Regulation remains in sharp focus. Digital participants from across the financial markets spectrum are keen to dive in headfirst while others, partly due to a perceived supervisory gap, remain on the sidelines.
Regulation remains in sharp focus. Digital participants from across the financial markets spectrum are keen to dive in headfirst while others, partly due to a perceived supervisory gap, remain on the sidelines.
With the global regulatory landscape very much in a state of flux, the US Securities and Exchange Commission has set to work on establishing a supervisory framework covering the proliferation of digital coins and assets. These potentially include treating certain cryptocurrencies and tokens as investment securities, together with further oversight of NFTs, while SEC chairman Gary Gensler indicated in September that crypto exchanges may have to register as securities markets.
The SEC also greenlighted the first US bitcoin futures ETFs – ProShares, Valkyrie and VanEck – on the New York Stock Exchange in October, while the Commodity Futures Trading Commission continues to weigh up the regulation of crypto derivatives in the same way it supervises traditional futures.
Across the Atlantic, meanwhile, the EU’s forthcoming Markets in Crypto-Assets (MiCA) initiative sets out proposed rules covering issuance and service provision of crypto assets, with a view to strengthening market integrity and improving investor protection. The plans also look to tackle the potential financial stability and monetary policy risks posed to economies by digital assets. In December, the European Securities and Markets Authority (ESMA) added crypto asset investing to its Alternative Investment Fund Managers Directive (AIFMD) Q&A.
Co-ordination
Early last year, the UK’s Financial Conduct Authority weighed in, warning that consumers investing in crypto assets “should be prepared to lose all their money.” The watchdog pointed to significant price volatility and product complexity in the asset class, and suggested it can be difficult to price reliably.
While developed markets have inevitably taken the lead, industry participants point to the “hodgepodge mishmash” of fractured rules and requirements globally. While El Salvador, for instance, enacted legislation last summer permitting bitcoin to be used as legal tender for the payment of goods and taxes, China has maintained its tough stance against cryptocurrencies, outlawing trading services, token issuances and digital currency derivatives, and prohibiting overseas exchanges from offering services in mainland China.
Concerns over the shape of regulation loom large among hedge funds. According to a Hedgeweek survey of 50 fund managers, more than a third of those polled identified regulation as the single greatest obstacle to launching a digital assets hedge fund strategy currently.
Asked specifically about the biggest risk facing hedge fund managers in this space, “Changes in securities law covering the asset class”, “Frequent regulatory changes” and “The cost of regulation and time consumed by regulation” were among the responses given.
“We need stable and well thought-out regulation,” remarked one respondent who manages a crypto fund and is looking to launch more strategies this year.
Acknowledging the complexities and challenges of supervisory oversight, Asen Kostadinov, head of strategy, Copper, says the “number one challenge” for regulators is how new and different digital assets are in comparison to other markets and asset classes.
“The first thing is understanding what it is, and once they understand it, they try to liken it to something that they’ve seen before and put it into the current regulatory framework,” Kostadinov observes of the current regulatory approach.
“The next thing I think they will start grappling with is the global aspect of this – co-ordination on a global level is going to be very difficult but also key.”
Speaking at last year’s Hedgeweek DigitalAssetsLIVE summit, Anthony Tu-Sekine, head of blockchain and cryptocurrency group at Seward & Kissel, described the current regulatory landscape in the US as something of a “mixed bag”.
“In the crypto mainstream, if you have investments in bitcoin and ether, I don’t think there’s a huge danger that regulators will change their mind on their existing guidance with respect to those assets,” Tu-Sekine noted. But moving towards the more esoteric crypto assets, Tu-Sekine believes there is “significant regulatory risk” as market authorities continue play catch-up on the fringe elements.
Revolution
Underlining the complexity of the challenge, the view that digital assets is not so much one single asset class, but part of a broader technological revolution – encompassing DeFi, Web3, the metaverse and more – is taking hold among many market participants, who see attempts at regulatory scrutiny in a financial markets context as merely scratching the surface.
But while some managers and investors have cited regulatory uncertainty as one of the biggest barriers to entry in digital assets, there have been “leaps and bounds” made over the past 12 months as regulators get to grips with how crypto markets operate, according to Stephanie Ramezan, director of business development at Gemini.
“It’s fantastic for the digital assets space to have somebody who is proactively having conversations,” Ramezan says of the approach taken by SEC chair Gary Gensler towards a more comprehensive regulatory environment.
Ramezan acknowledges that in the UK the “psychology” towards digital assets remains somewhat behind the US in terms of institutional and retail perspective. “But I think the US has always been far more bullish, across a variety of asset classes generally. In the UK, through the FCA, we have the FCA Crypto Asset Register, which I think is exactly the right approach for the UK to be taking.”
While regulation improves and strengthens around core elements of the crypto assets ecosystem – notably custody exchanges and coins – other areas, such as decentralised finance (DeFi), remain outside the regulatory scope. And with interest in DeFi booming among hedge funds, the sprawling, labyrinthine array of assets and products could raise fresh questions surrounding oversight for both investors and regulators.
“Ultimately, the very large allocators may decide they are not comfortable with the non-regulated parts of the marketplace, because it’s too much of a risk to take and so they’re just not willing to allocate big sums to a manager that’s playing in those parts of the market,” Dan Smith, president and head of US Fund Services Operations at Trident Trust, tells Hedgeweek.
“I expect that managers who want allocations from those big investors will play in the neater, tidier part of the marketplace. You’ll still have the retail and individual investors, maybe even the very small funds with just high-net-worth investors who are less concerned about that who will still play in those less-regulated areas.”
Conflict
Paul Frost-Smith, founder and CEO of Corinthian Digital Asset Management, believes there is a “fundamental conflict “at the theoretical level” between “anything that’s decentralised and particular institutions trying to regulate it.”
He points to different regulations across different jurisdictions, noting there are various rules depending on whether a market participant is buy-side or sell-side.
“Because no specific regulations are really being targeted at crypto yet, everyone is really trying apply the existing regulatory regime that covers traditional hedge funds and traditional asset classes to crypto. But due to the nature of decentralisation, I’m not sure you can actually regulate the products themselves. I think you have to take an approach of regulating certain participants,” he adds.
“You can regulate activities – like marketing, or exchanging fiat for crypto – and I think you can regulate some of the participants in the infrastructure. But because of the actual nature of the industry I don’t think it’s actually capable of being regulated easily.”
Aiming to address some of the supervisory challenges surrounding DeFi, Los Angeles-based Quadrata is developing an identity and compliance element for prospective market participants in decentralised blockchains.
Lisa Fridman, Quadrata’s president and co-founder, and former partner and global head of research at PAAMCO Europe, points to the sizable opportunities in blockchain technology, particularly within the realm of decentralised finance, with “huge potential” for DeFi to provide a viable alternative to traditional financial services, with potentially lower costs, faster transaction speeds, and more transparency.
“DeFi originated as a permissionless system, with a broad reach. But regulated institutions are not necessarily able to participate in permissionless pools where they may be commingled with potential bad actors,” Fridman tells Hedgeweek.
“What we are developing at Quadrata is introducing this identity and compliance layer to decentralised finance across different blockchains. What we aim to achieve is to enable institutions and individuals to leverage their off-chain reputation to transact on-chain.”
Specifically, this involves the introduction of a passport-like verification system – Quadrata Passport – where trusted entities will be able to verify and attest to data in those participants.
“Initially, it will be KYC, AML-type of reviews and assessments that will be posted to the passport, and in the future we anticipate adding further fields to the passport. We can help mitigate some of the risks of being commingled with unknown participants.”
Catch-up
Ultimately, large institutional investors, banks and central banks all have a vested interest in there being more regulation of this space, according to market participants.
“The regulators at the moment are scrambling to catch up, but they will catch up. They will hire enough people and will get there in the end,” says Lee Robinson, founder and CIO of multi-asset class hedge fund manager Altana Wealth. “They can’t be seen to not be in control of a USD3 trillion market that is very volatile.”
Robinson believes there is clear direction of travel in regulation of DeFi, and ensuring the owners of DeFi platforms are regulated, which will bolster trust in the eyes of institutional and retail investors.
“It’s going to go that way, and people will go to platforms they trust and regulated platforms – I think it’s a really good thing for the industry.”
Looking ahead, Asen Kostadinov expects a degree of supervisory ebb-and-flow as regulators play catch-up with a rapidly-evolving landscape.
“You can’t really grapple with the pace of growth, so perhaps in the beginning it’s going to be overly restrictive,” Kostadinov observes.
“It’s not easy to forecast, but the idea being is that in the short-term they feel like they need to get a very firm grasp of it and to restrict some of the activities. That what they’re doing now.
“Overall, it’s positive – if you want to get more institutional flow, if you want to get broader adoption, then you need to give people basic peace of mind that what they’re dealing with has been sanctioned by somebody else. Above all, ensuring and maintaining the integrity of all financial markets is absolutely key.”
Read the full Institutionalising Digital Assets: Powering the hedge fund crypto surge Insight Report here.
