Token troubles: key risks in the digital assets space

November 2022  |  FEATURE | FINANCE & INVESTMENT

Financier Worldwide Magazine

November 2022 Issue

Evolving considerably since its inception in 2009, the digital assets space, and the vast universe of associated products and services associated with it, has matured in recent years, and is now bringing significant value across many industries, with financial services one of the most notable beneficiaries.

As defined by Taurus, digital assets are digital representations of any types of assets, securities, rights, currencies or units of accounts registered on a distributed ledger, such as a blockchain. They include, but are not limited to, cryptocurrencies such as Bitcoin, Ethereum or Litecoin. They can also include securities such as classical shares or bonds registered on a distributed ledger.

​​​​​From a regulatory perspective, according to the 2018 Swiss Financial Market Supervisory Authority’s (FINMA’s) ‘Guidelines for Enquiries Regarding the Regulatory Framework for Initial Coin Offerings’ (ICOs), digital assets can be classified in four categories: payment tokens, utility tokens, asset and security tokens, and hybrid tokens.

Whatever the classification, the rise of digital assets has been meteoric. In 2021, digital assets hit a number of important milestones in their march to prominence as an asset class, including reaching trillions in value, having the first major crypto company to go public with the initial public offering (IPO) of Coinbase in the US, and non-fungible tokens (NFTs) exploding onto the scene.

Underlining this seemingly inexorable rise is the White House’s 2022 ‘Executive Order on Ensuring Responsible Development of Digital Assets’. A related briefing noted that the market for digital assets has evolved significantly over the past few years, expanding to a market capitalisation of more than $3 trillion, up from approximately $14bn in early November 2016.

The briefing went on to recognise that the digital assets space has introduced new assets and technologies which offer several benefits and opportunities, as well as attracting the global attention of individual investors, financial institutions (FIs), central banks, regulators and legislators. Monetary authorities globally are also exploring, and in some cases introducing, central bank digital currencies (CBDCs).

What, then, makes digital assets an attractive proposition? According to KPMG’s 2022 report ‘Assessing crypto and digital asset risks: actions amidst evolving regulation’, the benefits digital assets and their underlying technology offer include: (i) near instantaneous transaction speed, and efficiency and certainty without geographic limitations; (ii) automation through smart contracts; (iii) simplified compliance and enhanced security; (iv) greater liquidity for assets; and (v) ‘democratisation’ of markets and financial inclusion.

“The opportunities and potential benefits of digital assets have led to the formation of additional market participants that facilitate the use, trading and functionality of digital assets,” states the KPMG report. “These include dealers, secondary market exchanges, custodians, wallet providers and repositories, adding further complexity to the digital assets marketplace.”

Key risks

In terms of risk, first-off, it should be understood that digital assets are deemed to be highly speculative investments. According to Taurus, the items outlined below are a non-exhaustive list of some of the key risk scenarios investors should be aware of when delving into the digital assets space.

First, the value of digital assets is subject to high volatility, i.e., the price of digital assets may rapidly go down as well as up, on any given day, including on an intraday basis. Moreover, investments in digital assets are deemed highly speculative investments, and the risk of substantial or total loss in purchasing or selling exists.

Second, setting a value to digital assets can be difficult depending on which category is chosen and, in some cases, there may not be any proven valuation methods.

Third, the market capitalisation of the digital assets industry is mainly led by Bitcoin, which represents more than 50 percent of the total market capitalisation. A significant position in any digital asset other than Bitcoin (and, depending on the case, including Bitcoin) may require several days or weeks to be unwound, with a possible negative effect on the price of the digital asset.

Fourth, technology relating to digital assets is still at an early stage and best practices are still being determined and implemented. Technological advances in cryptography, code breaking or quantum computing, among others, may pose a risk to the security of digital assets. In addition, alternative technologies could be established, making some digital assets less relevant or obsolete.

Fifth, since there is no central body (for example, a central bank or a government agency) overseeing the development of technology relating to digital assets, the functioning of digital assets, as well as further improvements of such functioning (such as the ability to increase the number of transactions, reduce processing time, reduce transaction fees or implement security updates), relies on the collaboration and consensus of various stakeholders.

Sixth, the particular characteristics of digital assets – for example, they only exist virtually on a computer network and transactions in digital assets are not reversible and are done anonymously – make them an attractive target for fraud, theft and cyber attacks. Various tactics have been developed (or weaknesses identified) to steal digital assets or disrupt digital assets technology.

Seventh, existing laws and regulations, changes to the legal, tax and regulatory framework and related measures by regulators or other governmental authorities may affect the compliant issuance, domestic and international tradability and transferability or convertibility of digital assets, and may potentially result in a full or partial loss of units or reduction of value.

Eighth, digital assets do not have the function or the full characteristics of a legal tender and are currently not supervised by any authority or institution such as a central bank. Consequently, there is no authority or institution which may intervene in the market to stabilise the value or prevent, mitigate or counterattack irrational price developments.

Ninth, sending digital assets to an incorrect distributed ledger address leads to a total and irremediable loss of funds. Once a transaction is executed, it is impossible to cancel or reverse it. As a consequence, users must always check that a destination distributed ledger address is correct before confirming a transaction.

Lastly, in the case of tokenised securities, the risk of default or bankruptcy of the underlying issuer is material in line with private equity or private debt investments.

“FIs are much more sensitive to large drawdowns than the retail investor,” adds Ben McMillan, founder and chief information officer at IDX Digital Assets. “When there are investment committees involved, the risk of an asset class that can easily drop in value by 50 percent, or more, is front and centre for institutional investors.

“In addition, many FIs that do not want exposure to the market risk of digital assets are being drawn to various yield-oriented plays within the crypto space, such as lending or ‘staking’,” he continues. “Naturally, the promise of high yields in a low rate environment was enough to attract institutional capital.”

NFTs

One aspect of the digital assets space that has been receiving particular attention is the NFT – a unit of data stored on a blockchain that certifies a digital asset to be unique and therefore not interchangeable.

However, in many countries, the nature of NFTs is not specifically qualified; in particular, whether an NFT is a security or not is dubious and may vary from one NFT to another or from one country to another.

In the view of Taurus, it is important to pay attention to the potential consequences resulting from this uncertain qualification, in terms of taxation, cross-border and sales limitation, and restrictions in the admission to trading, all possibly with retroactive effect.

In addition, notes Taurus, as an NFT is a claim to an exclusive online location, the location to which the object’s ‘ownership’ refers itself may be relocated. Then, the NFT will not even provide the correct location of supposed ownership. Therefore, there is no guarantee that the ‘object’ the NFT refers to will stay at the same online location during the custody time, and ownership may be lost.

“NFTs have been an interesting development over the last few years,” observes Mr McMillan. “As with any first-generation technology, however, ‘working out the kinks’ will always be key. Furthermore, the decentralised nature of blockchain technology also brings with it unique challenges.

“These include not only the actual development cycle but also the difficulty of navigating the regulatory framework, since anything in finance is generally highly regulated,” he continues. “A lot of the crypto development world, which comes from tech, is not prepared for that.”

Boom or bust?

Having experienced something of a fall from grace in 2022, with prices dropping significantly – the jury could still be said to be out as to whether the drop is only temporary or otherwise.

“The adoption of digital assets is still in its early stages for both financial services as well as institutional investors,” notes Mr McMillan. “The last few years in digital assets has looked a lot like the late 1990s for tech stocks where we saw a lot of early excitement about disruptive potential which gave rise to investors’ ‘irrational exuberance’ in the space.

“Now, digital assets have gone through their own version of the ‘dotcom bust’,” he continues. “What is interesting, however, is that while the recent drop in prices has blunted investors’ enthusiasm for the asset class, it has done little to slow down development in the space.”

In fact, in the US, large investment banks are hiring blockchain engineers to establish real development capabilities in blockchain technology. “The slowly increasing regulatory clarity surrounding the space has only helped this adoption,” adds Mr McMillan. “This is all very encouraging longer term, but we are still in the early innings.”

Exposure versus downside

Despite recent volatility in the space, the general consensus is that digital assets are going to be a permanent feature of FIs and asset managers’ investment portfolios for the foreseeable future, with FIs across the globe working to integrate and expand their offerings and investments related to the space.

So, forsaking their previous ‘wait and see’ approach, FIs are formulating their strategies so that they may take advantage of the benefits of disintermediation that digital assets offer, while looking for the risk management and secure infrastructure that they have come to expect.

“In the near-term, we think there will be an acceleration among the institutional investor class to add digital assets to their portfolios,” suggests Mr McMillan, “As more come to recognise this moment as a very clear analogue to the generational buying opportunity in technology stocks in the early 2000s, the opportunity cost of having no exposure is starting to outweigh the current downside risk.

“That said, the current environment is still one in which macro factors, such as federal policy in the US, is driving all risk assets,” he concludes. “As a result, many investors are still in a cautious holding pattern with their portfolios. But as the macro risks subside and the risk appetite returns, we fully expect digital assets will be a much larger share going forward.”

© Financier Worldwide

BY

Fraser Tennant