Cryptocurrencies in asset management: first steps in Europe?
At the end of October 2022, we celebrated the 14th anniversary of the Bitcoin white paper, signed by a certain Satoshi Nakamoto. Bitcoin and the cryptocurrencies that followed its release were designed to serve as a payment method. Their development and their promise of return have distanced them from their primary goal by making them attractive as speculative instruments. The world of asset management and retail banking in general is increasingly using them as an asset class in its own right. How does the world of asset management position itself in relation to these new digital assets?
After peaking at more than €3 trillion in valuation in November 2021, the value of cryptocurrencies is now near the one trillion euro mark1. This sharp correction that began a year ago in November 2021 marked the beginning of the "crypto winter".
The institutionalisation of the market has resulted in a higher correlation with technology stocks. The macroeconomic environment also contributed to this correction. Moreover, the correlation between technology assets and bitcoin has increased steadily since the start of the "crypto winter". The latter stood at 0.92 when stock prices were at their lowest in June 2022. This figure has been closely scrutinised by analysts.
Risks related to decentralised finance and certain market events such as the Terra Luna crash, as well as some popular "hacks" by the press, have contributed to weakening this promising market and creating difficulties for some market players. Has the technology sector entered a crisis? The market remains optimistic given the potential of this sector and its use cases. It should also be noted that we have seen some stabilisation in stocks over the last three months.
Asset management and crypto
Despite its decline, the asset management industry remains highly interested in positioning itself on this market. The United States has historically dominated the field, creating more than 50%3 of hedge funds and crypto funds. Large US asset managers - such as Fidelity - have already been in crypto for more than two years, while others have entered the field more recently, such as Black Rock, which offers bitcoin exposure to its clients4.
In Europe, the regulatory surge with MiCA ("Market in Crypto Assets") has given more clarity to the ecosystem and therefore to the development of such initiatives. However, the bill still needs to be passed in the European Parliament, most likely in February 2023.
Crypto funds can take several forms:
The majority of cryptocurrency asset management projects aim to position themselves on an exposure through a basket of cryptocurrencies. This type of fund will allow investors to have exposure via a professional vehicle and thus avoid going directly to markets that could prove risky (i.e. value and security risk). Investors can choose "buy and hold" or more sophisticated funds, but this latter category will undoubtedly have the hedge fund monopoly.
Some funds, such as private equity or venture capital funds, want to take advantage of this promise of return to gain a partial exposure, either directly or by converting holdings in innovative companies into tokens. This conversion will require the use of digital asset providers. This attractive mechanism will certainly increase with the development of web3 projects. Metaverses are also the focus of this enthusiasm, and some of these projects are beginning to show their potential.
The simplest way to build exposure to this market is still by creating a fund investing in funds with crypto exposure. This type of simple structure will make it possible to benefit from alpha5. This is already the case in Luxembourg.
Considerations to be made in entering crypto funds
European regulations and the FAQ6 published by the CSSF at the end of December 2021 confirmed that it is possible, in a regulated universe, to launch a crypto fund. Now, this path is open to alternative funds with institutional investors. Against this backdrop, the management company Arquant Capital launched two funds in September 2022 with Société Générale Securities Services (SGSS) as an asset services provider, which expanded its securities offering to funds investing in cryptocurrencies.7
Launching a fund will require in-depth risk analysis, either of the fund itself or of the asset service provider.
Given the nature of the risks, the cybersecurity programme will be a crucial part of this endeavour. It is therefore more secure to opt for regulated exchanges and crypto custodians in controlled jurisdictions. Since the initialisation phase is risky, it is essential to define rules and procedures in order to limit risk. The recent market movements linked to Binance's non-acquisition of FTX8 are in line with this in-depth analysis, which is necessary to avoid any risk of a loss of assets, regardless of the size of the players.
As the value of cryptos is inherently volatile, the addition of certain leveraged instruments in investment policy will also lead to increased risk. The risk management and competence of the teams will be monitored for licensing.
Given the risks mentioned (particularly those of security and volatility), the establishment of a set-up with regulated players will be necessary in order to guarantee maximum security. The formalisation of procedures and clear communication between these players will be a key factor in success.
To fully understand these challenges and risks, the asset service provider will need to develop targeted skills to better understand the risks and challenges of the world of digital assets in asset management.
As Nasir Zubairi, CEO of LHoFt, points out in a recent interview, “education is the foundation for success”9 - and in the crypto world, this concerns not only investors but all players in this new value chain.
The United States has been a pioneer in adopting crypto in asset management. Europe is arriving more timidly on the scene. Growth in this area in Europe can only be achieved with the support of regulations that are favourable to it and with the development of a complete ecosystem. Risk management and targeted skills are key to making cryptocurrencies a sustainable asset class in the asset management world.
Laurent Marochini, Head of Innovation, Societe Generale Securities Services Luxembourg
Article published in l’AGEFI Luxembourg in November 2022.