The Next Wave of Institutional Digital Asset Adoption

Skeptics are taking a cheap shot at framing the FTX debacle as the end of crypto’s mainstream appeal and adoption. Nothing could be further from the truth. If anything, the collapse of one of the largest centralized exchanges is a clear sign that in 2023 and beyond we will see more reliance on decentralized infrastructure and better regulation.

As many have pointed out, Sam Bankman-Fried's litany of alleged crimes and abuses was a failure in CeFi, not DeFi. A look at DeFiLlama shows that decentralized exchange (DEX) volumes are up by almost 70% despite negative market sentiment. A portion of the market is clearly doubling down on crypto’s decentralization ethos.

Sean Lee is the co-founder of Odsy Network and serves as the executive director of the Switzerland-based Odsy Foundation. This article is part of Crypto 2023.

But there’s also a way in which crypto’s influence will continue to grow in traditional finance despite the controversy. A 2022 survey by The Economist found that 85% of investors “agree there is a need for open-source digital currencies as a diversifier in a portfolio or treasury account.” However, that same survey found that a lack of regulation was the most cited barrier to digital asset adoption among institutional investors and corporate treasuries.

(Tellingly, “lack of regulation” was tied with “financial market structures” as a barrier, which will be discussed as well.)

In 2023, a side effect of the FTX and Alameda Research debacle will be a shift towards more traditional regulated entities as the entry points into digital asset markets. This will be especially true for users who still prefer to use more straightforward and familiar service providers over centralized finance (CeFi). Why go with middling services? Go fully DeFi or fully traditional.

Read more: 23 Blockchain Predictions for 2023 | Opinion

After the market recalibrates and regulations catch up, these are the firms that will be primed to meet the rising demand for digital assets among institutions, family offices and even many retail customers. It’s easier to imagine a family office going to a regulated and reputable firm like Fidelity for diversification into crypto rather than directly into Uniswap or some new CeFi contender that may or may not operate similarly to FTX.

Is TradFi prepared?

Now, the important question is: Are these firms ready for this? The truth is that there are some significant challenges they face at the moment. Although federally chartered banks in the U.S. have had a green light for crypto since 2020, most firms have shied away from offering digital asset products other than some exposure to BTC or ETH in limited capacities.

Custody and regulations

The first challenge they face comes from the responsibilities that are created by taking custody of digital assets. There are potential liabilities that firms have to take into consideration when offering crypto due to risk management policies and consumer protection laws.

There’s also added complexity in the fact that different regulations might have to be taken into account for different digital assets. While the global regulatory landscape continues to evolve, when a firm retains custody of an asset, some of these questions fall under its responsibility. For example, determining whether a particular asset is considered a security or a commodity, and how it may be treated differently in other jurisdictions, becomes relevant to how it needs to be managed by the firm.

See also: 5 Digital Economy Predictions for 2023 | Opinion

Infrastructure

Then there are a number of infrastructure problems that need to be solved before firms can expand their product offerings into digital asset markets effectively. At the root of them is the fact that crypto is an incredibly fragmented space with assets being managed in different blockchain networks, and has minimal crossover with current financial market structures (as found in the aforementioned survey by the Economist).

A firm looking to offer digital asset products has a hard time building products that can count on a consolidated view of the crypto space. They would have to set up and run dedicated systems for each blockchain network and all the different crypto or tokenized assets that run on them.

In fact, crypto on-ramp services often have entire teams dedicated to addressing the compliance and technical development issues of adding new assets to their offering. It’s easy to see how solving these complex problems on their own is not a priority for traditional finance firms despite the growing demand for digital assets.

All of these challenges point to a broader problem that can be summarized as follows: Crypto and Web3 infrastructure are evolving quickly, but developers still ignore rules-based access control as the main starting point.

Where they are now

Currently, traditional financial firms looking to offer digital assets have limited options in terms of implementing compliant custody and infrastructure. They rely on either siloed proprietary software or turnkey solutions that offer the same product to every other competitor and eliminate any competitive advantage firms might develop.

These approaches go against an overall transition towards open-source software infrastructure for institutions that pre-dates Web3 and offers known benefits in security, customizability and community-driven innovation with no vendor lock-in. Moreover, they leave little room for developing financial products that meet customer needs such as user experience, access rights, self-custody, risk controls or rule-based frameworks and guardrails for local regulations.

Where they should be

What would be a better option that allows these firms to meet customer needs? A decentralized and open-source access control layer for crypto and Web3.

This layer would take the form of a single network dedicated to dynamic decentralized wallets (dWallets) that are programmable, transferable and able to sign transactions across different blockchains. This new open-source-based infrastructure for wallets could take on the burden of custody and off-load much of the complexity in infrastructure-building for traditional firms.

Read more: 2023 Should Be the Year of On-Chain User Security | Opinion

As a result, financial services firms could just focus on expanding their digital asset offerings as they see fit in an almost plug-and-play manner. As long as their services are built on top of this layer, they can introduce crypto into existing financial products with ease and even develop their own digital asset products. All of this happens while custody stays with the customer and all the necessary rules for the product are mapped into existing risk and compliance policies set by the firms but enforced by the decentralized network.

Such a layer would enable firms to address customer needs by offering services such as:

• Non-custodial products that are decoupled from potential associated liabilities and reduce regulatory burden
• Easier expansion into new assets thanks to multi-chain compatibility
• Consolidated views and portfolio curation across digital asset markets
• Allow listed liquidity pools or licensed trading venues restrictions
• Standardized rule-based products with risk controls, investment profiling, regulatory compliance and particular customer preferences for exclusion of certain assets (ESG considerations)

For their customers, digital assets would feel like an easily-digestible extension of the financial products they already know. It would simply be another component of products like pensions, insurance or savings accounts.

Rather than diverting resources in technical infrastructure implementation and integrations, firms could then continue to prioritize their roles in their relationships to customers as follow:

• Financial advisory
• Portfolio curation
• Product construction
• Auditing and reporting
• Risk management
• Compliance enforcement

Once you build decentralized access control, the decentralized world of Web3 and the traditional world of finance can finally be brought together, forever leaving behind the current divergence in user experience, expectation and regulatory compliance. This eliminates the space in the market for debacles like FTX.

This is digital assets done right. In 2023 we will see a move towards decentralized infrastructure and better regulation. But more importantly, we will see new solutions that bridge both trends.