Managing digital asset and cryptocurrency risk
September 2022 | TALKINGPOINT | FINANCE & INVESTMENT
Financier Worldwide Magazine
September 2022 Issue
FW discusses managing digital asset and cryptocurrency risk with Thomas Choo, Peter Hodgins, Lee Bacon, Zhen Guang Lam and Alexandra Lester at Clyde & Co.
FW: Could you provide an overview of key market developments shaping digital assets, including cryptocurrencies? How would you describe interest levels and activity in this space?
Choo: We are seeing a ‘crypto winter’ due to a variety of factors including the Terra collapse, a drop in tech stocks prices and US interest rate hikes. It is not clear when the market turbulence will eventually settle. Despite the many reasons for apprehension, there is room to be optimistic. The industry is in a stronger place because of an onset of proper regulations and there being more digital assets use cases and users; for instance, decentralised autonomous organisations (DAOs) were unheard of several years ago but we are now receiving a steady increase in enquiries about their legal nature and possible legal structures. Non-fungible tokens (NFTs) are another example that still has legions of buyers and sellers. And while most investors are hesitant on closing digital assets related deals in the current crypto climate, we are seeing matters involving acquisition and investments of crypto and Web 3.0 companies.
“Identifying and enforcing against digital assets is therefore possible, but presents unique challenges, and requires industry knowledge and a clear strategy to attain.”
FW: What impact are digital assets and cryptocurrencies having on the financial services (FS) sector? What risks and opportunities do they present?
Hodgins: Cryptocurrency and virtual assets fundamentally impact the infrastructure of financial institutions (FIs) and obviate the need for a centralised banking system. They facilitate accessibility, as only internet access is required to undertake transactions and can reduce investment cost. However, these investments are exposed to significant volatility and may be more susceptible to market manipulation. There is currently limited insurance protection available for cyber risk, such as denial of access of digital assets and counterfeiting. Inevitably, the anonymity of participants and lack of traceability of the users gives rise to intrinsic anti-money laundering (AML) and sanctions risks; albeit, to some degree this is being mitigated through greater regulation of the sector. As regulations develop across the globe, there is also the risk of inconsistency in the regulation between various jurisdictions, which may deem certain transactions legitimate in one jurisdiction and not in another.
“The crypto space is an evolving area and regulators understand that any sort of drastic move or unwelcomed measures may kill innovation.”
FW: Where do non-fungible tokens (NFTs) fit into this ecosystem? What particular areas need to be addressed when reviewing NFTs?
Bacon: NFTs differ from other digital assets, such as tokens and coins, as they are intrinsically linked to an underlying asset. A fungible token can be exchanged for another asset, its value being determined by some other extrinsic matter, even if just market sentiment. NFTs offer a way of bringing either complex or fast moving assets to market and can attract liquidity. For example, investment in certain types of real estate asset classes can be tokenised, with a token representing ownership of a specific percentage of a particular asset. The use of NFTs for digital artwork, perhaps the most high profile at this stage, shine a light on issues that need to be addressed. In particular, what does a holder of an NFT actually own: the underlying asset, a share of it or just the right to IP rights in the same? If the right is to intellectual (IP) rights, are these limited in any way?
“NFTs offer a way of bringing either complex or fast moving assets to market and can attract liquidity.”
FW: How would you characterise the legal and regulatory framework surrounding digital assets?
Lam: No two jurisdictions have the same legal and regulatory framework surrounding digital assets. However, we do note that most digital assets legislation is generally risk-based; the underlying policy objectives are essentially to prevent money laundering and the financing of terrorism. Recently, the prevention of cyber attacks and hacking of users’ accounts and wallets are increasingly focused upon by lawmakers and regulators, given the boom in cryptocurrency hacking and theft cases. Additionally, most digital assets legislation tries to keep an eye on and be closely aligned with international developments, such as enhanced Financial Action Task Force (FATF) standards for virtual asset service providers (VASPs). For jurisdictions with a more matured regulatory landscape, a consultative, calibrated and pragmatic approach to digital assets legislation is observed to be generally taken. Industry views are sought before new laws are introduced. The crypto space is an evolving area and regulators understand that any sort of drastic move or unwelcomed measures may kill innovation.
FW: What challenges do digital assets and cryptocurrencies present when it comes to investigations, asset-tracing and recoveries in both a civil and criminal context?
Lester: The first challenge is how to identify and gain technical control over a digital asset. This requires specialist forensic interrogation of data sources, and analysis of who controls the asset at a code level and can provide access to it or prevent its dissipation. A further challenge is whether the digital asset is recognised as susceptible to protection and enforcement in the jurisdiction. There have been some recent positive developments – for example Singapore and English courts both recently recognised an NFT as property capable of protection by an injunction and freezing order respectively. English courts also recently permitted service of proceedings via blockchain. Identifying and enforcing against digital assets is therefore possible, but presents unique challenges, and requires industry knowledge and a clear strategy to attain.
“Regulation will drive greater accountability for financial services firms and will lead to increased scrutiny as to the sources of funds and the ownership of digital assets.”
FW: What steps can FS firms take to manage or address the transactional risks associated with digital assets?
Hodgins: Inevitably, regulation will drive greater accountability for financial services (FS) firms and will lead to increased scrutiny as to the sources of funds and the ownership of digital assets. In the interim, the use of depositories is fulfilling a similar role. A fund depositary is primarily responsible for overseeing the fund, verifying ownership of assets and ensuring that a fund is managed in accordance with its offering memorandum. FS firms can use independent depositaries to effectively monitor transfers between digital asset exchanges, movements of assets between the digital asset custodian and the exchanges, reconciliation of assets to the relevant blockchain, and overseeing the valuation function of the fund. Due to the complexity of digital assets, this will require engagement by FIs to develop the necessary systems and processes and will also require active participation from the depositary community if they are to be prepared for engagements in this space.
FW: Looking ahead, how do you expect the digital assets space to unfold? What trends and developments are on the horizon?
Bacon: The market for digital assets has grown out of two competing forces. First, the desire for control outside of regulated markets. Second, it is a function of the move of commerce onto digital platforms. Digital assets offer the prospect of enabling digital markets and transactions. To do so, however, requires either consistency in technology and standards or interoperability, combined with increased focus on security and digital identity. We have seen already the growth of custody operations and anticipate significant investment in the area of digital identity for corporates and individuals. Web 3.0 is still embryonic, but at its core represents an attempt to draw these threads together: consistency, interoperability, privacy and identity. We look forward to watching the winners and losers as the market evolves.
“We are seeing a ‘crypto winter’ due to a variety of factors including the Terra collapse, a drop in tech stocks prices and US interest rate hikes.”
FW: What are the key risks in the digital assets and cryptocurrency ecosystem? Are there solutions which organisations can implement to mitigate these risks?
Choo: Much has already been said about the volatility and sharp speculative price swings of cryptocurrency. Further, blockchains were until recently seen as an ‘unhackable’ technology, but we are increasingly seeing a rise in the number of cyber security attacks and theft on blockchain platforms, for example attacks on the so-called ‘blockchain bridge’ which is regarded as a crucial piece of the digital assets ecosystem, as well as hacks on wallets holding NFTs. Notwithstanding the inherent risks of digital assets and cryptocurrency, there are solutions which organisations can and should consider adopting to mitigate the risks. Actively educating customers, especially retail customers, should no longer be regarded as optional, and should be a priority for organisations to increase the standard of crypto education with potential and existing customers. In addition, establishing and maintaining sound and robust technology and cyber risk governance should be central, if not integral, to an organisation’s overall risk management framework.
Thomas Choo leads Clyde & Co’s corporate and employment practices in Singapore. He has extensive experience advising technology companies, such as e-payment providers, cryptocurrency exchanges, token issuers and FinTech companies, on business establishment and licensing, acquisitions and disposals, portfolio transfers, outsourcing arrangements, cross-border business structures and regulatory compliance, in Asia-Pacific. He can be contacted on +65 6544 6507 or by email: thomas.choo@clydeco.com.
Peter Hodgins has over 24 years’ experience in the financial services sector and routinely advises financial services sector entities on the establishment and licensing of new entities in the GCC region, the development of new products and day-to-day regulatory compliance. He can be contacted on +971 50 900 1633 or by email: peter.hodgins@clydeco.ae.
Lee Bacon is a London-based arbitration and dispute resolution partner and has been involved in considering the impact of smart contracts, blockchain and related technologies since 2015 and is co-founder of the firm’s Clyde Code consultancy. He can be contacted on +44 (0)20 7876 4410 or by email: lee.bacon@clydeco.com.
Zhen Guang Lam’s practice focuses primarily on matters pertaining to technology, data protection and FinTech. He regularly advises clients on transactional projects such as technology outsourcing and procurement, and advisory matters focusing on data protection, technology risk management and cyber security. He can be contacted on +65 9139 6380 or by email: zhenguang.lam@clydeco.com.
Alexandra Lester is a dispute resolution lawyer with a wealth of experience assisting her clients to resolve complex commercial disputes in international arbitration, court and mediation. She specialises in the technology, media and telecommunications sectors. She can be contacted on +971 4 384 4356 or by email: alexandra.lester@clydeco.ae.
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