A buyside perspective on the latest digital asset use cases

Lori Heinel (LH): At State Street Investment Management, we view blockchain technology not as a passing trend, but as a shift in how financial markets operate. Blockchain has parallels to the internet in the 1990s with the potential to reshape the infrastructure of global finance. It introduces a new paradigm of decentralized trust, enabling peer-to-peer transactions, real-time settlement and immutable record-keeping.

Blockchain technology has the potential to significantly democratize investing by making asset classes available to consumers in different digital wrappers that wouldn’t otherwise be available on a mass scale. For instance, we have an active engagement underway, including with State Street, to work with digital assets in the cash space. Digitally native cash is compelling in that you can post it as collateral and you can access native buyers working with wallets as opposed to traditional brokerage accounts. We also have a relationship with a third party, Galaxy Asset Management, for our Standard & Poor’s Depository Receipt Galaxy Digital Asset exchange-traded funds, to tokenize existing assets.

Digital assets encompass a broad spectrum — from cryptocurrencies like Bitcoin and Ethereum to stablecoins, central bank digital currencies (CBDCs) and tokenized versions of traditional assets. Each of these plays a different role in the evolving financial ecosystem. For us, the focus is on how these instruments can enhance portfolio construction, liquidity management and operational efficiency.

Daniel Farley (DF): When we think about how an asset class fits into a portfolio, it is critical to have a sense of what its return expectations are, its risk expectations and its correlation with other assets in order to model it in a multi-asset class framework. While we can calculate correlation and standard deviation based on the somewhat limited history, we’ve found it difficult to come up with a reasonable framework to determine an expected return for these assets given their attributes and what’s truly driving returns. Most fundamentally driven approaches, for both financial and technology assets, would suggest a much lower price that what we have seen in markets.

Is cryptocurrency pricing the same driver of the underlying technology? We haven’t been able to connect those dots yet, and until we’re able to accurately forecast the return, it’s difficult to position it in a portfolio strategically. But in the opportunistic bucket of a portfolio, investors might want to allocate resources on a smaller scale.

LH: We see several opportunity areas — enhancing portfolio performance through additional returns, diversification with existing asset classes, and potentially unlocking liquidity in traditionally illiquid asset classes.

With respect to the return opportunities presented by digital assets, we see this solidifying over the next several years. To date, cryptocurrencies are the first segment that comes to mind when investors consider digital assets but there are still many unanswered questions about crypto’s fundamental purpose. Is it a currency or store of value? Or should it be viewed as a real asset with inflation hedging features? Or is it really just a bet on technology and US exceptionalism? These questions are one reason why cryptocurrencies are still far from being broadly adopted by institutional investors.

An alternative way to gain exposure to crypto is one that involves investing in equities that will benefit from growing adoption of crypto. This approach has the benefit of using well-understood equity risk/pricing frameworks but still having the potential to gain from crypto’s expansion. The Galaxy ETFs are a good example of this, because a certain portion of their investments are in crypto, but this is for opportunistic strategies, similar to what Dan described. It’s an equity component of companies that stand to benefit from growth in the blockchain and crypto industries, plus options and a hedging strategy to manage volatility.

DF: When looking at the ETFs, digital assets’ exposure to the use cases for the underlying technology across the ecosystem makes it more of a direct play than crypto itself. Think of the early internet in the late ‘90s. You didn’t know who the winners and losers would be in terms of the sites and online services that were cropping up, similar to crypto assets now. There was definitely money to be made, from an investment perspective, in the companies providing the underlying internet enablement and access technology.

As we start to move on from tokenizing money funds and even equities and ETFs, what’s interesting is the idea of tokenizing private assets. We’re a long way from that, and the devil is in the details, as the saying goes. For example, if we all own a tokenized version of a building, and there needs to be a repair, who do we go to for that? So there’s some operational work that needs to be done to make it practical. But the concept is exciting.

LH: First, the industry has to build the operational interfaces and onboard technology that enables everyone to work with digitally native assets. Custody, insurance, compliance and risk management tools for digital assets are still maturing. Institutions need the same level of confidence in digital asset operations as they have in traditional markets. Then there’s the question of intermediation. People trading crypto can make transactions on a platform, but at the institutional level, with tokenized asset classes requiring underlying liquidity that needs to be manufactured. There are practical considerations for moving that whole ecosystem on-chain in an interoperable fashion. It’s not as simple as two people trading crypto with one another.

Many tokenized assets are being developed on proprietary or siloed blockchains. Without common standards, it’s difficult to achieve the network effects needed for liquidity and scalability. That’s why we’re supporting initiatives like the Tokenized Asset Coalition and InterWork Alliance, which aim to create open standards for digital assets.

DF: I would add the unknowns around regulatory uncertainty. While jurisdictions like the EU and Singapore are making strides with frameworks like Markets in Crypto-Assets (MiCA), the global regulatory landscape remains fragmented. This creates friction for cross-border investment and could limit institutional participation.

DF: What some people like about crypto is the freedom to exchange and the lack of regulation, but this is actually getting in the way of its maturity. The idea of crypto as an easily exchangeable, transactionable currency that you can use to buy a loaf of bread will require a level of regulation. Tokenizing ETFs or assets, for example, is conceptually fine, but for it to become mainstream there will need to be a foundation of regulation and plumbing that are currently available in the traditional world.

LH: There definitely needs to be better rules and regulations around how these systems get established. How do you observe and regulate all the activities done on-chain or with this technology to make sure everything is transacting properly? How do you get native liquidity within these platforms? What kind of cybersecurity and technology challenges do you have to think through from an investor protection perspective? I’m not sure that last point has been pressure tested, and we’ve seen some successful fraudulent and phishing activity in the on-chain world.

It's difficult to picture an environment without the institutions and regulations governing all of this. They exist for good reasons, and those reasons don’t go away because the underlying technology changes.

DF: A huge part of it is also how the existing platforms embrace the technology. The traditional gatekeepers, wealth platforms and independent financial advisors need to adopt this technology because they’re the interface. The demand exists, but it’s a question of how quickly they can build the operational infrastructure.

LH: And it’s not clear at this point who wins. Right now, you can only trade a limited number of things in a wallet, whereas in my share dealing account I can trade pretty much anything. This will probably include digital assets in the near future, so there might be a situation where the wallet providers’ technology wins, but the incumbents are actually in the better positions to capitalize on that.

As an asset manager, we want to deliver our investment products and strategies in whatever form the clients want it, whether that’s a mutual fund or a digitally native representative of an asset. The underlying decision-making isn’t necessarily affected, because it’s still a portfolio manager making allocation decisions. But we need to be able to manage and leverage this digital ecosystem in a different space than our traditional platform, because it’s what our investors care about.

It’s through the strength of these frameworks that you’ll see mass adoption and confidence that will enable this technology to thrive.