In my last article I discussed how policy and regulatory developments in the United States might be conducive to faster and more widespread adoption of digital assets in that country.
But the ‘top down’ influence of governments and regulators is only one element to growing a successful market. Industry innovation from market participants is also essential.
Our research shows the investment industry believes in a wide range of benefits available to them from blockchain and tokenisation technology. Substantial numbers of respondents to our last study anticipated a combination of cost savings and revenue increases in diverse areas such as distribution, data transparency and improved liquidity.
But mainstream institutional adoption means combining these benefits, with the focus on security and risk management that asset managers and owners have come to expect from their traditional investment operations. Tellingly, cyber security and a lack of blockchain options designed to operate with the trad-fi environment were both cited as significant impediments to adoption by our respondents.
The absence of comparable risk practices in the digital native world was shown up by the FTX crypto exchange collapse in 2022, where asset segregation measures essential to traditional asset custody were not in place and client assets were mismanaged as a result.
More recently, another crypto exchange, Bybit, was subject to the largest crypto hack in history, when North Korean hackers stole $1.5bn from it in February.
The model of exchanges also being custodians is common with crypto, but custodians are typically independent of exchanges in the trad-fi environment. There are crypto specific custodians (wallet providers independent of exchanges), but these have had cyber security problems too. In 2023, crypto custodian BitGo was forced to fix problems with its Ethereum wallets that investigators found made them vulnerable to hacks. Fortunately, no funds were lost before the weakness was discovered.
At current, relatively small scale levels of crypto and digital assets adoption, some managers have also created their own wallets (‘self custody’), but this becomes less practical and significantly riskier at institutional scale.
This is where the traditional investment servicing world can continue to demonstrate value in a de-fi world. Longstanding histories of engagement and compliance with detailed legal and regulatory frameworks designed to meet investors’ needs over decades, covering such essentials as appropriate levels of capitalisation (not a requirement for crypto exchanges or custodians), inbuilt risk practices such as segregation and established resolution and restitution processes can be summed up in one word: trust.
Despite all of this, there remains a role for newer specialists in digital assets technologies in the new world. The banking industry has been building out its technology expertise in areas such as tokenisation and on-chain custody. But the future is still likely to involve a network of partnerships between established institutional asset servicing providers, and dedicated financial technology companies offering particular products and services where they have specific skills and expertise.
But, crucially, this interaction between older and newer market participants will take place in an environment of trust, as defined above. It is our view, at State Street, that eventually, institutional investors will treat digital assets as just another part of the portfolio, to be handled with established safeguards. Only on such a foundation of trust can institutional adoption truly scale.
For a more detailed analysis of the regulatory and technology issues discussed in this article, keep an eye on statestreet.com for our next Digital Digest publication.
- James Redgrave is VP, Global Thought Leadership and Editorial at State Street
