Pushing Your Performance by Providing Access to New Asset Class of Crypto Assets

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Cryptocurrencies got off to a rocky start, characterised by scandals, like the collapse of the Mt. Gox exchange. Since then, however, the crypto market has matured significantly and regulated exchanges, as well as brokers, have opened the market to the masses.

In addition, new, innovative business models based on blockchain technology have emerged, and even the first regulated banks are offering crypto services, mainly to buy, hold, and sell digital assets. The risk related to holding private keys and trading crypto assets has decreased and more vendors are accepting major cryptocurrencies to pay for their goods.

In consequence, the trust of institutional investors in crypto assets has increased and led to a growing acceptance, unveiling their potential beyond cryptocurrencies, too. On the other hand, central banks continue ‘printing’ more and more fiat money.

Following those developments, the crypto market has gained in market capitalisation, diversity, and liquidity. And many crypto assets, such as Bitcoin, have established themselves more as a store of value rather than as a means of payment. This is not unexpected, however.

Common cryptocurrencies or ‘payment tokens’ have no fundamental value (i.e., are not backed by any scarce physical commodity, nor do they incorporate any claim against their issuer, as traditional credit money does).

Although some may grant you access to a certain service or even goods, the price of cryptocurrencies is still mainly driven by the expectation of capital gains. This makes them very volatile against fiat currencies, which are legal tender by law. However, the unique characteristics of crypto assets and the technology they are backed by come with huge upside potential, too.

Crypto assets are digitally scarce or even show deflationary tendencies (i.e., if keys get lost or coins get ‘burned’). Their scarcity is given by an immutable computer code every network participant must comply with. For example, there will never be more than 21 million Bitcoin, and they will be issued at a predefined rate.

As soon as the next block halving takes place in 2024, the growth rate of Bitcoin, as the main cryptocurrency that still dominates the market by means of its capitalisation, will be lower than that of physical gold.

In fact, research shows that, based on data from the last 10 years, unbacked cryptocurrencies have established themselves as a new asset class of their own, which makes them extremely attractive for investors in a portfolio context.

• Unbacked cryptocurrencies are characterised by very homogenous returns and are closely correlated with each other.
• This homogeneous behaviour comes with external heterogeneity. Unbacked cryptocurrencies have shown systematically different returns than traditional asset classes, such as equities or bonds, to date.
• Holding cryptocurrencies in the long term is likely to lead to a risk premium overcompensating for their high volatility.

Including cryptocurrencies in a well-diversified investment portfolio, therefore, increases the expected return of this portfolio or could reduce the portfolio risk by maintaining the expected returns. In other words, the diversification effect is sufficient to shift the efficient frontier of a portfolio upwards or outperform the same portfolio without cryptocurrencies in the long run (risk-adjusted).

Every crypto investor needs a solution for trading and holding their assets. While the demand to get exposure to crypto assets has increased, especially by institutional investors, there are still not many banks and wealth managers that offer their clients investment opportunities in cryptos today. And, if they do, they barely include them in their advisory or discretionary investment solutions.

The inclusion of crypto assets in investment solutions offers a wide range of opportunities for banks and wealth managers to increase their net new money, assets under management, and profit margin, which include:

• Attracting new clients by providing a differentiated investment offering
• Positioning the firm as a modern and digital bank for the new generation
• Providing potential for outperforming the common benchmarks, as well as offering access to new finance solutions
• Accessing higher custody and management fees for cryptos, compared to traditional assets
  

For banks, the opportunities in this space are attractive, as they can leverage their banking licence and core capabilities, as well as extend them to the specifics of crypto assets.

Before recommending crypto products to clients, a bank should ask themselves a few questions to define a robust framework, such as:

• Which investment strategies would benefit from the inclusion of crypto products and what are the target client groups we want to address with crypto investments?

• How do we select and evaluate crypto products to come up with a recommendation?
• Which crypto product(s) do we want to offer?
• What preconditions, in terms of investment suitability, are needed for a recommendation?

Understanding crypto assets requires an understanding of their diverse risks along with their technical infrastructure. They are prone to high volatility and a total loss of an investor’s capital is possible. Therefore, banks are required to build up expertise in understanding crypto-related market dynamics and associated risks. A close collaboration between the investment office and the front office ensures up-to-date education on the sales front.

When deliberately invested, crypto assets provide upside potential. Based on common models used for portfolio optimisation purposes, research shows that in the past, adding cryptocurrencies to an investment portfolio in the range of up to 10% of the portfolio value could be beneficial in terms of optimising risk and return based on a client’s risk preferences.

In summary, a crypto framework is built on the basis of a thorough analysis of crypto products, the careful selection of relevant clients, as well as their education about crypto products. All these are key elements of a successful integration of crypto products into the advisory universe.

Once such a framework has been defined, execution-only clients can also benefit from the availability of crypto products. Moreover, the bank can ask themselves whether they want to include their recommended crypto products in their discretionary mandates, too.

Crypto assets are exposed to risks, specific to their underlying technology. For example, the counterparty risk that your keys get lost if you do not hold them yourself and you or your delegate loses access to your funds may not be underestimated. This can likely happen due to technical or backup failure at the point of storage, or due to human error.

Hence, our experience shows that it is crucial to decide on how to implement crypto assets in the investment service offering. There are several options, and each should be evaluated carefully, especially in light of your strategic goals and target operating model.

For example, you could:

• Provide your own or hosted integrated storage solution to customers to hold and trade cryptocurrencies at the bank itself to make yourself fit for future use cases.

• Gain crypto exposure by providing access to listed and physically backed mutual funds (e.g., in case of discretionary or portfolio advisory mandates).
• Invest in structured products that replicate the development of the price of the underlying cryptocurrencies.

Each option comes with its own benefits and risks. Depending on the one chosen, the complexity of the implementation can vary greatly since you may need to seek approval from your supervisory authority. In any case, we have found that it is crucial to align the implementation solution with other potential business cases that the bank might want to implement, as well. Ideally, a service can be reused or leveraged for other business cases.

Based on our experience, we have identified some general factors behind the success of a crypto initiative, which include:

• Educating the bank’s leadership and all its project managers or investment advisors at the beginning of the initiative is crucial so that they all understand the basic concept of blockchain and crypto assets. This will enable the opportunities and risks to be assessed correspondingly.
• The bank’s solution should focus on leveraging existing processes. While the technology and many of its features are new, the services essentially remain the same. It is, however, necessary to adapt the processes to comply with regulatory requirements and take cryptocurrency specifics into account.
• The bank should build up a strong opinion about cryptocurrencies and needs to ensure it educates its clients about the risks, as well as the opportunities, of this new asset class.

Our assessment shows that, by getting to grips with the challenges described, banks can access the field of crypto assets and service offerings successfully. Today, this may still lead to a competitive advantage by attracting new clients. Whereas, tomorrow, it seems inevitable that any bank providing investment services will also provide access to the new asset class of crypto assets.

Synpulse can support you in all these steps, thanks to our long-standing advisory expertise – from education, to facilitation, right through to validation of a market fit, operating model integration, and implementation.

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