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November 2022
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AAM Magazine
November 2022

Volatility and the digital transformation: Surviving the cryptowinter

By State Street   
  • Asia
  • Global

This summer’s extreme market volatility created what’s being called a ‘cryptowinter’ for digital assets. Yet while the difficult conditions tested investors’ nerves, they are far from putting allocations on ice. State Street’s third Digital Digest explores the ongoing appeal of cryptocurrencies.

The summer of 2022 was cold for crypto. In fact, conditions were so bleak for the alternative asset class that it lost a third of its value with the largest currency, Bitcoin, dropping from its November 2021 highs of almost $69,000 to just $19,000 by June.

‘Cryptowinter’ has seen the currency in the throes of negative investor sentiment and damaging media coverage.

However, compared to the performance of safe-haven assets since 2020, crypto appears to have fared relatively well. It remains the fourth most popular asset for investors after stocks, mutual funds, and bonds.

Institutional investors still regard digital assets as the future, and they are considered an important diversifier for portfolios. In the last year, large institutional investors have started to accumulate bigger volumes of Bitcoin and Ethereum, both to combat inflation and to deliver a reliable income stream.

Protecting the investors in crypto

While the environment for crypto has been decidedly chilly, regulators continue to warm to more legislation of the sector, which should prompt greater appetite from institutions currently deterred by reputational risks.

Regulatory authorities across all major regions are acting to improve clarity around cryptocurrency and pave the way for responsible market growth.

This June, in the depths of cryptowinter, the Japanese Financial Services Agency (JFSA) released a public consultation proposing a removal of the ban on Japanese trust banks from conducting a cryptoasset safekeeping business. The idea is to leverage trust banks’ experience and risk management resources for cryptoassets, which would strengthen investor protection and promote market development.

Meanwhile, the Hong Kong government introduced pioneering legislation, giving the Securities and Futures Commission of Hong Kong responsibility for virtual asset service providers by issuing them licenses, in a bid to combat money laundering.

At a global level, this July the Financial Stability Board issued a statement on International Regulation and Supervision of Cryptoasset Activities, which called for harmonised regulation of digital assets and the need to manage financial stability risks.

Enhancing the ESG credentials of cryptoassets

Cryptoassets are not always seen as compatible with investors’ environmental, social and governance (ESG) investment strategies. Yet recent developments in the sector suggest the conditions for the G, at least, are improving.

Decentralised Finance (DeFi) platforms are an innovative financial technology that uses distributed ledger technology (DLT) and blockchain to eliminate the need for intermediaries.

The interest in DeFi by institutional investors is increasing and, while the premise suggests lower levels of governance in the absence of intermediaries, DeFi platforms are reinforcing the blockchain community’s commitment to decentralisation by issuing governance tokens to users.

These governance tokens transfer agency, responsibility, and control of platform management from a project’s small group of founders, employees, and insiders to the globally distributed and decentralised community of stakeholders that uses the platform and engages with the wider DeFi ecosystem.

As more participants join, so the governance of these tokens improves and ultimately this innovation improves the freedom and security with which investors can participate in cryptoassets.

Improvements in the technology powering crypto

A volatile summer for cryptocurrency has not stymied technological advances. Indeed, the technology underpinning cryptocurrencies could dramatically alter the way other financial assets are used in investors’ portfolios.

In particular, the transformative potential of blockchain and DLT could see illiquid assets such as infrastructure and private equity become more easily tradable through ‘fractionalisation’.

Effectively, the physical infrastructure or property is broken up into digital tokens – or ‘token shares’ – that represent parts of the underlying asset to be traded much like an equity.

This is an important development since it would open the private markets to retail investors, notably defined contribution pension members, who have long struggled to include illiquid assets in their portfolios.

ETFs and mutual funds also stand to benefit from having their shares and units tokenised, creating a new way for participants to issue, hold and trade assets.

The recent volatility in the digital assets market has given rise to greater innovation and improved oversight.

To find out more about the digital transformation, visit: Digital-Digest-III-Volatility-and-the-Digital-Transformation.pdf (statestreet.com)


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