As businesses, investors and consumers increasingly embrace digital solutions, the diversity of investible asset types is set to increase significantly – with funds wading into the digital asset universe
The march of digitalisation continues unabated, although in many quarters nervousness remains around the emergence of digital solutions as a new investment class.
But with new applications relentlessly being developed, it is important for investment professionals, their clients and regulators to become better educated about digital investing.
Like most developing sectors, early growth in the digital investment space continues apace. It’s time for regulation to catch up with what is likely to be an unstoppable investment phenomenon.
Cryptocurrency, following the arrival of Bitcoin in the late noughties, is now an everyday word. And it’s already prevalent in the investing space to some degree.
A Stradivarius violin was sold via Sotheby’s using a multimillion-dollar Bitcoin contract in 2014, for example; El Salvador was the first country to accept Bitcoin as its official legal tender in 2021; and the use of digital tokens underpinned by blockchain technology is maturing.
Meanwhile, countries and major banks including the Bank of England and the People’s Bank of China are looking at developing their own digital currencies to facilitate the drive towards completely cashless business.
Digital benefits
While some in the investment sector are evangelical about the benefits of digital assets as an investment fund asset class, others remain nervous of the risks involved, the volatility of the digital markets and the lack of regulation.
“There are risks associated with digital assets, as we can see from some players filing for bankruptcy,” says Alex Smyth, Director at Oakbridge Fund Services (Jersey).
“But it is very much thought that crypto – and particularly the blockchain technology that powers it – is here to stay and that it may also begin to revolutionise traditional finance. We currently support five crypto asset-focused funds that are live.”
Richard Doyle, Managing Associate at Ogier in Guernsey, observes: “People have voiced concerns regarding the value of all cryptocurrencies – in other words, a systemic risk to the entire concept of cryptocurrencies – but the risk of something as cataclysmic as this coming to pass is highly unlikely.”
Regulatory concerns
A more circumspect view is held by Carmen Tyler, Director and Head of Investment Solutions at Spring IM.
“We have taken the position that these types of assets are not suitable for our portfolios due to their heightened volatility and lack of regulation. Until we see a materially more stabilised market, we would not look to change our position.”
She cites fraud, hacks and heists in other justifications as reasons for the cautious view adopted by some investment management firms.
“There are further elements that could threaten the use of cryptocurrencies. Governments could take steps to crack down on crypto activity. Last year, the Chinese government banned cryptocurrency trading and mining, in an intense crackdown,” she adds.
“Crypto markets have also been likened to the dotcom bubble. Both promised major economic change driven by new tech and saw a sharp rise in prices that have since dramatically fallen.
“And so, the camp appears to be split between those who believe that blockchain technology is of great value and that users of blockchain need a digital currency to function, and those who are sceptical either of blockchain’s importance or the need for a digital currency.”
Crypto collateral
So, where does the appeal lie for financial services and investment funds in particular?
Doyle explains: “The area of DeFi (decentralised finance) – an emerging financial technology based on secure distributed ledgers like those used by cryptocurrencies – is one where we are seeing substantial growth, both in terms of funds and other financial product providers.
“The broad concept is that anyone can act as a lender and anyone can act as a borrower and the transaction can complete via participating exchanges in a matter of minutes.
“The transaction details are immutably stored in the blockchain and are usually heavily collateralised, providing a substantial level of security.”
Doyle adds: “I think the mainstream appeal of DeFi is currently somewhat limited as a result of very high mining fees – primarily due to congestion on the Ethereum network – so DeFi currently favours high-value lenders over smaller players.”
Smyth says: “Some large financial institutions – from investment banks to stock exchanges to central banks – are considering blockchain-based solutions in order to stay on top of this innovation.
“For example,” he adds, “it is thought that the clearing processing time could be drastically reduced using distributed ledger technology.”
Fund launches
“We are seeing a number of crypto funds launching, or in the process of launching, with a focus on various strategies and uses for the technologies behind them,” Smyth continues.
“It is felt that developing regulation will help to increase the mainstream confidence in cryptocurrencies. Many funds are looking to attract institutional players that wish to hold digital assets in a secure environment that provides alternative liquidity options.
“Many investors are not just buying virtual assets to make a bit of money here and there, they are buying the longer term value of its underlying technology as well.
“It is thought that the traditional financial system will evolve, with blockchain technology playing an important role. If you take that view and research these areas fully, it’s quite exciting and can be a positive investment.
“There’s also a trading view where, for example, typical hedge fund models will try to outperform certain indices through algorithmic trading of different assets and instruments, using arbitrage strategies.”
Reticent investors
Despite that, Tyler expands on some of the risks that have prompted reticence from a whole section of the investment community.
“Blockchain has come under fire for its use in illegal activity, the most notable example being Silk Road, an online dark web illegal drug and money laundering marketplace that was shut down by the FBI in 2013.
“The dark web allows users to buy and sell illegal goods without being tracked, making illegal purchases in Bitcoin or other cryptocurrencies,” she explains.
“If you consider traditional investment markets, in the UK and globally – where regulations require financial service providers to obtain information about
their customers when they open an account and to verify their identity – this practice is not applied to decentralised digital asset markets.
“There’s also been a lot of financial fraud activity with initial coin offerings, the method in which new coins come to market,” she continues.
“Furthermore, digital asset exchanges can be, and have been, hacked, whereby a further risk is posed by electronic wallets. Users have been tricked into giving away their private keys and their assets stolen.”
While such threats give rise to the need for more robust regulation in this area, Doyle believes that this will be fairly straightforward. “Some additional education in the basics of blockchain and cryptocurrency will certainly be helpful for regulators to get more comfortable with the concept and the asset class,” he says.
“While there’s no denying that blockchain – and crypto in general – has its fair share of complexity, the fundamental concepts are not as complicated as people might think.
“Beyond a fundamental understanding, regulators are not required to become experts in any specific asset class – and I would question why crypto should necessarily be treated any differently.
“The recent crash in cryptocurrency values has received a huge amount of media attention and maybe made regulators more cautious than they need to be,” he adds.
“While I think that retail investors should have perhaps received greater levels of protection, many sophisticated and institutional investors are fully aware of the risks, and potentially large upside, inherent in crypto products.
“I don’t think regulators should be viewing crypto products in a different light to other asset classes with regard to products and funds aimed at such investors.”
Smyth, for one, can see the whole investment community coming to the digital table eventually – but he advocates an objective approach.
“Most investment professionals that we speak to keep a close eye on crypto market developments – a case of fear of missing out – but one should approach digital investments with an open but educated, risk-aware mind rather than with a closed, sceptical ‘traditional assets are the only way to invest’ mind,” he says.
Doyle says: “People are attracted to it because of security, speed, efficiency, global reach and decentralisation. It allows access to finance and financial transaction for people who may otherwise have been locked out of the traditional finance system, especially in developing countries.
“As long as there’s a consensus among people that it has a value, that’s going to ensure it does have a future.”