In the annals of cryptocurrencies, 2022 will become the year 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.
The first Asian futures ETFs for Bitcoin and Ether join a growing list of initiatives that will go some way towards ameliorating the current legitimacy crisis facing virtual assets. A big drag is the confusion surrounding the secure custody of crypto holdings. Sam Bankman-Fried’s FTX, the most spectacular of last year’s crypto debacles, has brought the hapless customers of the failed Bahamas-based exchange before a Delaware bankruptcy judge who will determine whether they are entitled to their funds in advance of other creditors.
But FTX isn’t the only test for cryptocurrency custody. Last month, a US bankruptcy judge ordered insolvent Celsius Network LLC to pay back the roughly $50 million it had never earned any interest. However, the fate of billions of dollars of user funds locked up in interest-bearing accounts is still up for debate: Does the money belong to the debtor’s estate or to customers?
This anxiety-inducing uncertainty should ease with more cryptocurrency investments moving to regular exchanges as regular securities, no different than stocks and bonds. This will bring customers’ assets under the umbrella of standard protections, precluding the need for costly legal maneuvers to recover their money. For example, the new CSOP Bitcoin Futures ETF will entrust the custody of client funds to the Hong Kong licensed trust company of HSBC Holdings Plc which, as noted by Bloomberg Intelligence, undergoes regular bank reviews and audits.
This is what fund managers have been waiting for. Adults entering the crypto box will bring the adult rules with them. No one knows if any of today’s digital assets will be anything more than vehicles for speculation. But the tokens of the future could represent significant economic value. Based on this premise alone, it might be worth creating a safe and secure setup now for capital to flow to them.
Hong Kong’s cryptocurrency ETF is just one of several recent examples of the financial sector trying to provide protection in a legal vacuum. The Bank of New York Mellon Corp., custodian of $43 trillion in client assets, recently opened its vaults to receive the cryptocurrencies of some institutional clients. BlackRock Inc. has also entered the fray by adding cryptocurrencies to its Aladdin platform, which is used by pension funds and other large investors to oversee their portfolios. Fidelity Investments, the brokerage unit of the wealth management giant, has been offering custody services to hedge funds since 2018. It is now launching a commission-free Bitcoin and Ether trading service for retail clients.
Olivier Fines, head of advocacy for Europe, the Middle East and Africa at the London-based CFA Institute, warns against reading too much into private sector-wide efforts. “The de facto insurance offered by a BNY Mellon, Fidelity or HSBC is definitely a product of their size and scale; it’s not something smaller institutions can easily replicate. For there to be a competitive market in cryptocurrency custody services, new laws need to plug existing legal loopholes,” Fines said.
One such loophole is in the US Securities and Exchange Commission’s client protection regulation. Under it, broker-dealers are required to separate clients’ cash and securities from their own. This is an important guarantee for customers parting with their money. They would be reluctant to line up next to general creditors to recoup pennies on the dollar if a broker went bankrupt.
But is an exchange token, such as FTX’s FTT cryptocurrency 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 says FTT is a security. So far, however, “custody protections, like other investor protections for digital assets, remain largely untested in court,” Fines and his Washington colleague Stephen Deane wrote in a new report summarizing current views. of the investment management industry on putting cryptocurrencies on their menus.
“Revolutionary or not, technology alone cannot offer protection from secular financial crimes, ranging from market manipulation and front-running to fraudulent disclosures and Ponzi schemes,” the CFA Institute report said. “The crypto ecosystem urgently needs a strong and clearly defined regulatory framework.”
For too long, the goal of cryptocurrency supervision has been to prevent money laundering. Customer protection was not the priority. But now the pendulum is starting to swing, perhaps a little too much in the opposite direction. In March, the SEC issued new accounting guidelines for financial firms that have an obligation to safeguard clients’ crypto assets: They must explicitly record a liability and a corresponding asset. But this requirement can backfire if it is perceived as too onerous. A swollen balance sheet will increase banks’ capital requirements, making them reluctant to offer custody services to customers.
This regulatory tug of war will eventually settle, hopefully investors feel better protected than they do now and intermediaries don’t step away from the field. The techno-anarchist founders of trustworthy blockchains won’t be happy that the same big brokerages they wanted to ban are trying to hijack their creation. But with any luck, future industry historians would conclude that the worst cryptocurrency vulnerabilities emerged from wood in 2022. Since then, things have progressively gotten better. Digital assets continued to remain unsuitable for most risk-averse small investors, but at least they became a safer bet for those who didn’t mind volatility.
More from Bloomberg’s opinion:
• Money Stuff by Matt Levine: Manipulating cryptocurrencies has consequences
• Beware of the Dangers of Cryptocurrency Overregulation: Tyler Cowen
• Beware of cryptocurrency billionaires who brag about audits: Lionel Laurent
This column does not necessarily reflect the opinion of the editorial board or of Bloomberg LP and its owners.
Andy Mukherjee is a Bloomberg Opinion columnist covering industrial companies and financial services in Asia. Previously, he worked for Reuters, Straits Times and Bloomberg News.
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