Cryptoassets and the unseen risks

Beyond the investment risks associated with cryptoasset markets, important questions remain around how to ensure acceptable standards of asset protection and investor safety.

One fundamental question confronting market authorities is how digital assets – including virtual currencies such as bitcoin – should be regulated. Should the instrument be treated as a currency? As a security? As a “security token” (providing rights of ownership in an underlying security or a share in future cash flows)? Or perhaps as a “utility token” (which can be redeemed for access to a product or service)?

Typically, regulators take the view that when an instrument “looks and behaves” like a security, it will be regulated as a security. But as digital instruments become more complex, often they do not fit cleanly into any of these categories.

A more urgent problem is how financial supervisors should protect investors against losses arising from weak asset servicing standards.

For investment in “traditional” securities, tried and tested guidelines have been developed over decades regarding how these instruments should be held in “safekeeping” and how losses can be minimised resulting from theft, fraud, political unrest or the insolvency of a financial entity holding these assets in their care.

The Securities and Exchange Commission, the US securities market regulator, defined principles under Rules 17f5 and 17f7 of the Investment Company Act which have subsequently been adopted as a global standard for safekeeping assets on behalf of an investment company. These specify that assets must be held with an “eligible custodian” – and that the custodian must meet an exacting set of requirements before it may be appointed to this role.

For digital assets, an equivalent liability regime and set of custody standards has not yet been established – and while this is the case, digital assets are likely to remain off limits for many institutional investors.

The take-away message is that the risks associated with cryptoasset investment extend well beyond the price volatility of the asset. Although some cryptoasset investors do currently use an eligible third-party custodian, others may be using a service where standards of asset protection fall well short of those required under 17f(5) or 17f(7). Recent losses at QuadrigaCX, the Canadian cryptoexchange, illustrate the dangers when investors do not understand their custody risks and do not conduct effective due diligence on their service provider.