Rob Behnke
April 26th, 2023
Digital assets, including cryptocurrencies and other blockchain-based assets, are rapidly gaining acceptance as a legitimate asset class among institutional investors. As more financial institutions look to incorporate digital assets into their portfolios, they are faced with the challenge of managing these assets in a way that meets their unique requirements for risk management, compliance, and operational efficiency.
This challenge has given rise to the need for institutional-grade digital asset management solutions that can provide the necessary infrastructure and tools for managing digital assets at scale. However, institutionalizing digital asset management is not without its challenges. From regulatory compliance to security risks, there are a variety of considerations that financial institutions must take into account when developing their digital asset management strategies.
In this blog post, we’ll explore some of the key considerations and challenges that financial institutions must consider when institutionalizing their digital asset management operations. We will also provide insights into best practices and emerging trends in digital asset management that can help institutions stay ahead of the curve and capitalize on the opportunities presented by this exciting asset class.
One of the key considerations for financial institutions when institutionalizing their digital asset management operations is regulatory compliance. Given the relative novelty of digital assets as an asset class, there is still a great deal of uncertainty and ambiguity surrounding regulatory frameworks in many jurisdictions. This can make it difficult for institutions to navigate the regulatory landscape and ensure compliance with applicable laws and regulations. As such, financial institutions must work closely with regulators and industry groups to stay up-to-date on emerging regulatory trends and requirements.
One important regulatory trend is the increasing focus on anti-money laundering (AML) and know-your-customer (KYC) requirements for digital asset transactions. Regulators around the world are increasingly imposing AML and KYC requirements on digital asset service providers, such as exchanges, custodians, and wallet providers. These requirements may include collecting and verifying customer identification information, monitoring transactions for suspicious activity, and reporting suspicious activity to regulators.
For example, in the United States, the Financial Crimes Enforcement Network (FinCEN) has issued guidance requiring virtual currency exchanges to register as money services businesses (MSBs) and comply with AML and KYC regulations. Similarly, the European Union's Fifth Anti-Money Laundering Directive (5AMLD) requires virtual asset service providers (VASPs) to register with national authorities and comply with AML and KYC requirements.
Financial institutions must therefore ensure that their digital asset management operations comply with these and other regulatory requirements to avoid regulatory sanctions, reputational damage, and legal liability. This may involve implementing robust AML and KYC procedures, investing in compliance infrastructure, and staying up-to-date on evolving regulatory trends and requirements.
Another important consideration is security. Digital assets are inherently digital and thus vulnerable to cyber-attacks, hacks, and other forms of digital theft. Given the often high-value and low-liquidity nature of digital assets, financial institutions may be attractive targets for cybercriminals.
As such, it is critical for institutions to implement robust security protocols and practices to safeguard their digital asset holdings, including:
Multi-factor authentication (MFA) is a security measure that requires users to provide two or more forms of authentication to access their digital asset holdings. This may include something the user knows, such as a password or PIN, something the user has, such as a mobile device or security token, or something the user is, such as a biometric identifier like a fingerprint or facial recognition. By requiring multiple forms of authentication, MFA can help prevent unauthorized access to digital asset holdings in the event that one factor is compromised.
Cold storage solutions are a type of storage solution that stores digital assets offline, away from the internet and other potential security threats. This may include using hardware wallets, paper wallets, or other physical storage solutions. By storing digital assets offline, cold storage solutions can help protect them from hacking, malware, and other online security threats.
Regular security audits and assessments involve conducting regular reviews of an organization's digital asset management operations to identify vulnerabilities, potential threats, and areas for improvement. This means conducting vulnerability assessments, penetration testing, and other security audits to identify potential weaknesses in an organization's security infrastructure. By conducting regular security audits and assessments, organizations can proactively identify and address potential security issues before they can be exploited by cyber criminals.
Financial institutions can implement access controls to restrict access to their digital asset holdings to authorized personnel only. This may require using role-based access controls, such as granting different levels of access to different personnel based on their job responsibilities.
Financial institutions can use encryption to protect their digital asset holdings from unauthorized access or theft. This may involve encrypting data at rest and in transit, as well as using encryption to secure private keys and other sensitive information.
Financial institutions can implement redundant systems and processes to ensure that their digital asset holdings are protected in the event of a security breach or other disaster. This may include implementing redundant storage solutions, such as distributed or mirrored storage, as well as redundant authentication and verification processes.
Financial institutions can develop incident response plans to ensure that they are prepared to respond to security incidents or breaches. This means establishing protocols for detecting and responding to security incidents, as well as developing processes for notifying customers, regulators, and other stakeholders in the event of a breach.
Financial institutions can train their employees on digital asset security best practices, such as how to recognize and respond to phishing attacks, how to secure their devices and accounts, and how to handle sensitive information.
By implementing these and other security measures, financial institutions can help protect their digital asset holdings from unauthorized access, theft, and other security threats.
Operational efficiency is another important consideration for financial institutions when institutionalizing their digital asset management operations. Digital assets can be highly complex and require specialized knowledge and expertise to manage effectively. Financial institutions may need to invest in new technology and infrastructure, as well as hire or train personnel with the necessary skills and knowledge.
By investing in automation tools and integrating their digital asset management operations with other financial systems, institutions can streamline their operations and reduce the risk of errors. As the volume of digital asset holdings increases, institutions must be able to scale their operations accordingly and adapt to changing market conditions.
Additionally, institutions must consider the impact of digital assets on their existing operations, such as trade settlement, clearing, and custody, and integrate their digital asset management operations accordingly.
By focusing on operational efficiency, financial institutions can improve their ability to manage their digital asset holdings effectively, reduce costs, and capitalize on the opportunities presented by the digital asset market.
In addition to these key considerations, there are a number of emerging trends and best practices in digital asset management that financial institutions can leverage to stay ahead of the curve.
One of the most important trends is the use of blockchain technology to provide secure, transparent, and efficient digital asset management solutions. Blockchain-based digital asset management platforms (eg. Coinbase Custody, BitGo and Ledger Vault) can provide a range of benefits, including enhanced security, increased transparency, and improved operational efficiency.
Another important trend is the rise of decentralized finance (DeFi). DeFi is a rapidly growing trend in the financial industry, which refers to the use of blockchain technology and smart contracts to create financial applications that operate without the need for traditional financial intermediaries. DeFi has the potential to revolutionize the financial industry by providing decentralized and transparent access to financial services such as lending, borrowing, trading, and investing.
As DeFi continues to gain popularity, financial institutions need to pay attention to this trend and explore ways to implement DeFi solutions in their operations. By leveraging the benefits of DeFi, financial institutions can reduce costs, increase efficiency, and offer innovative new products and services to their clients. Additionally, by integrating with the DeFi ecosystem, financial institutions can also increase their reach and access new markets and customer segments.
However, as with any emerging technology, financial institutions need to carefully evaluate the risks and challenges associated with DeFi and ensure they have appropriate risk management and regulatory compliance frameworks in place.
Finally, there’s the emergence of new digital asset classes, such as non-fungible tokens (NFTs). Financial institutions can leverage the NFT trend by providing a range of services to their clients, including investment opportunities, custody services, trading and brokerage, financing options, and advisory services. By doing so, financial institutions can capitalize on the growing demand for NFTs while also providing clients with trusted and regulated access to this emerging asset class.
Financial institutions that can stay ahead of these trends and leverage them to their advantage will be well-positioned to capitalize on the opportunities presented by the digital asset ecosystem.
In conclusion, institutionalizing digital asset management presents a range of key considerations and challenges for financial institutions. However, with careful planning, a commitment to regulatory compliance and security, and an eye towards emerging trends and best practices, financial institutions can successfully navigate the digital asset landscape and capitalize on the opportunities presented by this exciting asset class.
If you’re a financial institution looking for help managing and securing your digital assets, get in touch with Halborn today.