Crypto shouldn’t be dismissed as an unsafe investment option
In crypto annals, 2022 will go down as the year when this industry nearly died. But then December saw the birth of a pair of exchange-traded funds in Hong Kong, offering new hope. Asia’s first futures ETFs for Bitcoin and Ether join a growing list of initiatives that could ameliorate the crisis of legitimacy facing virtual assets. A big dampener is confusion over safe custody of crypto holdings. Sam Bankman-Fried’s FTX, the most spectacular of last year’s crypto debacles, has brought hapless customers of the failed exchange in front of a US bankruptcy judge who’ll determine if they’re entitled to money ahead of other creditors. But FTX is not the only test for crypto custody. Last month, a US bankruptcy judge ordered the insolvent Celsius Network to return roughly $50 million that never earned any interest. But the fate of billions of dollars of user funds stuck in interest-bearing accounts is still in question: Does it belong to the debtor’s estate or to customers? Uncertainty should ease as cryptos move to normal bourses as regular securities, like stocks and bonds. That will bring customer assets under standard safeguards. For instance, the new CSOP Bitcoin Futures ETF will entrust custody of customer funds to HSBC’s licensed Hong Kong trust firm that undergoes [checks].
This is what fund managers have been waiting for. Adults in the crypto playpen will bring grown-up rules with them. Nobody knows if today’s digital assets will amount to anything more than speculation vehicles, but tokens of the future might represent meaningful economic value. On that premise alone, it may be worthwhile to create a safe set-up now for capital to flow into them.
The Hong Kong crypto ETF is just one of several examples of the financial industry trying to provide protection in a legal vacuum. Bank of New York Mellon, custodian of $43 trillion in customer assets, recently opened its vaults to receive some institutional clients’ cryptocurrencies. BlackRock added crypto to its Aladdin platform, used by pension funds and other large investors to oversee their portfolios. The brokerage unit of Fidelity has been offering custody services to hedge funds since 2018. It’s now launching a zero-commission Bitcoin and Ether trading service for retail clients.
Olivier Fines of CFA Institute cautions against reading too much into private industry-level efforts. “The de facto insurance offered by a BNY Mellon, a Fidelity or an HSBC is very much a product of their size and scale, it’s not something smaller institutions can easily replicate. For there to be a competitive market in custodial services for crypto, new laws must fill the existing legal holes,” Fines said. One such gap is in the US SEC’s Customer Protection Rule. Under it, broker-dealers are required to segregate customers’ cash and securities from their own. This is an assurance to clients who’d be loath to stand in line with general creditors to recoup pennies on the dollar if an intermediary goes bankrupt.
But is an exchange token, such as FTX’s FTT or Binance’s BNB, a security or a utility? In its complaint against FTX co-founder Gary Wang and former Alameda Research CEO Caroline Ellison, the SEC claimed that FTT is a security. So far though, “custodial protections, like other investor protections for digital assets, remain largely untested in court,” Fines and his colleague Stephen Deane said in a CFA Institute report. “Revolutionary or not, technology alone cannot offer protection from age-old financial misdeeds, ranging from market manipulation and front-running to fraudulent disclosures and Ponzi schemes,” said the report. “The crypto ecosystem urgently needs a strong, clearly defined regulatory framework.”
For too long, the focus of crypto supervision has been on money-laundering. Customer protection wasn’t the priority. Now the pendulum has begun to swing, though, perhaps a bit too much in the other direction. In March, the SEC came up with new accounting guidance for financial firms that have an obligation to safeguard customers’ crypto assets: They need to explicitly record a liability and a matching asset. But this requirement may backfire if it’s seen as too onerous. A bloated balance sheet will push up banks’ capital requirements, making them reluctant to offer custodial services.
This regulatory tug of war will settle down at some point, hopefully with investors feeling better protected and intermediaries not shying away from crypto. The techno-anarchist founders of trustless blockchains won’t be pleased that the same large middlemen they wanted to banish are trying to hijack their creation. But with some luck, future historians of the industry would conclude that crypto’s worst vulnerabilities crawled out of the woodwork in 2022. After that, things got better. Digital assets remained unsuitable for most risk-averse small investors, but at least they became a safer bet for those who didn’t mind the volatility.
Andy Mukherjee is a Bloomberg Opinion columnist covering industrial companies and financial services in Asia.
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