Institutionalizing the Digital Asset Industry: No Longer a Mysterious Black Hole

June 14, 2021 - 6 min read

In the past two weeks, we have explored the state of digital asset institutionalization and the milestones already achieved on the regulatory front. Part 3 of our serie’s focuses on the similarities between the digital asset niche and the conventional financial system and discusses why institutions are in a great position to capitalize on the new trends and ensure better service for their clients.

Key takeaways:

  • In many aspects, the crypto niche draws a parallel with the fundamentals of the conventional financial industry. Due to its maturation, the digital asset space is no longer a universe of unknowns but instead follows the path financial markets have been paving for centuries;
  • Both industries should work together — traditional finance must honor the client expectations set by digital assets, and digital asset companies must live up to the expectations set by traditional finance. Service providers that manage to blend the two will be the leaders of tomorrow;
  • Traditional industry actors are well-prepared to join the digital asset niche, even if they aren’t fully aware of it. Over the last couple of years, both industries have become much more interconnected, which is a prerequisite for a seamless transition;

Following the publication of Satoshi’s whitepaper, there was an unsupported assumption that digital assets posed a threat to the conventional financial system. While it is highly unlikely that virtual currencies will ever entirely displace the current ecosystem, they will undoubtedly play a role in its adaptation to promote a more digitized, globally connected economy.

The goal of the digital asset industry is to build upon the progress the conventional financial system had made over its centuries-old history and strip away its deficiencies to make it more robust. For the industry to progress and thrive, we should stop looking at digital assets and mainstream finance as mutually exclusive. They can co-exist to create a more diverse, functional, resilient, and transparent environment accessible to anyone worldwide.

Similarities Between Digital Assets and Traditional Finance

The digital asset industry clones much of the fundamentals of the conventional financial system, which is why they share various similarities, including:

Regulatory similarities

Under the existing regulations (learn more in our dedicated post), cryptocurrency service providers in many parts of the world are treated as financial institutions and are required to comply with established laws and regulations, including KYC and AML.

According to estimations, banks lose between $15b and $20b per year from identity fraud. To ensure their compliance, some European banks have invested up to €30m. McKinsey concludes that blockchain solutions for client onboarding can help save up to $1b in operating costs, reduce regulatory fines by $2b, and cut annual losses from fraud by $7b.

It can also allow banks to enhance KYC procedures by ensuring adequate Know-Your-Transaction processes, keeping track of the whole journey of the funds — from origination to execution and settlement. While KYT won’t replace KYC, it will complement it and enable banks to better meet their AML obligations while increasing customer trust.

Comparable instruments, products, and services

Earlier this year, we saw the launch of the first Bitcoin ETF (ticker: BTCC) on the Canadian stock market which was a major sign of the industry’s maturation. Furthermore, it eased the investment process for many conservative institutional investors who were willing but struggling to get exposure to digital assets (_learn more _here). While the SEC still sends mixed signals on when the first US Bitcoin ETF would be approved, one thing is clear — digital assets are coming to traditional markets, and there is no question about it.

Other instruments that are now increasingly favored within the crypto niche but come from traditional finance include futures and options on cryptocurrencies, illiquid funds with VC features, highly liquid hedge funds, and market-based investment vehicles.

The trading niche aside, there are also credit line and interest-earning account service providers that take cryptocurrencies as collateral.

Another aspect where the digital assets niche can complement what we have today is remittances. According to McKinsey, payment processing tends to be clunky, opaque and highly mediated, resulting in excessively high costs of up to 10% of the transaction value. Blockchain-based services are already proving to be much cheaper, faster, and convenient.

What This Means for Institutions

Some of the leading financial institutions and investment banks worldwide are already embracing crypto, whether publicly or behind the scenes. Fidelity’s Institutional Investors Digital Assets Survey 2020 reveals that more than 80% of investors find something appealing in digital assets and indicated they would be interested in institutional investment products that hold digital assets.

In an era where there is appetite for digital assets and a demand for exposure to this new asset class, institutions must align with the demands of their clients. Looking the other way is no longer a viable option for organizations that want to retain their competitive advantage and protect against reputational risk. As a result, the sentiment within the industry is that many banks and investment firms will be looking to enhance their product portfolio with digital assets to better serve the needs of their clients. KPMG’s most recent industry analysis concludes that the most successful firms will feature retail and commercial interfaces that allow seamless engagement between crypto products and services and traditional assets.

The reality is that clients are already exposed to the potential of digital assets. What is guaranteed is that they will be seeking ways to capitalize on it. The question that remains is whether you would be the one to help them or your competitor?

A lack of proactiveness on that front will potentially result in the loss of clients. This might happen on two levels — on the retail front, small-scale investors and crypto enthusiasts might switch to service providers that offer flexible digital asset-based products. However, it might also be felt on a higher level, considering that currently, the vast majority of investors in crypto hedge funds are either high-net-worth individuals (54%) or family offices (30%).

This whole idea was raised back in 2015 by KPMG, which at the time branded digital assets as a threat for financial institutions. According to the auditing firm’s report, the threat wasn’t coming specifically from digital assets, rather than from banks’ lack of agility to adopt them and the challenger institutions that are quicker to respond to changing trends.

Fast forward to today, and the statement is still relevant. The main threat is still rooted in the lack of responsiveness to customer needs, driven by the hesitation to join the digital asset revolution. In most cases, this hesitation is unreasonable as financial institutions are more prepared to enter the digital asset space than they realize. As for the remaining concerns, Tom Jessop, President of Fidelity Digital Assets, is confident that they are mainly focused on issues that will resolve themselves as the market evolves further.

Institutional Investors and Digital Assets: A Matter of When, Not If

Digital assets for the financial industry are what the internet was for traditional media — it enhanced it and made it more accessible and complete.

Financial institutions need to embrace digital assets and do it quickly. The fact that the niche has evolved to a point where the opportunities are increasingly growing, the regulations are coming into place, and the retail market is already familiar with it means the more challenging part of the journey is already behind us. Financial institutions don’t have to engage in raising awareness — all they have to do is capitalize on the niche’s momentum and address what their clients want.