Torsten Dueing, Head of ETC Platforms | HANetf
The crypto market might be at the Lycos Europe stage, the infamous IPO that rang in the “dot-com” burst. We may be even earlier than this. What this asset class needs is a killer app and for that app to be in everyone’s hands. For the internet, it started with e-mail. But before everyone had an e-mail account, we were all frantically downloading Star Wars pictures via our dial-up modems. It was enough to get a critical mass excited about the web, and of course we found a lot of gamesmanship along the way – steel mills adding websites and “.com” to their names to see their valuations rise, “investor newsletters” written by “gurus” following the old technique of pump and dump – buy the shares, talk them up in your newsletter and then dump the shares once the masses piled in and prices rose. For the web, it could have all stopped with Lycos Europe and a sour aftertaste in the mouths of investors after losing a lot of money. It didn’t. The technology was too exciting to be left alone.
We may well approach this stage in crypto. A lot of people managed to get very good returns (kudos to them). A lot of people left money on the street. A lot of rogue behaviour – deliberately or naively – led to a loss of trust in the asset class. Many of the past 12 months’ mistakes look painfully familiar for those that have been in the markets for long enough. In all, 2022 has turned out quite differently to what many digital asset investors were expecting. Unfortunately, instead of that killer app, we found ourselves thinking about rather benign but potentially lethal structural questions about how to invest and benefit from this technology in the long term.
I recently spoke on a panel alongside representatives from companies spanning Decentralised Finance, Asset Management and the ETP space – it was an intriguing mix. What became apparent from that discussion was that many of the crypto market events of 2022 were less about crypto per say, and more about traditional risks materializing. Each of us focused less on market volatility and more on the imperative of protecting investors’ assets. That is, the importance of sound operational and structural product design. For those running investment platforms, market related losses can be explained: the market went down and hence the investors have (potentially unrealised) losses in their portfolio. But it is a harder conversation to tell investors their assets have simply vanished because they were warehoused on exchange, or with an unregulated high-risk custodian, or were lent out to a borrower that is now insolvent.
Many crypto traders have treated their exchange accounts as traditional brokerage accounts with the expectation that assets on it are protected/segregated from the exchange’s operations. Some exchanges on the other hand expanded aggressively from their core function of price discovery, and became conglomerates of different proprietary trading activities (such as lending the assets out, generating additional leverage for their own accounts, issuing their own tokens). Neither of these were sounds practices, and neither is possible when you are a traditional exchange such as the LSE or Deutsche Börse. But for a crypto-native exchange set up in a decentralised organization and with no regulatory body to oversee it, all this was part of the value maximisation game. There was a certain deliberate “ignorance” from both sides of the markets, given the high level of expected returns.
Hence, in 2022, while investors were focussed on the markets, inflation projections, risk-on/-off metrics and adoption of crypto in general, they were forced to rethink their base lines: contagion risks that were possible due to concentration risks between counterparties led to multiple failures – a near textbook example of systemic risks. We had not a single but multiple of such events, each triggering a de-leveraging of the whole asset class. The cascade of events took many by surprise given, in traditional markets, these would have been at least cushioned through regulation, central clearing and enforced capitalisation of entities. In the deregulated, decentralized space of digital asset organizations however, there was little place to hide.
This might well have changed – many elements what could be attributed to a robust market infrastructure have matured or gained market participants’ attention in the past year. There is indeed a lot to be excited about:
1. Regulation is (finally) coming
- MICA being a prime example of a broad approach how to define the asset class for investors and what to hopefully expect on a more global stage.
2. Market infrastructure has vastly improved
Custody cold storage is widely available from regulated entities in different tier 1 jurisdictions.
- Off-exchange settlement straight out of storage is available and will become wide-spread standard.
- Risk management companies that analysis protocols are emerging and provide investors with insights into the various protocols, allowing investors to better understand what has value, and what not, without becoming crypto-experts in themselves. Analytics that allow investors to gain more and more detail about a coin’s history are wide spread and in use. This will drive down further the perception digital assets are encumbered with illicit activities (US authorities have already found in a recent report that Crypto assets are on average cleaner than the USD
3. Mindset is shifting
- Investors start to focus on understanding the utility (and hence intrinsic value) of a coin vs treating the whole asset class as same.
- Proliferation of indices allow investors to (i) identify participants of different sectors, and (ii) provide an investment tool to express their convictions for a sector without having to take single asset risk.
- With so much spotlight on the asset class and the events of 2022, investors start to differentiate more actively between coins
Coming back to our panel and the different or not-so different views of its participants: there are clearly many tracks for digital assets to enter your portfolio, and neither of these need to be particularly risky (if you use what is available to mitigate your risk, e.g. not keeping asset on a centralised exchange but move them yourself into some form of custody). All of these though come with different pros and cons, and unsurprisingly ETPs have emerged as a convenient entrance gate for many investors.
- Using ETPs gives you the risk exposure you want – not less risk because you benefit from full physical backing, and certainly not more risk unless you explicitly select an ETP that allows your assets to be lend out to generate extra yield for you. Details and structure matter, of course.
- ETPs take care of a lot of the cumbersome aspects of trading and then safely warehousing your digital assets – all of this at an institutional grade level. All an investor requires is a security brokerage account and the journey into digital asset investments may commence.
- ETPs may not provide for nearly 20,000 different protocols to be traded (the actual number accessible via European ETPs is sub-50). Once you go beyond the 50 – 100 coins ranked by market cap, the market depth and capitalisation of the individual coins beyond this becomes quickly rather thin, hence one may argue ETPs serve institutional investors best.
- Indices are best accessed in a pre-packaged way, taking away the need for investors to buy and sell the constituents to track the index. In traditional markets, people buy an S&P500 ETF if they want to get exposure to these 500 stocks, or a CAC40 ETF if they want to hold the top 40 French blue chips – rarely does an investor buy 40 individual stocks by themselves. Digital asset indices will follow this route, and the ETP is the natural home for investors who seek to diversify their digital asset holdings.
- ETPs benefit from multi-levered regulatory oversight. To launch an ETP, the Issuer will need to be regulated by a Financial Services authority at its home jurisdiction / where it is incorporated. The prospectus, under which an ETP is documented, requires approval by the regulators of the region it will be offered in (EU, Switzerland, etc). Lastly, to list the ETP on a traditional security exchange (such as Deutsche Börse or SIX), it needs to conform with eligibility rules of the respective exchanges. These rules in turn are subject to local regulator’s oversight and/or approval. This is all in place even before crypto-specific regulation such as MICA comes into force in the near future.
We haven’t found our Walt Disney equivalent in crypto yet, but once it comes, investors have the tools to safely invest in it.