Digital Assets: With Institutional Interest Resilient, Vendors and Infrastructure Providers Prepare for Hybrid Portfolios of Digital and Traditional Assets

By Monica Summerville, Head of Capital Markets, Celent

Institutional investors have been slow to embrace digital assets and, based on events over 2022, a healthy measure of restraint and skepticism has been no bad thing. However, despite headline-grabbing meltdowns across the crypto ecosystem, engagement remains strong across various sectors including venture capital, central banks, blockchain infrastructure, regulators, and institutional investors. Digital asset management platforms and DeFI protocols are still attracting funding, both the US and UK are moving forward with central bank digital currency (CBDC) plans, and Web3 developer activity continues to rise. 

Regulatory activity remains strong. In November last year, the Dubai Finance Services Authority (DFSA) Crypto Token regime came into force; the Hong Kong government indicated it will be opening up the digital asset industry; and the DLT Pilot Regime in Europe, which will allow market participants to operate DLT-based market infrastructure, will be applicable from March 23 this year. And just this month (January 2023) the UK has reaffirmed its aim to be a global digital asset hubs by confirming a tax break for foreign investors purchasing digital assets through investment managers based in the country. 

When it comes to institutional investors specifically, findings of a recent survey of institutional asset managers, asset owners, and hedge funds confirmed a ramping up of the adoption of digital assets in response to investor demand and a maturing infrastructure. Institutions can increasingly choose from both incumbent custody banks and digital native custodians for digital asset services. But investors need greater clarity before they make the technology investments necessary for this fragmented, evolving market to scale. As they incorporate digital assets into their portfolios, institutional investors should consider the state of progress and how to move ahead.

Institutions focusing on tokenization and digital cash

As detailed in the survey-based report Migration to Digital Assets Accelerates, commissioned by BNY Mellon with research developed and executed by Celent, a research and advisory firm focused on technology use across financial service, institutional investors are expecting to increase allocation to digital assets. Report findings are based on a global survey of 271 institutional investors—traditional buy-side entities (asset owners, such as for pension funds, sovereign wealth funds, etc.; institutional asset management firms; and hedge funds, excluding crypto-specific funds or alternative fund managers)

Across all institutions surveyed, respondents would be comfortable allocating “up to 29%” of assets under management (AUM) to digital assets (this could include crypto assets but also tokenized traditional assets, new assets, or digital cash tokens) in the coming 2–5 years, “if the regulatory environment was favorable and the necessary infrastructure in place.” A key takeaway therefore for vendors in the space is that investment management solutions and platforms will need to support hybrid portfolios, consisting of both traditional and digital asset types.

Other key takeaways from the research include:

  • Tokenization: Tokenization—the process by which an issuer creates digital tokens on a distributed ledger or blockchain, which represent either digital or physical assets—promises to revolutionize asset management. Client demand is strong, with 91% of respondents indicating that they’re interested in investing in tokenized products. More than half (53%) of firms said they currently invest in or are exploring tokenized securities. Nearly all (97%) respondents agree that tokenization would “be good for the industry.” Perceived benefits include access to new or non-standard asset classes, such as private equity (PE) funds, real estate, and non-fungible tokens (NFTs); the immutability and transparency of data, which supports the tracking of token ownership; and the increased liquidity of the underlying physical asset. The significant tech investments needed are daunting, though, and inhibiting many (60%) from moving forward. Yet it may be worth the investment, as 79% report that clients expect exposure to tokenized assets. 
  • Digital cash: The survey showed that institutional investors are comfortable with a digital representation of cash using blockchain-based technology—but a key caveat is that digital cash comes from a reliable player. Currently the most common forms of digital cash are settlement coins and stablecoins. Today 88% of the investors surveyed are comfortable using digital cash; those who aren’t are concerned with the interoperability between existing and new infrastructure, along with cybersecurity risks. The vast majority (93%) already see the value of “extending current payment windows to move cash and securities 24/7/365” and 77% are already using or exploring anytime cash movement. 

Improved custody and execution will drive adoption of digital assets 

Today’s digital asset custody and execution market is evolving rapidly, but is currently fragmented. Among survey respondents, “72% would like an integrated provider for all digital asset needs,” 18% prefer to work with a “best of breed provider for each individual need,” and the remaining 10% prefer “an integrated provider with an open platform (to allow best-of-breed integration),” indicating that the convenience of integration is higher than the need for specialization. 

The majority of these investors, comfortable relying on traditional custodians, are looking for integrated ways to accommodate everything from product feature sets, legal and regulatory matters, and consolidated views of both traditional and digital assets. While these are currently pain points, each is also an opportunity for custodians to drive improved investor satisfaction. Investors are currently using a wide variety of digital asset service providers, with many investors using multiple custodians. As institutional investors look for yield, DeFi solutions (decentralized finance, offered through digital native blockchain-based firms) may help, though currently about half of institutions prefer to use a TradFi (traditional finance, run in a centralized manner) custodian.

Integrating the old and the new

The move toward digital assets for institutional investors has now begun. A significant number are investing, moving the industry toward a tipping point and mandating that optimal conditions are met. This is particularly the case for the combination of hybrid portfolios, which combine digital and traditional assets. TradFi entrants, with established traditional rails, are in a good place to support this hybrid approach. Their robust (often mandated) capital-, cyber-, and regulatory-compliance processes can help TradFi build market share, particularly as the regulatory picture comes in to clearer focus. TradFi custody banks may use their position to gain traction with digital asset services. 

Concurrently, many firms are already engaged with a wide range of digital assets, especially tokenization, staking (a feature of certain blockchain protocols that allows users to earn passive income), and access to DeFi protocols. Engagement may range from building internal expertise in order to launch initiatives in this space, to working through proof of concept (PoC) projects with service providers. 

At the time the Celent survey was run (after the collapse of the Luna crypto network, but shortly before FTX’s bankruptcy), despite the market downturn, most institutional investors (88%) said they anticipate moving ahead with plans around digital assets. To deliver on clients’ preferences, solution and market infrastructure providers should be building in support for traditional and digital assets in their solutions and infrastructure rails; institutional investors meanwhile should be working through the pain points associated with current digital asset custodians and prioritizing the technology budget required for upgraded investment management systems that will help move beyond current inhibitors.