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Why counterparty risk is the key to crypto market institutionalisation

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Major advances in the way trading and custody infrastructure tackles counterparty and exchange risk in digital assets are helping to assuage investor fears and will help further drive institutionalisation of this market further down the line, industry participants say.

Major advances in the way trading and custody infrastructure tackles counterparty and exchange risk in digital assets are helping to assuage investor fears and will help further drive institutionalisation of this market further down the line, industry participants say.

As hedge funds and other asset managers continue to seize on the assortment of investment opportunities in cryptocurrencies and blockchain technology, many big-ticket long-term allocators – pension funds, insurance companies, foundations and endowments – may be sitting on the sidelines thanks to continued concerns surrounding asset security.

A recent investor survey by decentralised infrastructure technology provider VALK found that more than half – 54 per cent – of respondents are ‘very concerned’ about custodial services in DeFi. At the same time, some 52 per cent of the those polled (100 institutional investors holding USD1 trillion in assets) are ‘very concerned’ about security issues in crypto.

The core issue stems from the way crypto assets are traded on exchanges – a central component to the market architecture – and how the security of hot wallets, which are used in order to trade, is managed.

In recent years, a slew of digital assets custody platforms including Copper, Fireblocks, Gemini, and Komainu have developed advanced services for trading and exchange, while Fidelity, Anchorage and BitGo are among those platforms offering buy-and-hold services.

Seeking comfort

“There are now very powerful solutions in place, but the knowledge is yet to be disseminated so that institutional investors can take comfort,” says Anatoly Crachilov, founding partner and CEO at London-based Nickel Digital Asset Management. “The reputational angle of crypto is improving, and that will help open the gate for institutional arrivals.”

While the digital assets hedge fund space initially blossomed around crypto-native managers willing to accept greater risk and more operational leg-work in return for attractive investment opportunities and sizable alpha generation potential, the market will not fully develop unless larger traditional asset managers and investors come onboard, suggests Asen Kostadinov, head of strategy at London-based crypto custody service provider Copper.

“But for them, a lot of the key details – like counterparty risk, and how settlement is done – are going to be non-negotiable,” Kostadinov tells Hedgeweek. “At the beginning of any market, people actually can compromise – they want to be there and they will make do with whatever they have. However, as this market develops, the details start to matter a lot.

“Fortunately we have, to some extent, a blueprint of what the infrastructure should look like, because we’ve know how traditional markets operate.”

For Copper, an understanding of the traditional finance space and creating products that can provide the same safeguards traditional asset classes enjoy is vital for fostering investor confidence, and that stance forms the basis of its Walled Garden and ClearLoop products.

“Ultimately, you are trying to create a market structure resembling the market structure that you see in traditional finance,” he observes.

“In crypto, one of the first things you immediately notice is that the whole market is concentrated within exchanges. You need to be moving your assets to exchanges in order to trade. When you move your assets to an exchange, if you’re a fund manager, this means that you are in complete control of the assets that you manage. And of course, these are not always your own assets – you are managing these assets on behalf of investors. So one of the core responsibilities of a custodian is actually to manage that conflict between a fund manager that is managing assets on behalf of somebody else and ensuring the fund manager observes the agreements they have with their investors.

“It’s important for you as a provider to be offering a solution to your clients where they can actually operate in a paradigm close to the traditional space. That’s what ClearLoop does – it allows you to trade on an exchange, but custody your assets at Copper, so that your assets never move to that venue. This puts the first building blocks towards creating a central clearing model for crypto and can open up the market to much more sophisticated operations.”

Dan Smith, president and head of US Fund Services Operations at Trident Trust, notes how custody services remain “very expensive” for asset managers, adding that smaller and emerging crypto-focused hedge funds are trying to find the right balance of taking that next step towards expansion while remaining cognisant of how they can readily afford to incur such costs.

“From the investor perspective, meanwhile, it is absolutely about having assets more tightly protected where the odds of a hack, or a lost key, or a misappropriation by fund personnel are lowered.”

The other challenge for managers, adds Smith, is that investors are becoming smarter about the right questions to ask.

Four pillars

“They’re asking more probing questions – ‘Who is your custodian?’; ‘How is your internal trade mechanism set up to stop misappropriation of funds?’,” he says. “Investors want exposure – but they want to ensure risks are being addressed and managers are doing things the right way.”

For many, having crypto custody solutions mirror the service already firmly established within the traditional finance sector is key.

“Our four pillars are security, products, licensing and compliance, and that is always how we have approached any market, any type of clients,” explains Stephanie Ramezan, director of business development at Gemini Europe.

“The challenge for any fund manager, whether it be digital assets or traditional currency, is security. As part of our Gemini Foundation, we like to talk about the attributes that differentiate us from competitors in the crypto space, but we also see that our policies and procedures very much mirror that of traditional regulated, financial institutions.

“Because we have our licensing and regulation, we are already a very different type of player in both the exchange and in the custody side of things.

“In terms of our custody, we have different types of offering. Anybody who trades on the Gemini exchange gets to take advantage of the custody on exchange. That’s used by people who wanted to be trading very proactively. However, if someone who wants to just buy-and-hold, people have the option of our segregated custody, which is cold storage.”

She also points to Gemini’s recent acquisition of London-based startup Shard X, which has developed multi-party computation technology allowing for the security of cold storage with the accessibility of a hot wallet.

Ramezan tells Hedgeweek that a perennial risk for hedge funds is client reaction and reputational risk.

“If you are a crypto native hedge fund, then of course your GPs and LPs are going to be far more open to investment into this space. Traditional hedge funds, aside from not necessarily having the right team in place or having the knowledge base, they also have that reputational risk and a different type of investor to answer to. I think this is where we can see the crypto-native hedge funds really pulling away very, very quickly out the starting gate.

“What do fund managers have to think about? It is security, it is risk. When we onboard with new customers, we fill in – if they wish – a DDQ, just like any bank would. That comes back to the point of mirroring those regulated financial institutions. That’s the absolute core of what we do.”

So as the crypto asset landscape evolves and expands, is the question of safe asset custody – a pivotal point in the road to market institutionalisation – close to being resolved?

“It’s definitely very much more advanced than it was three years ago. The reason why I can’t say it’s completely resolved is because we are still very early in the development of this market,” explains Kostadinov.

“I would say that in its basic form, the custody issue has been solved. There are providers you can go to get custody services and have some peace of mind. In the US, a number of these providers are well-regulated. With regards to just basic functionality and being able to find good custodians, there has definitely been progress compared to three years ago.

“It’s adequate for the time being to some extent, but it needs to develop a lot more in order to serve the market and enable the market to expand.

“And, of course, it’s not just custody – there are a lot of other things that also need to develop. Take a look at exchanges – their technology in a lot of cases is now outdated; there is a lot of patching that needs to be done. The way data is shared and generated in this space; the way some of the execution services are being run.”

Underlining this point, he describes the current iteration of the digital assets industry as ‘version 1.0’.

“The first version of any particular niche or particular industry – it doesn’t necessarily need to be financial services – will always have the early adopters and first movers, and they can make do with inefficiencies at the start,” he says. “But ultimately, when you see the version 2.0, or v3 or v4, that market will be completely different, and the level of service that you’ll have will be completely different, to what you have today. It’s just natural evolution.”


Read the full Institutionalising Digital Assets: Powering the hedge fund crypto surge Insight Report here.

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