Corner Office Views | Q4 2022
Managers are looking to blockchain to digitize transactions and ease cumbersome processes associated with alternative investments
- Firms are exploring the use of blockchain mechanisms for middle- and back-office functions.
- A flourishing venture capital ecosystem seeking to invest billions has also emerged around the technology.
Matt Apkarian, CFA
Matt is a member of Cerulli’s Product Development practice, which focuses on trends related to asset managers’ product development and management functions. This broadly includes assessing the opportunity for product development, evaluating emerging product trends, and understanding distribution and product positioning for investment products across retirement, retail, and institutional channels.
Prior to joining Cerulli, Matt held roles in
several business units at Fidelity Investments, including Workplace Investing,
Personal Investing, and Fund Operations. Most recently, he worked as an
Investment Data Analyst for Strategic Advisers, LLC.
Full biography here.
Rise of digital asset investing
The rise of digital asset investing has brought significant attention to the world of digital assets, mainly due to the massive price appreciation that has occurred for many digital asset tokens over the last decade. Importantly, Cerulli notes that many digital asset tokens are not simply cryptocurrencies, or tokens meant as a store of value and unit of exchange, but that the digital asset ecosystem includes many other applications of blockchain technology. The Digital Asset Classification Standard was launched by CoinDesk Indices in 2021. The system categorizes the digital asset ecosystem into six sectors, 23 industry groups, and 36 industries. The framework allows a better understanding of the types of technological developments and investment opportunities that lie within the digital asset realm. While the majority of digital asset market cap exists within digital currencies and smart contract platforms, other sectors are emerging as innovative ideas and projects come to market.
Though cryptocurrencies have been able to provide impressive returns for investors over the past decade, the use of blockchain for investment purposes is not the only thing that traditional and alternative asset managers are looking into. Firms are exploring the use of blockchain mechanisms for middle- and back-office functions. While there is potential for blockchain technology to be used for the entirety of securities trading and other operations in traditional finance, an early use case is appearing and gaining traction for illiquid alternatives. Many elements of the illiquid alternatives investment process create pain points for investors, advisors, and funds, such as the subscription process, valuation reporting, and the lack of secondary market trading of these investments.
Smart-contract digitization of transactions
The benefit of blockchain technology to enable smart-contract digitization of transactions has the potential to bring efficiencies to highly cumbersome processes associated with illiquid alternative investments. Providers of blockchain technology for these purposes and early adopters of the technology believe that the industry will need to move in the direction of broader use, to enable further efficiencies among funds and intermediaries. One provider, RealBlocks, is aware that firms may not be able to entirely transition their processes in one swift movement, so they have enabled their technology to integrate with both on-chain and off-chain tasks as needed, referring to their offering as an open-architecture solution. iCapital announced in early 2022 that it is leading a consortium of asset managers, wealth managers, and service providers that seek to use blockchain technology as a solution for alternative investments. This move by a key player in the alternative investment ecosystem gives hope to the success and adoption of the technology, though it still received considerable scrutiny by industry thought leaders.
In addition to efficiencies in the operational processes for these investment types, blockchain also can facilitate secondary market trading of illiquid alternatives through tokenization. A process which would typically involve several intermediaries including lawyers and approvals from fund managers can be overhauled and made nearly seamless through the execution of a smart contract to obtain necessary approvals and execution of the transaction on the distributed ledger. This undertaking can bring a form of liquidity to an otherwise illiquid market and would have benefits for fund managers and investors alike. Overall, the introduction of blockchain technology into the alternative investment ecosystem seeks to democratize access to alternative investments, making it more easily accessible for participants in alternative investment markets.
Most digital asset investing occurs through direct token ownership, in BTC and ETH, the native tokens of Bitcoin and Ethereum, in addition to trust-based vehicles and ETFs, which are now available for future-based exposure to certain cryptocurrencies. Only 22% of advisors report that they use cryptocurrency in client portfolios or at least discuss cryptocurrency exposures based on client request. A majority (64%) of advisors who account for or use cryptocurrency for their clients report using the trust-based products or ETFs as of 2022.
Investment opportunities are increasingly available in the form of private investments such as hedge funds and venture capital funds. Most of the top-10 venture capital (VC) funds are vintages that began fundraising in 2021 or are still open in 2022. According to Pitchbook, VC deal activity spiked in 2021, with 1,206 deals totaling $23.8 billion in funding. This rose from a prior high in 2018, when there were 403 deals for a total funding level less than $5 billion. The rise in deal values can be partly attributed to a shift in deal stage, where a higher proportion of late-stage deals are occurring relative to early-stage deals in prior years.
Cryptocurrency hedge funds use a variety of strategies to provide exposure to and generate investment returns from mostly liquid cryptocurrencies. From long-only to market-neutral quantitative strategies, several of the largest cryptocurrency hedge funds came to market in 2021 from firms such as One River Asset Management and Skybridge Capital. Outside of making directional bets on cryptocurrencies using market events, technical factors, and assumptions on future cryptocurrency demand, firms can generate returns through methods such as yield farming, in which a holder of cryptocurrency can stake their cryptocurrency to generate returns. Staking involves lending cryptocurrency to a decentralized application such as a decentralized exchange, earning interest on their loans as a reward for providing liquidity and network security to proof-of-stake blockchain protocols. Historically, investors in cryptocurrency hedge funds have included high-net-worth individuals and family offices, although other asset managers and funds of funds are becoming more prevalent.
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