Turmoil in the cryptocurrency market has done little to dissuade the asset and wealth management industry from moving forward, albeit more cautiously, into the digital asset market.
AWM firms have been actively engaging in digital assets primarily through direct holdings of crypto assets, indirect holdings through investments in funds and or equity investments in digital asset natives. The interest in digital assets has also extended to investments in blockchain technology as asset managers explore opportunities for “tokenization.” In addition, AWM service providers are participating through custody, trading and infrastructure support.
Pursuit of the digital asset market, however, isn’t without challenges. For starters, trust in space is fractured. Enhanced regulation may help rebuild some trust, but firms should be prepared to take their own proactive steps to understand and manage risks, including evaluating internal controls, conducting thorough due diligence on vendors and designing plans for how to respond to potential risk incidents.
Asset managers should transform their governance, risk management and compliance, people, process and technology to compete effectively. Here’s our look at some key trends in the digital asset space that we see impacting asset managers globally and some steps your firm can take to help turn today’s challenges into tomorrow’s opportunities.
In the wake of recent turbulence in the cryptocurrency market, some policymakers and leaders in the AWM sector are calling for stricter regulation of digital assets, particularly the cryptocurrency market.
With that, we expect several advances in regulations in the coming years, especially around definitions, such as which digital assets re commodities and which are securities. We also expect to see regulatory progress around stablecoins since US and global regulators have been studying those assets closely. What’s more, we may see regulators move aggressively to limit certain higher risk lending practices such as taking out loans on collateral received.
Digital assets are increasingly becoming a bipartisan issue in the US, and regulatory updates are also expected for disclosures and tax guidance. Similarly, various jurisdictions in Europe and the Organisation for Economic Co-operation and Development (OECD) are making progress. Given the borderless nature of digital assets, it will also be important (and complicated) for multiple jurisdictions and government agencies to collaborate. A clear, holistic and global regulatory framework for digital assets would enhance an asset manager’s ability to navigate the global markets with consistency and confidence — but absent such a framework, asset managers will face hurdles in maintaining a thorough understanding of the rules and regulations for the various markets they operate in.
While there is some guidance on the tax treatment of income from digital assets, tax policy is likely to be reactive as the digital assets space and associated economics continue to evolve at a rapid pace. In the US, for example, we expect an expansion of reporting standards and tax reporting requirements. As regulators adapt, so too will tax policymakers and, in time, some may offer tax and non-tax incentives to digital asset players.
Your firm should also be mindful of the local tax rules regarding cryptocurrency and other digital assets in the various jurisdictions where you plan to do business. For example, fund structures need to be fit-for-purpose for the particular jurisdiction you conduct business in and for the type of investor you want to target.
In the US, the Biden administration has laid out its first-ever framework to harness the potential benefits of digital assets while decisively mitigating the risks. The framework encourages US agencies to continue efforts to ramp up enforcement and issue new guidelines as needed for cryptocurrencies, including addressing and limiting financial institutions’ exposure to digital asset risks.
The European Union is in advanced stages of finalizing its Markets in Crypto Assets (MiCA) regulation, designed to create investor safeguards, capital requirements and corporate governance rules for the broader crypto market. Overall, a significant number of countries are researching, defining, consulting, negotiating and legislating in order to bring digital assets under the existing financial services frameworks.
Source: Fact Sheet: “White House Releases First-Ever Comprehensive Framework for Responsible Development of Digital Assets,” September 16, 2022
Source: Press Release: “Digital finance: agreement reached on European crypto-assets regulation (MiCA),” Council of the EU, June 30, 2022
Growing interest in digital assets by the industry and investors alike is prompting many AWM firms to evaluate their control environments, including vendor selection and oversight, specifically custody controls.
Custody options include securing assets on a platform at an exchange, using a third-party digital asset custodian or self custody. Whether you’re self-custody or outsourcing this function, having the appropriate, robust controls in place to safeguard funds and confirm that books and records match third parties and the respective blockchain is under immense focus and scrutiny.
Digital assets are subject to both existing and evolving regulations. AWM firms should secure their and/or their clients’ digital assets with a qualified custodian who meets 40 Act requirements, including the Bank Secrecy Act and Anti-Money Laundering (BSA/AML) measures. Qualified custodians should also provide certain protections to client assets in bankruptcy.
In addition, you or your custody services provider will need to address transaction monitoring and operational controls, complaint and fraud processes, and capital adequacy, among other issues. Keep in mind that new rules are being proposed all the time, which is why implementing a modern compliance strategy will be critical for your firm no matter if it secures its own assets or if you use third-party custody services.
Especially among the majority of high-net-worth investors, who according to a recent PwC research, have invested in nontraditional products such as alternatives, cryptocurrency and ESG. HNW investors are seeking to increase their allocations for long-term appreciation and portfolio diversification.
"Due diligence on the governance of counterparties and trading platforms has heightened importance given that the digital assets market is in the early stage of maturity. Asset managers, early on, must gain an understanding and comfort level with various factors, including the background and experience of the management team; the entity’s board structure, operations and overall effectiveness; and the level of transparency and disclosures available for all counterparties or trading platforms."
Tokenization is set to create new markets and unlock trillions in value. Categorized as the process through which any kind of assets — tangible or not — are issued as or converted into a digital form and then stored on and transferred over a blockchain, tokenization can help open a number of alternative investment markets.
Assets that can be tokenized include cash, securities, identities and real-world assets. And using tokenization, asset managers can further modernize traditional paper-intensive investment protocols, increase liquidity options through simplified transferability and enhance efficiencies with automation. Tokenization may also provide value by adding liquidity, broadening access, offering secondary trading and unlocking funds for AWM firms to reinvest.
But — and this is an important but — there are many factors that you’ll need to take into consideration when launching funds via blockchain using tokenization, including operations, connectivity/interoperability, data and compliance.
For now, the use of tokenization by AWM firms is still in the early adoption phase, and the sector is likely to be challenged to replace a proven method of launching and servicing funds — one with an established legal and regulatory framework — with new technology.
Firms considering tokenization should start by conducting a thorough analysis of the business case and implications it entails. Firms should establish a regulatory strategy and assess the value of the assets to be tokenized before integrating assets into internal systems (KYC/AML, ERM) and the external ecosystem (wallets, payment gateways).
As the AWM industry’s advancements into the digital assets market are in an early stage of development, governance strategy will be critically important. Establishing policies and procedures to monitor various risk factors, such as diligence on counterparties and trading platforms, may have significant impact on the long-term sustainability of your digital assets strategy.
We believe establishing trust in digital assets starts with education and awareness of the potential risks, which can be both complex and unforeseen. Your firm should focus on risk management, for both its own operations and for vendors and counterparties. Confirm that you’re working with and outsourcing to the right firms by considering operations, technology and other important risk factors during initial due diligence and through ongoing monitoring and oversight.
Proper due diligence for third-party vendors is also important to ensure that your firm is meeting its digital asset tax obligations. It’s critical to have a thorough understanding of what services and reporting, if any, your vendors are able to provide in order to confirm appropriate compliance with tax and investor reporting obligations.
Success in the digital asset market will likely come to those companies that build trust in digital assets. The better you understand and mitigate specific digital asset risks, the more successful you’ll be.