Against a backdrop of volatility and multiple black swan events, industry watchers expect compliance and regulation to play an increasingly central role in digital asset management in 2023. Portfolio managers must ensure they have a toolkit that can support rapid and effective decision-making in a changing environment, while providing appropriate analytics and insights to ensure compliance and due diligence.
With the costs of the collapse of centralized exchanges and DeFi operators mounting, investors are understandably cautious about further risks mounting up. While DeFi startups have also suffered from the contagion, failures of firms such as Celsius, Three Arrows Capital and FTX are widely seen as coming from a more centralized point of failure – namely human shortcomings. A combination of poor corporate governance, lack of transparency, and centralization of capital has allowed bad actors to take big risks with client funds.
Therefore, while DeFi was previously perceived as one of the riskier areas of the digital asset sphere, there is an increasing recognition that blockchain’s strengths can be leveraged to minimize the risk of future incidents and points of failure. Permissioned DeFi combines institutional-grade KYC and compliance with code-enforced transparency. Typically, a DeFi operator collaborates with a trusted entity that vets and whitelists entrants to permissioned liquidity pools.
Venture investors are now doubling down on investments into DeFi offerings that focus on regulation and compliance, while the Monetary Authority of Singapore has been running an experiment exploring DeFi applications in wholesale funding markets, together with DBS and JPMorgan.
Backed by the tailwinds of an emerging political consensus around the need for new legislation, a number of new regulatory frameworks are also set to be enacted — such as the Digital Commodities Consumer Protection Act in the US and the Markets in Crypto Assets Regulation in Europe. Although the creation of these new rules predates the collapse of FTX, several elected officials from the EU and beyond have been vocal about the need to ensure that any regulation is sufficiently robust to prevent history from repeating itself.
Moreover, given the fallout of 2022, investors and institutions are placing increased scrutiny on funds, meaning that compliance is not only a matter of regulation – it is a question of meeting the explicit mandate set by the client. This shift is robustly raising the bar for the implementation of compliance practices across the entire industry.
This constantly evolving environment means that portfolio managers need to rely more than ever on having the right tools and services at their disposal. At the same time, innovation continues apace and we are now seeing for example new indexing tools and an impressive array of Open AI services continue to come on stream, opening up new opportunities for finding alpha.
Building the portfolio toolkit
The insolvencies and deleveraging events of 2022 showed portfolio managers the dangers of becoming overdependent on any one vendor or exchange. Now more than ever, it is important to spread risk and exposure across a diversified range of centralized and decentralized providers.
Given the consolidation in the industry and the links between entities that were previously less than transparent, it is imperative for managers to understand the correlations between investments that were previously thought of as uncorrelated. Portfolio Managers will need the right static, market and on-chain data integrated into an advanced portfolio management and analytics platform that can combine together all the assets of the portfolio irrespective of the number of diverse accounts and wallets on which they are held to be able to provide the portfolio-level analytics of where correlated concentration hotspots are as well as critical exposures.
The PMS should not just give base exposure data or real time portfolio value data but also advanced analytics to highlight risk and uncover investment opportunities such as allowing a PM to manage the portfolio based on sector, network or asset allocation that aligns with the client mandate or fund KID investment profile.
The increasing focus on compliance is contributing to positive developments in digital asset regulatory technology (regtech), helping portfolio managers in their ability to comply with regulatory requirements as well as adhering to client demands to actively manage and manage their optimal risk/reward profile.
Thanks to the public and transparent nature of blockchains, wallet intelligence services can scan on-chain activity and flag suspicious wallets. One such real-world use case is when a fund takes on new assets from a client in the form of digital assets or tokens (not Fiat). Funds need to KYC the client and KYT the tokens. In the United States, OFAC regulation has sanctioned virtual currency mixers such as Tornado Cash (https://home.treasury.gov/news/press-releases/jy0916) so funds need to be able to verify that wallets and tokens are not connected to mixers or tagged with fraudulent activity.
The tools that facilitate compliance will also help to play a role in adherence to the upcoming MiCA regulation, which places an obligation on funds to demonstrate that their advice, including risk assessments, is backed by data, knowledge and experience. For instance, they could help funds gain deeper insights into a client’s historical transactions to create a more individualized risk profile. Furthermore, MiCA also requires that Crypto Asset Service Providers (CASPs) such as exchanges and custodians are registered. In this regard, automated flagging and checking of a CASP’s registration status are likely to become common in future.
Compliance also heavily features in facilitating participation across permissioned DeFi, so there are many reasons why tools and platforms with built-in compliance technology are becoming a must-have for portfolio managers.
A combination of on-chain and market analytics to track digital asset portfolios is required. While the need for market data is well understood, the value of on-chain metrics should not be underestimated. On-chain data provides fundamental insights into areas such as the overall health and performance of a blockchain network as well as trader sentiment and behavior. On-chain metrics are also the most reliable way to gain insights into the DeFi markets.
Leveraging industry advancements
As the cryptocurrency sector matures, new tools and services are emerging that make it easier for portfolio managers to benchmark and track the performance of digital assets, and build trading strategies.
The industry has long suffered from a lack of standardization, making it impossible to benchmark performance. Now, institutional-grade index providers offer a standardized methodology to track single assets or bundles of related digital assets — for instance, those that share a common use case or base layer.
Developments in AI are also unlocking intriguing new possibilities for portfolio managers. Tools like the OpenAI Codex can be used to write computer code in twelve common languages. It is most proficient in Python, which is already frequently used to develop trading algorithms.
Such tools could be harnessed to write strategies faster and code custom queries using natural language prompts. In the longer term, AI tools could also be harnessed to research the tokenomics and fundamentals of specific tokens or to conduct sentiment analysis.
Nuant will soon launch its integrated solution for digital asset portfolio management, offering a real time global view of the portfolio in a unified interface combining the portfolio assets that reside across multiple centralised exchange accounts, on-chain wallets and custodial solutions. Users can drill down into the specific performance of assets, analyze portfolio exposure to counterparties or sectors for risk management, carry out on-the-spot portfolio analytics for decision-support needs, and ensure compliance with KYC and AML rules for new fund assets. Register your interest today via our homepage.