In a recent episode of The Gage, Sean Kiernan, CEO of Greengage, talked to Tim Grant, Head of EMEA at another challenger ‘merchant bank’, Galaxy Digital.

Opening the discussion, Tim sought to distinguish ‘merchant banking’ from traditional investment banking. “The simplest distillation of what separates merchant banking from retail or investment banking is that it typically means that there’s an element of off-balance sheet investment.”

Galaxy itself runs a billion-dollar portfolio of off-balance sheet venture investments, as well as an asset management business. Its partner model harks back to Goldman Sachs/Morgan Stanley in the 70s and 80s, albeit largely phased out by the end of the 90s with the advent of new regulations around segmentation of activities (and assets). Like Greengage, Galaxy is leveraging the burgeoning digital asset world to “redefine and redraw some of these lines” and to reintroduce partnering and relationship management more akin to classic merchant banking.

A key element of the digital merchant banking value proposition is that beyond banking services such as credit, treasury services, liquidity/working capital management there is also an element of principal and capital risk through investment in customer businesses. In Galaxy’s case, its value proposition also embraces a tokenisation stack with a cold storage custody back end (through its recent acquisition of the institutional self-custody platform GK8.

Where is the institutional crypto market heading?

“We’ve all seen booms and busts in crypto, including the FTX calamity at the end of 2022; it’s the famous 4-year cycle and every time we go through this cycle we end up with new players, each with slightly different complexions of risk and investment appetites.”

While financial markets regulation is evolving, real momentum and evolution in the digital asset space will only happen when large volumes of institutional capital are coming through the door. The current perspective seems to be increasing financial industry differentiation between ‘wild west’ crypto investment and the potential opportunity and value presented by tokenisation and other digital assets and technologies. While institutional sentiment seems to be to maintain a watching brief and see what happens in the short term, according to Tim “we don’t see any lack of momentum in institutional adoption in the background”, driven primarily by client demand. Wealth management, in particular, might be considered the next frontier of large pools of institutional capital, so it is important to figure out how to service this segment and to leverage traditional finance (TradFi) regulation and product ‘wrappers’ to give market participants the comfort and confidence to engage.

Role of structured products

Structured products are one of the big drivers of adoption. A huge, multi-trillion structured products market has functioned for decades to service wealth managers and the private banking community. It represents a significant amount of capital as well as considerable revenue opportunities on the sell side. The growth of the [crypto] derivatives markets is important in building structured products in order to put hedges in place, for example, to create a bankable security with an ISIN similar to a bond, and an embedded payoff against a position on the movement of the underlying market.

It is still early days for structured crypto products because the gatekeepers to the end client are still cautious about cryptocurrencies and many cannot have crypto assets on their balance sheet for capital and/or regulatory reasons. The demand side of the equation is there – wealthy individuals may phone up their banker and say ‘I want to go long Bitcoin but with capital protection/yield enhancement’ and this is no different to current practice with regards to structured treasury products.

As with any financial market, there is a psychological element: nobody wants to go first but once the gates are opened, more and more players will want a piece of the action. With regulatory confidence and clarity, greater crypto derivatives market liquidity and a discernible shift in institutional appetite from ‘way too risky’ to ‘let’s dip our toes into the water’ there is likely to be a major shift in institutional interest and demand, fuelled to no small extent by demand for structured products.

Benefits of tokenisation

Tim is ‘fascinated by tokenisation’; he previously left a TradFi hedge fund unit in a leading global bank to join R3, the software blockchain consortium, as CEO of its financial services lab. During this time, the number of global financial institutions engaged in the lab increased from 42 to over 100.

With respect to tokenisation, initial discussions were around tokenised bonds with a smart contract, managed on chain. That was back in 2015, and it is fair to say that it has not yet really taken off – the bond market still functions pretty much exactly as it did before. Nonetheless, there is ‘proof of concept’ that you can tokenise pretty much anything – equities, structured products, funds, physical objects and so on, and multiple supporting initiatives in play, including a regulated central securities depository (CSD) exchange for digital assets in Switzerland, and Archax operating the first FCA regulated global digital securities exchange in the UK. There is also greater regulatory clarity in some jurisdictions around what it means to issue and represent an asset on chain.

Despite activity from the European Investment Bank (two major issuances), UBS (CHF385m STX issuance) and KKR’s fund
tokenisation, and interest from Goldman Sachs, Santander and Société Générale, we have not yet reached the point of a
‘minimum viable digital capital market’ but it seems inevitable that it – along with asset tokenisation – is going to be a reality given the potential efficiencies, counterparty risk reduction and liquidity improvements available.

Traditionally, financial markets innovation has been driven by the sell side, not least because they were better resourced to invest in doing things differently but today it is the asset owners themselves that are influencing and driving change. With respect to tokenisation, this is a potentially huge opportunity relating to hundreds of trillions of assets.

Whither the Metaverse?

The gaming world, in particular, has embraced Web3 technology and the metaverse, with significant investment in metaverse gaming and enablement, backed by sizeable funds; big players in Silicon Valley seem to have no difficulty raising millions in capital at the touch of a button.

The demand side of the equation comes, literally, from schoolchildren and younger people that are already fully immersed (and practised) in ‘experiential’ gaming technologies and have first-hand experience of using digital objects (de facto tokenised assets) as payments or rewards within games.

With respect to Web3 and digital assets, Blackrock has launched a metaverse Exchange Traded Fund (ETF) that includes Meta, Nvidia graphics cards, Roblox and other new and shiny digital things. It is less apparent how the metaverse might translate outside of the gaming use case from an ‘experiential’ perspective, although Tim observes that the movie ‘Ready Player One’ may prove to be prescient.

Bad actors driving positive regulatory action?

“We should work with regulators to generate, as quickly as possible, clear guidelines that don’t throttle innovation and enable new products and services to be launched in a safe way”.

The FTX fiasco was a salutary reminder that regardless of rules and regulations, it is not possible to prevent bad actors from using smoke and mirrors to conceal bad acts. While FTX (and Silvergate) are cautionary tales, they may also prove to be something of a path to industry redemption with respect to accelerating the pace in which digital assets and crypto industries are brought within the broader financial markets regulatory fold.

Alongside regulatory mandates, self-regulation is also important, along the lines of OTC markets like FX with its voluntary, principles-based Code of Conduct rooted in ethical behaviours and standards of industry best practice. This approach harks back to the days of “my word is my bond” with its implied or presumed integrity that market participants will ‘do the right thing’ based on the importance of a good reputation in the market for continued business opportunities. To circle back to the opening comments, this was certainly the modus operandi of old school merchant banks who traded in rarefied circles often with a focus on repeat client business.

While FTX’s founder, Sam Bankman-Fried, may be the most recent poster child for bad behaviours, it is important to say that these were not associated specifically with new digital markets or technologies, but an apparent and flagrant disregard for established, industry-wide operational practices such as segregation of business activities/funds. That said, his eventual fall from grace will hopefully serve to deter others from following in his footsteps.

In the meantime, there is much flip-flopping in regulatory jurisdictions. China has banned cryptocurrency trading and mining, yet permits Hong Kong to carry on. The US made an almost complete volte face from a position of broadly positive engagement to the recent and relatively heavy-handed SEC crackdown on all things crypto. In Europe, the EU is pushing through MiCA (Markets in Crypto Assets) regulation across member states making it potentially very attractive for doing ‘crypto business’. In the UK, a perceived negative view of the FCA is arguably at odds with the Government’s oft-stated intention to position the UK as the ‘leading crypto hub’ but this is changing and momentum is growing in support of this objective.

Digital markets are moving at pace and we are seeing service providers, trading communities, intermediaries and regulators collectively considering how best to deliver a secure infrastructure and environment that assures more positive outcomes for participants. The crypto asset market is gradually growing up.

To learn more, listen to our podcast series, The Gage Episode 16.