Regulation, blockchain and the crypto-market: a headache brewing for fund managers?

13th July 2018 2540 - Article - Blog Posts

Andrew Frost, Executive Director at Lawson Conner, provides an update on the rise of crypto and reflects on the challenges that blockchain and the new technology may eventually pose to fund managers. 

Cryptocurrency and blockchain-related topics are being much more widely discussed and this trend is converting many from prospective investors into real ones

The last few years have seen a boom in the number of cryptocurrency funds launched with an estimated asset value of $3.5-$5bn across 251 funds. Hedge funds have been quick to capitalise on the rising value in cryptocurrencies with 43 cryptocurrency-focused hedge funds launched in 2017 and eight more this year. However, despite the first quarter of 2018 seeing a drop in value in cryptocurrencies, a strong recovery in April has soothed the path for cryptocurrency-focused hedge funds. According to HFR Blockchain Index, the benchmark used to measure the monthly performance of crypto funds, April saw a 47.1% leap after declining 34% the previous month which has instilled a renewed confidence in the market.

What is driving this renewed confidence? The bottom line: money and market dominance.   Coinbase, one of the largest crypto exchange platforms, reportedly earned more than $1bn last year from trading fees. With blockchain and the fintech industry threatening financial services incumbents’ dominance in all things financial, they can no longer risk falling behind in yet another arena. Only a few months ago these currencies were shunned by institutionalised investors. Jamie Dimon, of JPMorgan, called bitcoin a “fraud” and Lloyd Blankfein of Goldman Sachs claimed that bitcoin was not for him. Yet today both banks are moving towards cryptocurrencies with JPMorgan promoting a fintech expert to a new role exploring cryptocurrency use across the corporate and investment bank, and Goldman Sachs announcing the opening of a cryptocurrency derivatives trading desk as well as hiring a head of digital asset markets to lead the bank’s effort and explore the possibilities of trading actual cryptocurrencies in the future.

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The increased awareness of cryptocurrencies and blockchain technology has also driven institutional investors’ interest in the crypto-market. Cryptocurrency-related topics are being much more widely discussed and this trend is converting many from prospective investors into real ones. As these institutional investors enter the market, bringing with them knowledge and expertise, some of the issues hindering the market’s growth, primarily regulation, will be addressed and further investor confidence will increase.

The thought of further regulation entering the financial services industry is undoubtedly many hedge fund managers’ worst nightmare. The breadth of global regulatory change post the financial crisis of 2008 has been significant and unlike anything the world has ever seen before. The financial services industry has been inundated with new rules and regulations (Mifid, AIFMD, Dodd-Frank, BRRD, Basel II and more) which have consumed resources and increased spending on compliance and regulatory reporting at a time when the industry has also been under increasing competition from fintech firms. While further regulation is needed to address many of the issues presented to the financial services industry vis-à-vis the crypto-market, there is no doubt that hedge funds and other financial institutions will struggle under the extra burden. At a time when they need to focus on what they are good at: trading and raising capital; the regulators are heaping on the pressure in other ways and strengthening their oversight of crypto hedge funds. For these reasons, we are witnessing a rise in the number of financial institutions of all shapes and sizes outsourcing their regulatory, compliance and reporting services.

Getting down to basics, blockchain is simply a type of distributed ledger technology (DLT). DLT is a system of digital data that is duplicated, shared, and synchronised across multiple locations. While a type of DLT, blockchain uses unchangeable, encrypted, packages of data stored in a connected chain as the ledger of data. Here, each new piece of data is verified by all locations and then is added to the existing chain of previous data making it virtually impossible to defraud. This system thusly provides users with a trustworthy source of information.

New institutional-grade trading technology is being developed in this vein for cryptocurrency markets. The Blockchain Terminal (BCT), for instance, creates a complete compliance loop by connecting regulators, hedge funds and their compliance departments through transparent, encrypted trading records with embedded audit functionality. The advanced trading tools and services provided by the terminal allow institutional traders to improve trading and risk management performance. BCT and other such products are designed to converge crypto and traditional currency trading worlds and help hedge funds lower their rising compliance costs. By tightening reporting requirements, regulators have been pushing hedge fund trading activity into the spotlight. Here, however, on a blockchain which is inherently transparent, these often opaque transactions are executed by smart contracts which link each transaction to the one before it, creating an immutable and trackable trading record.

It sounds simple enough. However, setting up and managing an infrastructure of this size to support these kinds of solutions takes time and can prove to be disruptive to begin with. While such technology has an overwhelming potential to revolutionise and improve many of the processes within financial services and the crypto-market, they cannot realistically be adopted in-house overnight. Populating a database is all well and good and certainly a first step, but using the algorithms to extract data, check and update it, analyse and communicate it efficiently requires the all-important expert know-how.  A trusted service provider can not only set up the shared ledger facility but also manage it to ensure that all regions communicate with one and other by sharing the same analysed information ensuring that requirements from regulators around the world, which often differ significantly, are all met.

Outsourcing such services is the smart thing to do. A trusted service provider will give financial institutions the confidence to trade on these new platforms in the knowledge that their compliance and reporting is all in hand. The cryptocurrency market differs greatly from the incumbent markets with ICOs requiring an extremely long list of obligations to be met in a very short time period including global anti-money laundering, know-your-client and onboarding services and expertise; a global scope of a vast amount of data and complex structures to be analysed; AML escalating structures be put in place as well as ongoing monitoring of global regulations; IT expertise for data exchange over multiple offices and jurisdictions; full reporting and audit trail; and a scalability function for potential further capital raisings in the future. With the right service provider in place, fund managers and investors will be able to sleep well at night in the understanding that these extra regulatory burdens are taken care of.

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Lawson Conner’s dedicated practice for alternative investment managers and hedge funds offers knowledge and expertise to help managers focus on what they are good at. The award-winning investment manager platform, and provider of outsourced compliance services solutions, provides a one-stop solution to hedge funds and alternative investment fund managers, including: regulatory infrastructure, managed compliance services, post trade surveillance, delegated risk management, regulatory reporting and compliance software.