16 August 2024
Navigating the Crypto Challenge: Key Issues for Asset Managers in the Insurance Market
The digital assets market has entered a new phase of regulatory legitimacy this year. January witnessed the SECs approval of eleven Bitcoin spot ETFs and similarly, the FCA approved the listing of Bitcoin and Ethereum ETPs in May followed by Hong Kong regulators also warming to the asset class and offering approval for a Bitcoin ETF. Over USD50 billion is currently held in the US Bitcoin ETFs alone (at the time of writing). This is a far cry from the challenging landscape and sentiment witnessed in 2022, notable for a sharp fall in digital asset values, the collapse of FTX and a number of other high-profile digital asset-related corporate failures.
Aside from the ETFs and ETPs, global digital asset hedge fund assets under management (AUM) have also grown to more than USD15 billion. Yet, crypto still has a long way to go before it’s accepted as an established asset class challenging traditional investments, certainly in the eyes of the insurance market.
Regulatory clarity for digital assets, whilst quickly developing around the world, is still a work in progress and there is, currently, a lack of investor protection. While not a direct investment management issue, these factors, combined with the perceived high rates of fraud in the digital assets space, as well as its status as one of the ransomware payment methods of choice (along with the US dollar) have resulted in an apprehensive insurance market. However, the market is now starting to positively respond to the insurance requirements and recommendations of regulators.
For these reasons and others, asset managers who wish to take advantage of the insurance market’s developing appetite for professionally managed digital assets investment vehicles will still face challenges when renewing their financial risks insurance coverages if the process is not managed carefully.
Aside from the ETFs and ETPs, global digital asset hedge fund assets under management (AUM) have also grown to more than USD15 billion
“We are seeing increased interest from more insurers willing to consider offering coverage to digital assets related clients, encouragingly, also from certain insurers which had previously refrained from entertaining this space in the past. The tide is certainly changing in terms of appetite; however, it is incredibly important that the interaction with insurers is done so impeccably to achieve the very best results”
Alan Chapman Head of Digital Assets, Gallagher Specialty
Rising interest
The positive investor response to the new Bitcoin ETFs in the US has unequivocally demonstrated that, despite past concerns with the asset class, mainstream investors are keen on digital assets.
Following a debut at the beginning of the year, by August 2024, the Blackrock iShares Bitcoin Trust had grown to become the world’s largest digital assets fund, with a market value of USD21.1 billion. It had taken circa six months to achieve such status.
According to research conducted by Nickel Digital Asset Management, hedge funds in both the US and the UK have expressed significant interest in exchange-traded products which offer access and exposure to digital assets investments within an established regulatory framework and allow institutional investors the comfort of avoiding the complexities and risks associated with self-custody.
Also, investment giant Morgan Stanley has stated that it will soon permit its c. 15,000 financial advisors to actively promote Bitcoin ETFs to eligible clients, marking the first time a major Wall Street bank has taken such a step.
With Bitcoin becoming a US presidential campaign discussion point following former president Donald Trump’s speech at the recent Bitcoin conference in Nashville with a commitment to form a ‘US Strategic Bitcoin Reserve’ if elected - the popularity of digital assets is expected to increase, perhaps even quicker than first expected which should accelerate the insurance industry’s offering evolution.
Custody and cold storage
In traditional asset management, a third-party custodian protects and services the asset holder’s securities. Spurred by the failure of FTX and other high-profile collapses, fraud concerns, and a greater emphasis on risk management - institutional investors are increasingly relying on insured third-party qualified digital asset custodians.
When the London Stock Exchange announced plans in March 2024 to list Bitcoin and Ethereum ETPs, one of its requirements was that a custodian hold the ETP’s assets. A second requirement was that at least 90% of the ETP’s underlying assets needed to be held in cold storage, an offline wallet. Because the private key required to transfer the assets isn’t connected to the internet, the assets are safer from hackers and other bad actors. The downside is that accessing that key takes some time and multiple steps. This creates an operational challenge from a trading perspective.
Regulatory conundrum
Although outstanding regulatory questions about digital assets continue, one of the most crucial to the growth of the market — who regulates digital assets — is slowly being addressed.
In the US, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) went back and forth in discussions over whether cryptocurrency is a security or a commodity. Even as the SEC began to gain increasing regulatory control, its chairman, Gary Gensler, referred to the digital assets space as, “…rife with non-compliance, where investors have put hard-earned assets at risk in a highly speculative asset class”.
In the UK, the fourth quarter of 2023 was a turning point for digital assets regulation. The Financial Conduct Authority (FCA) published a discussion paper on regulating digital assets and began enforcing new rules on promotion.
The D&O dilemma
With so many headlines about fraud and regulatory fines, it’s understandable why insurance companies might shy away from underwriting financial risks coverage for asset management firms with large digital asset portfolios. For example, certain digital assets’ prized perceived anonymity makes it challenging to know if a firm complies with Know Your Customer (KYC) regulations. Yet, underwriters should not ignore the changes in this market, which could make digital assets a more acceptable risk.
In addition to the SEC and FCA more actively engaging in digital assets regulation, their decisions to approve listed ETF/ETPs could be viewed as evidence that digital assets are developing more legitimacy in the eyes of the regulator. Hedge funds and alternative managers who use ETF/ETPs to gain digital assets exposure rather than directly holding it should be more attractive from an underwriting perspective.
Currently, many insurance companies are uncomfortable underwriting financial risks insurance for firms with a certain percentage of their AUM. sometimes as low as 10%, held in digital assets. However, this percentage-based metric may be unjustified.
With the rapid growth of this year’s crop of new ETF/ETPs in mind, Gallagher advises that firms look for an insurer to accommodate a larger digital assets allocation as their AUM could grow significantly through a combination of fund inflows and asset appreciation expected as a part of the current bull cycle.
Underwriters should not ignore the changes in this market, which could make digital assets a more acceptable risk
How can Gallagher help?
· A dedicated Digital Assets unit which merges with our Asset Management team.
· We ensure that engagement and negotiation with the most appropriate insurers (whether that be specialist digital assets insurers or traditional financial institutions insurers, depending on the risk profile and digital asset activity) is carefully managed to achieve the best results.
· Access to our proprietary broker-designed insurance products which have been specifically designed to respond to the evolving needs of digital asset-related clients including those in the asset management space.
· Pre-agreed access to specialist digital assets recovery services as a part of our Crime insurance offering allowing for rapid tracking of misappropriated digital assets (regardless of who is responsible for custody) potentially leading to the legal freezing of assets and subsequent recovery.
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