In the annals of cryptocurrencies, 2022 will go down as the year when the industry nearly died. But then December saw the birth of a pair of exchange-traded funds in Hong Kong, offering new hope to both retail and professional investors.
Asia’s first futures ETFs for Bitcoin and Ether join a growing list of initiatives that will go some way toward ameliorating the current crisis of legitimacy facing virtual assets. A big dampener is the confusion surrounding safe custody of crypto holdings. Sam Bankman-Fried’s FTX, the most spectacular of last year’s string of crypto debacles, has brought the hapless customers of the failed Bahamas-based exchange in front of a bankruptcy judge in Delaware who’ll determine if they’re entitled to their funds 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 LLC to return the roughly $50 million that had never earned any interest. However, the fate of billions of dollars of users’ funds stuck in interest-bearing accounts is still in question: Does the money belong to the debtor’s estate or the customers?
This anxiety-inducing uncertainty should ease with more crypto investments moving to normal bourses as regular securities, no different from stocks and bonds. That will bring customer assets under the umbrella of standard safeguards, precluding the need for costly legal manoeuvrings to recover one’s money. For instance, the newly launched CSOP Bitcoin Futures ETF will entrust custody of customer funds to HSBC Holdings Plc’s licensed Hong Kong trust company that, as Bloomberg Intelligence notes, undergoes regular bank examinations and audits.
This is what fund managers have been waiting for. Adults getting into the crypto playpen will bring grown-up rules with them. Nobody knows if any of today’s digital assets will amount to anything more than vehicles for speculation. But tokens of the future might represent meaningful economic value. On that premise alone, it may be worthwhile to create a safe and secure setup now for capital to flow toward them.
The Hong Kong crypto ETF is just one of several recent examples of the financial industry trying to provide protection in a legal vacuum. Bank of New York Mellon Corp., the custodian of $43 trillion in customer assets, recently opened its vaults to receive some institutional clients’ cryptocurrencies. BlackRock Inc. has also entered the fray by adding crypto to its Aladdin platform, used by pension funds and other large investors to oversee their portfolios. Fidelity Investments, the brokerage unit of the asset management behemoth, 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, the London-based head of advocacy for Europe, Middle East and Africa at 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 Securities and Exchange Commission’s Customer Protection Rule. Under it, broker-dealers are required to segregate customers’ cash and securities from their own. This is an important assurance to clients parting with their money. They would be loath to stand in line alongside general creditors to recoup pennies on the dollar in the event of the bankruptcy of an intermediary.
But is an exchange token — such as FTX’s cryptocurrency FTT or Binance’s BNB — a security or a utility? In its complaint against FTX co-founder Gary Wang and former Alameda Research Chief Executive Officer Caroline Ellison, the SEC is claiming 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 Washington-based colleague Stephen Deane wrote in a new report that summarizes the investment management industry’s current views on putting crypto on their menu.
“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,” says the CFA Institute report. “The crypto ecosystem urgently needs a strong, clearly defined regulatory framework.”
For too long, the focus of crypto supervision has been on preventing money-laundering. Customer protection wasn’t the priority. Now the pendulum is beginning to swing, though, perhaps a bit too much in the other direction. In March, the SEC came up with new accounting guidance for financial companies 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 perceived to be too onerous. A bloated balance sheet will push up banks’ capital requirements, making them reluctant to offer custodial services to clients.
This regulatory tug of war will ultimately settle down, hopefully with investors feeling better protected than now and intermediaries not shying away from the field. 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 progressively got better. Digital assets continued to remain unsuitable for the majority of 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. Views are personal and do not represent the stand of this publication.
Credit: Bloomberg
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