Opportunities in Digital Assets Await Both Asset Managers and Servicers

Globally, investments into digital assets such as bitcoin, alternate coins, stablecoins, NFTs and DeFi are on the rise, with more than 300 million users. Also, institutions investing in cryptocurrency increased from 33% in 2019 to 52% in 2021 according to Bloomberg Intelligence’s Crypto Outlook. After mainstream adoption, many global regulators approved inclusion of digital assets in institutional portfolios, and retirement (IRA/401k) accounts.

Hence, it’s imperative for traditional asset managers to start offering digital ETFs and mutual funds as part of their product set. Also, digital assets can be added to multi-asset portfolios along with equity, bonds, cash, and alternatives to achieve desired growth, income, or risk level. For these purposes, asset managers should enhance their front-, middle-, and back-office capability by partnering with digital trading platforms, custodians, and asset servicers to cater to all functions in the life cycle of digital assets.

In anticipation, leading asset servicers have also partnered with leading digital trading platforms, and other niche technology firms for connectivity, data analytics and compliance services. Few asset servicers have started custody, corporate actions, fund administration, accounting, reconciliation, transfer agency and other services for digital assets.

Crypto ETFs, Mutual Funds – regulations and market structure

Various global and regional regulators in capital markets industry are working with legislators on addressing challenges in investor protection and transparency gaps, to find a balance between current rigid regulations in the funds industry and the freedom cherished by digital firms. In Canada, ETFs are approved for listing in exchanges since crypto transactions are legal and treated as commodity.

In the U.S., there is no comprehensive legislation, leading to confusion around jurisdictional boundaries between multiple regulators. For example, the SEC is classifying digital assets as securities, but the CFTC is viewing most digital assets as commodities. So, they are seeking additional statutory authority from legislators. Meanwhile many ETP/ETFs are available for U.S. investors, and few mutual funds received approvals with restriction on direct investment into cryptocurrencies. So, these funds use derivative contracts, especially short-term futures for investments.

In Europe, European Commission published draft regulation on markets in crypto-assets (MiCA) to focus on 3 categories of assets: Utility tokens, Asset-referenced tokens, and e-money tokens. With respect to crypto mutual funds, and there are no approvals for any funds in Europe yet due to limitations in UCITS on holding derivatives and any single constituent. Germany went ahead and permitted institutional investors to invest up to 20 percent in crypto assets.

Across Asia Pacific, Japan legalized cryptocurrency and governs trading platforms while Australia treats crypto as commodities and exchanges are legal.

Opportunities and challenges for asset managers

Traditional asset managers have established trust among investors by providing core services on reliable technology infrastructure by collaborating with solution partners for outsourcing specific functions. With maturing market infrastructure for digital assets, technology barriers are no longer a major hurdle to interface with niche digital platforms.

However, one major challenge is that there is no established institutional ecosystem to support buy side asset managers in trading, custody, and post trade functions. Other risks include market risks such as natural price volatility of products, emerging regulations across geographies, and continuous technology disruption. A major concern is the potential illegal deciphering of private keys of cryptocurrencies using powerful quantum computers in future.

Key Business capabilities for asset managers

In anticipation of digital assets finding their place in the majority of institutional portfolios, asset managers must enhance their technology and operations capability across all business functions. The impact is high for most of the functions due to inclusion of digital assets as depicted in this picture.

Figure 1 Impact to asset management business functions due to inclusion of digital assets

Front office: Major changes required in the front office are related to investment management agreements, contracts to fulfill legal and compliance obligations, fees and account management charges, and reseach reports covering digital assets. Real time valuation for portfolio risk analytics, stress tests, sensitivity and scenario analysis, models, and ratios are other priority functions which need enhancements. Market and product intelligence for new digital assets, modifications in product development and product control, and required benchmarks are key focus areas.

Middle office: Processing client and fund mandates specific for digital assets, which affect order management, transaction management, portfolio administration functions are key requirements in middle office. Also changes in performance/ attribution calculation engine with added parameters, historical performance calculations and fund reports such as factsheets, GIPS and regulatory reports should be incorporated.

Back office: Major focus is on partnership with institutional grade crypto custody providers who cater to accounting,  reconciliation, corporate actions processing, financial statements preparation and audit requirements. Data management, transfer agency and securities lending specific to crypto transactions have to established by evaluating in-house capability or external solution providers.

Asset Servicers

Asset servicers must establish market infrastructure connectivity with digital platforms to provide ETF services, custody, fund administration, reconciliation, fund accounting, transfer agency and other shareholder services. They should also enhance their technology, business operations and automation capability to include digital assets in the existing structure to cater to the changes described in the previous section. Leading asset servicers have already partnered with digital trading platforms to provide custody, fund administration and ETF Services.

Digital Custodian

There are multiple options for investors to safeguard their digital assets such as self-custody, exchange wallets or third-party custodians, with options for multi-signature wallet, smart contract wallet, hot storage, cold storage, etc. While regulations are silent which type of custody must be chosen by investors, third-party custodian is the safest option since they provide deep cold storage with air-gapped connectivity to ensure the maximum security for investors.

A few leading custodians started offering digital custody, tokenization, and compliance services by building internal platforms and working on integrating digital assets with existing fund services for portfolio management, performance reporting, and other functions.

Conclusion

Asset managers and their asset servicers are balancing between customer demand and regulatory maturity to scale up investments into digital assets.  Asset managers must also foresee requirements such as usage of digital assets as collateral for margin trading in the future.

Overall, there is a healthy competition among asset servicers to garner revenue from digital assets services by becoming early adaptors in providing standard services such as custody, fund administration, transfer agency along with other niche solutions such as bond tokenization and including cryptocurrency in treasury.