Investing in digital assets and their underlying technology

Digital assets have been a hot topic in recent years but suffered from the negative publicity involving questionable digital assets service providers over the course of the past year. Nevertheless, digital assets are still considered an interesting investment opportunity. Financial intermediaries, including asset managers and family offices, can offer their clients exposure to this asset class in different ways. Each of these ways requires specific attention regarding the associated risks and the regulatory requirements to be fulfilled by the financial intermediary offering it.

Different types of investments and exposure

It should first be noted that one possible alternative to investing in digital assets per se is to invest in the underlying technology (in particular the distributed ledger technology). This can be achieved by investing into companies that are active in the blockchain, crypto, or digital assets space, such as start-ups or already more mature companies active in this field. Investments are possible in the classical way (equity, debt, or mezzanine) or also by acquiring tokens of the respective companies (e.g. a utility token that provides access to the services of the respective company).

Then, when investing into (properly blockchain-based) digital assets, investors and their financial intermediaries can choose between holding digital assets directly (involving hosted or un-hosted wallets) and being exposed indirectly through financial instruments whose underlying are digital assets.

As digital asset exchanges are usually opened 24/7, direct holding has the advantage of offering better reactivity in case of market movements, allowing the initiation of transactions at all times. For example, this also provides the possibility to set stop-loss orders triggering to sell the position in case of falling prices. Depending on the token and the exchange, the liquidity can be quite good. If the custody is performed by a bank, a securities firm, or a DLT trading infrastructure, the investor may expect an institutional-grade infrastructure that avoids operational risks to a minimum.

Indirect investments can provide investors with exposure to digital assets within the traditional infrastructure without the need for directly holding digital assets. This is particularly interesting in case the involved service provider does not (yet) offer custody or brokerage of digital assets. Through actively managed certificates (AMCs), exchange-traded products (ETPs), or funds it is also possible to offer investors diversified portfolios of digital assets which can be actively or passively managed. Whereas the indirect holding of digital assets is simple for the investor, it also has its share of challenges. These range from usually lower liquidity at the product level, and restricted trading hours to additional fee layers, and therefore higher costs. In addition, many products which are set up as AMCs or ETPs offer less investor protection than regulated investment funds.

Adjusting to the regulatory requirements

Financial intermediaries who intend to provide their clients with access to digital assets have to clarify which regulatory requirements they have to comply with for this. Depending on whether they want to use digital assets in the context of asset management, portfolio, or transaction-related investment advice or whether they only want to advise clients on technical matters (e.g., how to acquire and store digital assets safely), different regulatory requirements will arise. The qualification of the concerned tokens also influences the regulatory requirements. While payment and utility tokens do not qualify as financial instruments under the FinSA, asset tokens generally do. This is for example detrimental for the question of who must hold the assets in custody. If access shall only be provided indirectly through financial products with a crypto underlying (such as AMCs, ETPs, or crypto funds) fewer changes will be required. In general, financial intermediaries entering into the digital assets space are recommended to assess:

whether they have already sufficient know-how in this area or whether new personal needs to be hired or existing personal upskilled;
whether the extension of the activity to digital assets requires an authorization of FINMA (e.g., in case the organisational regulations need to be amended);
whether there are organisational changes required;
whether there is a need for an amendment of existing policies or the drafting of new policies;
whether there is an impact of the risk and compliance framework;
whether changes in the contractual framework with the client including the general terms and conditions and the risk disclosures are necessary;
and whether the insurance coverage should be extended.

In case the new services shall be offered on a cross-border basis financial intermediaries also need to be aware of the fragmented regulatory landscape surrounding digital assets and ensure that they are complying also with the local laws and regulations.

Choosing the right service providers

If financial intermediaries and their investors choose to invest directly into digital assets, they need to evaluate the service providers they want to use. How and by whom shall the acquired assets be custodied? Who provides access to the digital assets in scope (i.e., who shall act as the broker)? What grade of security do the providers offer? From a technical perspective, there are a lot of different setups possible. However, as mentioned, depending on the digital assets and the services involved there are also regulatory considerations that need to be considered.

After the collapse of FTX, we observed that clients increasingly wanted to deposit their digital assets with regulated financial institutions. In Switzerland, there are meanwhile a variety of banks and securities firms offering digital assets-related services in a FINMA regulated environment. Also, Bank Julius Bär offers a range of services that allows their financial intermediaries and clients to buy, sell and store digital assets in a safe environment. If a financial intermediary can also use its traditional custodian bank for investments in digital assets, this lowers the barriers to entry into the new space and simplifies the processes considerably.

In conclusion

Despite the challenges, digital assets offer an exciting investment opportunity for financial intermediaries and their clients. The market is still in its early stages but there is significant potential for growth. By staying informed and taking the necessary steps to ensure they are providing the best options, financial intermediaries can help their clients navigate the world of digital assets and potentially collect the rewards.