Fintech on Friday: Private banks prepare to take crypto plunge

Wealth managers may have been slow to embrace digital assets, but with client demand increasing, many are now looking for the best way to boost their offerings

Crypto assets have become wildly popular with wealthy business owners and entrepreneurs, promising fast and high returns. This has driven speculative bets, as well as longer term portfolio allocations, as today’s investors seek the safest, most productive way to exploit the latest innovations.

Blockchain and digitally native assets, such as cryptocurrencies – which exist only virtually, unlike tokens of real world assets – are expected to play a pivotal role in creating the infrastructure and user experience of Web 3.0. This is heralded as the next and most effective iteration of the internet. As a decentralised digital infrastructure, which will allow power to shift from big tech companies to individual users, Web 3.0 is predicted to transform both our society and economy.

Cryptocurrencies and bitcoin, the largest blockchain-based digital asset, invented only in 2008, represent the lion’s share of investments.

Bitcoin ETFs and metaverse-related investments are also popular ways to gain exposure to digital assets.

The strongest interest appears to be coming from younger, tech-savvy investors, who recognise the disruptive potential of blockchain, the technology underlying most crypto assets. Ninety-one per cent of HNW individuals under the age of 40, and 71 per cent of the wealthy have invested in digital assets, according to recent Capgemini research.

In order to match this demand, private banks have started offering services in this space. Last year, Morgan Stanley was the first big US bank to offer wealthy clients access to funds enabling bitcoin ownership. BBVA Switzerland offers private banking clients bitcoin trading and custody services, with plans to extend services to other cryptocurrencies.

Partnerships are also proving valuable. BNY Mellon has teamed up with Fireblocks for digital asset custody capabilities, while Julius Baer allows customers to trade and hold crypto assets in conjunction with its partner digital asset bank, Seba Bank.

Italy's Banca Generali acquired a stake in crypto wallet provider Conio last year, allowing customers to trade bitcoin by themselves, from their current account. Singapore’s DBS Bank offers crypto trading and custody services to accredited and institutional investors, using its in-house digital asset exchange.

Risky business

Yet, most private banks are still unable to advise on digital assets. Digital coins and their derivatives can certainly be a risky business, as demonstrated by the recent collapse of the Terra stable coin ecosystem.

Volatility is a huge concern too. In recent months, the price of bitcoin, ether and other major tokens has dramatically dropped, with bitcoin losing almost 70 per cent of its value since its peak. Bitcoin’s sharp decline has contributed to the fall of the broader crypto market from $3.2tn in November to $1tn today.

Regulatory scrutiny of complex technologies underpinning the crypto market is also likely to escalate, while tax treatments of crypto assets are unclear and scams remain a big concern. They cost their victims $14bn in 2021, mainly due to the rise of decentralised finance (DeFi) platforms, according to blockchain analytics firm Chainalysis.

But with interest increasing, especially among the younger generation of clients, and market capitalisation for crypto expected to increase four-to-fivefold by 2030, according to Boston Consulting Group (BCG), is it time for private banks to take the plunge?

“Wealth managers need to weigh the risk of losing customers to crypto-enabled rivals or crypto exchanges against reputational and regulatory risks,” says Anna Zakrzewski, global leader wealth management at BCG.

As of today, 95 per cent of crypto wealth is bypassing traditional wealth management channels, potentially putting up to $1tn of new assets on the table for wealth managers, according to BCG. Indeed, wealth management clients are ready to engage with advisers around this topic. Nearly 80 per cent would
consider increasing crypto holdings if wealth managers offered advisory and education services. Two-thirds who sourced crypto investments from third parties did so believing their wealth managers did not offer such services, BCG’s survey findings show.

Private banks can offer crypto services in different forms and at varying levels of complexity to suit different levels of business engagement and operational readiness, says Ms Zakrzewski. These range from light-touch offerings that require little change to an organisation’s existing business model, such as educating customers on crypto topics and giving access to tokenised financial instruments, through offering direct custody and trading of crypto, all the way through to advising customers on crypto exposure and access to DeFi products that demand greater expertise and investment, adds Ms Zakrzewski.

Different regulatory restrictions across jurisdictions also impact institutions’ decisions. At one end of the spectrum, China has banned its citizens from owning private digital currencies, imposing restrictions on crypto mining and trading. At the other end, Switzerland openly encourages crypto investments for retail and institutional players. Other countries, including the US, Germany and Singapore fall somewhere in the middle.

“We are definitely seeing more interest from private banks, but while some are further along in their education journey, there remains a certain amount of reticence to advise on positions in digital assets,” states Chris Tyrer, head, Fidelity Digital Assets Europe, whose largest client segments are family offices and hedge funds.

Speaking at PWM’s Wealth Tech Summit in June, Mr Tyrer described volatility as “the single largest obstacle” that prevents European family offices from allocating to crypto assets. Factors related to custody, liquidity, security associated with infrastructure are however becoming less of barrier.

High volatility

“People say they are concerned about volatility, but nobody is worried about making money too quickly. They are worried about the downside deviation,” he says, pointing to the staggering growth of the crypto market in just 13 years. Investors should tackle this issue through position sizing, believes Mr Tyrer, reporting that several studies demonstrate a small allocation, between 1 to 5 per cent, “significantly increases a portfolio’s risk adjusted returns, as they are non-correlated assets”.

He expects “dampening of volatility”, as more and more institutional investors enter the space so far dominated by retail clients, maturation of the asset class and greater regulatory clarity to drive private banks towards advising on crypto assets.

In Europe, the EU Markets in Crypto Assets EU regulation agreed in June, expected to come into force at the end of 2023, is the first attempt at creating a comprehensive regulatory framework for digital assets in the region, ensuring minimum standards in service provision.

If crypto evangelists are convinced digital assets should be treated as alternative investments, with bitcoin often nicknamed ‘digital gold’ as the ultimate store of value, most private banks’ CIOs are yet to be converted.

Of the 50 private banks’ CIOs PWM interviewed in January as part of its global asset tracker (GAT) study, only 7 per cent believed digital and crypto assets would generate attractive risk-adjusted return opportunities this year, versus 70 per cent for private equity investments. Nevertheless, a quarter expected allocation to digital assets and cryptocurrencies to increase in their clients’ portfolios during 2022. Interestingly, 85 per cent believed their clients had no allocation to these assets yet, which suggests customers do not discuss these investments with their private bankers.

Supporting clients

It is crucial though, for private bankers to support and service client investments in crypto, even if investments in this space are not recommended yet, believes Shannon Saccocia, CIO of US bank SVB Private. “It’s our job and responsibility to understand the space and the risks our clients have in their portfolios, even if it’s apart from what we might recommend for them,” she says.

High volatility is a big obstacle to using crypto, she explains. “I do not think adding crypto in the form of tokens into our discretionary managed portfolios, at this juncture, creates a higher Sharpe ratio or a better outcome for my clients. It’s a highly speculative, highly volatile and risk asset,” says Ms Saccocia believing there is, as yet, no fundamental application of intrinsic value for cryptocurrencies.

The top reasons for investing in bitcoin have been its lack of correlation to the equity market and its inflation hedge characteristics. But bitcoin has not held up under scrutiny for either of those two bases, she says.

Indeed, bitcoin is acting just like just another stock, she suggests, as the cryptocurrency’s plunging value has mirrored losses in the Nasdaq benchmark, weighted toward tech stocks. Inflation is even higher than it was in the fourth quarter of last year and cryptos are down meaningfully.

The disruptive potential of blockchain across industries will be clearer in the next few years, but investments in sectors such as healthcare offer more efficient and future growth oriented ways to invest in this technology, she believes.

Yet it is undeniable there are “huge, long-term secular tailwinds for digital assets and for the digital transformation in the financial services industry”. These include providing digital access to people that do not have access to the traditional financial system. Opportunities to add baskets of cryptocurrencies in client portfolios may also emerge in the future, expects Ms Saccocia.

Diversification test

For most of their time in the financial limelight, cryptocurrencies have followed a path of their own, says Stéphane Monier, CIO at Lombard Odier. In depth analysis from the Swiss bank shows the relationship between cryptocurrencies and traditional assets since 2020 varies depending on whether the stockmarket is upward or downward trending. Bitcoin is nearly twice as sensitive to the S&P500 in periods when it is falling, which is particularly apparent this year.

“Cryptocurrencies offer the least diversification at times when it is most needed. In other words, cryptocurrencies are more correlated to stocks during market downturns,” says Mr Monier. Beyond their dire performance, the infrastructure supporting the ecosystem has also failed to provide liquidity, with
several exchanges freezing recently, he adds. “As such, we judge cryptocurrencies to have failed their first major bear market diversification test.”

The current stage of liquidity contraction has disproportionately affected long duration assets, especially those with negative cash flow, which most crypto assets are, says Yves Bonzon, group CIO at Julius Baer, also a panelist at the PWM Wealth Tech summit. The impact has been worsened by the high leverage used by many market participants. While the drawdown of the ecosystem has been of “historic proportion”, drawdowns are part of the liquidity cycle and part of the price discovery mechanism in new asset classes, he says.

Limited data remains a constraint. “I don’t think short-term historical analysis brings much in terms of the merits of adding digital assets to a multi asset portfolio,” says Mr Bonzon.

Tightly regulated industry

Rather than volatility, the main obstacle preventing private banks from allocating to digital assets is the amount of “homework needed to understand the asset class and even then, you are never quite sure”, he adds. Moreover, private banks operate in an “extremely tightly regulated” industry, quite the opposite of the decentralised financial system. This explains why “private banks have been admittedly quite slow” in embracing digital assets.

Enhancing the risk management framework has been an important step at Julius Baer, which is already “selectively” advising clients on digital asset opportunities. “It’s a rather limited universe, because we are under very intense scrutiny from regulators in the countries where we operate,” says Mr Bonzon.

Requirements around KYC (know your customers) and AML (anti-money laundering) to ensure that wealth has not been fraudulently acquired “are extremely stringent".

Most digital assets should be considered venture capital assets, he says. “Private banks should take the opportunity of this ‘crypto winter’ to learn more about the space and understand the implications, because there will be disruptive implications for traditional asset classes too.”