Why more big investors are now seeking interest and yields in DeFi

Transcript

Angie Lau: Is custody the next step in crypto’s institutional adoption? Are Asian crypto hubs the stepping stone to European expansion? And regulators warn against retail trading throughout Asia — are banks and institutions the beneficiaries of these alerts?

Welcome to Word on the Block, the series that takes a deeper dive into blockchain and the emerging technologies that shape our world at the intersection of business, politics and economy. It’s what we cover right here on Forkast.News, I’m Forkast Editor-in-Chief Angie Lau.

Well, through the last couple of months, we’ve seen Asian authorities send warnings against retail crypto trading from India to Hong Kong to even Singapore. The trend has been on the rise, but as we’ve discussed recently here, on Word on the Block, the validation of digital assets is intriguing to banks and institutions. So what’s the next step for institutional adoption? Perhaps, it’s time to talk about custody. Joining me right now is the CEO of digital asset custodian Hex Trust — who just closed a six million dollar series A round — welcome to Alessio Quaglini. Alessio, welcome to the show.

Alessio Quaglini: Thanks for having me here, Angie.

Lau: Absolutely. So we’re both Hong Kong-based. We’re here in Asia. The perspective is just so clear to us here in this region. But for everybody else who’s just joining in from around the world, what are you seeing here in Asia from the custodian point of view that you think can really accelerate adoption for institutions and traditional investors here in this region? What are people looking for?

Quaglini: In the past few months, there has been a great shift from a more retail and unregulated type of business to a more institutional business. The shift to the institutional business is just a reflection of a couple of things. So the first one is the interest of the wider group of investors in getting exposure to a new asset class that has different characteristics from the more traditional asset classes. The second one is an interest in the new business models in financial markets that the blockchain technology has brought to the financial markets itself. So what we are seeing now is actually the institutions trying to get into this space in order to enable digital asset services for their clients, both at the wholesale banking space and at the retail space. Asia, as the home of innovation, is actually at the forefront of this innovation.

Lau: I agree with you, Alessio. Hong Kong and this region of the world is really the forefront of innovation. What specifically are you seeing that allows your firm to really thrive and grow and get to a point that it has now? And congratulations, by the way, you just closed US$6 million series A round.

Quaglini: In the wider blockchain market, custody really represents a very important piece of the whole market. It’s not just about bringing services to the market, but as we move to a more institutional market, as we move to a more regulated and compliant market, every single player will need to have an underlying platform that allows you to basically comply with the four key factors. One, there is security. The second one is regulation and compliance. The third one is interoperability with all the other systems and service providers available in the market. And the fourth one is scalability. And how we see custody in Hex Trust is really to address these four main topics that are so critical in the blockchain market.

Lau: And it’s really validating the rising interest in cryptocurrency here in Asia as well. On the institutional and traditional side, can you share just what your experience is so far and where you’re seeing growth?

Quaglini: As we are seeing more or less everywhere, we have a lot of institutional investors’ interest come into the space. This comes, first of all, as a reflection of the investors wanting that exposure to a new asset class that is different from the traditional asset classes, especially in this kind of moment in the history of the world where central banks are kind of competing with each other in printing money. There’s an interest in an asset class that behaves in a different way. And there’s a difference in the new business models that blockchain is bringing to the financial markets. And the different business models are the ones that we’re currently exploring and talking about in providing interfaces to, which are the business models in the DeFi space, the new business models in the CeFi (centralized finance) space that allow actually, to earn while holding the assets in your portfolios. We’re talking about the lending and borrowing platforms, we’re talking about the staking platforms, we’re talking about different types of investing, yield liquidity, and businesses that are embedded in the blockchain space.

Lau: See, that’s really interesting because we are also increasingly watching this space move DeFi into CeFi. Obviously, traditional firms are watching the DeFi space very closely and then trying to think about how to incorporate that or take advantage or even leverage. What you’re talking about sounds really interesting in that as a custodian for traditional and institutional investors to have that entire asset class of Bitcoin or Ethereum or whatever other cryptocurrency that they ultimately hold in their corporate treasury, that then they could also, in effect, act as a CIO and use DeFi. But how do you ensure that all of the stakeholders from the board all the way down to shareholders, that hedge already in crypto, which we’re seeing enormous volatility is going to be applied in DeFi? How can the institutions think about that and still remain compliant?

Quaglini: There’s a couple of things that have to be taken into consideration here. Corporate treasury function within corporations and also the management of the assets and liabilities in financial institutions will have to shift from a secondary function to a first-order business function. So their management of liquidity going forward will take that primary stage in the business activities of large financial institutions and corporations. And we’re seeing this not just in the news because of Tesla or MicroStrategy buying Bitcoins, but we’re seeing this also from smaller companies or family offices of smaller businesses, even listed companies here in Asia that are looking at doing the same.

Then at the same time, once you opened the door to digital assets, then you find that you have a lot of options on the table on what you can do with these digital assets. And you’re right. So how do you make sure that you can control the volatility and that you are doing the right investments, managing the risks that comes with them? So that’s why you will need to handle it as a business function, where there is a risk department that is able to understand not only the financial risks of these assets but the compliance risks and all the other risks that have to be controlled with the other business functions of a company.

The DeFi space is very interesting. When Compound came to market last year, what it created was a very big shift from the way we look at cash management before DeFi and after DeFi. Before DeFi, if you have U.S. dollars in your bank account, you either have U.S. dollars or you have to invest them into something. With DeFi, you have the birth of a new asset class, which is the interest-yielding currency so you can transform the U.S. dollar into a CUSD and this CUSD is the same thing as a U.S. dollar with the only difference that itself can earn interest and increase in value. So all of a sudden you have a kind of see the instrument in your balance sheet and it increases in value at every single block that is confirmed on the blockchain. But the interesting thing is that this instrument becomes negotiable and can be used to purchase other assets or can be used to be invested itself. So we’re really shifting from pure non-yielding assets to yielding assets that have interest-bearing functionalities built into the assets itself. It’s a very powerful shift that the blockchain is bringing to the whole financial market.

Lau: I absolutely agree with you. Right now, it is still in its very much infancy. It’s growing up fast — but infancy in the way that, how do we see the migration of DeFi and these new ways of thinking about financial instruments and then actually applying it in a more traditional landscape.

Do you think there is an opportunity for institutions and for firms like yourself and so many others who are actually working on solutions right now that they can manage the cryptocurrency assets and still play in the space and really have it function as a hedge and more?

Quaglini: You are referring to it as a hedge against the other currencies available in the market?

Lau: That’s right, I’m talking about negative yields, I’m talking about the U.S. dollar, Japanese yen, Singapore dollar, traditional fiat, Yeah.

Quaglini: I think there is another important shift in the market. So especially in periods of high volatility, investors always look for a safe haven asset. The safe haven assets historically has been the Swiss franc, the Japanese yen, sometimes the U.S. dollar, depending on what investors were looking for.

Lau: Or gold.

Quaglini: Or gold, exactly.

Now we are in a period of time in which investors are becoming more and more aware that by just holding a traditional safe haven asset, they will experience depreciation of the asset itself. In this money printing of the central bank will actually have a clear impact on the depreciation on the medium and long term on these assets. Investors are aware of that and are looking for alternatives. Obviously gold is an alternative, but gold comes with all the issues that we know about transferability, whether it can be spent, whether it can be reinvested, etc.

Lau: Sounds very familiar.

Alessio Quaglini: Digital assets are really an alternative. Obviously, within digital assets, you have a whole range of very different things. But if we talk for a second just about Bitcoin, it is really the typical asset that investors are looking forward to hedge against this money printing process that is going on around the world. Then you have other assets like the secondary blockchain, such as Ethereum, Polkadot that are used to sustain the whole blockchain ecosystem and blockchain on top of which all the other blockchain-based businesses, including DeFi, will have to be built. So if investors think that this new way of building financial markets is going to actually gain market share in the financial markets, then Ethereum and other smart contracts blockchains will actually play a role in the hedge against the financial, the traditional financial markets. Then obviously on the other side of the blockchain world, you have art NFTs, you have other kind of tokens that behave more like securities, you have community tokens, governance tokens, and all of these assets that will behave in a completely different way compared to Bitcoin, even though obviously now we’re seeing a very high correlation and the market is usually going just in one direction following the largest cap asset.

Lau: It’s true. When you take a look at the regulatory space here in Asia, how do you compare Hong Kong and Singapore? How do you compare what’s happening in the region?

Quaglini: Ok, so first of all, a general statement on what governments are doing. Regulations coming to this space and this is not surprising at all. It was supposed to be happening. It’s just, my opinion, happening a little bit too late, right? And delay and denial. Some governments around the world actually getting into the space and bringing some regulations and regulatory framework actually had the opposite effect of spurring unregulated businesses, targeting most of the times the weakest group of clients and investors. So right now, due to the lack in bringing regulatory frameworks to the space to have huge businesses offering to the widest group of unsophisticated and uneducated part of the population, very sophisticated products such as perpetual futures, options, leverage up to a 100 times. This is just the reflection of a big delay in coming to this market by the authorities. This regulation is coming.

If we want to compare Hong Kong to Singapore, I don’t really want to take a side. But what I would say is that both Hong Kong and Singapore have very active blockchain markets and we have both very established businesses, as well as growing or new enterprises entering the market in Hong Kong and Singapore. If we just want to focus on the regulatory perspective, I would say that Singapore has been more agile than Hong Kong in proposing some types of regulatory framework that are more conducive to running cryptocurrency businesses under the sun. In Hong Kong, we’ll have to catch up if we want to stay competitive and if we want to avoid that digital asset businesses or innovative businesses in general that start moving even at a faster pace to Singapore.

Lau: It’s a race, there’s very little doubt about that. You’re expanding both in Singapore and Hong Kong to, as I read in my notes here, to meet Asia’s soaring institutional interest in digital assets. I also note that you’re also expanding to Europe. What are you bringing to Europe that you’ve learned in Asia that you think can be exported to the rest of the world?

Quaglini: First of all, our key market is obviously Asia, where we want to become and be the regional leader for digital asset custody. But we also understand that the blockchain business is a global, 24/7, 365-[days] business and it cannot be run just from one geographical area. So if you want to run a global business and being able to cover clients and provide an uninterrupted service globally, you have to have presence in different parts of the world. So Europe for us is also a strategic market. We were planning to actually set up a strong presence in Europe in 2020, then the global pandemic kind of slowed down this process. But we are currently reevaluating the strategy. And in 2021, we will decide where we want to be, which parts of Europe we want to be, and when we want to set up, what type of business. But certainly in 2021, we will have a strong presence in Europe. Let’s call it continental Europe.

Lau: Got it. You’ve got extensive experience in finance and in banking. And obviously this has been a very regulated space. The institutional investors that are coming on board obviously need those rails, those regulatory rails to even be thinking about doing business in crypto. So now that these products are coming to your point, the regulatory space is shifting, whether at a speed that doesn’t necessarily match the innovation. But still, it feels very much that the regulatory space is tightening. How do you navigate that, number one? But how does that also change the game for banks and institutions? I mean, is this still a level playing field?

Quaglini: Absolutely. To be honest, this is a big competitive advantage for us. When we set up the company three years ago, the idea was really to bring on one side a very competitive product platform for custody, settlement and interoperability of digital assets. But on the other side, to bring it to the market within a fully regulated and compliance framework. So we planned ahead for this to come. And we were expecting that regulators will come with the strictest regulations for this market. 

The whole business, the way we set it up, the licenses that we applied for, the licenses that we obtained, the type of partners that we worked with, the certification that we obtained in the market, it was all done strategically thinking that strict regulation will come to market. To answer your question, the barrier of entry to this market is much higher than before. New entrants will not only have to compete in terms of product competitiveness and the sophistication of requests and requirements from clients now so much higher than before. But they will also have to compete on the regulatory side, which is becoming much, much harder to comply with. And we’re not only talking about AML, we’re not only talking about CTF. We’re also talking about GDPR rules. We’re talking about how to comply with the new travel rule regulations and how to make sure that you can comply with this regulation on a global or at least multi-geographical basis. So our target clients are global businesses that operate in different jurisdictions. So how can we allow that to be compliant in the jurisdictions where they want to launch this crypto asset business?

Lau: What you’re doing and others like you really providing on-ramps of trust for some smart money, and by smart money, a lot of it, these are tranches of hundreds of millions, if not billions when we think about even just at the one to two percent level of corporate treasuries around the world. That brings an enormous amount of liquidity in the space. I also note that it is also a transfer of power or players in the retail space, but now there’s serious money into this space. It’s displacing maybe the early anarchists and the cypherpunks that bought pizzas with their Bitcoin. 

Now, people are hedging their corporate treasury in crypto against negative yield environment, in over stimulus, in many people’s opinions as to what central banks are doing around the world. That’s really different. So now you’re providing this liquidity into this space, what do you think is going to launch all of this money, all serious money? The regulators are here to create the rails of trust. What do you think it’s going to launch in the next decade when it comes to financial vehicles to DeFi to the next layer of innovation in blockchain in financial services?

Quaglini: Obviously, this is a very complex question. But what I would say is that, first of all, the trend is unstoppable. So you’re right to say that we’ve seen probably 2017-18 more of a kind of retail movement. Now we’re seeing not only the institutions, not only the listed companies, but we’re seeing the family offices. We’re seeing the high net worth individuals. We’re seeing the corporates. We’re seeing a lot of different types of investors that are looking at the space. And this interest is growing. Since you mentioned what if corporates actually allocate part of the treasury to cryptocurrencies in the next few months?

There’s a very interesting study that was published in January 2021, by ARK investment’s Catherine Wood. They estimate that if only 1% of the cash in the S&P 500 corporations are allocated to Bitcoin, the price of Bitcoin will basically reach US$100,000. So I think this is something that we will see happening. It will not take such a long time as we were expecting some months ago. On the other side, in terms of business models, what we’re looking at here is a big revolution.

So Bitcoin is just this small part of it. Everybody’s interested in the price of Bitcoin, in the safe haven aspect of it. But what we’re looking at here is a rebuild of a complete financial system. If you look at what Ethereum is right now, for example, and if you look at what Visa is going to do with Ethereum, it is basically using Ethereum as a global settlement layer that operates on a 24/7, 365 days a year. And it is a programmable settlement layer that works globally. So this is very powerful because right now we are basically running our financial services on a legacy system that works quite well, but has a lot of deficiencies. But this financial infrastructure can actually be replaced by what we are building currently in the blockchain space. So this is what I think is the long term trend that we will see, not even the next 10 years, but we’ll see the next five years. So innovative companies working to rebuild this global settlement, financial infrastructure layer.

Lau: And we’re not talking even about DeFi anymore, we’re also thinking about new digital asset classes like NFTs. Do you think there’s institutional interest in NFTs?

Quaglini: NTFs actually represent a lot of things. Obviously, the NFT that are more interesting right now are digital art or other kinds of computer games, experiments, et cetera. This is actually probably going to be a small niche of the NTF segment. But we will see more and more NFT being applied to IP, to identity, to legal contracts, and to probably to some parts of the financial market. So NTFs will actually become an integral part of this new financial market infrastructure that was mentioned before. As a consequence, businesses operating in the space and offering services to institutional clients, they will have to have a full integration for not only the Bitcoin or ERC-20 standards on Ethereum, but also the new NFT standards or even the new standards set of baskets of NTFs and traditional tokens. So this is going to be a proliferation of new standards that will have to be supported by custodian businesses like ours.

Lau: Listen, I think I’m going to coin this new rule right now, the digital economist is coming. We’re going to need economists who are well versed in this space and think about how it applies to that digital layer. That day is coming faster than anyone can imagine.

Alessio Quaglini, thank you so much. Great to understand just the dynamic in this region, but also with more and more institutional money that is coming into the space. We’re not even talking about Bitcoin prices anymore. You’re truly talking about what that next layer of innovation is going to look like. Thanks for shedding a lot of light into the potential of what we can see in the future. Alessio, thank you so much for joining us.

Quaglini: Thanks for having me here.

Lau: And thank you, everyone, for joining us on this latest episode of Word on the Block. I’m Angie Lau, Forkast.News editor-in-chief. Until the next time.