Analysis

State of the Digital Asset Market: ‘Crypto Winter’ and Silver Linings

Hugo Jack

For investors in digital assets, and cryptocurrencies in particular, the last couple of months have been something of a nightmare. Ongoing macro and geopolitical pressures have continued to hit the digital asset ecosystem as investors – both retail and professional – have continued to exit the market as uncertainty around the regulatory and fiscal environment remains. While 2021 was officially the year in which institutional investors entered crypto in significant numbers, it is fair to say that the digital asset sector is still reminiscent of the early days of the Internet, evidenced by ecosystem failures, the misallocation of capital, and poor investor protection.

That said, while a much-needed shakeout (mostly of irresponsible leverage trading) is taking place, a digital asset future is still very much on the cards. Just as the tech bubble in 2001 paved the way for the Internet success stories of today, now global banks, financial institutions and FinTechs are continuing to invest and build new operational models and DLT-based infrastructure. The scope for this new environment is not just cryptocurrencies, which constitute a meaningful but relatively small asset class, but all financial instruments including equities, bonds, funds and alternative assets that will in time all likely run on blockchain rails. That said, as cryptocurrencies currently comprise the largest part of today’s real use cases for digital assets, it is worth taking a look at what is happening today: where things are going wrong, but also the continuing positives driving the industry forward.

Digital assets continue to dive amid macro uncertainty and ecosystem failures

In the past couple of weeks the cryptocurrency sell-off has continued as bitcoin crashed to its lowest level in two years. The period from May to June has seen one of the largest month-on-month declines with over USD 416 billion wiped from the total market capitalisation, which now sits at USD 933.0 billion. Considered a key line of support, bitcoin crossed its 200-week moving average (200W MA) last week, which has reportedly only occurred three times in its 13-year history. Historically, this has usually correlated with a market bottom. That said, central bank tightening is likely applying greater pressure to markets globally, which in crypto is compounded by miners of bitcoin needing to sell their BTC rewards to cover their operational costs which currently stand at approximately USD 20,000 per bitcoin. Consequently, there may still be some way to go before any sign of a true turnaround can be found.

The crypto markets are still reeling from the collapse of the Terra/Luna ecosystem in May, which impacted tens of thousands of investors globally including a well-known Dubai-based crypto focused hedge fund, Three Arrows Capital (3AC). It was quickly reported that 3AC was facing insolvency after incurring at least $400 million in liquidations. It failed to meet margin calls and is now considering multiple options including an asset sale, or a bail out by another firm. Celsius, a crypto lending platform which at one point claimed more than USD 20 billion in assets under administration, has come under pressure by investors in an old-fashioned “bank run”, with depositors scrambling to pull assets from the platform. On Monday 13 June Celsius released a community memo announcing its decision to pause all withdrawals, swaps and transfers between accounts, an option which it reserved under its terms of use. According to reports, Celsius is similarly in the process of considering insolvency proceedings and has appointed a legal firm that specialises in business restructuring, as well as hiring Citigroup as an independent advisor to brainstorm possible financing options. Nexo, another lending platform, put forward an unsolicited offer to acquire “any remaining qualifying assets”, although following a swift initial rejection it is unlikely the offer will be accepted.

It is unclear where the market goes from here. A significant amount of speculative capital has been put into the crypto ecosystem over the last couple of years during a period of exceptionally loose monetary policy and government stimulus; however, a flight to safety is now well underway across all asset classes. In addition, well established and high profile firms have put their reputations on the line and acquired significant amounts of bitcoin; the poster child for this tactic is MicroStrategy (Nasdaq: MSTR) which has 130,000 bitcoin, acquired at a cost of circa USD 3.97 billion, on its balance sheet, bought with cash from sequential debt offerings totalling nearly USD 2.4 billion. As a significant holder of bitcoin, all eyes are on the institution which at current prices is facing an unrealised loss of over USD 1 billion. In May it was reported that if bitcoin fell to USD 21,000 then a margin call would be triggered on a USD 205 million loan it took with Silvergate Bank in March to purchase additional bitcoin. That number was reached last week and has in the following thereafter gone as low as USD 17,744 as of Saturday 17 June. There is an inevitable concern that further liquidations would panic the market even further, however, MicroStrategy CEO Michael Saylor confirmed last week that a margin call had not been made, and that the company has reserves to protect against bitcoin dropping much lower.

Re-evaluation of business needs triggers firing and hiring

The bear market and general downturn is causing concern across the industry, as companies grapple with the implications of a looming recession and even stagflation. Financial considerations are being made a priority amidst declining revenues. Consequently, some digital asset institutions have announced reductions in head count. Coinbase (Nasdaq: COIN), one of the leading digital asset custodians and exchanges, announced cuts to staff of 18%, or approximately 1,100 staff, and furthermore rescinded 300 new hire offers. Gemini, an equally established exchange, expects to lay off 10% of its employees, while BlockFi and Crypto.com, more retail focused entities, will reduce headcount by 20% and 5% respectively, citing a “dramatic shift in macroeconomic conditions worldwide” which are impacting growth. However, at odds with the trend is Citibank, which this week announced its intention to hire 4,000 tech workers in a $10 billion effort to enhance online customer experience. It is joined by Binance and Kraken, two of the largest and most well-known cryptocurrency exchanges, which have similarly advertised their on-going efforts to recruit for 2,000 and 500 new positions respectively.

Longer-term sentiment remains positive as adoption increases

Despite the obvious pain that is being felt by the market during the latest crypto winter, sentiment around the future of the ecosystem and about cryptoassets remains positive. This week, Bank of America carried out a survey in which 91% of US adults said they plan to buy more cryptoassets over the course of the next six months, with 30% of respondents confirming their intention to hold their assets for at least the next six months despite the uncertainty. Echoing this sentiment, PwC’s Global Crypto Hedge Fund Report showed that allocations by crypto-focused and traditional hedge funds have increased over the past year, with 38% of traditional hedge funds currently investing in digital assets, up 21% from a year ago. Furthermore, 27% of the traditional funds that had not yet invested in digital assets reported that if the main barriers to adoption were removed they would accelerate their investments in them. Capgemini, a leading technology consulting firm, also released its 2022 World Wealth Report last week. Of the 2,973 global High Net Worth Individuals (HNWI) polled, 71% of them have allocated capital to cryptocurrencies and other digital assets. Furthermore, in assessing the demographic of respondents, 91% of under 40s have invested in digital assets, with Capgemini observing that cryptocurrencies remain their favourite digital asset investments for now. Even J.P. Morgan – whose chairman and CEO Jamie Dimon has been famously anti-bitcoin – has declared cryptocurrencies its new favourite alternative asset in preference to real estate, and has set a ‘fair value’ for bitcoin of USD 38,000, nearly twice its current price. And a joint PayPal and Deloitte survey of 2,000 senior U.S. retail executives found that nearly 85% of them expect digital currency payments to be ‘ubiquitous’ within the next five years.

Continued growth in institutional products and services

In other news, Goldman Sachs (GS) has launched a derivatives product linked to ether (ETH). The non-deliverable forward will enable investors to speculate on the price of ether without having to hold it directly. It comes at a time when investor confidence is low in the short term, however the firm reinforced its belief that digital assets are still desirable, stating that “institutional demand continues to grow significantly in this space”, with this offering helping the firm to evolve its nascent cash-settled cryptocurrency capabilities. And despite the reputation of stablecoins taking a knock of late, demand for them remains high as Circle Internet Financial – creator of the popular USDC dollar-pegged token – launches a new regulated euro-pegged stablecoin, EUROC, fully backed by euros held in custody by US qualified custodians.

Digital infrastructure for the repo market is also having a good month. BNP Paribas recently joined J.P. Morgan’s Onyx Digital Assets system, a tokenisation platform whose Intraday Repo application has processed over USD 300 billion of US treasury-based transactions in the year since it launched and is now looking to tokenise money market funds and other traditional securities as collateral. Meanwhile, Finteum’s DLT-based intraday FX swap and repo trading platform – due to go live next year – has been successfully tested by 14 banks, including Citi, NatWest and Barclays.

In Japan, the country’s two largest banks are making further moves in the digital asset space. Nomura – already one of the backers of custodian Komainu – will launch a new wholly-owned subsidiary to offer a range of digital asset services to institutional clients, with an unnamed executive quoted as saying, ‘If we don’t do this, then it’s going to be more difficult down the line to be competitive’. Meanwhile, Tokyo cryptocurrency exchange Bitbank has partnered with Sumitomo Mitsui Trust to create a new institutional digital asset custodian to be named Japan Digital Asset Trust. And the country has just become the first to pass legislation to limit yen stablecoin issuance to licensed institutions and guarantee their redemption back into fiat currency at par, a move that come into effect next year as a consortium of 74 Japanese banks and corporations moves to launch a private sector yen stablecoin.

Growing pains belie a maturing sector

The current market shake-up is inflicting short-term pain on investors, and the drying up of the previous flood of cheap capital that led to poor investment choices is now consigning thousands of weaker tokens and their associated projects to the scrap-heap. Investors are being reminded of the need to focus on utility and fundamentals over speculation. The last crypto market crash occurred in early 2018 when cryptocurrencies were the preserve of retail investors and the bravest of hedge funds, and institutional-grade services and infrastructure were not yet established. Four years later, the build-out of the foundations of the future financial system has got off to a strong start and continues apace. At the same time, regulation is beginning to catch up with the exuberant growth of this sector. We are witnessing the latest shift in a free market that should lead us to a more robust digital asset economy. Perhaps this moment will be seen in retrospect as an inflection point in the march towards a future financial system that encapsulates the best aspects of both stability and innovation.

TerraUSD Fallout – Debating the Future of Stablecoins and CBDCs

Thomas Murray Digital team

Following the recent failure of the TerraUSD algorithmic stablecoin, the fallout affecting the cryptocurrency markets and the policy questions that the incident raises have continued to dominate discussions. At issue are what – if any – role privately-operated stablecoins may have in the future of wholesale and cross-border settlements, the parameters and priority of stablecoin regulation, and the degree to which Central Bank Digital Currencies (CBDCs) – previously viewed by some major economies as more relevant to retail applications – could assume wholesale roles.

Finance ministers from the G7 group of nations meeting in Germany this month with representatives from the International Monetary Fund, World Bank Group, Organisation for Economic Cooperation and Development, and the Financial Stability Board discussed the potential role that CBDCs could play in realising greater efficiencies, in the context of the G20 Roadmap for enhancing cross-border payments. They highlighted the potential international uses of CBDCs and the need to minimise negative effects on the international monetary system by introducing consistent and comprehensive regulation of digital asset issuers and service providers. They noted in particular the need to achieve widespread compliance with the Financial Action Task Force’s ‘travel rule’ and the need for greater reporting requirements of the assets backing stablecoins.

Policymakers at the Bank of England have previously been open about their view that any so-called ‘Britcoin’ would not be a priority for wholesale settlement, given the introduction in 2021 of omnibus accounts permitting regulated entities to commingle tokenised money in order to settle among themselves. The Bank’s governors also cited the ability of the private sector to manage such settlements, which have fewer complexities and policy implications than retail CBDC usage, without government involvement. However, the UK Treasury has this week published a consultation paper titled Managing the failure of systemic digital settlement asset (including stablecoin) firms that proposes that the Bank of England be designated as the regulator of stablecoins, giving it the power to appoint administrators should so-called Digital Settlement Assets encounter difficulties. Similarly, the Financial Conduct Authority would bring stablecoin activity under its existing electronic money and payments regulatory regime.

In South Korea, the government has reacted to Terra’s collapse – believed to have affected 280,000 Koreans – by proposing a new digital assets committee to oversee the imposition on the industry of investor protections equivalent to those for securities, uniting a currently fragmented regulatory environment under one roof.

The US and Japan commenced preparations for the regulation of stablecoin issuers last year. In November, the President’s Working Group on Financial Markets coordinated a report on stablecoins that proposed that issuers should be treated like banks. And in December, Japan’s Financial Services Agency proposed legislation to limit the number of stablecoin issuers by restricting their issuance to banks and wire transfer companies, positing that this would increase trust in them and help to avoid runs that could crash their value and potentially destabilise the wider financial markets.

While TerraUSD – a bold and unusual ‘algorithmic’ (rather than fully asset-backed) stablecoin – may not have enjoyed widespread institutional use, its collapse has put a sharp focus on its more traditionally structured erstwhile competitors.

The long-running controversy over Tether (USDT), the first and largest stablecoin, continues as the company behind it has still not produced an audited set of financial disclosures, despite past promises, to offer assurance that it has adequate asset backing for the USD-pegged tokens it has issued. Its CTO, Paolo Ardoini, has hinted at a reluctance to publish full details of the constitution of Tether’s reserves, or of its counterparties, calling the information its ‘secret sauce’. Senator Elizabeth Warren has called this lack of transparency a ‘gigantic red flag’. Tether’s accountant, MHA Cayman, introduced new language in its latest attestation report dated 18 May, covering Tether’s Consolidated Reserves Report as at 31 March, stating that there is significant uncertainty regarding the value of large parts of the reserves – for example, during a run on its tokens – and Tether’s exposure to risk resulting from potential issues with its unnamed custodians and counterparties:

“The valuation of the assets of the Group have been based upon normal trading conditions and do not reflect an unexpected large-scale sale of assets, or the case of any key custodians or counterparties defaulting or experiencing substantial illiquidity, which may result in materially different or delayed realisable values. No provision for expected credit losses was identified by management at the financial reporting date.”

MHA Cayman also states that Tether’s management makes no provision for the potential costs of two legal cases that it is currently defending nor for credit losses.

At the end of March, approximately 47% of the reserves were in less liquid and riskier forms such as digital tokens, commercial paper, corporate bonds, and money market funds. Just under 5% of its reserves were held as cash.

By contrast, Tether’s younger rival Circle – issuer of the USD Coin (USDC) stablecoin – is making hay from Tether’s misfortunes. Its CFO Jeremy Allaire published a blog post provocatively titled How to Be Stable asserting that USDC’s reserves are held entirely in cash and US Treasuries with maturities of 3 months or less, and that those assets are custodied by Bank of New York Mellon, US Bank and BlackRock. It has also recently stepped up publication of the full breakdown of its reserves from a monthly cadence to weekly, with monthly attestation reports from accountants Grant Thornton continuing.

USDT chart May 2022 — Tether’s USDT market capitalisation, May 2022 (CoinMarketCap)

USDC chart May 2022 — Circle’s USDC market capitalisation, May 2022 (CoinMarketCap)

As of writing, the market capitalisation of Tether’s USDT has fallen by approximately USD 11 billion since 7 May (when TerraUSD first showed signs of instability) while that of Circle’s USDC has risen by about USD 5.5 billion over the same period.

SEC Prompts Crypto Custodians to Move Client Assets On-Balance Sheet

Andrew Wright

Photo by PiggyBank on Unsplash

Coinbase, one of the world’s largest crypto custodians, has disclosed that “in the event of bankruptcy, crypto assets we hold in custody on behalf of our customers could be subject to bankruptcy proceedings.” The admission was part of a quarterly earnings report the company filed with the US Securities and Exchange Commission (SEC). Coinbase CEO Brian Armstrong revealed that this was because of the recent publication of SEC Staff Accounting Bulletin (SAB) 121 which requires any crypto asset custodian to ‘present a liability on its balance sheet to reflect its obligation to safe-guard the crypto-assets held for its platform users.’ The SEC expects such disclosures to be made by all businesses that ‘custody’ crypto assets no later than in financial statements covering the first interim or annual period after 15 June, so we will potentially see a wave of similar disclosures in the near future.

Coinbase’s declaration that customers’ assets may potentially form part of any bankruptcy estate, and that the customers may be treated as general unsecured creditors, has caused a stir within the crypto industry. Were Coinbase to go bankrupt, the implication is that many of the assets it holds for customers may go with it. Coinbase Custody, which has a New York state banking licence, points out that it has never had a security incident in over 7 years of operations. However, customers choosing from competing custody services will want the absolute minimum risk in exchange for their fees.

Coinbase’s custody business is standalone from the rest of the group and only provides cold storage, so it could rapidly end up being obsoleted and out-competed by traditional, larger bank custodians. This is a view shared by Nadine Chakar, the head of State Street Digital, as expressed at a recent Fund Forum panel discussion. Global Custodian reports Chakar as commenting, “unless you have larger custodians moving into the space and be the big kids at the table, it’s (digital assets) unlikely to see institutional adoption”. She called for more regulation to provide clarity.

SAB 121, published on 31 March, expresses the views of SEC staff but is not a formal rule. Despite this, it is very prescriptive regarding the detail and format of disclosure it expects to see. The financial statement impact is as simple – and dramatic – as moving the value of assets under custody onto the service provider’s balance sheet through a liability and matching asset at the fair value of those assets at the time of each filing (broken down into each significant crypto asset in notes to the accounts). The suggestion is that this should take place regardless of the entity’s assessment of the actual “legal ownership of the crypto-assets held for platform users, including whether they would be available to satisfy general creditor claims in the event of a bankruptcy”. As such, it would mark a sharp divergence in practice compared to the accounting treatment for assets under custody in traditional asset classes. Further, there should be a detailed discussion of the technological and legal risks and uncertainties facing the business in relation to safekeeping digital assets in other areas of filings outside the financial statements.

Coinbase’s lawyers will doubtless have considered the potential impact of this disclosure but, due to the lack of clear legislation and regulation cited by Chakar, and a desire to be seen as compliant with SEC expectations, have concluded that they should acknowledge that clients’ custodied assets “could be subject to bankruptcy proceedings”. It remains to be seen whether other crypto custodians will fall into line given the arguably optional nature of this guidance, pending the debate it is causing being worked through to a conclusion.

The new guidance overrides the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification 940, which states that broker-dealers holding client assets should keep them off-balance sheet – although the SEC is not yet licensing broker-dealers for crypto activity – and that otherwise custodians should assess whether they have a sufficient degree of control over those assets, as they would with traditional assets under custody. In other words, the FASB treats this as a judgment-based decision that may hinge on aspects such as the degree of customer control of their own assets through measures such as key sharing.

One of the five Commissioners of the SEC, Hester Peirce (a Trump appointee) has responded to the bulletin. Her view is that the SEC and the market have been aware of risks for a long time and already review custodians’ financial statements; that an interpretive Staff Accounting Bulletin is not the appropriate place to make rule changes; and that the SEC has itself been partially responsible for creating the legal and regulatory risks that have driven this accounting treatment by failing to provide adequate guidance on crypto assets. She also believes that some consultation with the FASB and with affected companies would have been helpful.

These are fair points, if politically motivated; the end result may be worthy, but Peirce is far from alone in denouncing the SEC’s methods. Around the same time, on 16 March, members of Congress from both parties wrote to Chair Gensler to criticise the SEC’s behaviour relating to crypto businesses, pointing out that its many requests for voluntary disclosures outside its remit amount to a jurisdictional land-grab by stealth, and also set it up in competition with the CFTC in some areas. These requests are accompanied by enforcement actions and fines despite clear guidance from the SEC; a reluctance to license broker-dealers and to authorise crypto-backed ETFs; and a determination that interest-bearing lending products are unlicensed securities. President Biden’s recent Executive Order may effect a change in attitude, particularly as one of its main goals is to ensure that the US is a competitive and attractive market for digital assets and related technologies.

Algorithmic Stablecoin Failure Crashes Cryptocurrency Markets

LUNA USD price chart

Ben Ashley

The past week saw another crash in the value of cryptocurrencies; bitcoin fell to USD 24,000, its lowest value since December 2020. Although bitcoin’s price has been slowly falling since the end of the last year – reflecting the current macroeconomic climate of increasing inflation and interest rates facilitating a risk-off environment – this latest capitulation was a result of the TerraUSD (UST) stablecoin catastrophically losing parity with its dollar peg and the fallout thereafter.

UST, an algorithmic stablecoin, works in conjunction with the Terra blockchain to maintain a 1:1 peg with the US dollar via a set of on-chain mint and burn mechanics. In theory, these mechanics ensure that one dollar of UST can always be swapped for one dollar of LUNA, the Terra blockchain’s native token, by allowing traders to take advantage of arbitrage opportunities. However, on 8 May this mechanism began to fail, and the value of UST fell below USD 0.8 the following day. Although the price managed to recover to USD 0.94, 11 May saw the sticking plaster ripped off and the price falling below USD 0.3 as trader sentiment around the stablecoin dropped. At the time of writing UST is now trading below USD 0.1, over 90% down on its supposed peg.

This de-pegging resulted in a significant knock-on effect for the price of the LUNA token used to help maintain the peg. The token opened May with a price of USD 80, down from its early April all-time-high of USD 120. However, at the time of writing the token’s price is a measly USD 0.0002, meaning the price has fallen over 99% in little over a week. Before the rout, LUNA was a top ten crypto asset with a market capitalisation in excess of USD 30 billion, while UST was the third largest stablecoin with a market capitalisation of USD 18 billion. The combined market capitalisation of the two tokens is now around USD 2 billion, meaning investors have lost over USD 45 billion.

The after-effects have rippled throughout the crypto market. The price of bitcoin fell over 20% in the three days following UST’s de-pegging, triggered by sell-offs of 80,000 bitcoin from the reserves of the firm behind LUNA and TerraUSD and a loss in sentiment, while the total market capitalisation of all cryptocurrencies fell over 30%. This – together with bitcoin’s value more recently falling in step with technology equities rather than ploughing its own furrow – suggests that the ‘bitcoin as an inflation hedge’ narrative is now well and truly dead. This is the first time since its creation that the cryptocurrency market is experiencing rising inflation and interest rates, and it is currently performing as badly as equity markets.

Tether (USDT) – the largest stablecoin with a market capitalisation of over USD 70 billion – also lost its dollar peg for a time. USDT differs from UST as it is supposedly backed 100% by a combination of cash, commercial paper, fiduciary deposits, reserve repo notes and treasury bills. Tether fell to USD 0.95 as fear and uncertainty spread throughout the market. Although the price recovered, it did not stop investors from redeeming USD 7 billion worth of the token.

The collapse of TerraUSD and the brief de-pegging of Tether have seen an outpouring of calls for the introduction of stablecoin regulations, including from the US Secretary of the Treasury Janet Yellen. With the rapidly increasing size of the stablecoin market, it is now obvious that regulation is needed to protect investors and address the risks posed to financial stability. The stablecoin debacle could lead to central banks rethinking the use cases for CBDCs and imposing themselves on the wholesale settlement markets after all, rather than prioritising exclusively retail-oriented applications. Indeed, as the European Central Bank’s Fabio Pannetta states: “Recent developments in the market for crypto assets illustrate that it is an illusion to believe that private instruments can act as money when they cannot be converted at par into public money at all times.”

Navigating the Future: Network Managers Get to Grips with Digital Assets

Digital assets become a strategic priority

Institutional exposures to digital assets are rapidly rising. A recent study conducted by Global Custodian and Citi found that 43% of asset managers anticipate interest in digital assets and their related services will grow, while 38% of respondents acknowledged they were already actively participating in the nascent market.

As institutional investors increasingly pile into digital assets, some of the leading banks are beginning to develop their own proprietary crypto-custody solutions, providing safekeeping of private keys to digital assets, as well as crypto-brokerage and even crypto-derivative clearing services. For example, SC Ventures, the innovation arm of Standard Chartered, recently collaborated with Northern Trust to launch Zodia, an institutional-grade custody solution for cryptocurrencies. Elsewhere, Citi is reportedly looking to expand upon its digital asset servicing capabilities including in areas such as trading, financing and custody.

Beyond the banks, a number of fintechs have also established digital asset custody solutions aimed at supporting the growing chorus of institutional investors now participating in the market. As institutional-standard providers increasingly offer these services, investors will become more comfortable with buying digital assets. This comes following the Citi/Global Custodian survey, which found that broker-dealers’ biggest concern about digital assets is the absence of secure market infrastructures.

Aside from investing into digital assets, a number of Central Banks are looking to launch so-called Central Bank Digital Currencies (CBDCs), i.e. digital versions of their own currencies. These are distinguished from today’s mostly electronic forms of money by their cryptographically secured and fault-tolerant distributed nature. While they differ from the original goal of cryptocurrencies to avoid centralised control, they still bring many of the advantages of crypto to governments’ toolkits. CBDCs should not necessarily be seen through an investment lens but rather as a tool by which to obtain massive trade settlement efficiencies.

Proponents of CBDCs argue that the technology could even result in the emergence of instantaneous settlement or DVP (delivery versus payment). “CBDCs [are] mostly about settlement and the unification of asset and payment cycles. The adoption of digital tokens would allow exchanging tokenised financial instruments by simple token swaps to enable instant and atomic exchanges where both legs of the transaction need to succeed or none of them will, thereby eliminating open positions in trading and all settlement and credit risks”, says an article by the London School of Economics.

A number of tests involving CBDCs have been conducted. For example, one high-profile CBDC pilot involved a EUR 100 million bond issuance by the European Investment Bank on the Ethereum blockchain, which was subsequently settled using a CBDC from the Banque de France, the country’s central bank. Elsewhere, The Bank for International Settlements is currently overseeing two pilot schemes – Project Nexus and Project Dunbar – to build prototype platforms in order to conduct cross-border settlements in CBDCs between multiple countries.

Network Managers must prepare for change

The shift away from traditional financial instruments towards digital forms will create challenges for Network Managers, but these ought not to be insurmountable. As demand for digital assets increases, Network Managers have a greater imperative to recalibrate their due diligence efforts to conduct checks on digital asset servicers and infrastructures. Today’s assessment questionnaires and methodologies are not entirely appropriate for the digital asset ecosystem, and omit several new critical considerations.

“At the most rudimentary level, Network teams will need to familiarise themselves with new technologies, principally the distributed ledger technology that facilitates the trading and settlement of digital assets, and how asset servicing requirements such as income distribution, tax, corporate actions and proxy voting work in this environment. They may also need to assimilate new ‘blockchain events’ such as forks, airdrops, staking and mining into their processes. Network Managers need a firm grasp of the mechanisms that support the core ‘custody’ of digital assets – chiefly the protection and management of the private cryptographic keys that unlock the transfer of assets which exist ‘live’ on the Internet (in the form of distributed ledgers). This differs greatly from the traditional model of a central ledger in which a trusted authority acts as the ultimate record-keeper of ownership. In addition, Network Managers should improve their understanding of cyber-security, given some of the challenges cyber-crime has caused in the digital asset marketplace. This is an area where Network Managers will need to call on IT experts from within their organisations and trusted advisors to support them. Apart from these new areas, assessments of digital asset service providers – versus traditional custodians – will still rely on most of the principles familiar today. Many of the standard risk assessment components such as reviewing balance sheet capital strength or monitoring Straight Through Processing levels and settlement rates will continue to contribute to the due diligence process when applied to digital asset service providers,” says Andrew Wright of Thomas Murray Digital.

Adaptations to the market review process will also need to be made. Whereas some of the more advanced economies are in the process of introducing meaningful regulations to help oversee digital asset trading and settlement, such as the EU’s Markets in Crypto-Assets Regulation (MiCA), there are concerns about some of the more laissez-faire policies being pursued in certain emerging markets such as El Salvador. “Network Managers must ensure regulatory standards, investor protection measures and asset safekeeping mechanisms – as they apply to digital assets – are robust across markets and at the service providers that operate in them. Again, this will require Network Managers to leverage the expertise that they have obtained when conducting traditional market reviews and to apply it in a digital asset context. Bringing this rigorous approach to the sector will be one of the ways that banks can begin to make up for the ground lost to fintech providers, who may lack the risk management approaches and depth of regulatory relationships enjoyed by traditional service providers,” notes Wright.

Moving into a new investment universe

Traditional assets are not going to be swept aside abruptly. Instead, the general consensus within the industry is that conventional financial instruments will co-exist alongside digital assets for a long time to come, until the point at which they have all transferred to run on digital rails – either as new assets issued natively on blockchains, or existing assets represented in new token form. As Wright concludes, “Network Managers undoubtedly need to improve their understanding of digital assets and how they work if they are to remain relevant and flourish moving forward. Fortunately, many of the skillsets synonymous with contemporary Network Management can be adapted so that they can be applied to digital assets. Opportunities are there for those that are willing to invest that effort.”

Regulatory Change Sweeps Through the Digital Asset Universe

Bringing tokens into the regulatory fold

Amid concerns about potential mis-selling and a lack of proper investor protections, regulators are now looking to bring in new rules to oversee digital assets. Nonetheless, they are conscious that digital assets are a diverse asset class, meaning a one-size-fits-all approach towards their supervision is not appropriate. Many regulators have made clear that there are significant differences between tokens such as cryptocurrencies and so-called stablecoins (tokens pegged to traditional securities, assets or fiat currencies) versus those that behave like securities. In the case of security tokens – digital assets that confer similar rights to the governance, value and income from an underlying enterprise as do an equity or a bond – regulators have generally said that these will be subject to prevailing securities laws. Conversely, cryptocurrencies are generally considered to be unregulated assets thus far.

“The EU’s proposed Markets in Crypto-assets Regulation (MiCA) states that crypto-assets such as security tokens fall outside the regulation’s remit, although it notes that they must comply with existing rules including the Markets in Financial Instruments Directive II (MiFID II). Security tokens are also subject to similar requirements in the US and UK. However, the EU’s proposals go further as they will create a pilot regime for market infrastructures to facilitate the trading and settlement of regulated crypto-assets (i.e. security tokens) using distributed ledger technology. This is an ambitious move, which could help accelerate more institutional inflows into security tokens,” said Hugo Jack of Datm.

Emerging regulation of securities tokens will be the subject of the next article in this series; in this first part, we focus on the more common cryptocurrency and payments use cases of today.

A delicate balancing act for cryptocurrencies

While global regulators look to be adopting a broadly similar – if less well-advanced – approach towards overseeing security tokens, the same does not ring true for currently non-regulated digital assets, particularly cryptocurrencies and stablecoins. The EU’s proposed MiCA rules are perhaps the most developed, as they introduce stringent regulation (including disclosure and transparency requirements) covering the issuance and trading of such crypto-assets. In addition, the proposals also demand that all manner of crypto-asset service providers, issuers of asset-referenced tokens and issuers of electronic money tokens be fully licensed. Accordingly, this will subject providers – including digital asset custodians – to minimum disclosure requirements, new governance arrangements; prudential requirements, market integrity measures such as compliance with the Market Abuse Regulation, and additional rules on safekeeping clients’ funds and complaint handling procedures.

“By imposing regulation on previously lightly supervised crypto-asset providers, safety and confidence in the asset class will improve and institutional investors may become more comfortable trading in digital assets – at least within the EU,” noted Jack.

In the UK and US, digital assets such as cryptocurrencies will remain unregulated for the time being, although this could change in the future if these countries choose to follow the EU’s lead. Global bodies including the Basel Committee for Banking Supervision are already talking about imposing tough risk-weighted capital obligations on financial institutions holding cryptocurrencies, stressing that their volatility could be destabilising for banks. It has suggested that a risk weighting of 1,250% be applied to banks holding bitcoin, meaning a USD 100 investment in bitcoin would correspond to USD 1,250 of risk-weighted capital. This would make it prohibitively expensive for most banks to trade cryptocurrencies.

Elsewhere, the UK government and the US Federal Reserve have made clear that they are taking a closer interest in stablecoins. According to reports, both governments are prioritising regulation of stablecoins over cryptocurrencies, as they believe the former has the potential to play a significant role in cross-border payments as well as retail and wholesale transactions. The rationale is that the pegging of stablecoins’ value to an underlying stable asset, such as the US dollar or euro, makes them less prone to violent price fluctuations and more suited for payment use cases than volatile non-backed cryptocurrencies like bitcoin.

Despite compelling uses cases, some lawmakers are adopting an uncompromising position toward cryptocurrencies. Having already outlawed cryptocurrency exchanges and initial coin offerings (ICOs) in 2019, the Chinese authorities have since banned financial institutions and payment companies from providing services related to cryptocurrency transactions. Reuters notes that banks and payment companies in China cannot provide clients with any services involving cryptocurrencies, including registration, trading, clearing and settlement. This comes amid Chinese concern about the volatility of cryptocurrencies and, likely, a desire to keep hold of the reins of means of payment. Other leading markets – including India – also have a track record of hostility towards cryptocurrencies. A 2018 circular issued by the Reserve Bank of India (RBI) prohibited banks from facilitating cryptocurrency transactions, although this was recently struck down in a Supreme Court ruling, meaning financial firms can now participate in the market. With the lack of joined-up regulation across different countries, crypto-assets may struggle to acquire broader momentum.

Getting the standards in place

In order for digital assets to thrive, there need to be sensible and proportionate regulations that are broadly aligned in terms of their objectives. Hugo Jack comments, “As of now, there is a plethora of different approaches and requirements across markets that risks persisting for years unless consensus can be reached. Although regulations overseeing security tokens – where they exist – may largely replicate pre-existing securities laws, the rules governing other digital assets like stablecoins and cryptocurrencies are highly divergent and frequently contradictory. Investors of all sizes appear keen to explore this new asset class, but they must first have a clear picture of what activities are permitted and to whom. The present playing field is uneven and its boundaries poorly defined. Equally, if trading in digital assets is to increase, regulators clearly need to bring in heightened checks on digital asset service providers. This will be vital in preserving market security, integrity and confidence.”

Datm will next examine the implications that regulations will have for security tokens, and the impact this could have on markets and service providers.

Snapshot of Global Progress Towards Acceptance of Cryptocurrencies

Vlad Totia

Last week El Salvador officially adopted bitcoin as legal tender, thus becoming the first country in history to start using a purely digital and decentralised form of currency. Salvadorans can now pay taxes, take loans, and use bitcoin for the exact same purposes as they use the US Dollar, the country’s only other official currency.

The adoption of bitcoin as a national currency is a monumental milestone for digital assets. For now, the experiment raises more questions than answers, with concerns such as initial protests against the measure and the disrupted launch of the government-issued wallets. However, this is not the only significant change to happen in the regulatory landscape regarding cryptocurrencies. These past few months have been filled to the brim with regulatory changes in every corner of the world.

Another sizeable leap forward for digital assets has been the US Senate’s vote on the Infrastructure Bill and its definition of the ways in which cryptocurrencies can be taxed and reported. It shows that the US Government is moving on from a previously sceptical and even adversarial attitude. There is now a legislative package to shape a more predictable and regulated environment in which these assets and services can grow. Moreover, it has recognised cryptocurrencies as an asset class that should eventually have the same legitimacy as fiat currency.

While some countries are optimistic and friendly towards cryptocurrency acceptance, others have outright banned its use. It is likely that we will continue to see differing attitudes and approaches to the regulation of digital assets more broadly. However, while all eyes are on El Salvador and its leap into cryptocurrency adoption, it is worth taking a step back to look at the larger picture with regard to crypto regulation worldwide.

The opposers

Although governments are becoming more comfortable with digital assets, there remain some areas of the world that continue to treat them with varying degrees of scepticism. China cracked down on crypto-exchanges and miners in the country in July, contributing to the 20% drop that bitcoin experienced – part of a trend down to a level less than half its April peak value. This move was the latest and most significant in a series of periodic shake-ups of the sector, with the declared purpose of guarding against financial risk. Where exactly cryptocurrency regulation is heading in China remains to be seen, but the shorter-term impact is that the country’s dominance over the Bitcoin network and other blockchains by means of controlling mining or ‘hashing’ power is dropping rapidly. The miner exodus and an increase in mining in other regions of the world have caused the Chinese share of Bitcoin mining to drop 55% since the beginning of the year. These events have led to a more even share of blockchain responsibility and have potentially thereby strengthened network governance.

Turkey is another example of a country that does not look kindly on widespread use of cryptocurrencies as it has banned paying for goods and services with them. The central bank cited concerns such as anonymity, protecting existing payment systems (a further step beyond its long-standing ban on PayPal), illegal activity, and the potential for retail investors to lose money. The ban does not extend to the ownership or purchase of cryptocurrencies via a personal bank account, potentially leaving the door open for regulated investment use cases in the future. This has interesting implications for a population that has already demonstrated its keenness to hedge against high inflation and the devaluation of the Turkish lira.

Similarly to Turkey and China, India is another country that has considered banning digital assets in one form or another. The latest digital currency bill proposal is under review. The legislative package mostly targets how exchanges operate and what the regulatory landscape they fall under should look like. This potentially presages a ban on the ownership of private cryptocurrencies while paving the way for an official Indian central bank digital currency (CBDC).

While these countries may not be seriously considering an outright ban of blockchain technology or cryptocurrencies, these regions are likely to see significant regulatory restrictions on digital assets for a long time.

The cautious

Despite pushback from some countries, most are not opposed to blockchain adoption, and maintain a cautiously positive outlook on the emerging digital asset ecosystem. The European Union is actively interested in blockchain technology and has set up and funded a variety of initiatives to encourage its advancement while working on its proposed Markets in Crypto-assets Regulation, or MiCA. Arguably the most encouraging development is its own push for a CBDC, also referred to as the digital euro. The initiative was initially announced with a planned rollout in 2025, but the European Central Bank has expedited the timeline and launched a two-year investigation phase in July. It is encouraging that even a massively bureaucratic organisation such as the European Union senses the urgency in moving forward with digital money.

Despite the positives, the aforementioned US Infrastructure Bill passed by the Senate last month caused the cryptocurrency community concern. The bill’s most controversial elements see legislators taking a tough stance by potentially classifying most entities that are involved with cryptocurrency-related transactions – even tangentially – as ‘brokers’ that must be tightly regulated. While its intentions have not yet been clarified, the United States has clearly begun to catch up when it comes to defining its stance towards digital assets. This is a key precursor to the clear regulatory environment demanded by investors. As a whole, regions such as the United States and the European Union are approaching digital assets at a more methodical pace but are certainly not opposed to them.

The optimists

While only official legal tender in one country thus far, cryptocurrencies like bitcoin are slowly starting to be legalised and accepted as a payment method in various parts of the world. One of the most recent countries to authorise a slew of cryptocurrencies for merchant payments is Cuba. The resolution, which came into force on 15 September, regulates "the use of certain virtual assets in commercial transactions" in "operations related to financial, exchange and collection or payment activities" in or from Cuban territory. Digital assets, and more specifically cryptocurrencies, are already quite popular in the Caribbean Island, with an estimated 10,000 Cubans using them to transfer money.

Germany is another example of a country moving forward positively in the regulatory space. Earlier this year, it passed legislation allowing investment funds to allocate up to 20% of their value to cryptocurrencies under a provision called ‘spezialfonds’ or special funds. On a similar note, France has also ramped up its regulatory programme, proposing EU-wide regulations for cryptocurrencies. The proposal’s language is positive as it recognises the potential benefits in terms of market efficiency and economies of scale enabled by digital assets. Countries such as Germany and Cuba are examples of an understanding of the benefits that blockchain technology can bring to help meet demand and solve inefficiencies specific to their own socio-economic landscapes.

The pioneers

There still remain few countries in the world that have taken the initiative when it comes to regulating such a new technology. Switzerland has a reputation as a pioneer in banking and financial services, and it has no intention of missing the digital asset boat. Just last month, payments via cryptocurrencies started to be offered within the country through a partnership between Worldline and Bitcoin Suisse, and several cantons accept payment of local taxes in cryptocurrency. Switzerland has also consistently allowed the many financial institutions that it harbours to experiment with digital assets through permissive legislation. This has cemented the country’s status as a hub for a variety of crypto-asset companies.

As of 7 September 2021, El Salvador became the first country to accept bitcoin as legal tender, putting it on par with the United States Dollar, the official fiat currency of the state. While there are many questions to be answered regarding how or if the central bank will be able to exert any form of monetary policy on a currency which it cannot control, El Salvador has started one of the most interesting economic experiments of the century. How international financial institutions, banks and corporations will support bitcoin use within the country is yet to be seen. Several other Latin American countries and Ukraine are observing closely as they consider their own plans to follow El Salvador’s lead.

Countries like Switzerland or El Salvador have taken the first bold steps in approaching a wide range of questions from regulation to the taxation of digital assets. They have secured their places in the history books by creating templates for other countries to follow when it comes to architecting the digital asset ecosystem. The potential to attract innovation and growth this early on in a strategically competitive new field is significant.