Traditional diversification approaches are a start, but digital assets present a unique set of challenges
Friday, August 27, 2021
By Michael Shari
As high-net-worth investors, family offices and other professional and institutional investors diversify into cryptocurrency and other digital assets, a question arises about readiness: Have institutional asset managers cultivated the skills required to manage the exotic and convoluted risks that this emerging asset class is presenting?
According to investment consultants and asset managers, traditional strategies apply to some extent. Managers are thus able to treat digital assets as “an additional asset class that brings the benefit of diversification to a new portfolio,” says Kamil Kaczmarski, a Frankfurt-based partner in Oliver Wyman's asset management practice.
Just how sophisticated and bespoke a crypto investment strategy becomes is a function of an investor's level of maturity.
“At the beginning, you will start with long-only, and you probably will also go indirect through a fund, an ETF [exchange-traded fund] or some kind of certificate,” Kaczmarski explains. “Over time, you probably will start direct trading. As you move up the maturity ladder, you might actually employ derivative structures behind it.”
The developing consensus is that active management will be the most lucrative type of strategy until crypto matures as an asset class.
“We're in that sweet spot of active management right now in digital assets where it's inefficient, it's not well known,” says Jeff Dorman, chief investment officer of digital-asset manager Arca Funds in New York.
Passive strategies only make sense for bitcoin, which as the biggest and oldest cryptocurrency is mature enough to justify a buy-and-hold strategy, Dorman says. The value that Arca adds to a bitcoin fund is the convenience of buying a readily available asset; it charges a 45 basis-point management fee. Arca's actively managed funds, which employ derivatives, charge performance fees on top of management fees.
Asset managers must bear in mind, though, that digital assets' risk profiles differ from those of equities, bonds and commodities.
“What we've observed in some of our discussions across the Street is, 'What is the difference between a bitcoin-related future that is traded on ICE [Intercontinental Exchange] and a commodities future?'” says Roy Ben-Hur, managing director in Deloitte's Risk & Financial Advisory practice. “The assumption that there is no difference increases the risk.”
The discrepancies are as basic as calculating the net asset value (NAV) of a fund that holds digital assets, a perfunctory matter for a mutual fund. Because the market for cryptocurrency operates 24 hours, seven days a week, there is no agreed closing price. As a result, different methodologies have emerged for timestamping a given price.
“There are hundreds of exchanges across the globe that all have very fragmented pricing and volume,” Arca's Dorman points out. “Each pricing service and each admin might be using a slightly different source for that pricing.”
Like most banks and brokers, the vast majority of asset management firms still lack suitable systems for risk analysis, trading, pricing and reconciliation for crypto, says Tim Davis, a Deloitte Risk & Financial Advisory principal. Compounding this issue, he says, is that companies that first offered crypto custody services were unregulated - or at least started out that way.
Crime, Cyber and Regulatory Risks
Money has been known to literally vanish from cryptocurrency exchanges. Oliver Wyman's Kaczmarski cites Africrypt of South Africa, whose founders allegedly absconded with $3.6 billion in bitcoin.
Institutional managers are finding that counterparty risk lies more in whom they are dealing with than where the transactions take place.
“What's worrisome about collecting all this data is not that we should figure out who the bad people are, but where you are going to store it so that it's safe,” says Kristin Boggiano, co-founder and president of trading and investment platform CrossTower.
Cybersecurity risk demands close attention. “Eventually, some of these [cryptocurrencies] are going to fail,” says Deloitte's Davis. “Even if just for reputational preservation reasons, these asset managers would likely stand behind that and probably make the customers whole.”
As an example of what can go awry with an issuer, Arca's Dorman points to decentralized finance (DeFi) venture Gnosis, which in exchange for one ethereum coin issued a token that sank to pre-issuance lows for nearly three years until January, while the ethereum currency more than doubled.
As rules governing crypto evolve around the world, regulatory risk grows. Deloitte has found that some of its clients are assembling dedicated groups to monitor public statements by regulators that could impact digital assets.
“There is so much regulatory uncertainty,” says Ben-Hur. “That's one of the risks that the asset manager will need to monitor on a more regular basis.”
With the U.S. Securities and Exchange Commission being slow to authorize exchange-traded products, some asset managers have invested in available Canadian and European ETFs. “The question is,” says Ben-Hur, “if some additional clarity comes from the SEC, or even the CFTC [Commodity Futures Trading Commission], how is that going to impact the assets for U.S. clients when they suddenly realize they can't hold them?”
Boggiano contends regulators should provide the same kind of clarity for digital assets that they have for equities, bonds or commodities.
According to Kaczmarski, the regulatory environment is already “more advanced” than many asset managers would expect. He says Germany's allowing institutions up to a 20% allocation in crypto assets will allow asset managers to offer separately managed accounts with those holdings.
Deutsche BÖrse Group's Eurex derivatives arm has announced the September 13 launch of Bitcoin ETN futures, making it the first regulated bitcoin-related derivatives market in Europe. The physically delivered contract is based on the Frankfurt Stock Exchange-listed BTCetc Bitcoin Exchange Traded Crypto, with central clearing and settlement over the Deutsche BÖrse infrastructure.
Risk Appetite and Due Diligence
Though they may not be accustomed to investment risks on the crypto frontier, asset managers can go down familiar paths. “Start with the risk appetite, to simply understand your appetite to actually lose money, or the kind of protections you want to implement to remain within your risk appetite boundaries,” Kaczmarski advises.
Arca's Dorman says managers can stay in traditional comfort zones - sizing positions correctly, using cash on the balance sheet, securities lending, and trading options and futures to reduce volatility.
Price volatility is the main perceived impediment to institutions considering crypto investments, according to survey results revealed in July by Fidelity Digital Assets and Coalition Greenwich. The next greatest barriers are lack of fundamentals to gauge value and market-manipulation concerns, said the survey, which found that 52% of institutions were already taking digital asset positions.
“By now, the most sophisticated investors use the full spectrum of instruments, from direct to derivative structures, just to avoid the market impact,” Kaczmarski says.
Some asset managers have built internal scoring systems to rate issuers of digital assets. Arca, for example, won't invest unless the company has an online client portal, human customer-service representatives, real-time financial information, a coherent corporate structure, transparency, corporate governance, and documentation such as FINRA broker checks.
Arca and CrossTower have systems to ensure that the companies they deal with have know your customer (KYC) and anti-money laundering (AML) compliance. “There are ways to mitigate those risks by doing proper due diligence,” says Arca's Dorman, “even though this industry has largely been plagued by negative headlines.”
In-House or Not?
Many asset managers routinely face the decision of whether to build systems internally or rely on third parties, says Deloitte's Davis. “Very few if any of those systems work for cryptocurrencies; banks are having to look at re-platforming or coming up with new systems to deal with digital assets.”
The Fidelity Digital Assets survey indicated institutional investors are expecting more services from digital asset custodians; 63% want a custodian that offers electronic trading, 56% market data and analytics.
When an issuer disappoints investors, asset managers can always start activist investor campaigns. After Arca drew attention to the underperformance of Gnosis' token, it was converted into a decentralized autonomous organization (DAO). Tokens of a DAO are explicitly backed by its assets.
Such risks are so murky that “it could take decades for the asset management industry to come to a consensus on how to manage them. But it's an effort worth undertaking,” Kaczmarski says. “Some institutional investors and asset managers are willing to consider that crypto might at some point have a reputation similar to gold when it comes to storage of value. This is how big it can be in future.”
That suggests that building the necessary risk disciplines will ultimately be worth the effort.