The Big Conversation - Deep Dive Interviews
Episode 2: The institutional adoption of digital assets
In this episode of our deep-dive interview series, we take a look at digital assets. The world of crypto and decentralized finance has become incredibly tribal, with multiple technologies jockeying for market leadership. But one area where probably everyone agrees is the capital from institutional investors will help the progression towards mass adoption. Kristen Mierzwa, Managing Director of ETP Strategy and Business Development at FTSE Russell, and Doug Schwenk, CEO of Digital Asset Research, discuss the developments that are taking place on the road towards an institutionally acceptable investment framework.
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The world of crypto and decentralised finance has become incredibly tribal, with multiple technologies jockeying for market leadership, but one area where probably everyone agrees is that capital from institutional investors will help the progression towards mass adoption.
Digital assets will be a part of everyone’s asset allocation in the future, over time. Of course, it helps diversify any type of asset allocation.
There is a line of sight to institutional adoption. In the past, we didn’t know when or if. Now, it is a when, not an if.
Institutions have been waiting in the wings, and not always because they don’t understand the technology, but they absolutely do need certain regulatory and infrastructural requirements to be met before they can become major investors. These steps are now starting to take shape. Kristen Mierzwa of FTSE Russell, and Doug Schwenk, CEO of Digital Asset Research, discuss the developments that are taking place on the road towards an institutionally acceptable investment framework.
A few years ago, the crypto space was very much a niche market, but the development of multiple different products has also accelerated the interest of institutional investors.
We went from what was a very retail-driven, retail-focused market in 2017, when most people first heard of Bitcoin, into a market now that has mature custody solutions, fund administration, major banks getting into the space, as well as interest in assets beyond Bitcoin, institutionally, not just Ethereum but also DeFi and a big promise of technology that can solve quite a few problems in finance that don’t require you to be a believer in Bitcoin.
What’s exciting right now is how quickly the industry is moving. Even with some volatility in the markets, I think people are really understanding this is an established asset class and they need to take a hard look at it and figure out where does this work in my portfolio. The other thing that’s really great is seeing the regulators, globally, working together in this space and trying to figure it out I think is a great thing for the asset class.
Asset managers have not been able to simply run headlong into investments within the digital asset space. They have both regulatory and infrastructure needs that have to be fulfilled before they can participate.
What we’re seeing on the institutional side, and where they are in moving into this new asset class, is of course they need to get all of their infrastructure put together, so they need to get the data feeds coming into, they need someone who’s going to trade, they need to figure out who’s going to be their custody agent, who’s doing fund admin for them? And we’re seeing a lot of clients start to do this internal-only, so they’re working on getting all their plumbing put together.
There are definitely some hurdles on the regulatory side that have been slowly coming down. The counterparties, broker-dealers and such, two or three years ago couldn’t provide services, or providing services was difficult. Banks as well didn’t have the green light to do custody or provide services. Those hurdles have been lifted slightly. There’s now special purpose licence for custody by broker-dealers, the LCC has given its green light. There are regulatory frameworks that have been proposed in Europe and in other jurisdictions. We’ve got a new regulator at the SEC, and Gary Gensler, a new administration who is very focused on allowing crypto to grow.
What we’ve been doing at FTSE Russell, in our conversations with our clients and everyone else in the marketplace, has been really about governance and infrastructure. So we’ve always seen our role as providing transparency to the markets with our data points, and the main data point we’re really thinking about when it comes to digital assets is a clean price, and then also volume. A master unique identifier’s important. And then taxonomy. So we’ve created a taxonomy around digital assets that’s much like a classification system where you would decide what sector a digital asset goes into.
But why we’ve done all this is for asset managers who need help with the infrastructure in this new asset class. They’re constantly asking us, give me parallels of how this is like fixed income or how it’s like equity. They kind of want to see and feel the data and put it into their systems the same way they would with those other asset classes.
Over the last few years, and the last 12 months in particular, an institutional framework for digital assets has started to take shape.
There are a number of key changes that have happened. One is the regulators have gained a lot of knowledge. Look at it three or four years ago, they didn’t understand what was crypto. Many of the market participants are more sophisticated now, they’ve been able to represent to the regulators what the technology does, how an asset class that is largely uncorrelated can be helpful, how this market can evolve. And that education has been key.
I think the new administration, the changing of the guard into an administration that is more sophisticated around crypto, has helped that education as well. And now, we have, unfortunately, the experience of the pandemic, and an asset class that is seen as uncorrelated to central bank issuance of currency during a pandemic has really brought a lot of players into the market that maybe would have stayed out in the past.
What’s important is all of the infrastructure that we put into the platforms to go and do whatever we need to do down the line. But the biggest hurdle we really had was working on governance and compliance and getting everyone comfortable with we’re going into this space. And for whatever reason, this asset class has a lot of speculation around it, you hear the word nefarious used a lot with the asset class, so it’s getting governance and compliance teams comfortable with what’s really going on here.
And how we did that, on our side, was creating a structure where we put best-in-class AML-KYC policies in place, who’re only trained to work with the best actors from the exchange perspective. And then on the asset perspective, we do a long vetting process to decide which assets would be eligible for our indices, and thus pass the vehicles down the line.
The adoption of decentralised finance will be transformative for financial markets in a way that the Internet was transformative for the retail sector.
When the Internet came around, all that technology was fantastic and you saw traditional industries really embracing the technology and pivoting their business model. Like retail, so many people shop online now, they still use their brick-and-mortar but they have definitely gotten comfortable with online shopping, but you never really saw the Internet fundamentally change the financial markets.
Sure, you can do online trading with your apps with your brokerage account, but when you really think about the way that banks and financial services do their business, the Internet didn’t really change it except that kind of front-end user experience. But the technology of digital assets really is going to change the financial services industry in a big way.
There’s a generation of young professionals, people in that millennial generation, who largely want to invest in crypto and see it as part of what they want in a future. And then, when we look at how the underlying technology can be used to allow 24-7 trading, same-day settlement, very interesting products built on top of the DeFi stack, we see some primitives that are very much about programmable money.
And programmable money does have a lot of efficiencies for Wall Street and other financial apparatus, as well as an opportunity to serve people who may not have access to financial services, the unbanked. If you think about the crypto technology as being a set of rails that can allow not just pure-crypto assets like Bitcoin to trade on them but to allow traditional assets, like securities that we all know, equities, fixed income, etc., to trade on top of those same technology rails, it can create a tremendous overall efficiency and bring a flood of institutional money into this market.
FTSE Russell and Digital Asset Research have been developing a framework for institutional adoption, performing the necessary due diligence and product analysis that’s required to satisfy the regulatory requirements of large-scale asset managers.
So, if you think about digital assets, as we know they’re not a listed security, so digital assets can trade on any exchange, you can trade with a friend through a wallet. It’s much akin to the currency market, there’s no centralised exchange. So that means there’s not a centralised data point for what is the price of Bitcoin, what is the price of Ethereum.
So what we’ve done in our partnership with DAR is DAR vets the exchanges out there, and we’re looking for exchanges that have great KYC and AML policies and they look and feel just like a traditional exchange, where we’re pulling spot from those exchanges of real economic buyers and sellers, and then we’re aggregating that price from the vetted exchanges to show a true reflection of where the market is.
The institutional money is looking for money to create returns that are uncorrelated, investing on behalf of those retail investors that are in their products or the endowment or the pension that they represent, or the fund that they represent. And these returns being uncorrelated, historically, gives them an opportunity to manage risk, the fact that they can access these assets in a more efficient way and create a cost-saving by not paying as many of the Wall Street middlemen.
We’ve got live indexes up and running, and our client base has been asking for single digital asset indexes, which is a little bit different from a traditional market cap-weighted index that you would think of on the equity side, but why we need those single digital asset indexes is really all about the governance that goes into the price that drives that particular index.
And then, when you move beyond that, it gets really interesting. Of course, you can do a broad-based index with our vetted assets, which we’ll call the benchmark index, and right now we’ve got a little over 40 digital assets that have made it through our vetting process to go into that, but then if you starting thinking beyond that, we’ve got this toolkit that works great with our other asset classes, so we can start doing really interesting things, like the Russell 1000 Technology Index plus 5% Bitcoin, or you could do the FTSE 100 valued in Bitcoin. We could do FTSE emerging markets hedged to Bitcoin. And you can really do that blending of the different asset classes.
The world of crypto and decentralised finance is a rapidly-moving sector. Institutional capital has stringent requirements. They need regulatory oversight as well as an infrastructure that is compatible with their fiduciary requirements. FTSE Russell and Digital Asset Research are at the vanguard of a process that will help unlock the potential of institutional capital. This could be transformative for both the development of the digital ecosystem and ultimately the way in which we invest in the future.
LSEG and FTSE Russell had been bringing financial infrastructure supporting products to market over the last two years, and FTSE Russell has recently launched its first, but not last, single asset indexes to the market. This includes FTSE Bitcoin, FTSE Ethereum and FTSE Cardano indexes. To learn more about these indexes and FTSE Russell’s reference or pricing data, visit ftserussel.com/digitalasset. Indexes and data are also being made available through Refinitiv platforms, so please do get in touch with your Refinitiv account manager to find digital asset data on workspace and data scope.