FCA, have provided guidance and clarification on cryptocurrency taxonomy, which has been helpful in codifying how to distinguish a security token from a utility token, though the definitions are not universal across jurisdictions.
Challenge 2: Regulatory uncertainty and need for global regulatory oversight
London, New York, Singapore, Hong Kong, and Tokyo remain the main FX trading hubs. Where are the crypto trading hubs? Anywhere and everywhere, 24/7/365. Herein lies the challenge of trying to regulate a nascent industry which is decentralized, grassroots, and anti-establishment by nature.
However, when regulators and governments do not weigh in and allow a complete free for all, bad things happen. South Korea is one of the countries which experienced the extreme negative downsides of the ICO (Initial Coin Offering) mania of 2017; it created a massive bubble and unusual crypto trading concentration, dubbed the ‘kimchi’ premium amongst traders who were arbitraging between onshore crypto trading and offshore crypto trading.
The massive crash and subsequent outcries from the public, some of whom lost fortunes and savings overnight, prompted government officials to ban crypto trading and ICOs for a while, before they were convinced by stakeholders to consider a more moderate approach. China, similarly, experienced the rapid rise and fall of crypto and the extremes of ICO mania. Last year, however, Xi Jinping called blockchain a “core technology,” leading to increased investment and attention to the space, though crypto trading is discouraged and largely banned. Unfortunately, this reflects the simplistic ‘blockchain good, crypto bad’ view, which deserves a more critical evaluation.
The USA is the elephant in the global room; it has yet to get its act together at the federal level with respect to cryptocurrencies and crowdfunding via digital assets. In the USA, cryptocurrency is classified as ‘property’ by the IRS and ‘currency’ by FINRA, while the SEC and CFTC categorize them as ‘commodity’ or ‘security’ using the Howey Test, which was created in 1946 after a dispute over a citrus farm. No one and everyone seem to want a piece of cryptocurrency oversight.
Introduced in December 2019, the ‘Crypto-Currency Act of 2020’ is a bill proposed by Congress to clarify which Federal agencies regulate digital assets, to require those agencies to notify the public of any Federal licenses, certifications, or registrations required to create or trade in such assets. The Libra project announcement is largely the catalyst for recent acceleration of Congressional and central bank discussions around the world. The possibility of a 2.3 billion person social network getting access to near frictionless, cheap payments is a game-changer and the world’s monetary leaders are paying attention.
To be fair, cryptocurrencies do not fit cleanly into existing financial laws and regulations because of their decentralized, borderless, paradigm-shifting nature. There are some countries which have led in providing clarity and thoughtful regulation, without stymying innovation. These examples should be reviewed and, where appropriate, followed by other countries and international regulatory bodies: good examples are Switzerland, Singapore, United Kingdom (though some recent FCA guidance suggests it is becoming less crypto friendly), Bermuda, and Japan (similarly with UK, guidance on licensing Japanese crypto exchanges in April 2020 is anticipated to be more restrictive), just to name a few.
Challenge 3: Lack of Pre-Trade, Trade and Post-Trade market infrastructure for Digital Assets / Crypto
The trading side of cryptocurrencies remains surprisingly basic, as the majority are spot trades with some leverage and several derivative products. Reminiscent of the FX markets of the ‘80s & ‘90s, crypto trading now lacks sophistication, is filled with frictions, and is generally bilateral spot with little leverage. However, key advantages remain: near instant confirmation and settlement, 24/7/365 trading, zero reconciliation across networks as transactions are immutable once confirmed (at least on public chains like bitcoin and ethereum).
Signs of market development, especially in derivatives and custody, are ramping up, with some of the largest financial institutions, like Fidelity Investments, NYSE/ICE’s Bakkt, and CME Group, developing and launching products and solutions for cryptocurrencies and digital assets.
For example, Fidelity Digital Asset Services recently received a charter from the New York State Department of Financial Services (NYDFS) that allows it “to provide a virtual currency custody and execution platform, on which institutional investors and individuals can securely store, purchase, sell, and transfer Bitcoin.” For its part, Coinbase Custody announced in June 2019 that it has over $1.3 billion in assets under custody (AUC) and “services over 90 clients. Of those, approximately 40% are outside of the U.S.” Both young crypto upstarts and incumbent financial institutions are entering and providing solutions where there are currently institutional market infrastructure gaps, though there are still many questions to be answered. How can asset managers hold and risk manage ‘digital private keys’? What about crypto insurance and liabilities? How do market participants ensure the same standards of fiduciary responsibility when they invest in crypto vs gold or commodities?
In the trading space, Legg Mason, Merian Global, and Aberdeen Standard Investments have “signed on to a new system launched” by fintech firm FNZ, “to replace the complex patchwork of IT involved in retail investors’ buying and selling of mutual funds with a single distributed ledger.” In May 2019, Calastone, the largest global funds network, announced that they would be moving their entire network of more than 1,700 financial organizations to the company’s new blockchain-based Distributed Market Infrastructure (DMI). In using DMI, Calastone hopes to create an “ecosystem within which the trading, settlement and servicing of funds is friction free, eliminating ever-growing risk and costs for fund managers and investors, embedded within the current system.”
The key to adoption: Institutional Buy Side: Rise of Cryptocurrencies and Digital Assets Funds, new growth driver?
In the past three years we have witnessed the explosive growth of crypto funds. As of Q1 2019, there were an estimated 150 active crypto hedge funds with a collective $1 billion AuM.
In 2019, the Fairfax County’s Virginia’s Police Officer’s Retirement System and Employees’ Retirement System invested $55 million in crypto-focused Morgan Creek Digital’s second venture fund, up from their previous $21 million investment. Other notable examples include the decision by influential fund manager David Swensen to invest some of Yale University’s $29.4 billion endowment in Andreesen Horowitz’s inaugural $300 million crypto fund. In February 2019, The University of Michigan also announced that it planned to double down on its initial $3 million investment in the crypto network technology fund (CNK Fund I) managed by Andreesen Horowitz. Compared to five years ago, the asset management industry, in select areas such as crypto fund investment, compliance transparency, and efficient trade data management use cases, has made progress adopting new technologies. However, it is very early days for the buy side industry.
Key Trends to Watch in 2020:
Libra and Libra-look-a-likes: the crypto leapfrog of 2019 owes thanks to Libra Foundation’s announcement. Never before has one crypto announcement caused such handwringing and passion from central bankers and legislators around the world. Even if Libra does not take off, it has been a game-changer thanks to the power of Facebook’s 2.3 billion users.
Central Bank Digital Currencies (CBDCs): the Libra Foundation announcement not only led governments to threaten regulations, it also provided a catalyst to CBDC projects, and we will likely see a CBDC launched in 2020.
Big tech in Banking: GAFAA (Google, Amazon, Facebook, Apple, Alibaba) are entering financial services in their own ways and they are more willing to adopt crypto alongside other emerging technology innovations than incumbent banks, insurers, etc…
Fungible vs non-fungible assets – Collectibles and unique, tradeable digital items: in gaming, professional sports, art, and unique tradeable items, many groups are adopting the concept of digital unique versions of physical items, which can allow fractional ownership and secondary digital tradable markets.
Decentralised Finance (Defi): Decentralised finance and decentralized exchanges are another paradigm-shifting set of models that will be a challenge to those accustomed to regulating centralized entities and institutions. Financial services have always had issues around jurisdictional arbitrage, but how does this oversight work when there is no CEO and no central institution?
Geo-political crisis – rise in crypto adoption: when a country’s sovereign currency collapses, we have seen a subsequent spike in crypto adoption (e.g. Venezuela, Ukraine, Turkey, Zimbabwe, etc…) Cryptocurrencies are considered an alternative safe haven when a country’s fiat currency is in trouble.
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