This article is contributed by Irfan Ahmad, Singapore-based vice president and APAC product lead at State Street Digital.
The summer of 2022 was cold for crypto. In fact, conditions were so bleak for the alternative asset class that it lost a third of its value with the largest currency, Bitcoin, dropping from its November 2021 highs of almost $69,000 to just $19,000 by June.
The result of the ‘crypto winter’ is the currency is in the throes of negative investor sentiment and damaging media coverage. Trillions of dollars were wiped off crypto markets at its low, inflicting heavy losses on both retail and institutional investors. Many crypto firms have laid off workers, a few went bankrupt, and the remaining players are consolidating.
As winters go this one is ice cold, but it offers one big upside: it is accelerating regulation and innovation, and those two trends can help lay a solid foundation for the digital transformation of finance.
Also, this crypto winter didn’t happen in isolation: the major traditional markets in equities and fixed income have also suffered major losses this year. Compared to the performance of safe-haven assets such as government bond markets since 2020, crypto looks to have fared relatively well, and it remains the fourth-most popular asset for investors after stocks, mutual funds and bonds.
Institutional investors still regard digital assets as the future, and they are considered an important diversifier for portfolios. In the last year, large institutional investors have started to accumulate bigger volumes of Bitcoin and Ethereum, both to combat inflation and to deliver a seemingly, reliable income stream.
While the environment for crypto has been decidedly chilly, regulators continue to warm to more legislation of the sector, which should prompt greater appetite from institutions currently deterred by reputational risks.
Regulatory authorities across all major regions are acting to improve clarity around cryptocurrency and pave the way to responsible market growth.
This June, in the depths of the cryptowinter, the Japanese Financial Services Agency (JFSA) released a public consultation proposing a removal of the ban on Japanese trust banks from conducting a crypto-asset safekeeping business. The idea is to leverage trust banks’ experience and risk management resources for crypto assets, which would strengthen investor protection and promote market development.
Meanwhile, the Hong Kong government introduced pioneering virtual asset legislation, which will license virtual asset exchanges in a bid to combat money laundering by giving the Securities and Futures Commisssion (SFC) of Hong Kong responsibility for virtual asset service providers (VASPs).
At a global level, this July the Financial Stability Board (FSB) issued a statement on International Regulation and Supervision of Cryptoasset Activities, which called for harmonised regulation of digital assets and the need for regulations to manage financial stability risks.
Crypto assets are not always seen as compatible with investors’ environmental, social and governance (ESG) investment strategies. Yet recent developments in the sector suggest the conditions for the ‘G’, at least, are improving.
Decentralised Finance (DeFi) platforms are an innovative financial technology that uses distributed ledger technology (DLT) and blockchain to eliminate the need for intermediaries.
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The interest in DeFi by institutional investors is increasing and, while the premise suggests lower levels of governance in the absence of intermediaries, DeFi platforms are reinforcing the blockchain community’s commitment to decentralisation by issuing governance tokens to users.
These governance tokens transfer agency, responsibility, and control of platform management from a project’s small group of founders, employees, and insiders to the globally distributed and decentralised community of stakeholders that uses the platform and engages with the wider DeFi ecosystem.
As more participants join, so the governance of these tokens improves and ultimately this innovation improves the freedom and security in which investors can participate in digital assets.
We are also seeing improvements in the ‘E’ of ESG, with Ethereum transitioning to an energy-efficient Proof of Stake (PoS) consensus method. In September, the Ethereum developer community achieved this transition in a move called “the Merge”, part of a multi-step process of upgrading the Ethereum network. Scalability and security are important goals of this transition, along with energy usage.
A volatile summer for cryptocurrency has not stymied technological advances. Indeed, the technology underpinning cryptocurrencies could dramatically alter the way other financial assets are used in investors’ portfolios.
In particular, the transformative potential of blockchain and DLT could see illiquid assets such as infrastructure and private equity become more easily tradable through ‘fractionalisation’.
Effectively, the physical infrastructure or property is broken up into digital tokens – or ‘token shares’ – that represent parts of the underlying asset to be traded much like an equity.
This is an important development since it would open the private markets to retail investors, notably defined contribution pension members, who have long struggled to include illiquid assets in their portfolios.
ETFs and mutual funds also stand to benefit from having their shares and units tokenized, creating a new way for participants to issue, hold and trade assets.