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Cryptocurrency's relative youth means it is a controversial aspect of the financial services market, with numerous viewpoints about its legitimacy and efficacy. For fund operators, this confusion – and the ever-shifting regulatory landscape – means added headaches now and in the future.

If the ‘wild west’ aspect of crypto regulation can firm up, digital assets have the potential to take centre stage for asset managers moving forward. Traditional asset managers and fund operators, however, are more sceptical, arguing that cryptocurrency is ineffective and its downfall is imminent.

If the marketplace for digital assets continues to grow, adjustments will need to be made on the legal and operational side in order to accommodate this change – and as investors search for safer exposure to this asset class.

Few organisations were willing to offer specific comments on this topic, however, which could be indicative of its controversial bent and untenability.

Client desire outpaces infrastructure

Nic Basson, Chief Operating Officer at Old Street Digital, said that there is a lot of global demand for digital assets – a tide that won’t diminish any time soon. In his view, “the problem is regulatory certainty in Europe and the UK.”

In October 2022, the European Council approved the Markets in Crypto-Assets (MiCA) Regulation, one of the first global attempts to thoroughly regulate cryptocurrency markets. In the US, the difference between state-level and federal-level laws makes comprehensive regulations more difficult. In Asia, some countries – such as China – have banned cryptocurrency, whilst others are instead eager to join the bandwagon.

Because the infrastructure is so tenuous, clear and concrete legislation is necessary to proceed with material investment. Once governments can adequately regulate the legislating and handling of digital assets, there could be a swell of interest from larger institutional investors.

Right now, however, the instability of crypto from both a logistical and reputational standpoint – heightened recently by the collapse of FTX and arrest of Sam Bankman-Fried – poses too great a risk for many fund operators and asset management firms whose fiduciary duty to their clients must always come first.

For fund operators to hop aboard the band wagon, Basson said that structured service providers would be key. This is because currently those interested in managing crypto funds have to create them from scratch.

“People [are] trying to retrofit crypto into existing structures and product ranges. Existing systems and services just don’t fit.”

This is due to limited resources available for assessing digital assets. Often, knowledge on the topic is skewed: service providers lean heavily on the technical side of the equation, and not the financial side. “There is this element of people trying to retrofit crypto into existing structures and product ranges, which is difficult,” said Basson. “Existing systems and services just don’t fit.”

Operational headaches

The other option is building new systems and services for those bound by fiduciary duty that specifically accommodate digital assets. However, as it currently stands, the landscape for innovate crypto-traditional finance partnerships is barren.

“Larger firms are intrigued, but their grasp of crypto isn’t up to scratch.”

In Basson’s view, it’s a knowledge problem – a mismatch between traditional trade mindsets and the intricacies of blockchain technology. “Larger firms are intrigued, but their grasp of crypto isn’t up to scratch,” he said. “There are very few providers who understand, financially, how to integrate crypto into a broader agenda. They have traditional trade mindsets.”

This is largely because legal risks are completely different with digital assets, and custodianship is a concept that needs to be reconfigured under Decentralised Finance (DeFi) regimes. DeFi refers to variety of financial processes that occur with cryptocurrency or on blockchain technology, which means several stakeholders have copies of transaction history – it is decentralised.

There are stark operations difficulties that come along with DeFi. Accounting on crypto funds – the ones that do exist – is a headache, with operations teams needing to locate expert providers who can offer solutions tailored to blockchain, and away from a centralised counterparty.

“That technology rarely exists in a meaningful way,” Basson said. “The finance industry doesn’t know how to properly account for crypto yet.”

When it comes to pre-existing portfolio management and risk and reporting systems, stakeholders are trying to use what they already have and apply it to digital assets – with suboptimal effects. “This phenomenon might be all right for smaller, more traditional asset managers, but if you are a crypto asset manager and it’s your core system, you’re in trouble,” said Basson. “Technology providers are not custodians; they are neither trained nor insured to hold assets,” he added

“Partnerships between traditional asset managers and software providers will need to take centre stage.”

As the amount of crypto separately managed accounts (SMAs), exchange-traded funds (ETFs), and mutual funds on the market increases, “more partnerships between traditional asset managers and software providers will need to take centre stage. This is absolutely critical.”

Growth opportunities for crypto funds

Given that crypto funds are seen as stabler exposure to digital assets, growth opportunities do exist in this space – at least for the time being.

There are many opportunities for service providers and fund operators looking to outsource or develop external partnerships.

There is also increasing appetite amongst younger investors. In South Korea, recent Cerulli research found that “crypto trumps direct stock trading, ETFs, and mutual funds, in that order, among Millennials and Generation Z.”

In the same analysis, Ken Yap, Managing Director at Cerulli Associates, said that crypto presents an asset-gathering opportunity for managers. “For investors, the growing number of mutual funds and ETFs coming to market help to widen product choices or even legitimise crypto investing by providing arguably safer routes to accessing this asset class, compared to direct crypto investing.”

“Safety and security would be the key selling points for crypto-related funds.”

Yap added that “in an environment of increasing regulatory scrutiny and market volatility, safety and security would be the key selling points for crypto-related funds”. He also noted that better marketing and further education were necessary to these funds’ success.

This is because while general principles are similar between crypto and traditional investing, the details are different. Basson says this is what really matters,  because mutual funds are vehicles that organise collective investment, they have different tax implications, depending on their investments.

The most beneficial aspects of crypto funds are near instant settlement and finality, which reduces administrative burdens in the long-run.

For fund operators, however, the operational technology just isn’t there yet nor is the regulatory infrastructure. “The legal structure around crypto will take a lot of time and effort to get right,” Basson added.

 

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