Developing a digital assets strategy – considerations for asset and wealth managers

At a glance

• As a result of institutional interest and increased regulatory clarity in the EU and UK, asset and wealth managers are starting to shape their digital assets strategies.
• Weighing up potential opportunities against new and enhanced risks, some firms are considering what – if any – unbacked digital assets investment products to offer alongside their existing offering.
• This blog explores two investment use cases and key insights from the emerging EU and UK regulatory landscape: offering synthetic exposure to unbacked digital assets via cash-settled derivatives, and offering direct exposure to unbacked digital assets.
• Overall, in light of distribution restrictions and firms’ risk appetite, these offerings are generally targeted at institutional and sophisticated investors, rather than pure retail.
• From a business and regulatory complexity perspective, offering cash-settled derivatives is a more likely starting point for asset and wealth managers that want to enable their clients to have price exposure to unbacked digital assets. Nevertheless, this offering brings a range of risks to manage. For example, the sale of this product is banned for UK retail investors.
• Increasing EU and UK regulatory clarity means that some firms are starting to explore offering direct exposure to unbacked digital assets. Nevertheless, launching an offering with full regulatory clarity is likely to only be possible from 2025 in the EU, and potentially later in the UK. In the meantime, defining an approach to custody and trading unbacked digital assets is a key first step for firms exploring this use case.

Who this blog is for:

• Heads of Product, Chief Technology Officers, Chief Strategy Officers and other senior executives at asset and wealth managers involved in designing a digital assets strategy.
• Digital assets leads in risk, compliance and regulatory affairs teams.

Overview

In this blog, we explore two potential use cases for firms exploring offering their clients price exposure to unbacked digital assets:

• synthetic exposure via cash-settled derivatives, and
• direct exposure to digital assets.

For each use case we explore operating model, risk and EU/UK regulatory considerations. We conclude with a set of key considerations spanning strategy, governance, risk management and regulatory engagement for firms considering these use cases.

As part of their digital assets strategies, some asset managers are also considering leveraging the underlying blockchain technology to transform existing products, for example tokenising fund units or buying tokenised assets. This blog does not explore these use cases.

Drivers of asset and wealth managers’ interest in unbacked digital assets

Some firms are exploring whether and how to complement their traditional product offering with unbacked digital assets products and services. We observe three primary drivers:

1. Increasing institutional interest

Despite market disruption in 2022, some evidence suggests institutional interest remains relatively resilient. For example, 96% of respondents to a Laser Digital survey of professional investors in 2023 saw digital assets as an investment diversification opportunity.¹

However, institutional investors will undoubtedly take a measured approach to increasing their exposure to unbacked digital assets given ongoing market volatility and previous high-profile failures of firms in the ecosystem.

2. Emerging institutional-grade service providers

In response to market demand, an ecosystem of firms that specialise in supporting regulated firms’ digital assets offerings has emerged in recent years. These include institutional-grade custodians, trading platforms, and transaction monitoring and blockchain data services.

3. Increasing regulatory clarity

EU and UK policymakers continue to develop their long-term digital assets regulatory frameworks. These emerging frameworks give firms more confidence to consider their digital assets strategies.

Our recent report compares emerging international frameworks across key global financial centres. Read more about it here.

Use case 1: Offering exposure to unbacked digital assets via cash-settled derivatives

As of September 2023, derivatives make up 79.9% of the entire digital assets market.² Investors often use derivatives to achieve price exposure to unbacked digital assets (e.g. Bitcoin, Ethereum). Derivatives do not require direct ownership of digital assets, which overcomes the operational complexity of arranging custody.

Operating model considerations

Cash-settled digital assets derivatives generally require less investment in new infrastructure, compared to offering direct exposure to digital assets.

Firms can trade cash-settled derivatives on trading venues or over the counter. Firms may need to partner with new brokers and trading venues, depending on the extent to which their existing partners offer access to these products. Some digital assets derivatives trading venues and clearing houses targeted at institutional investors are emerging.

Firms should probe brokers on the suitability of trading platforms used. Specific focus areas include pricing and the platforms’ regulatory status to form a view on whether this is within the asset manager’s risk appetite.

Regulatory considerations

Cash-settled unbacked digital assets derivatives are classified as regulated financial instruments in the UK and EU. This regulatory clarity means that cash-settled derivatives is one of the initial use cases explored by asset and wealth managers as part of digital assets strategies.

In both the EU and UK, institutional investors can gain exposure via AIFs or individual mandates. However, digital assets derivatives are not eligible for UCITS funds.

UK firms will need robust controls to prevent distribution to retail customers. The sale of derivatives referencing unbacked digital assets to retail consumers is banned, including for high net worth and self-certified sophisticated investors. In the EU, individual Member State rules determine whether digital assets derivatives can be sold to retail investors. If considering selling to any retail investors, firms will need to pay careful attention to complying with MiFID II rules (and any updates from future reviews) on target market and client suitability.

Risk considerations

This use case entails a range of new or enhanced risks to assess when considering whether to launch such a product.

Use case 2: Offering direct exposure to unbacked digital assets

In this scenario the asset or wealth manager would directly buy, hold and sell digital assets for their funds or clients’ portfolios.

Operating model considerations

The infrastructure required for custody of digital assets differs significantly from traditional custody models. Digital assets custody is the management of the private keys used to execute transactions, a core component of the digital assets ecosystem.

In our experience, most asset managers exploring this use case will partner with a third-party custodian. This avoids the need to build new systems from scratch. Building a custody solution in-house is likely to be feasible only for firms with bigger technology budgets.

Firms also need to partner with new trading venues to trade unbacked digital assets. There are two common options that asset managers could leverage:

• Some institutional-grade custodians offer trade execution as an additional service, partnering with a range of trading venues.
• Trade digital assets in-house. In this scenario, firms should partner with a range of trading venues as liquidity is often fragmented in digital assets markets.

Defining the approach to custody and trading is an important first step for firms exploring this use case. In our experience, progressing from design to implementation can take 12-18 months. Since digital assets markets operate 24/7, firms will need the capability – e.g. on call portfolio management personnel – to react to significant market movements outside of normal trading hours.

Firms should enhance their existing third-party risk management capabilities to manage the risks of partnerships that may support this use case. This includes vendor due diligence, scrutiny of the partner’s ongoing financial and operational resilience, its approach to regulation, reputation, and effectiveness of controls. Firms should scrutinise trading venues’ operating rules, financial crime controls and operational resilience, including under market stress.

Regulatory considerations

In the EU and UK, digital assets can be included in non-retail AIFs or individual mandates. For retail investors, there are more hurdles. Unbacked digital assets cannot be included in UCITS funds.

From a regulatory perspective, unbacked digital assets could – in principle – be included in individual retail mandates in the UK. However, certain marketing restrictions will apply. For example, firms can only make direct offer financial promotions – specifying how a consumer should respond or include a form to do so – to restricted, high net worth or certified sophisticated investors. Retail distribution restrictions exist in some Member States, e.g. Luxembourg⁶.

However, in our experience, firms are considering a pure retail offering carefully from a risk appetite perspective, given the complexity and volatility of the product.

Firms will also be captured by regulatory requirements that do not explicitly reference digital assets but are particularly relevant to this business. These include, for example, prudential requirements to assess and mitigate potential harms to customers, markets and the firm and demonstrate adequate financial resources, and requirements to have adequate controls against financial crime.

Emerging EU and UK digital assets regulatory frameworks may give asset managers more confidence to explore this use case. Both jurisdictions will bring some of the key partners that will support this use case within the regulatory perimeter (Table 4). These include custodians, trading platforms and brokers.

However, two features of the emerging regimes may pose practical implementation challenges.

First, the EU’s framework – the Markets in Crypto-assets Regulation (MiCAR) – will include rules for firms providing advice and portfolio management concerning unbacked digital assets. However, the UK will leave these services outside the regulatory perimeter for now. Firms with a footprint in both jurisdictions could consider deploying policies and procedures developed to EU standards in their UK arm. The reputational risk management benefits may outweigh compliance costs.

Second, significant work remains to shape the detailed regulatory frameworks in both jurisdictions. The EU’s framework is more developed, with clarity on primary legal requirements. However, some important detailed requirements will only become clear in 2024 via technical standards and guidance. This is especially relevant for advice and portfolio management. Significant detail is left to ESMA to define in guidance, including criteria for assessing the client’s knowledge and competence, and client suitability recommendations. This guidance will only be finalised by end-2024. [Click here to read our separate insights article on MiCAR].

Risk considerations

This use case brings significant new or enhanced risks for asset managers to assess and manage.

Building a digital assets strategy – key underpinning capabilities

To ensure successful design and implementation, asset managers will need to underpin their digital assets strategy with a broad range of business capabilities, including those detailed below.

Strategy

• Understand client demand for exposure to digital assets.
• Define target clients. Financial services firms are generally taking a cautious approach to client suitability.
• Engage stakeholders across the business – including portfolio managers, product, strategy and technology teams – to understand how specific digital assets offerings interact with the firm’s strategy.
• Embed risk and compliance teams into digital assets strategy design to understand whether specific offerings are within risk appetite.

Governance

• Demonstrate Board and Executive review, challenge and sign-off of any digital assets products and services.
• Build dedicated digital assets governance capabilities as exposures increase. This includes a dedicated risk and compliance capability, a centralised point for digital assets activity. Ensure firm-wide risk alignment by establishing firm-wide digital assets risk and compliance steering committees, headed by the CCO and CRO with senior representatives from business areas.

Risk management

• Expand the risk appetite statement to capture the full range of digital assets risks. This should reflect the different client types served and the new or enhanced risks posed by specific use cases. The statement should include granular metrics and tolerances.
• The Board should sign off the assessment against risk appetite.

Regulatory engagement

• Engage regulators as early as possible on planned digital assets offerings. Engage before final go/no-go decisions, providing sufficient time to build regulatory considerations into design and planning work.
• Fully embed digital assets regulatory initiatives into horizon scanning capabilities, enabling the firm to spot and assess the impact of regulatory change.

Conclusion

Offering clients price exposure to unbacked digital assets brings a range of new or enhanced risks to manage, and operating model and regulatory considerations. Asset and wealth managers are progressing cautiously, assessing the risks and potential benefits carefully. Designing and implementing an effective digital assets strategy will require firms to bring together stakeholders from across the business and invest significantly in supporting governance and risk management capabilities.

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Endnotes

¹ Laser Digital, Laser Digital Investor Survey on Digital Assets, May 2023 (https://a.storyblok.com/f/174183/x/8e97b105b3/laser-digital-research-report-v3.pdf)

² CCData, Exchange Review, September 2023 (https://assets-global.website-files.com/63e3774c88285e5c6cbf3b9d/651edbe9835f453a27e6ffa0_Exchange Review September.pdf)

³ FCA, Policy Statement PS20/10, October 2020, p.12 (https://www.fca.org.uk/publication/policy/ps20-10.pdf)

⁴ When the scheme operator artificially inflates the price of an asset using false information in order to sell the assets at a higher price, before the price collapses.

⁵ Inverse of “pump and dump” schemes.

⁶ CSSF, FAQ Virtual Assets, April 2023 (https://www.cssf.lu/wp-content/uploads/FAQ_Virtual_Assets_UCI.pdf)

⁷ Hamrick et. al., An Examination of the Cryptocurrency Pump and Dump Ecosystem, January 2019 (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3303365); European Commission, Impact Assessment SWD(2020) 380, September 2020 (https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=celex%3A52020SC0380)

⁸ Speech by Sarah Pritchard, FCA Executive Director, Regulation of Digital Assets in the UK, April 2023 (https://www.fca.org.uk/news/speeches/regulation-digital-assets-uk); HM Treasury, Future financial services regulatory regime for cryptoassets, February 2023 (https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1133404/TR_Privacy_edits_Future_financial_services_regulatory_regime_for_cryptoassets_vP.pdf)

⁹ FCA, Cryptoasset AML / CTF regime: feedback on good and poor quality applications, March 2023 (https://www.fca.org.uk/firms/cryptoassets-aml-ctf-regime/feedback-good-poor-applications)