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Asset & Wealth Management

Hong Kong startup makes crypto custody play

HEX Capital’s gambit shows the pathways and pitfalls in making digital assets safe for institutions.

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A Hong Kong-based startup is throwing its hat into the crypto-custody ring, hoping its bespoke approach will vault into becoming an Asian version of Coinbase for investors in digital assets.

HEX Capital began existence in 2017 as a crypto fund run by Alessio Quaglini, an ex-banker (BBVA, First Abu Dhabi Bank). He teamed up with Rafal Czerniawski, a bank technologist and entrepreneur, to found HEX Capital in March of this year because they saw the lack of institutional-level custody as well as to advise corporations on their blockchain strategies.

HEX Safe, the division dedicated to building custody, is being built to meet asset managers’ requirements, but specifically for a crypto environment. Another division, HEX Technologies, advises big companies on how to develop blockchains.

For now, most versions of custody involve cold storage off-chain, often in a hardware solution like Ledger, but these do not provide the reporting and fund accounting services that a traditional custodian would offer. Nor do they allow asset managers to segregate their assets among different portfolio managers and analysts (with different access permissions), nor by portfolios and sub-funds held by a single client.

“We spoke with traditional asset managers about what they’d want a custody platform to look like if it were built from scratch,” Quaglini said.

Everybody’s doing it
The ultimate goal is to create an offer that will become competitive within Asia, which assumes that the nascent industry will cohere around a handful of big regional players – in which someone like HEX could become something akin to Coinbase Prime, which retains a largely U.S.-centered clientele.

There are competitive challenges to a company like HEX being able to achieve that kind of status. Competitors have already emerged from both the classical world as well as from boutique trust companies that are spinning themselves now as digital vaults.

What’s a custody platform look like if it were built from scratch
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On the classical side, Nomura has teamed up with Ledger and U.K. asset manager Global Advisor to offer prime broking (custody plus balance-sheet support for trades), while Northern Trust has introduced new, bespoke tools for helping traditional hedge funds trade and administrate digital assets.

Meanwhile, a number of small trustee companies that cater to family offices and rich individuals have begun digital-safekeeping operations, hoping to capitalize on the fact that family offices are the vanguard of institutional investment in crypto. This includes Fusang and Legacy Trust in Hong Kong, along with the likes of Kingdom Trust in the U.S. and Vo1t in the U.K.

Crypto fund managers in Hong Kong didn’t express much enthusiasm for these services, perhaps because they aren’t designed by blockchain experts: these companies may need to partner with outsiders to offer a digital-asset solution. (Fusang and Legacy did not respond to DigFin communications.)

Licensed versus pure
But they have something HEX does not: traditional trustee licenses, including those to deal in or advise on securities.

(There are other reasons why crypto funds may look for other solutions: one investor based in Hong Kong says there are tax disadvantages to using admin services here onshore.)

Henri Arslanian, PwC

Quaglini acknowledges licensing is a hurdle. He notes there is no existing license framework in Hong Kong for crypto-currencies that are not securities. “We definitely want to get a license as soon as possible,” including one for dealing in securities or for trusteeship, but the firm is still finalizing an initial funding round. “We will have all the right requirements in place to obtain [a license once one is available].”

Although licensing issues are short-term obstacles to pure digital plays, they may prove temporary – and possibly a distraction to more fundamental requirements to sustain a custody play.

“Investors and providers of digital-asset safekeeping should not focus solely on licensing,” said Henri Arslanian, fintech and crypto lead for Asia at PwC. He argues it’s more important to institute the right governance and control frameworks.

The to-do list
Obviously security is what custody is all about, but beyond this there are other considerations. Traditional custodians cut NAVs, but how do you ascertain an asset’s value in the 24/7 world of digital? What’s fair value when, so far, “utility” tokens are being used to speculate rather than for their purported underlying services? So rules and metrics need to be put in place.

Another overlooked area is insurance. HEX Safe, for example, has traditional theft insurance to cover the loss of private keys. Other players such as Altairian Capital have introduced custody based around cyber insurance. It’s too soon to know how investors and regulators will appraise these efforts.

Lastly is the structure of the safekeeping itself. In the decentralized world, the challenge for custody is the immutability of the ledger. In the classical world, errors such as an incorrect Swift message, the wrong counterparty or a fat finger happen all the time.

This is costly and manual to reverse: indeed, a selling point of decentralization is to cut out the need for so much reconciliation. But it can be reversed. Errors conducted in crypto cannot be: a lost private key or coins sent to the wrong account mean the money is gone, forever.

Therefore, security takes on a different meaning. In a decentralized situation, the ledger is distributed, and therefore it can’t be hacked. There’s no need for a big bank to spend zillions on defending its servers against hackers. The challenge is on reducing transaction errors.

Cold and hot
HEX Safe tries to address this through two versions. One is a cold wallet that is “air gapped”, meaning one device has no connection to the internet. Transactions are agreed to offline, and then broadcast to the blockchain network being used (e.g., Bitcoin) through the client’s own node. This suits long-only investors; Quaglini says HEX Safe already has some clients using this service.

In September it will unveil its hot-wallet version, which (like many other solutions in this space) relies on an algorithm called Shamir’s Secret Sharing: a secret, such as a transaction or a private key, is divided (or “sharded”) among three or more distinct parts, which must be reassembled to reveal the cryptographic hash. This is a more robust version of mulit-signature protocols because it can be applied agnostically to any distributed ledger.

HEX Safe is working with a Hong Kong-based trust company to safekeep the third shard; Quaglini declined to name the partner.

He says these hot- and cold-wallet protocols are standard, as everyone needs to rely on academically proven cryptography. What varies is the level of service and client understanding, including things like user experience and reporting capabilities. HEX Capital is building something it believes will appeal to institutional investors – rather than adapt a classical model or a solution originally designed for retail investors (such as Coinbase’s).

HEX Safe will also offer trading and execution capabilities: it isn’t trying to be an exchange, but to face crypto exchanges via its HEX Technologies arm on behalf of its custody clients, so they don’t need to build many interfaces.

Will investors go for this, over a licensed player or an offering backed by a traditional bank? Can HEX and others build into regional champions, or will everything gravitate to a few global giants in the U.S. and Europe? Right now, there is so much demand for a solution that it seems likely every entrant will win some clients. “And then it will be a war,” Quaglini said.

Asset & Wealth Management

Lu Global reverses the Lufax story

Lufax began as a P2P and became a wealth manager – in Singapore, it’s adding secondary trading.

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Kit Wong, Lu

Lu Global, a wealth-management fintech in Singapore, has just launched a marketplace to enable its customers to trade the same products they bought on the company’s website.

Kit Wong, CEO at Lu Global, says the company has developed its consumer-facing business and is now selling both funds and structured products.

But it believes some clients want to get out of these positions, particularly structured notes. Instead of having to hold them to maturity, they can now see if other users in the Lu system are willing to buy them (at a discount).

Wong says the firm, which has a capital markets services (CMS) license in Singapore, serves about 300,000 customers. Some are resident in Singapore (where the business can only market to accredited investors), others are from outside, who can be either professional investors or retail.

The biggest segment of investors are mainland Chinese, who already know the Lufax brand, but there are also a lot of Taiwanese and Hongkongers, and a growing number of Southeast Asian users, Wong says.

The electronic marketplace has just gone live, so it has no volumes to speak of. Lu Global does not take positions in this secondary trading environment – it merely matches its existing customer base in case users want to make trades among themselves.

Lu Global declined to state its assets under management. Wong says the largest number of products are mutual funds, issued by the likes of BlackRock and Pimco – but the biggest volumes are in structured products.

He believes this may have to do with economic and political uncertainty in the region, which is spurring demand for products with known outcomes and terms.

But such products only pay out upon maturity – and the same destabilizing factors may be leading more investors to want to cash out early, even if they do so at a loss. But providing a marketplace not only gives them access to liquidity (assuming there’s a buyer on the other side) but also lets them sell at a better rate.

The launch of this product is a strange parallel to parent Lufax’s journey. Shanghai-based Lufax began in 2011 as a peer-to-peer marketplace for transactions, financing, and investment management. It exited the transactions and financing aspects to focus just on wealth management.

Lu Global built itself first as a marketplace for wealth products – but now it’s expanding into secondary trading, creating a marketplace for customers to exchange financial products before they reach maturity among themselves – a different kind of P2P than lending, which mainland authorities are clamping down on.

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Asset & Wealth Management

Half of Invesco’s China sales now via digital

But as the PRC joint venture learns how to distribute digitally, Invesco remains unsure of robo’s role in Asia.

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Andrew Lo, Invesco

This week DigFin is highlighting three asset-management firms’ approach to digital distribution, particularly in China. See also strategies from AllianceBernstein and BEA Union Investments. Go here for more insights into digital asset and wealth management.

Invesco is using its joint venture in mainland China, Invesco Great Wall, to figure out digital distribution.

The business now manages about $50 billion of assets, of which about 80% is retail, making it the fourth-largest Sino-foreign fund house in China. Over the past two years, half of retail inflows have come from new digital channels, as opposed to the traditional reliance upon banks, says Andrew Lo, senior managing director and Asia-Pacific CEO of Invesco in Hong Kong.

This is in keeping with a broader trend in the global mutual funds industry, which is shifting from one based on products to one focused more on investment solutions. “There’s an emphasis on designing outcomes for clients, such as through asset allocation or structuring,” to combine types of risk and asset classes.

That’s driven both by client demand as well as market volatility and challenges to active fund houses to deliver alpha (outperformance) on a net-free basis, compared to ultra-affordable passive investments tracking a benchmark.

Reaching retail

That’s been an emerging story for the funds industry over the past decade. But on top of that is a new wrinkle: the ability to use technology to speed up operations and to reach more people.

“Technology is now changing the distribution landscape,” Lo said. “In China, it’s having quite an impact on reaching retail investors.”

For now this has been a story unique to mainland China, where existing bank channels (which dominate funds distribution in most Asian markets) are not well developed, and where regulation favors digital disrupters like Ant Financial.

The power of digital was evident in Ant’s success with money-market funds (under an affiliated fund house, Tianhong Asset Management), but it has now extended to equity and quant products onshore – products that Invesco’s J.V. now sells through fintech channels, including Ant, East Money Information, JD.com (Jingdong) and Snowball Finance (Xueqiu).

This has not been straightforward, however. Fund management companies are designed to cater to bank distributors, and are built on old-fashioned tech.

Still learning

“We learned how to do digital marketing,” Lo said. “It’s very different to traditional distribution. It’s iterative, it changes fast, and you have to listen to customer feedback.” Partnering with digital channels has also required a different sense of product design, and to rebuild the company’s operational process to support round-the-clock digital sales and support.

Lo says the experience will be increasingly relevant as other markets digitalize, although they may need to be tweaked, depending on local regulation, client behavior and distributor demands. “Some things we can learn and apply elsewhere as the world goes digital,” Lo said.

The onshore funds market manages about Rmb14 trillion (almost $2 trillion) in total assets among 135 asset managers authorized to sell to retail clients, of which are 44 Sino-foreign JVs.

But most of these JVs are run by the local partner, with foreign shareholders having less influence. They are limited to stakes no greater than 49%, and local partners are often banks or other powerful institutions. One analyst told DigFin that local fund houses are not particularly bold when it comes to digital channels; and even if they are, the lessons don’t flow to the foreign partner.

But Invesco Great Wall’s case is different. Both Invesco and Great Wall Securities own 49%, with two other shareholders holding another 1% each. Given that Great Wall Securities has its own in-house funds business, it has been willing to let Invesco drive the business. (Beijing has recently permitted J.P. Morgan Asset Management to take a 51% stake in its funds J.V.) Invesco Great Wall is also among the oldest funds JVs in China. It is today led by Shenzhen-based CEO Ken Kang Le.

Robo reservations

In China, Invesco is leading the way in digital opportunities. Elsewhere it seems to be running with the rest of the herd. In the U.S. and the U.K., it has made digital acquisitions: Jemstep, a B2B robo-advisor that services U.S. bank distributors, and Inteliflo, a British platform to support financial advisors.

“We haven’t found the right use case in Asia,” Lo said. Onboarding a digital B2B (of B2B2C) platform needs scale, but Asia is fragmented, with each market requiring its own business and compliance needs.

“Digital transformation is still evolving,” Lo said. “My guess is it can be like it is in China, where it’s a real thing that has become a major part of the industry.” But what that looks like elsewhere remains hard to know – or at least hard for justifying a business case.

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Asset & Wealth Management

New China distribution not just for money-market funds

Investors on digital platforms are beginning to look to other products, says BEA Union’s Rex Lo.

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Rex Lo, BEA Union Investment

This week DigFin is highlighting three asset-management firms’ approach to digital distribution, particularly in China. We will also provide strategies from Invesco and AllianceBernstein. Go here for more insights into digital asset and wealth management.

Retail investors in China accessing funds via digital platforms are beginning to diversify away from money-market funds. That is creating opportunities to push ETFs and active funds, says Rex Lo, managing director for business development at BEA Union Investments.

China’s retail funds industry is mainly about money-market funds (MMFs). The total industry size is Rmb13.2 trillion, or $1.9 trillion, of which MMFs account for 57%, or Rmb7.7 trillion.

Among MMFs, by far the biggest player is Tianhong Asset Management, whose product, Alibaba’s Yuebao fund, is Rmb1.2 trillion in size, or $162 billion – the largest money-market fund in the world.

It’s no surprise then that digital distribution platforms in China mainly cater to MMFs. Lo says until recently, MMFs accounted for about 80% of all funds sold on digital platforms. This is propelled businesses such as Tianhong (which of course is sold via Ant Financial) and a few bank-affiliated fund houses with big MMF products, such as CCB Principal and ICBC Credit Suisse.

But it has made digital distribution of limited interest for fund houses looking to sell equity funds or other actively managed products; for them, traditional distribution via banks has remained the only viable channel.

MMFs: less big

Lo thinks this is changing, however.

The popularity of MMFs lies mainly in the fact that they offered high returns combined with guarantees, real or assumed by investors – assumptions the government has been reluctant to upset.

Yuebao and other MMFs usually invest in non-standardized wealth-management products (themselves supposedly “guaranteed”, with investors assuming a government backstop), that returned 5% to 8% to those managers. They in turn offered investors 5%, an equity-like return on what’s meant to be an ultra-safe and liquid asset class.

Over the past few years, however, Chinese banking and securities regulators have been trying to shift the funds industry onto a footing that respects risk and return, and clamping down on the supply of shadow-banking instruments available to portfolio managers.

“Today MMFs return only a little over 2%, while A shares are doing well,” Lo said. “As demand for money market funds declines, turnover has fallen, so these distributors are now promoting index or active funds.”

In recent months, Lo says, MMFs account for only 70% of sales on digital channels, with ETFs now gaining ground.

Accessing the mainland market

BEA Union is able to sell its Hong Kong-domiciled Asia fixed-income fund to Chinese retail investors through a scheme called MRF, Mutual Recognition of Funds.

This program, which began in 2015, allows fund managers on either side of the border to sell eligible products through a master-agent arrangement. Regulators in mainland China have been slow to approve such funds, however, and there are only seven Hong Kong products available via MRF, including BEA Union’s (and 48 mainland funds available for sale in Hong Kong).

Lo is hoping to take advantage of the shifting fortunes among asset classes to use digital channels to push BEA Union’s bond fund.

Platforms such as Ant Financial are requesting the fund house for more material around equities and active funds management. It’s a big, long-term commitment to investor education – especially for foreign fund managers whose ranking is low on Ant Financial and other digital platforms.

“Domestic investors want familiarity,” Lo acknowledged. “But we continue marketing because we want to be on the platform. Today it’s more for exposure than real [inflows], and ticket sizes are as small as Rmb100 ($14). But if you have 100,000 investors, that becomes a lot of money.”

The intention of this ongoing marketing is to become sufficiently well known among Ant’s users to take advantage when retail investors want to invest overseas.

New ways of doing business

Adding platforms such as Ant to traditional distribution methods has been an eye-opener, Lo says. “They don’t think like a traditional finance company. They’re a fintech, so they’re very responsive and open to new ideas. And they’re independent – they’re not a bank with its own funds J.V. – so there aren’t conflicts of interest.”

Marketing was not the only part of business that had to adjust.

“I was amazed when we began to work with these firms,” Lo said. “Enhancements that would take months to get done in Hong Kong take them a few days. We can learn a lot from working with fintechs.” It’s knowledge that will come in handy as more banks in Hong Kong and Asia add mutual funds to their mobile trading apps, as Standard Chartered did earlier this year.

There are limits, however, to how far a fund house can go selling products on mainland China’s digital platforms.

GBA play?

Those channels are limited to funds from either local licensed retail-facing houses, or offshore products eligible via MRF. The retail funds market in China, at $1.9 trillion, is only a fraction of the total investments industry, which is about $9.7 trillion – but that includes separate licensed businesses for asset managers linked to insurance companies, or to trusts, or to banks. Those businesses for now can’t market to retail or use sell via e-commerce players.

BEA Union is a joint venture formed in 2007 between Bank of East Asia and Germany’s Union Investments. Its initial business model was to service local pension and insurance customers, so its investment expertise has been mainly in Asian fixed income. It has since developed funds in Hong Kong and Asia equities, and its total AUM is now $11.2 billion.

It is the only foreign fund house to establish a wholly owned foreign enterprise (Woofie) in Qianhai (part of Shenzhen), as opposed to Shanghai. This was partly because the authorities in Qianhai were very welcoming, and because Bank of East Asia has a presence in southern China, and the fund house hopes to take advantage of this should cross-border opportunities emerge (under the concept of a “Greater Bay Area”).

This medium-term ambition is another driver of BEA Union’s strategy to build an online brand on Ant Financial and other digital platforms.

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Hong Kong startup makes crypto custody play