In crypto annals, 2022 will go down as the year this industry almost died. But then December saw the birth of a pair of exchange-traded funds in Hong Kong, offering new hope. Asia’s first futures ETF for bitcoin and ether joins a growing list of initiatives that could address the legitimacy crunch facing virtual assets. The confusion surrounding the safe custody of crypto holdings is a major disappointment. Sam Bankman-Fried’s FTX, one of last year’s most spectacular crypto failures, has brought hapless customers of the failed exchange before a US bankruptcy judge who will determine whether they are entitled to money ahead of other creditors. But FTX is not the only test for crypto custody. Last month, a US bankruptcy judge ordered bankrupt Celsius Network to pay back nearly $50 million, which never earned any interest. But the fate of billions of dollars of user funds stuck in interest-bearing accounts is still in question: Is it the borrower’s property or the customers’? Uncertainty should decrease as cryptos move to normal exchanges in the same way as regular securities like stocks and bonds. This will bring the customer’s assets under the standard safeguards. For example, the new CSOP Bitcoin Futures ETF will hand over custody of client funds to HSBC’s licensed Hong Kong trust firm that [checks],
Fund managers are waiting for this. Adults will bring adult rules with them to the crypto playpen. No one knows whether the digital assets of today will be anything more than speculative vehicles, but the tokens of the future may represent meaningful economic value. On that basis alone, it may be worthwhile for them to create a secure set-up now to get the capital flowing.
The Hong Kong crypto ETF is one of many examples of the financial industry trying to provide security in a legal vacuum. Bank of New York Mellon, the custodian of $43 trillion of customer assets, recently opened its vaults to receive some institutional clients’ cryptocurrencies. BlackRock added crypto to its Aladdin platform, which is used by pension funds and other large investors to oversee their portfolios. Fidelity’s brokerage unit has been providing custody services for hedge funds since 2018. Now it is launching a zero-commission bitcoin and ether trading service for retail clients.
Olivier Fines of the CFA Institute cautions against reading too much into private industry-level efforts. “The real insurance offered by BNY Mellon, Fidelity or HSBC is a product of their size and scale, it is not something smaller institutions can easily replicate. For crypto to be a competitive market in custodial services, new laws must fill existing legal holes,” Fines said. One such gap is in the US SEC’s customer protection rule. cash and securities by themselves. This is a reassurance to clients who would be reluctant to stand in line with general creditors if an intermediary becomes insolvent.
But are exchange tokens, 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, “custodial protections, like other investor protections for digital assets, have been largely untested in court,” Fins and his colleague Stephen Dean said in a report by the CFA Institute. From running to disclosure of frauds and Ponzi schemes,” the report said. “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 safety was not a priority. Now the pendulum has begun to swing, though perhaps a little too much in the other direction. In March, the SEC came out with new accounting guidance for financial firms that have an obligation to safeguard customers’ crypto assets: they need to clearly record a liability and a matching asset. But this need can backfire if it is seen as too onerous. A bloated balance sheet will increase banks’ capital requirements, making them reluctant to offer custodial services.
This regulatory tussle will calm down at some point, hopefully investors will feel better protected and intermediaries won’t shy away from crypto. The techno-anarchist founders of trustless blockchains will not be pleased that the same bigwigs they wanted to banish are trying to hijack their creation. But with some luck, future historians of the industry will conclude that crypto’s worst vulnerabilities are 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 safe bet for those who didn’t mind volatility.
Andy Mukherjee is a Bloomberg Opinion columnist covering industrial companies and financial services in Asia.
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