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What financial services boards can do to prepare for digital assets

The financial services sector is facing disruption with cryptocurrencies, digital assets, distributed ledger technology and blockchain.

In brief

  • Consumers and investors are embracing crypto and digital assets.
  • Boards will need to assess how crypto and digital assets impact existing strategies and products and where they present regulatory or strategic risk.
  • Directors should inform themselves and prepare their organizations for continuous change.

Financial services directors recognize the need for positive innovation and developing offerings that satisfy current customer demand. At the same time, they are challenged with keeping up to date on this quickly evolving and emerging technology.

After more than a decade of profound change, the financial services sector finds itself facing still more large-scale disruption in the form of cryptocurrencies, digital assets, distributed ledger technology (DLT) and blockchain. These technologies are changing how we buy and pay for things, what we invest in and the infrastructure of financial markets around the world.

How EY can help

It’s no overstatement to say that a new type of economy is emerging before our eyes, one based on trust and consensus and taking place in the virtual world. But disruption at this scale and pace can make it quite difficult to separate hype from reality.

 

“Digital assets and cryptocurrency: opportunities, challenges and board oversight,” a series of meetings held by the EY Financial Services Center for Board Matters, explored the foundational concepts associated with these technologies and their impacts on the business. The sessions generated lively discussion among participants, which included directors from foreign banking organizations (FBOs), US regional banks, insurance companies and US-registered mutual funds. 

 

The many questions raised by directors — ranging from strategic issues and operational considerations to risk and regulatory matters — demonstrated the broad implications of crypto and digital assets on financial services markets. They also made clear that we are in the early days of a powerful long-term shift, which will present many transformation and innovation opportunities, as well as new competitive threats.

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Chapter 1

Crypto and digital assets: where we are today

Crypto and digital assets are here to stay despite the extreme volatility in their value.

Despite extreme volatility, digital assets, cryptocurrencies and blockchain have quickly become permanent features of the financial services landscape, as confirmed by huge consumer and investor interest, large capital flows and increasing activity by bellwether firms. Consider the scale of activity: 

  • As of November 2021, 16% of Americans said they had invested in, traded or used cryptocurrency.¹
  • 80% of bitcoin holders would choose to store it with their financial institution if offered.²
  • $33 billion of venture capital was invested in cryptocurrencies and blockchain in 2021.³
  • 84% of US and European investors are interested in institutional investment vehicles that include crypto assets, and 69% of US institutional investors would like to adopt digital assets as a part of their investment portfolio.⁴
  • 94% of financial advisors have received questions about crypto, and as of 2021, 15% are allocating to crypto in client accounts, with another 14% saying they would “probably” or “definitely” add crypto allocations in 2022.⁵
  • As of March 2022, about 18,500 cryptocurrencies existed, though only 10,000 were active.⁶,⁷
  • The rate of crypto adoption in its first 10 years is on pace with that of internet adoption — in excess of 100 million users in the first decade,⁸ which projects to 1 billion users by 2027. 

From revolution to evolution: where crypto goes from here

With all the hype, it’s easy to forget that bitcoin, the first cryptocurrency, is 10 years old. The collapse of several high-profile cryptocurrencies in spring 2022 certainly demonstrated the inherent risks, especially for speculators, and there is likely to be further rationalization. Few, if any, market analysts expect thousands of cryptocurrencies to survive, though it’s likely that some score or even hundreds may exist in the future.

The bottom line is that whatever one’s personal feelings about crypto and digital assets, and despite the extreme volatility in their value, they are here to stay. As market forces, they will be on board agendas for a long time to come. The same can be said of the metaverse. What feels revolutionary now — dramatic market activity, huge fluctuations in value and steep adoption curves — will continue to evolve.

A rapidly evolving landscape

Since our meetings in May 2022, cryptocurrencies have lost more than $2 trillion in market capitalization, and numerous regulatory enforcement actions have sparked concerns about sustaining commitment and activity on this topic in the marketplace. Nevertheless, “Crypto Winters” have occurred before, and the market has rebounded. A similar bear market four years ago saw bitcoin’s valuation 83% from its peak to as low as $3,217. By November 2021, it rebounded to nearly $69,000.9

One key difference currently is that both the institutional and retail adoption of cryptocurrency and digital assets has greatly evolved, with expanded use cases supporting money movement, payments, art, gaming, entertainment and more. Approximately 80% of central banks, including the Federal Reserve, are exploring their own digital currencies,10 while US lawmakers recently introduced a bill that would regulate most digital assets as commodities.11 At the same time, many large financial institutions have been building out their digital asset trading and custody capabilities to service clients, bolstering the space’s credibility and pushing it further into the mainstream.12

We are seeing the market downturn leading to the revisiting of operational and technology strategies within the crypto-native firms. With the decline in value, there has been a need to streamline operations, increase efficiency and reduce cost. Certain traditional financial services firms view this “retrenching” as an opportunity to accelerate their own strategies and gain competitive traction in this quickly evolving area.

Foundational concepts for the world of crypto and digital assets

Many buzzwords and a lot of jargon have attended the rise of crypto and digital assets, which make it harder to understand both individual concepts and the confluence of powerful forces that are reshaping financial services:

  • The shift from an internet of content to an internet of value (or Web 3.0, as it’s called) is based on direct, permissionless and peer-to-peer (P2P) connections that eliminate the need for middlemen and enable frictionless payments.
  • Blockchain, a DLT, keeps a record of each transaction occurring across a network. Because blockchains are hard to tamper with, they are ideal for facilitating information exchange and verification between parties that may not trust each other but want some form of point-in-time verification of information.
  • Decentralized finance (DeFi) refers to networks of internet-based applications that make it possible for participants to buy, sell, lend and borrow digital assets without the need for a bank, broker, asset manager or centralized exchange.
  • Digital assets are representations of value that can be stored and transmitted electronically. They include fungible assets (e.g., stablecoins, cryptocurrencies, central bank digital currencies (CBDCs), security tokens) that are identical to each other and, therefore, can be used and transacted interchangeably. Non-fungible tokens (NFTs) are unique and noninterchangeable assets that are stored and transmissible on a blockchain and can represent digitally native items or physical items that exist in the real world, such as art, memorabilia and tickets.
  • Central bank digital currencies are digital representations of fiat currencies. Digital fiat assets are tokenized, legally recognized as cash and are backed 1:1 with fiat currencies. The digital yuan in China, the Bermuda Sand Dollar in the Bahamas and the e-Krona from Sweden are among the most common CBDCs.
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Chapter 2

Major impacts and likely near-term use cases

Banks, wealth and asset managers, and insurers will each face risks and opportunities.

Boards and management teams at traditional financial services firms are conducting due diligence and having initial conversations. According to our in-session polling, the vast majority of boards are in the discovery phase, though a few directors said their boards are knowledgeable on these topics. Participants were forthcoming about where they are on the learning curve.

What directors say:

“I’m trying to figure out where and how the environment of the digital world and a reality-based regulatory world intersect. It’s hard to fathom how billions can get into these volatile, undefined currencies with so few regulations.”

“From a governance perspective, it’s very difficult to understand the risks of crypto and oversee it.”

“There’s a disconnect between the level of capital in these vehicles and the amount of volatility, which we wouldn’t accept for any other type of asset.”

A top priority for boards will be assessing how crypto and digital assets impact existing strategies and products and where they present regulatory or strategic risk. To be clear: no crypto or blockchain “killer app” has yet emerged for financial services incumbents. Given the breadth and depth of potential impacts, directors must consider a wide range of options. At most firms, strategic discussions are in their earliest stages. The full agendas of boards and senior management, as well as the backdrop of uncertainty, help explain why.

Varying impacts across sectors

All financial services firms are watching developments carefully, but banks, wealth and asset managers, and insurers will each face a unique set of risks and opportunities.

Banks

The opportunities to gain and provide exposure to crypto and digital assets can be viewed in terms of traditional vehicles and new, digitally native strategies. For instance, custody and administration for crypto assets, stablecoins, digital securities and NFTs are a natural fit for banks, given customers’ interest in placing these assets with banks.

Payments, including both trade finance and liquidity management, are another area where banks might make initial forays into crypto. Financing and collateral and investment banking will increasingly involve digital assets. Some banks may also look to create spot exchanges, over-the-counter desks and derivatives markets as part of their crypto strategies.

▉ Board discussions of digital assets and related investment strategies to date:
  • We have had discussions from an educational standpoint only: 43%
  • No discussions to date: 25%
  • We are evaluating how to incorporate into our strategy in the next year: 18%
  • We are building our strategy: 11%
  • We are well on our way in executing our strategy: 3%

Source: In-session polling

New capabilities and services — including yield farming and validator operations — may offer compelling returns for first movers and early adopters. Yield farming involves staking cryptocurrency to earn interest. Incumbent banks also seem well suited to serve as trusted transaction validators on complex ledgers and blockchains. Though digital natives have taken the early lead, there’s little doubt some traditional banks will seek to expand and innovate in these areas in the future.

Wealth and asset managers

The fund directors who participated in our sessions feel intensifying pressure to provide access to new asset classes and support transactions in digital currencies. But the lack of regulatory clarity means that wealth managers might take the lead. Certainly, those firms that already have crypto investments — typically through spot crypto, closed or private funds and trusts, derivatives and crypto-focused funds, and exchange-traded funds – expect to increase their allocations in the next year.

Buy-side firms are very much on the front lines. In a recent series of interviews, EY-Parthenon found that such firms already allocating to crypto expect to both increase allocation in 2022 and diversify beyond bitcoin and ether (Ethereum), the most popular coins. They are also planning to adopt more complex trading strategies. A survey of fund administrators found that 50% support more than bitcoin and ether and are moving toward DeFi, NFTs and other assets. The trend lines are clear: investors want to diversify their coin holdings and adopt more sophisticated trading strategies (e.g., staking, lending).

▉ Limits on your organization’s ability to execute a digital asset strategy:
  • Market uncertainty: 45%
  • Competing demands/other initiatives: 40%
  • Regulatory uncertainty: 35%
  • Not enough visibility to comment now: 20%
  • Too nascent: 10%
  • Shortage of skill set: 5%
  • Technology: 5%
  • Data limitations: 0%
  Source: In-session polling
  Note: Directors selected multiple options

Beyond giving customers what they want, asset managers will use crypto to hedge against inflation, diversify portfolios and generate yields, with more active asset managers looking to generate beta. As regulatory clarity and mainstream acceptance increase, asset managers are likely to pursue multiple options, including asset tokenization, staking funds, investing in NFTs, and creating separately managed accounts and simple DeFi strategies. Though consumers and investors have led the way on crypto, institutional firms are following closely behind.

Insurers

Insurers are feeling less pressure from customers compared to banks and wealth managers, both of which face competitive imperatives to offer access to these new asset classes, especially with wealthier customers. But the use of crypto in insurance is inevitable — and coming soon.

A few carriers have begun accepting premium payments in crypto, but few are offering coverage for digital currency keys, NFTs or other digital assets. Directors and senior insurance leaders are intrigued by the significant opportunities to offer new protections such as these, including in the metaverse (see sidebar), based on the idea that wherever there are assets, there should be insurance to protect them.

Blockchain’s implications for infrastructure

Directors are keenly interested in using blockchain and DLT to streamline back-office processes. But many expressed surprise that it had not yet been adopted at scale. The delays in large-scale deployments can be greatly attributed to the need for higher-volume computing and processing capabilities.

The goal is to create more secure, transparent, efficient and scalable “plumbing” for all kinds of market infrastructure, including exchanges and trading platforms, and for all types of transactions. But that potential value may present risk to traditional banks, as several directors pointed out. For instance, because DLT and digital currencies (including CBDCs) remove the need for “middlemen” between counterparties, banks could be disintermediated.

Treasury, cash management and transaction settlement are among the processes where blockchain, DLT and smart contracts can increase speed, reduce friction and lower costs. But it’s not just a matter of increasing efficiency — the innovation potential is also compelling. Consider how smart contracts informed by real-time risk visibility could enable flexible premiums in insurance. As with so much else in the world of crypto and digital assets, the risks and opportunities are intricately linked.

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Chapter 3

The regulatory outlook

Financial directors have concerns over the lack of regulatory clarity today.

The lack of regulatory clarity today is a concern to all financial services directors, especially given the growing pressure to take action. Clear guidance is not necessarily imminent, largely because regulators face the same steep learning curve as industry executives. The Biden administration’s Executive Order (9 March 2022) is a step in the right direction, especially in seeking to bring together multiple agencies into a single, unified perspective on systemic risk.

The core question of whether regulators think tokens should be subject to the same oversight as securities has yet to be answered. Similarly, the Executive Order promotes “responsible innovation” as an objective without defining what it means in practice. As the issues evolve, consultation periods are likely to be elongated and material uncertainty will remain.

In the meantime, boards and management will continue to feel the tension between rising consumer demand and the lack of requirements defining necessary controls. Directors are also keeping a close eye on increasing state-level regulatory activity. Several states seem to be positioning themselves as crypto-friendly havens, which may further cloud the risk and regulatory outlook.

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Chapter 4

Focusing on the right risks

In addition to regulatory uncertainty, directors know there are many other risks.

Directors see plenty of risk beyond regulatory uncertainty, and certainly, the development of a robust risk management framework will be a top priority. Anti-money laundering, know-your-customer and cybercrime were among directors’ top concerns. Strategic risks are similarly complex, incorporating the potential loss of market share, significant outflow of assets and the threat of disintermediation.

Here again, the risk profile varies by type of firm. Fund companies and asset managers will be focused on volatility and liquidity risk as they design and structure portfolios. They will also watch the evolution of traditional brokerage offerings, as well as custody and reporting requirements for the world of crypto. Rising demand from investors for more crypto offerings must also be viewed within the overall risk framework; however, the specific risks will vary based on individual fund strategies (e.g., high-frequency trading vs. holding assets for the long term).

As large investors, insurers face many of the same risks as asset managers. But insurers should also be aware of the strategic risks of delaying entry into these markets. After all, crypto platforms and NFT providers may soon offer their own protections against theft and loss of assets.

▉ Directors’ views on the biggest risks digital assets pose for their organizations:
  • Financial crimes/sanctions risk: 28%
  • Regulatory risk: 28%
  • Strategic risk: 22%
  • Reputational risk: 12%
  • Third-party risk: 10%
  • Keeping pace with customer demands: 0%
Source: In-session polling
Note: Directors selected two risks 

Banks are eyeing competitive risks, especially as crypto natives and FinTechs obtain banking licenses and customers flock to new channels offering tailored solutions and seamless experiences. They are also closely monitoring developments on the CBDC front — as well they should, since 105 countries, representing more than 95% of global GDP, are considering issuing digital currencies, according to the Atlantic Council.¹³

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Chapter 5

Moving forward: the need to “think differently”

Directors must examine the upside of their firms’ strategies while monitoring the underlying risks.

From a business perspective, it’s a matter of when not if crypto and digital assets become a bigger part of the business for banks, insurers, asset managers and funds. Directors recognize the need for positive innovation and market growth, as well as offerings that satisfy current customer demand for more exposure to crypto and digital assets. At the same time, boards will oversee the design and implementation of the necessary governance models and risk management frameworks. In other words, they must examine the upside of their firms’ strategies, even as they closely monitor the underlying and fluctuating risks.

In the meantime, directors want more information and broader perspectives on the fundamentals of digital assets. One director stressed the need to view the strategic opportunities not through a traditional lens but with “fresh eyes.” Another participant commented how crypto and digital assets are similar to environmental, social and governance (ESG) matters, as adoption has occurred rapidly despite a lack of regulatory standards or a clear definition of what success looks like for the business.

▉ Next steps for directors:
  • Build a foundational understanding. Commit to research and learning both now and for the long term — rapid developments put a premium on ongoing education. 
  • Learn through experience. Consider opening a digital wallet, buying NFTs and spending time and transacting in the metaverse — first-hand experience can provide valuable lessons.
  • “Think different.” Bring a new mental model and thought paradigm to this fundamentally different space — a traditional or incumbent lens may unnecessarily delay market entry or innovation.
  • Engage management. Raise key questions regarding strategies, risk appetite and internal controls, emphasizing both upside and downside risks — and shifting customer needs and preferences. For all the uncertainty and volatility, market demand can’t be overlooked.ed two risks 

Summary

You don’t have to buy all the hype relative to cryptocurrencies to recognize the profound long-term impact and transformative potential that crypto and digital assets offer financial services firms. For directors, it may be helpful to look beyond or even ignore short-term volatility in shaping strategies and building risk frameworks. Based on our sessions, it’s clear that directors are motivated and actively preparing themselves and their organizations for the long journey ahead.

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