Risk management and governance of digital assets has been saved
Risk management and governance of digital assets
Managing the evolving risks of DeFi, CeFi, and tokenization
Responding to the evolving risks that straddle TradFi, DeFi, and CeFi: Some lessons and observations
- DeFi/CeFi opportunities and use cases
- Increased regulatory focus
- Risk landscape
Despite the whirlwind of uncertainty in financial markets over the past year, as well as the failure of several key players in the digital asset industry, today blockchain and digital assets are witnessing greater levels of investment than in the two years preceding the crypto bull market of 2021 through Q2 2022. Globally, crypto curiosity has not waned. One hundred and five countries, representing more than 95% of global GDP, are exploring central bank digital currencies (CBDCs).i Moreover, proposed financial innovation regulations and policies have increased across the globe. All this could help pave the path toward greater clarity and transparency, a likely critical step for improving consumer confidence and promoting growth in the blockchain and digital asset industry.
Throughout 2022, institutional proponents of traditional finance (TradFi), including top-tier banks and fintech firms, continued to announce and roll out new cryptocurrency and digital asset services and solutions.ii Such sustained innovation could suggest that financial institutions and investors may increasingly recognize the benefits that blockchain technology and digital assets can offer beyond TradFi services and assets.
While the development of strategies to optimize the benefits of digital assets and blockchain technology continues, stakeholders also should consider how their exposure to the associated asset class aligns within their organization’s overall risk management frameworks. Although regulation is evolving, institutions should proactively engage with technology not only to help capitalize on its inherent benefits, but also to better enhance their risk management processes and mitigate the downside risk that may occur with future market dislocations.
This white paper seeks to provide an overview of different blockchain and digital asset use cases and their associated risks. It seeks to explain the different opportunities and potential risks in the crypto market, including new risks not associated with traditional financial institutions. Market participants of both centralized finance (CeFi) and decentralized finance (DeFi) may benefit from identifying and managing these risks to optimize future opportunities.
The past year indicated that there was a high degree of disparity among market participants’ expectations of the benefits of cryptocurrencies, which can be deduced from the price fluctuations of many cryptocurrencies such as bitcoin. That, as we’ll see, in part accounts for many of the disruptive market events.
Looking to the future, the likely next evolution of digitalization is the tokenization of real-world assets. That may have tangible and direct benefits for market participants through the efficiencies and opportunities offered by on-chain technology. If demand for tokenized assets increases, it may be likely that new participants will enter the market, which may further increase liquidity. Still, as with other conventional asset classes, a rapid increase in demand can overheat markets, raising the potential of another dislocation event. For sure, the lessons learned from crypto markets transcend that asset class and should also be considered in managing the future as the digital evolution continues.
DeFi/CeFi opportunities and use cases
Crypto-native and technology companies often support the ecosystem through the creation of decentralized protocols and the development of new digital asset use cases. Many may replicate or replace TradFi services, such as borrowing, lending, and trading through a direct, peer-to-peer environment, created through decentralized applications (dApps). Additionally, access to the open-source code within DeFi protocols may allow for a composable infrastructure. There, users can innovate, create financial services, build financial instruments, and tokenize physical assets. This trend may put pressure on TradFi to adapt and consider whether or not to incorporate digital asset offerings and on-chain transactions among their current product offerings to potentially help meet customer demands.
CeFi uses blockchain technology to allow market participants to access and transact digital assets through a centralized exchange. CeFi is an emerging industry that aims to offer market participants many of the benefits of DeFi but with the security and risk management aspects of TradFi. Retail and traditional financial institutions may use CeFi as a gateway to access opportunities in the digital asset ecosystem such as crypto trading, lending, staking, and asset tokenization. As we will explore shortly, these opportunities may also present risks for market participants, risks that require active monitoring and management to mitigate the associated downside exposure.
TradFi institutions should consider and weigh the pros and cons: Should we include digital assets as a product offering? Is it better to develop the blockchain infrastructure in-house or does partnering with a crypto service provider offer greater benefits? There appears to be a trend of convergence between TradFi and “crypto natives” (i.e., startups primarily offering blockchain and/or digital asset services/solutions), whereby emerging technology and innovative solutions are integrated with traditional financial services. If true, that may pave the way for financial services transformation. There have also been instances of traditional institutions, investment banks, and dealers partnering with crypto natives to offer and develop crypto products, such as custody solutions or providing customers access to crypto trading products.iii
Over the past few years, we have seen organizations reinvent the ways in which digital assets can replicate and enhance TradFi services across DeFi/CeFi. There are certain use cases that illustrate how DeFi and CeFi are impacting the financial services landscape. Nevertheless, these use cases may entail certain risks for market participants. Some common use cases are summarized below:
- Payments–Blockchain technology may enable 24/7 money movements, thereby helping solve cross-border challenges, as well as creating a direct peer-to-peer network—all to help facilitate a more efficient payment process.
- Market making, investing, and lending–Blockchain technology and smart contracts can allow for automation through self-execution of processes previously dependent on human involvement. This could promote several benefits, including more efficient collateral management and settlement of contractual payments.
- Tokenized assets–Tokenized assets can be created using smart contracts. That could provide investors with the opportunity for a broader spectrum of customized products to fit their investment or hedging profile, all the while reaping the benefits that on-chain technology offers.
Increased regulatory focus
Given the growth of digital assets and recent market events, Sovereigns around the globe are prioritizing the need for participation and regulation. President Biden signed an executive order on March 9, 2022, to establish a national policy for digital assets. Among its priorities are consumer and investor protection, financial stability, financial inclusion, responsible innovation, illicit finance, and US leadership in the global financial system.iv According to the White House, the significant rise in the popularity of digital assets creates an important opportunity for the United States to play a leading role in global governance consistent with the values of democracy and US global competitiveness.
Additionally, more than 100 countries, including the United States, are exploring or piloting CBDCs, which are digital forms of sovereign currencies.v
Increased regulatory focus in this space has resulted not only from the growth of digital assets, but also from the associated volatility to which market participants have been exposed during the recent “crypto winter.” The consequent failures and bankruptcies have also highlighted the risk for investors.
The advancements of cryptography have been proven fundamental to the security and trust environment that blockchain technology offers. However, the recent volatility of digital assets points to the need for greater transparency and could remind us that market participants are not absolved from applying the core principles of risk. In fact, elements of systemic and idiosyncratic risks that have been present in TradFi surfaced in the digital asset arena in the first half of 2022. The result? Several prominent bankruptcies and billions of dollars of lost investor value.vi
The crypto winter of 2022 may have taught us that, while the digital revolution advances, we aren’t likely to escape the gravitational pull of human behavior. Although there are significant opportunities for outsized returns, market participants are not immune to risks long familiar to participants in conventional financial markets.
Despite continued uncertainty, blockchain technology and digital assets are shaping up to be a transformational force in charting the future of financial markets. That fact notwithstanding, relevant risks cannot be ignored as the ecosystem continues to evolve. The existing regulatory frameworks used to address and mitigate risk in the TradFi regulatory environment provide a gateway for market participants who want to prepare for future regulation and manage the risks attendant to the DeFi and CeFi environment. These risks should be tackled head-on, in a thoughtful and comprehensive manner. And if executed appropriately, market participants may well have a parachute that allows for a safe landing during the next tail risk event … which is just one cycle away.
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i Ananya Kumar and Josh Lipsky, “Central banks are embracing digital currencies. Will the US lead or follow?,” New Atlanticist, June 2, 2022.
ii Goldman Sachs, “The future of digital assets,” accessed February 27, 2023; Ian Allison and Coindesk, “JPMorgan on its crypto plans: ‘The overall goal is to bring these trillions of dollars of assets into DeFi’,” Fortune, June 12, 2022; Ian Allison, “JPMorgan wants to bring trillions of dollars of tokenized assets to DeFi,” Coindesk, June 11, 2022; Samuel Indyk, “BNY Mellon says investors ‘absolutely interested’ in digital assets,” Reuters, February 9, 2023.
iii Berivan Demir, “A match made in crypto: Partnerships in a new age of finance,” Fintechly, July 21, 2022; Hubbis, “Fintonia secures CMS license upgrade, with mainstream adoption of digital assets driving greater demand for partnerships from traditional and crypto-native institutions,” February 9, 2023; David L. Portilla et al., “Blockchain in the banking sector: A review of the landscape and opportunities,” Harvard Law School Forum on Corporate Governance, January 28, 2022.
iv The White House, “Executive Order on Ensuring Responsible Development of Digital Assets,” March 9, 2022; Deloitte, “New layer to crypto policy emerges with digital assets executive order,” 2022.
v Kevin Helms, “105 countries are exploring central bank digital currencies, CBDC Tracker shows,” Bitcoin.com, June 6, 2022.
vi David Yaffe-Bellany and Erin Griffith, “How a trash-talking crypto founder caused a $40 billion crash,” New York Times, updated May 20, 2022.
vii International Swaps and Derivatives Association (ISDA), “Legal guidelines for smart derivatives contracts: Collateral,” September 12, 2019; Moody’s Analytics, “ISDA guide on collateral management under smart derivatives contracts,” September 12, 2019.
viii CoinGecko, “Lido Staked Ether,” accessed February 27, 2023; Ryan Browne, “What you need to know about staked ether, the token at the center of crypto’s liquidity crisis,” CNBC, June 20, 2022.
ix CoinGecko, “Cryptocurrency prices by market cap,” accessed February 27, 2023.
x Rob Massey et al., The Ethereum upgrade: Musing about the Merge (While keeping tax and accounting considerations in mind), Deloitte, October 2022.
xi Commodity Futures Trading Commission (CFTC), “CFTC imposes $250,000 penalty against bZeroX, LLC and its founders and charges successor Ooki DAO for offering illegal, off-exchange digital-asset trading, registration violations, and failing to comply with Bank Secrecy Act,” press release no. 8590-22, September 22, 2022.
xii Committee of Sponsoring Organizations of the Treadway Commission (COSO), COSO home page, accessed February 27, 2023.
xiii Board of the Governors of the Federal Reserve System (FRB), “SR 11-7: Guidance on Model Risk Management,” April 4, 2011.
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