Planning ahead when dealing with crypto-assets

by Ben Whitby, Regulatory Affairs at Qredo

Published Dec 5, 2019 2:21:45 PM

Are you under pressure from your clients to handle their crypto-assets? Here’s what you should consider to exercise proper oversight and control over their crypto investments.

Diversifying an investment portfolio to hold a balanced collection of assets that have a low correlation in performance is common practice. Your clients may now be looking to crypto-assets - a medium that many feel is resistant to government quantitative easing and rising in popularity with investors. They may want to invest in something new and exciting. Or, more simply, they may have heard about the interest being paid out on Decentralised Finance (DeFi) platforms and don’t want to miss out.

Whatever their reasons for investing in crypto-assets, it’s the asset manager who has to make sure there’s proper oversight and control over clients’ investments.

But how do you prepare to handle these types of assets? And, more importantly, what should you consider in regard to governance?

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What is a crypto-asset?

First things first, it’s worth noting that not all crypto-assets are the same. Different jurisdictions are developing different classification taxonomies.

The UK’s FCA currently recognises three main types of crypto-asset, each having different characteristics and implications:

1. Exchange tokens

These are assets — such as Bitcoin, Ethereum, and other cryptocurrencies — that are designed for use as a means of exchange but aren’t backed by a central authority. They’re usually unregulated because they confer limited or no rights and there’s no single issuer against whom these rights can be enforced.

2. Security tokens

Security tokens are assets that have been converted into a tokenized, digital format using a blockchain-based issuing platform such as Securitize, Harbor, or TokenMarket.

Security tokens are regulated, because they grant some or all of the rights a shareholder or debt-holder would enjoy, such as a share of future profits. For example, tZERO and the Tezos Foundation are planning to run a Security Token Offering that will give holders equity rights in a waterfront development in Manchester.

Other types of security tokens may give holders rights to tokens which the FCA considers specified investments.

3. Utility tokens

These assets give the holder access to a product or service (or a prospective one). Filecoin tokens, for instance, give users access to its decentralised storage platform.

Utility tokens aren’t usually specified investments, so they tend to be unregulated. The FCA is currently investigating some types which may end up being defined as e-money, in which case it’s highly likely they’d be regulated.

 

A client has invested in crypto-assets. Now what?

While not all crypto-assets are regulated, you will likely have to conduct anti-money laundering and proof of origin checks and be able to document a client’s source of wealth position. You’ll also have to try to assess the crypto-assets’ value and liquidity to determine the potential risks.

Understanding ownership

Certain crypto-assets have become famous — if not infamous — for the privacy and anonymity they supposedly afford. But the truth is that total anonymity is a myth.

In fact — and unlike other types of assets — a crypto-asset carries its entire lifecycle with it on the blockchain. This means you can often track a crypto-asset’s provenance back to inception, or to an exchange platform that converted the crypto-asset to or from fiat.

Of course, much will depend on the blockchain the crypto-asset lives on.

The more nodes there are spread across different locations, the harder it’ll be to shut that chain down. In comparison, while small private blockchains can be strong, fewer nodes concentrated in fewer locations may make it easier for bad actors to gain access and manipulate records, in which case security over the nodes themselves will be critical.

The consensus mechanism is also important.

  • Is there a strong actor that could alter it and change the data on the chain?
  • Can an attacker break his way in?

If so, establishing trust in the chain may be more tricky.

Determining value

This is possibly the most difficult part of managing a crypto-asset.

Sadly, many crypto-assets have near-zero liquidity. Their price also tends to be largely based on the issuer’s hope that they’ll fulfil their potential. In these cases, it’s next to impossible to determine their value.

That said, there are also crypto-assets that are tied to real-world investments. These assets have typically been tokenized to lessen the administrative burden and unlock liquidity. So they usually have clearer pricing and are easier to understand and value.

Here are some questions to ask yourself when trying to determine how much a crypto-asset is worth:

  • Does the token represent an underlying asset?
  • What is the value of the underlying asset the token represents?
  • What is the provenance of the underlying asset?

Context matters too.

Think about it this way. From afar, two books may look exactly the same. But when you move closer, examine and study them, you may find that one is a first edition and, so, much more valuable than the other.

The same often applies to crypto-assets and the underlying assets they represent. Indeed, freshly minted Bitcoin often trades over the counter at around a 30% premium over spent or used assets.

What about liquidity?

Many crypto-assets have highly manipulated market prices with little to no liquidity. But this doesn’t necessarily mean liquidity can’t be analysed.

Here are a few ways to go about it:

  • Look at trading volume and the patterns within the market
  • Keep track of trading pairs (whether it’s another crypto-asset or fiat currency)
  • Consider the trading volume of other exchanges and look for better prices
  • As with traditional asset management, compare the bid-ask spreads
  • Choose a security solution with instant liquidity

As the market shifts so fast, it can seem intimidating to establish the liquidity of crypto-assets at first. Paying attention to which crypto-assets are often bought and sold at low prices will help you when it’s time to liquidate a client’s assets.

It’s also worth considering the tax implications. In particular, keep in mind that there could be a tax liability at every position and conversion, from token to local fiat currency.

 

Securing crypto-assets’ private keys

Once you’ve established ownership, value, and liquidity, you need to consider where and how the crypto-asset will be managed.

Because of their decentralised nature, owners of crypto-assets (or their asset managers) can define their level of autonomy over the process and choose between a number of custodians. Here are the five main ways you can manage and control cryptographic keys today:

Hot wallets

Hot wallets store crypto-assets on a device with internet connectivity. They can include cloud, mobile, and browser-based wallets. They can also refer to your account on any kind of crypto exchange network.

Physical wallets

Physical wallets can come in the form of hardware, such as a USB stick. They can also be a simple paper record of your public and private keys. The ultimate physical wallet is a fireproof cryptosteel.

Cold storage

Cold storage is a firm that has layers of hardware security and operational processes to protect the physical manifestations on a physical key. Often, elaborate processes are involved to split and move the key to remote places, which tends to bring with it huge operational risks and time delays on retrieving any assets.

Multi-sig

Multi-signature functionality is available in certain wallets. It only allows a transaction to be authorised once multiple separate approvals have been given. This means approval would be required from other devices if any access point is compromised.

Multiparty computation

Secure multiparty computation allows multiple non-trusting computers to individually conduct computation on unique fragments of data. Because each computer is only responsible for its own fragment (and can’t access the other fragments), the private key is a collectively generated value. No single computer holds the complete private key.

 

How to vet a custodian

Of course, before you make any decisions, you need to decide which kind of custodian best suits your client’s needs and who will actually be in control of the account.

There are a number of things to consider when looking for the ideal custodian. In particular:

  • Do you give up title to your assets?
  • Do they have segregated accounts?
  • Can the asset be rehypothecated?
  • What does the redemption procedure involve? Is the release tiered? And who approves each stage? Most importantly, how long does it take?
  • What are the security procedures like?

Qredo operates a hardware-hardened blockchain running signed builds, and uses Fast Multiparty Computation to instruct transfer and settlement. This reduces the chance of an attack to impossible odds. On top of this, the blockchain is used as an on-chain custodial account, so liquidity can be achieved instantly and all assets are easily accessible.

 

Crypto-assets are growing in popularity. Are you ready?

In April 2019, 2,200 crypto-assets were being traded every day. And while this is nowhere near the trading volume of more traditional assets, more investors are seeing their value and trying to get a slice of the pie. So much so, that the crypto-asset market is expected to be worth $207 million by 2023, with some estimates even quoting $80 trillion by 2035.

As an asset-manager, understanding, valuing, and keeping crypto-assets safe comes with its own unique challenges. But taking steps to prepare means you can better serve clients and give your firm a competitive edge.

Want to find out more about how Qredo can help you keep your clients’ crypto-assets safe and secure? Book a free demo to find out.