Despoina Koutentaki: Could you start by sharing your perspective on the current challenges and opportunities in the market, especially in the context of institutional involvement and regulatory frameworks?

Jean-Marc Bonnefous: When we discuss the development of the institutional digital asset market, it’s vital to differentiate it from retail participation. The real potential for growth lies within the institutional landscape where significant capital can be deployed, enriching the entire ecosystem.

DK: What do you see as the primary hurdles institutions face when looking to get involved with Digital Assets? Does this differ across regions?

JMB: The foremost challenge to overcome in the institutional adoption of digital assets is establishing a robust and transparent regulatory framework. Regulation is the initial and most critical step in this journey.

Notably, the European Union has made considerable progress in advancing its regulatory environment, and other regions like Switzerland, the United Arab Emirates, and Singapore are also making strides.

However, the United States, being a substantial player, has yet to establish a proper regulatory framework for digital assets. The absence of regulatory clarity poses a significant barrier to institutional involvement, primarily because the U.S. is expected to be a major contributor to the future allocation of capital.

DK: What’s currently holding the United States back, and what does this mean for investor sentiment more generally?

JMB: The United States is the world’s largest allocator of financial investment assets, and its participation is crucial for the growth of the digital asset market. One of the key milestones is the introduction of a bill in the U.S. House and Senate to address market infrastructure. However, this progress depends on the outcome of upcoming elections, and it’s currently a political challenge.

Once the elections are behind us, it’s reasonable to expect that a regulatory framework for U.S. investors will be established. This is vital, as the absence of clear regulations has led some U.S. investors to withdraw from the market, impacting liquidity.

DK: What other areas need to be addressed to help with institutional digital asset adoption?

JMB: Beyond regulation, another significant hurdle involves establishing unified credit processes or a prime brokerage framework. This framework should enable traders and allocators to seamlessly access the market while addressing credit, counterparty risk, and custody issues.

Currently, the market offers modular solutions for custody, various solutions for market access, and some solutions for credit exposure indemnification. However, what’s missing is an integrated and harmonious approach, similar to the prime brokerage model in traditional Forex markets. The ability to put cash into a secure account and trade across various execution venues without the need for significant prefunding is crucial for capital efficiency.

DK: What makes capital efficiency so important in scaling digital asset infrastructure?

JMB: Capital efficiency is a vital aspect of the credit and prime brokerage issue. An efficient system should allow you to place your cash in a secure account, whether held by a bank or a trusted institution, and use that cash as collateral for your trades. Presently, this type of seamless transfer doesn’t exist. Traders need to prefund numerous venues, which is far from being capital-efficient.

Furthermore, extending this issue to traditional financial assets, there’s also a lack of ability to cross-margin digital asset trades with other financial trades. Large buy-side asset managers face the challenge of using different workflows for different assets, preventing them from efficiently cross-margining their collateral across various asset classes. This creates another significant obstacle to adoption and scalability.

DK: You’ve touched upon the regulatory aspects and infrastructure. What would you identify as the third missing component in the digital asset infrastructure?

JMB: I believe the third element missing to be a mature infrastructure for options trading. While it’s possible to trade spot and some futures and Delta One derivatives in the market, the infrastructure for options is limited.

There are some existing exchanges, one in fact, with a decent user interface, but we need more choice.

Having a number of venues for safe execution of option trades is essential because no financial asset can truly scale without a robust options market. Options markets add depth and provide opportunities for creating alpha, ultimately contributing to the growth and scalability of the asset class.

DK: What US regulations are on the horizon that may help the situation?

JMB: The roadmap for U.S. regulation is gradually coming together. The initial step is likely to involve the approval of a physical Bitcoin exchange-traded fund (ETF), which is very close to becoming a reality. As this ETF gets approved, it will create a gateway for U.S. retail and professional investors to access the market safely.

This development not only aids in regulatory concerns but also improves base liquidity. Once there’s a physical ETF, it becomes easier to build layers of liquidity on top of it, including options trading.

The next steps would involve providing a regulatory framework for stablecoins, followed by the issuance of tokens. These regulatory milestones in the U.S. will provide the necessary tools for digital markets to grow and scale.

DK: What would you anticipate as a reaction in other markets to these sorts of developments?

JMB: The impact of these regulatory changes will be significant. Initially, an ETF in the U.S. will boost liquidity and provide a sense of legitimacy to digital assets, particularly for retail investors.

This will pave the way for U.S. fund managers and trading firms to develop products based on the enhanced liquidity brought about by the Bitcoin ETF. The ETF will serve as an enabler for further product development, and it can easily fit into the existing regulatory framework. Moreover, U.S. regulatory clarity will encourage the allocation of digital assets in multi-asset portfolios.

However, while ETFs are a good starting point, they are limited, typically offering long-only strategies. Hence, institutions may look to alternative investment strategies to diversify their portfolios, including market-neutral, active long-short, and CTA-type strategies.

DK: How do you anticipate digital assets fitting into multi-asset portfolios in the coming years?

JMB: Once a regulated product like a Bitcoin ETF is available in the market, asset managers can present it to their compliance and risk teams, making it easier to integrate digital assets into multi-asset portfolios.

ETFs are familiar and simple for institutions, and they serve as a stepping-stone. Initially, we can expect to see simple allocations to single coins or baskets of digital assets. However, as the ecosystem evolves and further regulatory clarity is achieved, multi-asset managers can begin implementing diversified strategies within their portfolios. More sophisticated strategies, like market-neutral, volatility capture, or even active long-short strategies, will become possible with time, as the market matures and offers a wider range of digital asset products.

DK: Considering the integration of digital assets with forex trading, what role do stablecoins play in improving forex settlement?

JMB: Stablecoins have a significant role to play in improving forex settlement. Traditional forex trading often involves cross-border transactions and multiple intermediaries, leading to delays in settlement. Stablecoins, being digital representations of fiat currency, can significantly reduce the latency in settlement. They enable intraday settlement, meaning that after a forex trade is executed, the settlement can occur instantly or within a short timeframe. This can be a game-changer for the forex market, improving efficiency and reducing settlement times.

DK: Do you believe that forex might be the most crypto-friendly asset class due to these developments in settlement?

JMB: Forex is indeed a prime candidate for integrating stablecoins and digital assets, especially for improving settlement. While implementing such changes in the forex market might take time due to the complexity of existing infrastructure, it’s a logical and promising avenue for crypto integration. The potential benefits in terms of efficiency and reduced settlement times make it a particularly crypto-friendly asset class.

DK: For asset managers looking to adapt to the evolving landscape of digital assets, are there specific strategies you would recommend for them in terms of managing risk while pursuing growth?

JMB: Outside of previously mentioned ETFs, arbitrage strategies, particularly those focused on market-neutral, have gained popularity recently, but they might not be the best choice when compared to traditional risk-free rates. An emerging option is active long-short strategies, where investors can go long on assets they believe in and short those they think are overvalued. These strategies provide greater flexibility and risk management options, which can be critical in managing the inherent volatility in the digital asset market.

DK: Collaboration and education are crucial in this journey toward institutional adoption. How can institutions collaborate to provide comprehensive education and raise awareness about the benefits and challenges of integrating digital assets into multi-asset portfolios?

JMB: Collaboration among institutions is essential in building knowledge, fostering transparency, and raising awareness. Forums like The Finance Hive are excellent platforms for bringing industry experts and participants together to exchange insights and share their experiences.

Such initiatives enable institutions to collectively address common challenges, stay updated on the latest developments, and seek solutions collaboratively. By sharing their knowledge and experiences, institutions can enhance their understanding of the digital asset landscape, which ultimately aids in making informed investment decisions. Building trust and reassuring investors is crucial in the institutional adoption of digital assets.

DK: Finally, looking ahead, what watershed moment should people be on the lookout for?

JMB: There are two scenarios to consider: one is pessimistic, and the other is optimistic.

In the pessimistic scenario, if there is no significant regulatory progress, the market will continue to grow but not to its full potential.

On the other hand, in an optimistic scenario, we anticipate regulatory milestones leading to the participation of institutional investors. As institutions enter the space, they bring significant capital, improving liquidity and stability in the market.

This stability, coupled with the involvement of larger pension funds, will be the ultimate test of the market’s maturity. When pension funds allocate significant capital to digital assets, it will signify that the market has gained the trust and approval of a highly conservative and risk-averse group of institutional investors. This would be a monumental milestone for the digital asset ecosystem.