The collapse of cryptocurrency markets has wounded crypto firms, dulled interest among traditional banks and wealth managers in developing crypto-based products and services and has encouraged regulators to re-evaluate whether crypto is a suitable option for retail investors. Are legacy institutions free to retreat from cryptocurrency or should they seize on market pullback to find new opportunities?
In turbulent markets, investors are fond of repeating Warren Buffett’s observation that when the tide goes out, you find out who’s been swimming naked. The recent plunge in cryptocurrency prices certainly bears that out, as late investors to crypto saw their investments collapse in value.
In the most extreme example, two linked cryptocurrencies, TerraUSD and Luna, essentially vaporized. More broadly, recent developments have exposed three myths about crypto that challenge the beliefs of crypto proponents:
Myth #1: Crypto is an inflation hedge
One rationale for allocating assets to cryptocurrencies was that they would rise in value as inflation increased, providing a natural hedge. Yet, as the Federal Reserve and other central banks began increasing interest rates to staunch rising inflation, crypto prices moved in the opposite direction.
Myth #2: Crypto is DeFi
Decentralized Finance, or DeFi, is the umbrella term applied to the concept that financial transactions can be conducted directly between end participants without the intervention of traditional intermediaries like banks.
Recent research has uncovered “unintended centralities” in crypto markets, where observed behavior differs from theory. For example, in some crypto currencies, relatively few players account for the bulk of crypto mining activity (the production of new crypto assets) and trading volumes.
Myth #3: Crypto is anonymous
One of crypto’s presumed differences from traditional currencies was that the identity of buyers and sellers would always be shielded. No government or private entity could decompose a transaction.
Yet, the same research that shed light on the concentration of minting and trading of crypto assets also indicated that crypto buyers and sellers could be traced. The researchers stopped short because they were academics. Determined and well-funded government or private sector actors might not let professional ethics stand in the way and might even be motivated to uncover as much as they possibly can. This is good because removing some of the anonymity associated with crypto might actually relieve some regulatory concerns like AML.
Does the exposure of these myths mean that legacy banks should feel free to scrap their crypto plans or treat crypto as a phenomenon that has peaked? No, in this article we examine the many opportunities ripe for picking amidst the current market turmoil.
First: Crypto banking has become too big to ignore
There are more than 300 million people using cryptocurrencies around the world today. The world's most popular crypto wallet, Blockchain.com has created more than 82 million crypto wallets which customers use to buy, sell, and earn crypto.
This figure is projected to increase exponentially as cryptocurrencies go mainstream. The International Monetary Fund estimates that around 100 countries are currently exploring issuing their own Central Bank Digital Currency (CBDC). This will drive demand for crypto wallets as people will need a place to store them. Even if native cryptocurrencies like Bitcoin and Ethereum remain volatile and therefore appealing to a limited segment of users, digital currencies backed by central banks will offer both the convenience of crypto and stability.
Second: Crypto banking – where people increasingly turn to alternative methods to pay, save, and borrow – represents a source of revenue leakage
We estimate that 1 to 2 trillion US dollars are still sitting outside the banking system in crypto assets. The collective opportunity cost of foregone fees and spread revenue to the global banking system is 35 to 70 billion dollars.
Crypto wallets could also displace banks in the payments value chain. In a crypto-to-crypto payment arrangement, a customer makes payments directly with a merchant using a crypto wallet instead of using a bank-issued credit or debit card.
Similarly, in a crypto-to-fiat payment arrangement, payment network companies, like Visa and Mastercard, partner with a crypto wallet to issue crypto-linked cards. These allow cardholders to pay with cryptocurrencies and payments are converted to a fiat currency that the merchant will accept.
In both scenarios, banks risk losing share in the payments value chain. According to our analysis, reasonable growth in crypto-based payments would jeopardize as much as 16 billion dollars in revenue between lost interchange fees and spread income on revolving balances.
Third: Difficult as it may be to envision as crypto markets sink, investors and wealth management clients are increasingly expecting their banks to offer cryptocurrency investing and advisory services
In our 2021 survey, 40 percent of bank wealth management clients said they would like to invest in cryptocurrencies, while 35 percent said they expect their bank to offer advice in this area.
Spotting opportunity, a number of crypto brokerages have launched dedicated units to help high-net-worth (HNW) individuals – a key customer segment for banks to navigate crypto investing. Coinbase Private Client features high-touch services, personalized strategies, and access to institutional research and insights.
Similarly, bitcoin brokerage River Financial's private client unit promises to help HNW individuals add Bitcoin to their investment portfolios. No doubt the market downturn will dampen investor enthusiasm for these offerings, but the long-term trend in asset management has been the barbell: Passive index funds and electronic funds transfers (EFTs) on one end, and non-traditional assets on the other.
So, what’s the plan? How should banks and wealth managers respond to the demand for crypto banking and investment services in a post-crash environment?
The first element is to address the ways in which crypto is quietly going mainstream behind the headlines broadcasting volatile market conditions. Banks should consider how their current portfolio of investment services – including wallets, borrowing, lending, debit and credit cards – might present opportunities for crypto-based equivalents or even brand-new products.
Key considerations in the process would include the preferences and needs of high value customer segments that could potentially be better served via crypto alternatives. These considerations include whether offerings should be linked to state-backed or private cryptocurrencies, as well as whether technology, infrastructure, and distribution requirements can be better met in-house or through strategic partnerships.
In the wealth management sector, legacy players should consider what role crypto-based propositions might play in their asset management services and what new offerings might look like. In fact, crypto opens five broad possibilities for the development of new investment services:
- Discretionary mandates: Customized crypto portfolios tailored to individual investor risk and return preferences.
- Actively managed funds: Crypto portfolios designed to outperform the overall crypto market (deliver alpha returns).
- Index funds: Market-weighted crypto portfolios that deliver exposure to the overall crypto market.
- Individual cryptocurrencies: Long and short exposure to specific tokens or derivatives.
- Tokenization of illiquid assets: Conversion from hard to trade assets to bankable tokens to facilitate wealth transfer or to create liquidity (e.g., a real estate portfolio).
Each of these options will require wealth managers to handle several aspects. For example, they will need to consider whether their customer preferences and their own delivery capabilities are better suited to manufacturing or distribution. They must understand the breadth of crypto assets they’re willing to include in their value propositions. Furthermore, because this remains a developing market, they will have to assess and manage counter-party risks, ensuring that assets are safely traded and custodied.
Safe offerings and crypto regulation
As we mentioned above, wealth managers will need to ensure that all assets are safely traded. But safely offering crypto-based value propositions arouses further questions, such as:
- How can traditional banks and asset managers get comfortable with crypto market volatility or develop approaches and tools to manage it?
- Given that crypto adoption by some investor segments has run far ahead of mainstream financial institutions, how can legacy wealth managers convince themselves it’s worth the trouble figuring out?
As such, crypto regulation will be a critical issue for banks and wealth managers. Market turbulence often results in substantially increased regulation. Most major markets around the world are currently evaluating more stringent standards for crypto exchanges, initial coin offerings and retail investor protection.
Switzerland and Singapore, for example, stand out as global financial hubs that have stepped up regulation while continuing to make room for digital assets. The breadth of crypto options open to financial institutions will depend heavily on local market regulation.
How long the crypto bear market will last is open to conjecture. The groundwork for great success is often laid while conditions seem inhospitable. In 1975, a then little-known investor named John Bogle along with two analysts launched a new asset class during a protracted bear market. Their creation, the index fund, became the most successful innovation in asset management, and their firm, Vanguard, became one of the largest investment managers in the world.
While focusing on crypto offerings may seem counter-intuitive now, banks have a unique opportunity. Unlike weakened crypto rivals, banks remain stable and well-funded. Crypto talent is now more readily available and crypto firms are open to partnership opportunities. While a few mainstream banks and asset managers are offering crypto alternatives, whitespace is plentiful. Banks and wealth managers can still find opportunities to bring to market distinct, differentiated, and profitable offers.
Reach out to our experts if you’d like to find out more about how you can futureproof your business in the rise of crypto.