How can institutional investors assess and manage the risks associated with digital assets and the new market space, and what role does a depositary play in this ecosystem?

Digital assets, which first emerged more than 11 years ago with the creation of Bitcoin, have historically been the preserve of retail investors. However, interest and investment in digital assets by traditional fund management firms has grown as the industry slowly matures. Earlier this year, Paul Tudor Jones announced he was buying Bitcoin as a hedge against inflation. Elsewhere,  Fidelity launched its Fidelity Bitcoin fund in August while MicroStrategy recently purchased more than 21,000 Bitcoins. The estimated total market capitalisation for digital assets, principally cryptocurrencies, is in excess of $350 billion, of which an estimated $6 billion is managed by digital asset focused funds. The market continues to see growth month over month.

Unlike traditional asset classes, the often-opaque nature of the digital asset market presents many unique challenges. More than 350 digital asset exchanges currently operate in a globally fragmented market with varying degrees of security, operational integrity and regulatory standards. Headlines about exchanges losing client funds or facing regulatory scrutiny are common. It can be difficult to know what providers in the market are safe and trustworthy.

So how can institutional investors assess and manage these risks? Evaluating the quality and transparency of digital asset exchanges is critical to managing the risks of trading in digital assets. Once invested, institutional investors can also take comfort from the independent oversight role performed by a fund depositary that monitors transactions and verifies ownership of the digital assets.

When evaluating digital asset exchanges, there are several qualitative and quantitative factors institutions need to consider.

Qualitative factors

Due to the global nature of this market and the lack of strong regulatory oversight in many jurisdictions, qualitative factors – like robust KYC/AML policies – need to be examined closely. Such policies are designed to keep bad actors out and provide the basis for effective market surveillance. Unsurprisingly, exchanges with nonexistent or insufficient AML/KYC policies have been found more likely to disseminate what appears to be fake trading volume data.

It is also important to evaluate an exchange’s track record on safeguarding assets. A history of hacks, frequent unplanned downtime or a lack of transparency about operational security are indicative of vulnerabilities.

Firms should also verify that digital exchanges have transparent governance structures, a qualified leadership team, routinely updated business continuity plans, uniformly enforced fee structures, sound banking counterparts and decent insurance policies.

Quantitative Assessments

Manipulation in the digital asset spot market is a practice well known to both market participants and regulators. The US Securities and Exchange Commission has repeatedly said that the lack of a price that is free from manipulation is among one of its top concerns in the market, and a primary reason for its continued refusal to authorise a Bitcoin ETF.

Many exchanges will report large volumes, but a closer look reveals trading patterns and order book data that does not correspond with those volumes. The ability to flag suspicious trading patterns can help address concerns over wash-trading, inflated volumes or manipulated data.

Correlation testing is one example of a quantitative metric that can flag outlier behaviour. The digital asset market, while globally fragmented, is, in large part, an integrated marketplace with consistency of market activity across legitimate exchanges. By comparing the volumes and prices across exchanges of different sizes, jurisdictions and user profiles, it is easy to spot erroneous practices. Having a trusted source of transparent data in the digital asset space is key to spotting red flags.

The role of the depositary

Under the Alternative Investment Fund Managers Directive (AIFMD), EU and some non-EU based asset managers marketing alternative investment funds in Europe are required to appoint a fund depositary. The depositary is responsible for performing independent oversight of the fund, monitoring cash flows daily, verifying the ownership and existence of assets and ensuring the fund is managed in accordance with its prospectus.

To date, only a small number of digital asset funds have been set up which are subject to AIFMD depositary oversight. Due to the complexities of digital assets, few depositaries have invested the time to develop the necessary systems and procedures to take on these mandates. This lack of engagement has held back the development of the digital asset fund sector.

The depositary to a digital asset fund will independently oversee the trading and settlement activity of the fund, monitoring transfers to and from exchanges, movements of assets between exchanges and the fund digital asset custodian, while reconciling assets to the relevant blockchain and overseeing the valuation function of the fund. Asset managers and investors can take significant comfort from this independent oversight, which is performed on an ongoing basis.

The case for independent oversight of exchanges

Digital assets are a novel concept and the absence of effective oversight is a major factor impeding the sector’s growth. By leveraging depositaries – who have a robust track record in safeguarding investor protection under AIFMD and UCITS – the digital asset funds industry could enjoy exponential inflows moving forward.

By Bill Prew, CEO, INDOS Financial and Erin Friez, COO, Digital Asset Research

This article first featured on Global Custodian here: https://www.globalcustodian.com/blog/managing-the-risks-of-trading-in-digital-assets/

On 6^th October 2020, the European Union removed the Cayman Islands from its so-called blacklist of non-cooperative jurisdictions for tax purposes. This is good news for the offshore investment funds industry, but focus will now turn to demonstrating compliance with the various measures introduced by the Cayman Islands to ensure its removal from the list.

Reportedly one of the reasons for being placed on the blacklist in February 2020 was the delay to implementation of the Cayman Private Funds Law (CPFL). The CPFL reflected a clear directive by the EU to place closed ended private funds on a similar regulatory footing as open ended hedge funds which were already subject to the Cayman Mutual Funds Law.

Whilst the CPFL became law in February, existing funds were only required to comply from August.  Some 12,000 + funds registered by this deadline. The CPFL not only requires funds to register with the Cayman regulator, CIMA, but comply with a number of operating requirements, such as cash flow monitoring, record keeping, custody and asset ownership verification, which are heavily based on the depositary role under the EU Alternative Investment Fund Managers Directive (AIFMD).

There is a view that in the rush to meet the deadline to register funds with CIMA, not enough consideration has been given to the compliance with these operational requirements which private funds and their managers will now need to promptly address.

The registration of private funds will also shine a spotlight on those taking responsibility for compliance with the Cayman AML Regulations, with the identity of the AML officers of private funds being reported to CIMA for the first time since the revised AML Regulations came into Law in 2018.

At the same time, the Cayman Islands is under pressure to demonstrate its regulations are being complied with and commentators note that a greater level of enforcement is expected to result. In preparation, CIMA have updated their fines regime with significant fines for non-compliance with the CPFL, AML and other regulations.

We would be pleased to speak with firms that want to ensure that they are fully complying with the Cayman Private Funds Law and AML Regulations.  As a regulated AIFMD depositary, we are ideally placed to enable compliance with the CPFL operational requirements and our market leading CIMA AML officers service can immediately ensure compliance of this function without internal officers taking the personal risk.

By Jon Masters, Head of Business Development, INDOS Financial

INDOS Financial recently concluded a project to enable the Alternative Investment Management Association (AIMA) to become carbon neutral. It has been a pleasure to support AIMA through this process and help them achieve this important goal. As part of INDOS’ own focus on corporate social responsibility, we became a carbon neutral organisation in 2019. We have since assisted clients achieve the same status as part of our broader range of ESG oversight and assurance services for asset managers and their funds.

We would be delighted to assist other firms with their carbon neutral process. To find out how we can help please contact us at [email protected].

On 20^th September 2020, approximately 2,600 documents were made globally public, having been leaked from the Financial Crimes Enforcement Network (FinCEN) to BuzzFeed News and the International Consortium of Investigative Journalists (ICIJ). The FinCEN Files are primarily made up of records of the suspicious activity reports (SARs) submitted by Banks and Financial Institutions (FI) to FinCEN authorities between 2000 and 2017.

It should be noted that the filing of SARs is encouraged by Financial Regulators worldwide and is in line with international anti-money laundering standards in order to raise concerns of money laundering, terrorist and / or proliferation financing. FIs use SARs to report suspicious behaviour, but they are not proof of any wrongdoing or crime by the underlying client, just a suspicion that is more than fanciful. They do however offer the individuals and institutions a degree of protection against money laundering offences in the case of knowing/assisting an offence.

One of the key concerns raised from the leak is the continuation of business with clients for which an FI has submitted a SAR, and the purported lack of action from that FI and the authorities. Headline cases coming from the leak include big name banks that purportedly allowed fraudsters to move millions of dollars of stolen money around the world, even after being informed by  US investigators a  scheme was a scam, and another involving the movement of cash for a bank more than a decade after the client’s accounts had been used in funding terrorism.

In addition to the severity of the issues raised, the amount of money involved with the SARs leaked is staggering, as the estimated total transaction value tops USD2 Trillion. The number of different FIs involved in the leak also demonstrates the global nature of international money laundering through some of the world’s biggest banks.

The FinCEN Files have clearly shown that the system of reporting suspicious activity is well established, and this is certainly a good thing in combating money laundering. However the lack of action and capacity to address the SARs and stem the flow of money laundering has now been exposed and it will be interesting to see whether the FinCEN exposure leads to change.

By Matthew Queree, Head of AML, INDOS Financial 

The process of becoming carbon neutral has been around for over two decades. In recent years, the number of businesses including many in the asset management industry becoming carbon neutral has increased significantly. Obtaining carbon neutral status is an excellent way for asset managers to demonstrate to investors and other important stakeholders such as their employees they take environmental, social and governance (ESG) matters seriously. The carbon neutral process involves collecting data about a company’s carbon emissions which is then sent to an independent auditor to verify as a form of ESG oversight. Carbon credits can then be issued to the company, thereby offsetting the emissions.

Usually, the process for asset managers is straightforward: identify activities creating emissions such as the use of electricity (business premises) or business travel. However, in 2020 and the impact will be different. As a result of the Coronavirus,  many office-based employees are working from home, a  practice which is likely to become more widespread in future. Companies should therefore consider how to reflect this within their carbon footprint analysis.

While working from home as a trend existed before Coronavirus because of factors like access to faster broadband, the pandemic has accelerated this trend exponentially with over 45% of workers now reported to be working at home till at least the end of the year. This has exposed issues with the current system for counting emissions since from the standpoint of the measurement standard used, work from home (WFH)  emissions form part of a company’s “Scope 3” emissions which place them in the same category as the emissions from the products a traditional company sells. Placing WFH emissions within this category makes it optional to report whereas the inclusion of “Scope 1” office emissions are mandatory.

There have been reports that working from home is more beneficial for the environment as commuting travel has decreased. These savings are quite large, as much as 5% of a staff member’s footprint. This is likely a seasonal benefit due to the mild summers where emissions are lower. In the winter behaviour shifts as heating is needed and emissions from natural gas from boilers increases. For a typical flat, the emissions can lead to an additional 0.3-0.8 tonnes of CO2 over a year. For  companies with a lot of staff, this will start to represent a sizable amount of their emissions. Under the current measurement standard companies would under-report emissions as reporting WFH emissions, being a scope 3 emission, is optional and usually excluded.

From a broader asset management perspective, firms often do not fully understand the scale of scope 3 emissions as a whole. Ian Stannard, a Data Strategist at Urgentem commented: “it’s not just the magnitude of the impact that can surprise portfolio managers and asset owners, but also the distribution of the impact across sectors within a portfolio”. What the “new normal” in terms of work from home practices becomes is unknown. However, with work from home expected to increase significantly scope 3 emissions, already the largest category of emissions, is set to grow. Encouraging measurement and full disclosure of these emissions will be beneficial for transparency and enable effective ESG oversight within the asset management industry.