This week we will be looking at virtual assets. What are virtual assets and what are the potential of these assets in the financial industry?
Virtual assets are digital representations of value that can be digitally traded, or transferred, and can be used for payment or investment purposes. Examples of these virtual assets are crypto currency or asset- backed tokens.
To keep growing the sector must continue to drive optimal operational excellence to be in line or at least concurrent with Financial Services (FS) industry standards.
To sustain growth, the next step for Virtual asset providers (VASPs) is to incentivize the FS industry, to engage more closely, and to deliver what business- to- business (B2B) customers need and want. This requires VASPs to have operations that are streamlined, scalable and compliant and all without losing speed and agility. The four pillars that will support the growth of VASPs are:
The pandemic caused an almost immediate consumption shock, resulting from the forced shutdown of entire consumer service industries. The drop in consumption is by far the largest since the 1930s great depression in the US and since World War II in Europe. The consumption shock was triggered by lockdowns and health fears that severely curtailed spending on services, setting it apart from past recessions. On the flip side, there was a rise in household savings. This means the COVID-19 recession was dominated by the collapse in consumer spending and the rise in savings, making the consumer more important than ever as a trigger for investment decisions and achieving economic recovery.
– Clearing and settlement
Following customer engagement and regulatory compliance, scaled and stable operations are vital on the path to institutionalization. A fundamental focus must be on clearing and settlement, which are among the most critical day-to-day operations for VASPs.
Virtual assets have brought a significant simplification to the processes of clearing and settlement, thanks to the nature of the underlying distributed ledger design used, commonly known as block chain. The distributed ledger design offers immutability, irrefutable ownership, removal of novation of transactions, and instant data reconciliation. These factors have redesigned the way assets can be transacted and invested in.
There are two common types of settlement involving virtual assets: payment or exchange of virtual asset to virtual asset; and payment or exchange of virtual asset to (government- issued currency) (and vice versa).
Virtual asset exchanges are centralized platforms that connect buyers and sellers of a virtual asset. They automate the matching and execution of trades. Usman Ahmad, Chief Information Officer, BC Technologies Group, explains that on the exchanges, trades are matched and confirmed instantly through an account movement within the exchange platform. This is a non-public record, and the appropriate funds are reflected in the client’s account. When a client deposits or withdraws those assets (either through the exchange or through a designated custodian), the aligned blockchain ledger, such as Bitcoin chain or Ethereum chain, is updated with a public record. This instant settlement helps to eliminate risks such as counterparty, market, settlement, and credit risk, but shifts the degree of trust clients must place to the exchange and its operations.
However, new risks also arise. For example, the failure of the exchange to secure the traded assets, the inability to pre-fund trades, or the inability to move assets fast enough from a secure offline wallet to a liquid online wallet for settlement on the blockchain ledger. Therefore, thorough due diligence on the exchanges that investors use is critical.
Virtual asset to virtual asset clearing and settlement are executed by the VASP platforms and blockchain technology without further intermediaries. However, for most investors, the starting point to virtual assets is using traditional fiat money – a step referred to as ‘on-ramping’. Commonly, virtual asset exchanges are the bridge between fiat systems and virtual assets – also referred to as ‘clearing funds’. On the other side are traditional FS institutions such as banks or traditional payment providers which provide the ‘funds movement’ infrastructure.
A challenge for VASPs is that many global banks are not yet fully servicing VASPs, so often they can only open bank accounts with virtual or ‘challenger’ banks.
– Custody and asset management
The term ‘custody’ in the context of virtual assets refers to the management and safekeeping of the cryptographic private keys that virtual asset owners use to execute virtual asset transactions. Whoever controls these private keys can sign transactions and change the amount of assets owned in near real-time – effectively controlling the asset.
Therefore, custody plays a very important role on the path to institutionalization, with VASPs needing to offer their own custody approach, or engage with secure custody providers.
Customer due diligence
Most regulations and licensing regimes focus on robust customer due diligence and monitoring programs for the purposes of Anti-Money Laundering (AML) and Counter Terrorism Financing (CTF) compliance.
A key part of this is having a robust Know Your Customer (KYC) program, and in recent years, many VASPs have adopted some elements of a KYC program and practice. This uptake increased after global regulators clarified their expectations for ‘risk-based customer due diligence’ in the June 2019 declaration from the (Financial Action Task Force (FATF).
Risk based customer due diligence and KYC programs are often executed as a set of policies and processes that aim to set boundaries around the type of customers an organization and will not accept. Historically, many VASPs have met minimum KYC standards by establishing basic customer data collection practices, or integrating third-party solutions to support identity collection and verification (ID&V). This approach is influenced by the retail heritage of many VASPs.
Risk management and operational controls
The final operational pillar that supports institutionalization of the Virtual Assets industry is governance. VASPs are often fast growing, technology driven, and agile organizations. Therefore, it is critical to implement robust governance structures for sustainable operations. Strong internal governance helps with oversight and policing of internal processes and policies.
Similar to traditional FS organizations, a robust governance infrastructure should have ‘three lines of defense’. A first line would be implementing management and internal controls; a second strengthening security, financial controls, risk mitigation, and inspection and compliance obligations; and a third would both internal and independent audits.
Here are some factors to consider within these areas: Experienced leadership: VASPs must have experienced risk and compliance senior management in place, be aware of the risks to the business, and how they are to be managed.
Governance bodies: VASPs need a governance body, as well as a risk and audit committee, to help implement robust risk management, compliance, and internal control functions. This includes setting up a board and committees, defining the organization’s values, and establishing a risk culture to drive and reward the right behaviors.
Third party risk mitigation: Given the digital-first nature of VASPs, they often rely on third parties to enable certain functions. This outsourcing needs to be clearly included in the governance framework and controls. This requires robust vendor management, thorough due diligence of the vendor, and regular reviews of performance.
Source: Article KMPG ‘Investing in Virtual Assets’