• March
  • 2022

Digital Assets: Should Wealth Managers Go Decentralized?

In March, Mike Winkelmann – the digital artist known as Beeple – took the art world by storm selling an NFT of his work at Christie’s for $69 million. According to the auction house, this sale positioned him among the most valuable living artists. Since this first-of-its-kind transaction, the interest in NFTs (non-fungible-tokens) specifically and digital assets in general has risen dramatically. The wealth management community has received the news with a degree of skepticism – there is a consensus that all things involving blockchain technology are too risky to consider. However, the accelerated digitalization of the economy, the continuous development of distributed ledger technology and the growing ecosystem of players in digital custody, exchange, venture capital signal that the digital assets are here to stay. In today’s blog, we discuss digital assets and their underlying value, the potential impact of the expansion of metaverse on this asset class as well as look into one of the main challenges when it comes to this type of assets – managing uncertainty.

Digital assets are hardly a new concept. With the rise of digital realms, such as the internet and online gaming, their attributes have been acquiring value to those who use them. To date, Capgemini’s report defines five digital asset types: the first includes website domain names, apps and virtual assets in virtual worlds, the second includes private equity investments in digital assets and blockchain startups, the third refers to the direct investment in cryptocurrencies, the fourth includes indirect exposure through cryptocurrency exchange traded products, and the fifth are the non-fungible and security tokens. The core difference in categorization stems from the way the ownership of such assets is recorded and secured.

It might seem like digital assets bear no economic substance due to their intangible nature. However, in the context of a particular digital realm the value of an asset can become even more important than its manifestation in the real world. For example, online businesses do most of their branding and marketing activities online, spending considerable capital on social media advertising, graphic design and website development. Most of the assets that generate value for this business are digital in their form and they create value by, for instance, getting more customers to spend their time and money on buying  real-life or digital products of the online store.

In a similar fashion, in the digital realm, the NFT art can have investment and aesthetic value just like physical art but with (arguably) less contested provenance. The in-app purchases bring the user entertainment or informational value that they are ready to pay for. Cryptocurrencies are valuable because they can facilitate the exchange of funds in a decentralized manner within a trusted network. In essence, the value of a digital asset could be potentially expressed just like the value of a physical asset tying it to the cost of acquisition, market value or the sum of the future discounted cash flows that it is expected to generate.

The most controversial aspect of the investments in digital assets concerns the shift in the way the ownership of these assets is recorded. Keeping track of the ownership has traditionally been done in a centralized manner – the society would elect or recognize a central governing body, and this institution, usually commanding some degree of trust, would record and protect the ownership of an asset, sometimes charging fees for the service. 

Another, more recent form of recording the ownership is decentralized, which implies that there is no centralized authority needed to keep the records. Arguably the first but surely the most well-known example of this is blockchain (especially the one underpinning Bitcoin), a distributed database that is shared among the nodes of a computer network. Unlike traditional databases, a blockchain structures data in blocks that are connected to each other. This structure is intended to create an irreversible timeline of data. One of the important features of blockchains is that they are immutable, which means that the input data is permanently recorded and viewable to anyone within the network. Currently, blockchain is commonly applied as a transaction ledger for cryptocurrencies, but it is possible to use this technology for other types of data. For instance, in the case of non-fungible tokens, the digital asset can be bought or sold with a traceable and transparent ownership record that does not require a central authority to verify.

How does the future look for the digital assets and how does the decentralized ledger technology impact it? In October 2021, the CEO of Meta Mark Zuckerberg announced that the social media giant would focus on building the metaverse - a space where digital representations of people – avatars – interact at work and play, meeting in their office, going to concerts and even trying on clothes. Essentially, the world is about to create another digital realm with its own features, unique attributes and, possibly, businesses. As the metaverse expands, its attributes are likely to increase in value and so is the interest in them.

The form of recording ownership plays an important role in how digital assets are exchanged, and it remains to be seen whether society chooses a decentralized or centralized way of doing so. Along with numerous advantages such as the cost and speed of record-keeping, the absence of the third party, the relative transparency and potential increased liquidity associated with digital assets, there are a few concerns that keep this technology from the attention of the traditional wealth management industry.  

The first concern is security. Though blockchain technology is public and creates permanent, open-access records, it is not immune to cyberattacks and fraud. For example, a cyber-attack may result in a blockchain provider being compromised or the keys to crypto wallets being stolen. The breached blockchain-based platform Poly Network lost more than $600 million in cryptocurrencies in August 2021, marking the biggest theft in history of the sector. Therefore, cybersecurity remains a solid issue that blockchain platforms need to address in the future. Moreover, in part due to the anonymity, decentralized finance remains a popular ground for fraudulent activity. According to Crypto Crime Report 2022 by Chainalyse, in 2021 scamming revenue rose by 82% to $7.8 billion worth of cryptocurrency stolen from victims worldwide. More concerningly, according to the FCA’s Cryptoasset consumer research 2021, as blockchain technology awareness increases (up to 76% of the UK adult population have heard about crypto assets) the understanding substantially declines. Although the FCA has started taking steps to protect the consumers from the fraudulent activity in the decentralized finance sector, it is likely that the threat remains tangible for years to come.

The second concern is uncertainty. The underlying value of digital assets, and cryptocurrencies specifically, is difficult to gauge. To make matters worse, there aren’t any industry benchmarks or regulatory authorities that would survey the market or create independent standards applicable for a particular product. In most cases, wealth managers refuse to consider cryptocurrencies because of the difficulty in estimating the magnitude of this uncertainty. However, with OutRank, our financial simulation engine, evaluating the riskiness of digital assets becomes easier. Our team of quantitative finance professionals has created a risk factor universe that enables you to capture and model the common digital assets. Equipped with our tools, you can walk your customers through how investing in decentralized products can potentially impact their personal finances, visualize the risk they might be facing and compare it to other investment opportunities. That way, you can transform your meetings into more pedagogical experiences, fostering trust and confidence for your customers and helping them make an educated decision.

The Capgemini report exploring core wealth management trends of 2022 lists digital assets as an emerging asset class that merits consideration. Indeed, in the context of expanding digital universes, it is likely that this asset class would continue to grow in value and in importance. However, at this point it is even more critical to educate both clients and financial advisors about the risks and opportunities that this type of investment is exposed to. In this context, wealth managers should be able to help their customers choose the preferred form of recording and keeping track of their ownership of a digital asset – centralized or decentralized. Tools like OutRank can help them visualize the consequences of these investment choices, the implied risks and the alternatives. Although the consensus in the industry still stands – experts recommend investing only a minor share of the customers net worth in this type of assets – financial advisors can stand out by being able to have informed conversations with their customers, backed by reliable, interactive and visual illustrations of their reasoning.

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