06 Jan 2024

Navigating the Next Wave of Crypto Institutionalization: An Introduction to Due Diligence

As FTX demonstrated, operators of digital asset markets need to improve corporate governance standards. These are the key components as the industry prepares for another potential bull run.

Major US financial services institutions are anxiously awaiting the SEC's decision on their Bitcoin ETF applications, with critical deadlines of January to May 2024. The early approval of these ETFs, which already influences the Bitcoin price with a 26% increase in the last three months, marks a crucial moment in the evolution of the market.

The cryptocurrency sector is attracting attention due to factors such as the upcoming Bitcoin halving (which will fall in April 2024), its status as an uncorrelated asset class, the “digital gold” narrative, and macroeconomic conditions. prevailing.

Historically, bull runs in crypto markets have attracted significant interest from institutional investors and financial services providers who work with virtual asset service providers (VASPs) to offer trading, custody and structured products, enabling expansion beyond Bitcoin into areas such as tokenization, stablecoins and staking. and private capital.

The entry or re-emergence of institutions in this space highlights the need for robust due diligence. The lack of understanding about the unique risks associated with digital assets and their management became evident following the collapse of FTX and the findings of the recent trial.

A comprehensive due diligence framework that captures the unique risks in the digital assets space is essential to guiding institutions through this complex landscape. Must include:

  1. Governance and operational resilience

    The efficacy, roles, responsibilities, and accountability of board leadership are addressed through risk management frameworks and control functions. Operational resilience includes duties such as segregation of roles, business continuity, disaster recovery, and third-party oversight. Comprehending the governance and decentralization of Layer 1 and Layer 2 blockchains is also part of it, if relevant.

  1. Regulatory compliance:  

    VASPs must implement robust processes for evolving regulations, covering KYC/AML controls and crypto intelligence tools, trust structures, segregation of client assets, data protection, conflicts of interest and ethics.

  2. Digital Asset Trading:

    Prioritizing secure custody of digital assets is crucial. Technology controls should cover key lifecycle management, stablecoin management, staking activities, account management, transaction handling, change management, and understanding of tokenomics and blockchain technology. Contrary to popular belief, reviewing a SOC report may not be enough to address risks in these business operations.

  3. Financial Analysis and Reporting:

    VASPs should focus on financial metrics beyond traditional assessments, including on-chain reviews to gain insight into management and transactions, initial distributions, key personnel tenures, and related party transactions. It is vital to understand reserve asset management, customer liabilities, balance sheets and encumbrances on digital assets. Additionally, evaluation of accounting treatments and counterparty risks provides a comprehensive view of financial health and exposure. While the reserve test is gaining momentum, there are currently no standards from professional accounting bodies to ensure its adequacy.

  4. Financial risk management: 

    Strategies are necessary for liquidity risk management, evaluation of the financing strategy, liquidity and quality of digital assets and support systems. VASPs should also have mitigants for financial risk metrics, stress tests for liquidity events, capital management processes, and frameworks for credit, interest rate, and foreign exchange risk. The presence of an internal audit department is a positive indicator.Each category in this framework demands thorough exploration to maintain higher standards in effectively managing risks, fostering a more mature and secure crypto industry.

As the cryptocurrency market continues to evolve and intersect with traditional financial systems, the importance of these due diligence practices cannot be understated. They are not just compliance checkboxes, but vital tools to safeguard the integrity of the financial market and protect the interests of investors.

It is imperative that institutions go beyond mere participation in the crypto space to become responsible and informed players. This responsible approach is crucial to ensuring that the potential of the cryptocurrency market is fully realized, paving the way for its sustainable growth and integration into the broader financial landscape.

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