Oliver Fines says fiduciaries have no excuse for their falling prey to hype associated with crypto, as principles of prudence, care and loyalty should continue to apply.
If there is one thing for sure in capital markets, it is that there is no such thing as a free lunch, or a martingale guaranteeing financial performance on an a priori basis.
At the risk of stating the obvious, although we may have been led to believe otherwise for a short while, money does not grow on trees. Maybe one good reason for this is also that this notion is a misnomer in and of itself. More clearly, money is oftentimes confused for economic wealth, a typical paradox in a classical liberalism sense.
It is possible a decade and a half of quantitative easing and central bank intervention in the economy has led to the belief that an expanded money base equated wealth accumulation. Crypto was born out of this dichotomy and, ironically, may be experiencing its own identity crisis rooted in its delusion of grandeur. In other words, digital finance may be learning the hard way that money cannot be decoupled from economic reality and actual value creation.
This reality check seems to be what is bringing the digital finance world back down to earth these days, after a difficult 2022 mired in corporate scandals and malpractice discoveries affecting various companies and service providers that are part of the crypto ecosystem.
This sad turn of events, however, is distracting from the actual industry development that blockchain technology and cryptoassets may nonetheless bring to the economic world made up of micro-transactions between individuals and businesses.
We must attempt to see the forest for the trees. Fraud, malpractice, and poor business conduct are realities of any economic system. Reducing crypto to those would equally be a bad judgment call. However, they do point to the main problem that digital finance is facing as it develops, one of immaturity and the need to put in place the scaffolding that is necessary to stabilise its structure as a trustworthy node between economic agents.
Digital finance needs to move past its hype and start institutionalising. The irony being that, in so doing, the industry may need to re-introduce some form of centralisation which it was originally meant to part with. Finding the right balance between decentralisation, efficiency and security may determine the role that digital finance ends up playing in the economy.
It is in this context that CFA Institute has released its first in-depth research brief, Cryptoassets: Beyond the Hype, into this burgeoning field of financial services. Our conclusion was that digital finance faced three major hurdles to overcome at this early stage of its development, namely a difficulty to determine intrinsic value, how to reconcile crypto with fiduciary duty, and the issue of custody and safekeeping of client assets.
The current turn of events is also showing that regulators around the world are facing a serious conundrum as regards the role that digital finance and cryptoassets are playing in the traditional finance ecosystem. The cause of this conundrum includes the fact that cryptoassets seem to have developed from the retail and largely unprofessional sector, which is causing a dissemination pace that has taken policymakers by surprise.
Another issue is the difficulty to define whether or when cryptoassets correspond to a traditional understanding of what constitutes securities or if they are entirely new instruments for which specific regulation needs to be crafted.
A third problem is the sheer technological barrier that digital finance represents, which is challenging regulators’ traditional neutrality as regards technological choices. They are finding it more difficult to strictly focus on desired outcomes in the case of blockchain-based services which, by their nature, are lacking the traditional chain of centralised responsibility which has underpinned financial regulation until now.
Our report proposes a series of recommendations for institutions who act as fiduciaries, but also for regulators and policymakers.
For institutions and fiduciaries, important recommendations would include:
- Not to use hype as the basis for an investment case.
- The traditional rules of sound portfolio construction continue to apply and should not be downgraded to suit a new shiny opportunity.
- Crypto requires an even stricter and careful analysis of the proposed business model, not to fall victim of false promises.
- It has become ever clearer that custody and safekeeping of client assets in digital finance needs to be investigated with scrutiny. Asset segregation and the capacity to verify it is essential.
For regulators and policymakers, important recommendations would include:
- The need for regulation to be harmonised at an international level to match the cross-jurisdictional nature of digital and decentralised finance.
- The need to clarify the nature of the various cryptoassets, whether securities or something entirely new.
- Regulation should be technology-neutral and focus on desired outcomes, as opposed to prescribing a set of rules dedicated to any specific technology.
- Custody rules in digital finance need to be ascertained and enforced to the same standard as traditional finance.
- Regulators should put together the right tools to measure the build-up of risk in the system emanating from this burgeoning field of financial transactions.
A novelty or not, sound economic and financial principles should continue to prevail. Institutional and sophisticated investors, especially when acting in a capacity as fiduciary, have no excuse for their falling prey to the hype or pressure they may have experienced when considering potential exposures to cryptoasset services, products or ventures. The same principles of prudence, care and loyalty should continue to guide any prospective investment on behalf of end-investors.
We believe more work is required on the modelling of the intrinsic value of cryptoassets. We also think the drive towards the establishment of central bank digital currencies warrants a serious analysis of the potential consequences for capital markets and investment practitioners, but also for individuals, including from the point of view of data privacy and financial inclusion.
Olivier Fines is Head of Advocacy and Capital Markets Policy Research for EMEA at CFA Institute.