CFA Institute, the global association of investment professionals, presents an objective review of the development of digital finance. The report sets out recommendations for institutional investors and regulators. For CFA Institute, crypto assets need a stable and organized regulatory framework that protects investors. Without it, cryptocurrencies will not be in a position to gain mainstream acceptance.
The report, Cryptoassets: Beyond Fashion: An Investment Management Perspective on Digital Finance Development, presents key findings from interviews with investment professionals and crypto-asset experts around the world. It discusses three key emerging issues that the market will need to clarify before these assets can progress: valuation, fiduciary duty, and custody.
Through an objective analysis of the attractiveness and risks that the crypto market poses for a typical investor, the study highlights the dangers of a system in which traditional intermediaries would no longer be responsible for securing and securing transactions, facilitating price formation or raising capital. In addition, it introduces recommendations for investors, fiduciaries and regulators.
José Luis de Mora, CFA, President of CFA Society Spain: “It is necessary to establish a stable regulatory framework for the benefit of both cryptocurrency providers and users. Regulators must either agree to apply existing laws to parties to the crypto ecosystem, or craft new laws to address any legal loopholes that may exist. Confidence in the integrity of crypto markets, as in any market, is essential to attract investors and enhance their development.”
Olivier Fines, CFA, Head of EMEA Regulatory Affairs at CFA Institute: “Crypto platforms combine functions that in conventional finance are kept separate, such as the roles of intermediaries, exchanges, custodians and clearing agencies. Existing regulations, designed to prevent traditional financiers from using clients’ assets to fund their own companies or affiliated companies, would not always provide similar protection for cryptocurrency investors. The recent debacle in FTX shows the damage that investors and platform participants can suffer when their assets are not kept safe. The FTX example underscores the importance of custody issues and the responsibility of investors to base their decisions on rigorous investment analysis, not fads and speculation.”
Eight recommendations for regulators:
- To the extent possible, legislators should harmonize regulatory frameworks at the international level. Agree on definitions and supervisory programmes that take into account the specific nature of crypto-asset services.
- Determine whether crypto-assets are securities, other forms of financial instruments, commodities or currencies, and harmonize this definition internationally. CFA Institute is of the opinion that several crypto-assets would meet the definition of securities under US securities laws, for example, whereas, in the European Union, this debate takes place in the context of MiFID II. CFA Institute would argue against designing extensive new regulation as a simplistic response to the difficulty of rating crypto assets.
- Regulation on crypto-assets and digital finance must remain technologically neutral. Regulators should not judge which technological developments or guidance offer markets, investors and consumers the greatest benefit. Nor should lawmakers compromise investor and consumer protections because a technology is new.
- Regulate stablecoins for the potential for systemic risk. Stablecoins, a subset of crypto assets, must be properly regulated from a prudential, business conduct and investor protection point of view. The method used to maintain the link should be examined and its assurance independently verified. These instruments create linkages and ramifications with traditional financial markets, so they can pose a systemic risk to financial stability if not properly monitored.
- Monitor the crypto-asset market to ensure competitiveness and avoid wrongdoing. Monitoring programs should be established with a specific focus on costs, rates and business operation. The potential for consolidation should not result in a new value chain working in the interests of a selection of technologically advanced companies
- Monitor and control the risks of market abuse. Regulators must keep advanced forms of data science under control to monitor such activity and ensure market integrity. The fragmented nature of the crypto-asset market will require regulators to define information exchange mechanisms to ensure a consistent and complete understanding of transactions in it.
- Monitor and measure the accumulation of financial risks in the DEFI sector. Depending on the pace of development of decentralized financial services (DEBs), regulators must develop metrics to measure and quantify risk accumulation. Indebtedness and lending in the DEFI sector may require prudential measures similar to those related to financial institutions for their commercial securities lending operations.
- The custody of crypto-assets must be regulated and secure. Lawmakers should place a high priority on enacting a framework of laws and regulations to ensure the safe custody of customers’ crypto assets. Crypto platforms and companies should not be allowed to use customer assets to fund their own businesses. Customer assets must be segregated and protected even if the platform or company goes bankrupt.
Six recommendations for fiduciaries and institutional investors:
- Fashion and/or speculation is not a solid basis for an investment case. Proper analysis of value, merit, and risk remains necessary for fiduciaries to fulfill their duties of prudence, loyalty, and care.
- Continue to apply the basic principles of portfolio construction. In line with the lessons of the CFA Program®, it is recommended that investors continue to adopt a holistic and strategic portfolio building vision in their investments by balancing short-, medium- and long-term objectives.
- Careful analysis of the value and benefits of the portfolio is necessary. It is recommended that fiduciaries provide an informed analysis of the intrinsic value, volatility, correlation effects, momentum or technical characteristics of their proposed investment within the overall portfolio context, either directly in tokens or indirectly through a company’s equity, before asserting that such investment satisfies their usual standard of supervision.
- Intrinsic value must be related to a complete understanding of the use cases. It is recommended that fiduciaries interested in the fundamental value of crypto-assets conduct an in-depth and rational analysis of the use cases of the tokens, the project or the company.
- A careful analysis of the sustainability of the business model and customer acquisition strategy is necessary. It is recommended that fiduciaries pay particular attention to the potentially circular nature of the crypto-asset project being analyzed, focusing on the intrinsic and distinctive qualities of the project, along with its customer acquisition model.
- Fiduciaries must determine the chain of custody and security of clients’ assets. Therefore, they must demand the same standard of quality or care that they apply to all other assets, or hire a third party who can provide this standard of quality.
Stephen Deane, CFA, Senior Director of Capital Markets Policy at CFA Institute: “Proponents of cryptocurrencies often predict the promising future that awaits crypto assets and their disruptive technology. While investors do focus on the future, they should proceed carefully. There is no substitute for due diligence and prudent analysis if investment is to be distinguished from mere speculation. To end speculation, investors must think about what is real, what is potential, and what is merely aspirational. They must also distinguish between the underlying distributed ledger technology, which could well prove disruptive, and the business prospects for the thousands of individual crypto assets on the market today and more to come. At CFA Institute we firmly believe that there should be no shortcuts to professional and well-made investments.”