Will crypto ever be a safe investment?

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In the annals of cryptocurrency, 2022 will go down as the year the industry almost died. But then in December, a pair of exchange-traded funds was born in Hong Kong, offering new hope to retail and professional investors alike.

Asia’s first Bitcoin and Ether futures ETFs join a growing list of initiatives that will go some way to alleviating the current legitimacy crisis facing the virtual asset. A major annoyance is the confusion over safe custody of crypto holdings. Sam Bankman-Fried’s FTX, the most spectacular of last year’s string of crypto debacles, has brought the hapless customers of the failed Bahamas-based exchange before a Delaware bankruptcy judge to determine whether they are entitled to their funds in advance of other creditors.

But FTX is not the only test for crypto custody. Last month, a U.S. bankruptcy judge ordered insolvent Celsius Network LLC to return roughly $50 million that never earned any interest. However, the fate of the billions of dollars of customer funds stuck in interest-bearing accounts remains questionable: Does the money belong to the debtor’s assets or to the clients?

This anxiety-inducing uncertainty should diminish as more crypto investments move to normal exchanges as ordinary securities, no different from stocks and bonds. This will put clients’ assets under the umbrella of standard safeguards, eliminating the need for expensive legal maneuvers to recover one’s money. For example, the newly launched CSOP Bitcoin Futures ETF will entrust the custody of users’ funds to a licensed Hong Kong trust company HSBC Holdings Plc which, as noted by Bloomberg Intelligence, undergoes regular bank reviews and audits.

This is what fund managers have been waiting for. Adults entering the crypto playground will bring the adult rules with them. No one knows if any of today’s digital assets will be anything more than vehicles for speculation. But the tokens of the future could represent significant economic value. On that premise alone, it might be worth creating a safe and secure environment now so that capital can flow towards them.

The Hong Kong crypto ETF is just one of several recent examples of the financial industry trying to provide protection in a legal vacuum. The Bank of New York Mellon Corp., the custodian of $43 trillion in client assets, recently opened its vaults to receive cryptocurrencies from some institutional clients. BlackRock Inc. also entered the fray by adding crypto to its Aladdin platform, which is used by pension funds and other large investors to oversee their portfolios. Fidelity Investments, the brokerage unit of the asset management giant, has been offering custody services to hedge funds since 2018. It is now launching a commission-free Bitcoin and Ether trading service for small clients.

Olivier Fines, head of advocacy for Europe, the Middle East and Africa based in London at the CFA Institute, cautions against reading too much into private industry-level efforts. “The de facto insurance offered by BNY Mellon, Fidelity or HSBC is largely a product of their size and scale; it is not something that smaller institutions can easily copy. “For there to be a competitive market in cryptocurrency custody services, new laws must fill existing legal loopholes,” Fines said.

One such loophole is in the US Securities and Exchange Commission’s Consumer Protection Rule. Under it, broker-dealers must separate clients’ cash and securities from their own. This is an important guarantee for clients who part with their money. They wouldn’t like lining up with general creditors to make up pennies on the dollar in the event of a broker bankruptcy.

But is an exchange token — like FTX’s cryptocurrency FTT or Binance’s BNB — a security or a utility? In its complaint against FTX co-founder Gary Wang and former Alameda Research COO Caroline Ellison, the SEC alleges that FTT is a security. For now, however, “custodial protections, like other investor protections for digital assets, remain largely untested in court,” Fines and Washington colleague Stephen Deane wrote in a new report summarizing the investment management industry’s current positions on putting crypto on its Menu.

“Revolutionary or not, technology alone cannot offer protection against age-old financial wrongdoing, ranging from market manipulation and front-running to fraudulent disclosures and Ponzi schemes,” the CFA Institute report said. “The cryptoecosystem urgently needs a strong, clearly defined regulatory framework.”

For too long, the focus of crypto oversight has been on preventing money laundering. Customer protection was not a priority. Now the pendulum is starting to swing though, maybe a little too much in the other direction. In March, the SEC issued new accounting guidelines for financial firms that have an obligation to safeguard clients’ crypto assets: they must explicitly record the obligation and the corresponding assets. But this requirement can have a negative effect if it is considered too difficult. An inflated balance sheet will increase banks’ capital requirements, making them reluctant to offer custody services to clients.

This regulatory tussle will eventually calm down, hopefully investors will feel better protected than now, and intermediaries will not flee the field. The trustless techno-anarchist blockchain founders will not be pleased that the same big middlemen they wanted to oust are trying to hijack their creation. But with any luck, future historians of the industry would conclude that the worst vulnerabilities of cryptocurrency crawled out of the box in 2022. After that, things gradually got better. Digital assets remained unsuitable for most risk-averse retail investors, but at least became a safer bet for those who didn’t mind volatility.

More from Bloomberg Opinion:

• Matt Levine’s Money Stuff: Crypto manipulation has consequences

• Beware of the dangers of too much crypto regulation: Tyler Cowen

• Beware of crypto-billionaires who brag about audits: Lionel Laurent

This column does not necessarily reflect the opinion of the editorial board or of Bloomberg LP and its owners.

Andy Mukherjee is a Bloomberg Opinion columnist covering industrial companies and financial services in Asia. He previously worked for Reuters, Straits Times and Bloomberg News.

More stories like this are available at bloomberg.com/opinion

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