Technology

Where Next For Banks And Digital Assets?

Jeremy Boot 2 February 2023

Where Next For Banks And Digital Assets?

The rout in prices of cryptocurrencies and certain entities last year shook the sector and has left banks, wealth managers and other asking lots of questions. This article addresses some of them.

The past year was a tough one for enthusiasts of digital assets/cryptocurrencies the fall in tech stocks did not leave those areas unscathed, while big losses to so-called stablecoins, and the astonishing developments at the FTX exchange, created the kind of publicity that left the sector feeling battered and bruised. Does that mean banks and wealth managers should give this area a wide berth, or is there a more nuanced way forward? To discuss these ideas is Jeremy Boot, head of digital assets at Temenos. The editors are pleased to share these views; the usual editorial disclaimers apply. Jump into the conversation! Email tom.burroughes@wealthbriefing.com

Last year’s crypto rout shook the industry. Where does this leave banks, and could they be the surprise beneficiaries of the recent turbulence? Let's dive in. 
 
Investor interest remains
2022 was undeniably a tough year for crypto. Looking forward the future of digital assets remains a hotly debated and polarising topic. 

From an investor perspective, some research points to continued interest such as Standard Chartered’s Q4 report where 62 per cent of the 15,000+ respondents felt that digital assets still have a place in investment portfolios despite recent volatility. Given the modest outlook for traditional assets such as stocks and bonds, some diversification into alternatives remains popular. Early 2023 has seen crypto rally alongside risk assets as investors leap on improving consumer price index data in the hope of slowing rate hikes.

So investors are cautious but appetite for crypto does seem to persist. Could banks be the surprise beneficiaries?
 
Why banks could benefit from the crypto fallout
For people who want to hold these tokens there are two main custody options. They can self-custody with a private wallet such as a hardware device. This may work for some but comes with its own challenges. Seed phrase back-ups are at risk of hacks online, or loss or theft if kept at home. Incoming regulation may limit transfer or cash-out options, and handling tax reporting, and inheritance management is complex. Self-custody still feels clunky and difficult for the non-tech savvy masses.
 
The second option is to custody tokens with a third party. For obvious reasons in the post-FTX world, the CeFi players, crypto exchanges, and 'earn' products based on shady asset rehypothecation have fallen from grace. Surely all trust has evaporated for these new players to securely custody assets. 

The alternative is banks – trusted, secure, properly regulated, and fully integrated with the existing financial system. 
 
So one surprise outcome of the crypto winter – and ensuing regulation that is likely to follow – could actually be closer ties with traditional finance. By offering digital asset services banks can open new sources of revenue, position themselves as digital leaders, and reinforce their appeal to younger customers who are the primary segment driving adoption.

Incoming regulation
Regulators are widely expected to crack down on crypto in an effort to clean up the industry and protect investors. Many banks are understandably cautious about proceeding until regulation has caught up. 

The Basel Committee’s prudential treatment of crypto asset exposures covers risk, liquidity, and capitalisation requirements in detail. The publication of such guidelines is critical as global regulators now have a framework on which to build and provide clarity to banks’ compliance teams on how they can safely operate. The recently-updated version addresses initial concerns about which elements apply to customer-owned custodial assets. 

In Europe, the MiCA regulation will soon go through parliament. It provides a comprehensive legal framework for service providers across a range of topics including token issuance, and providing crypto asset services. Banks’ deep expertise in regulatory compliance will benefit them in applying new rules, such as adapting today's MiFid risk questionnaires, which assess customers' knowledge and experience of complex instruments over to blockchain as a condition for allowing crypto trading access.

Regulatory clarity will soon be here, and could in turn open the floodgates for banks and other providers keen to build out offers but currently waiting on the sidelines. Most industry participants welcome the prospect of allowing the industry to move forward.


Towards an era of asset tokenization
Beyond crypto trading and custody services, perhaps a bigger prize for banks is exploiting blockchain tech to optimise existing financial services, most notably in the area of asset tokenization.

Major banks having been jumping in – ABN AMRO, UBS, Bradesco, Credit Suisse, and JPMorgan to name a few. Banks are seeking gains in issuance processes, faster settlement, reduced counterparty risk, and better liquidity management compared with traditional systems.

The road ahead may seem long but some countries such as Switzerland already have clear legislation and legally-compliant security token standards, as published by the CMTA for example, which could pave the way to adoption.

Banks should be building expertise in digital asset custody if nothing else in order to prepare for this tokenized future.

Custody approaches
So how should banks go about it? They can work with third-party custodians to manage assets for them. This would typically offer faster time to market, a simpler integration architecture, and lower barrier to entry – they don’t require as much in-house expertise.
 
Alternatively, they can self-custody using infrastructure providers to manage customer assets in enterprise grade wallets connected to blockchains. With this approach banks can avoid additional participants that lower their margins, have greater flexibility in terms of managing tokens they want to support, and eliminate counterparty risk.

Banking platform integration
Integrating digital asset platforms to core banking systems is a necessary step for a full end-to-end capability. The core banking system needs to synchronise asset tokens as supported instruments available for customer trading, link customer records to segregated on-chain accounts, integrate on-ledger transactions to be able to mark-to-market customer assets, provide regulatory and tax reporting as well as provide the gateway to digital banking apps for customer accessibility.

To achieve all this, banks need to rely on a modern, flexible, and open banking platform that allows them to integrate their core systems to digital asset providers. By opting for established banking platforms with an ecosystem of pre-integrated digital asset partners, banks can quickly move forward with these new capabilities as local regulation allows.

Getting ready
Blockchain is still waiting for its killer-app moment. Nevertheless, real-world use cases across broader tokenization such as for securities may help drive the major blockchains and projects that are able to demonstrate value, and distinguish themselves from the speculative Dogcoin froth.

Regulatory clarity is urgently needed and should catch up in the months ahead. Now is the right time for banks to step into this new technology, refine their strategies, and start building. The digital assets future may just offer a wealth of opportunity.

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