Financial Institutions and Digital Assets: New Opportunities, New Risks

As interest in cryptocurrencies and non-fungible tokens (NFTs) grows, financial services institutions of all sizes are looking to move into the digital assets space.

Despite the recent volatility of the cryptocurrency markets, digital assets as an investment class have grown rapidly — cryptocurrencies’ global market capitalization currently stands at $1 trillion.

As the market becomes increasingly mainstream, financial institutions are entering the space to maintain a share of their clients’ “wallet,” rather than risk losing business to digital asset platforms and fintechs that offer a broad range of banking and digital asset-related services.

This pressure to enter new markets isn’t limited to the largest players. Small and mid-sized banks are eager to serve their customers’ digital assets needs as well, either as custodians of customers’ digital assets or through investing.

But these opportunities come with crucial decisions about how financial institutions can best serve and protect their clients’ digital assets within a regulatory framework.

“Traditional banks and financial institutions are trying to stay in front of their customer base’s expectations,” says Joel Sulkes, managing director and global financial institutions industry leader at Aon. “There is a real threat of disintermediation. All the classic banks, one way or the other, are considering how to provide their customers with digital asset exposure in a way that will comport with their risk frameworks and regulatory requirements. It’s really a race to stay relevant.”

As they increase their work with digital assets, financial institutions face a variety of risks, including traditional asset and regulatory risks. These challenges vary according to the financial institution’s role in digital assets and whether they’re acting in a custodial role or outsourcing custody, operating in a fiduciary capacity or serving another function.

“They really have to understand the hat they’re wearing,” says Sulkes. “They need to understand the different operational risks those offerings create for themselves, and then they have to manage it. And in some cases, insurance can be a tool to manage some of those risks.”

Insuring Digital Assets

Many banks have robust insurance programs for their traditional operations. But they now also have to determine whether those programs will cover digital asset activity or identify and address gaps in their coverage.

On top of this, some insurers who cover financial institutions’ business involving traditional assets might be less inclined to take on the risks associated with digital assets. In some cases, it might be most effective for financial institutions moving into digital assets to ring-fence those risks from their other exposures, creating a separate insurance program for digital asset risks.

Challenges for Smaller Institutions

Larger banks are more attractive to insurers covering digital assets because they typically have higher retentions in their risk-financing programs than smaller financial institutions. Plus, the larger banks’ digital asset business will likely represent only a small percentage of their overall operations. All this makes it more difficult for smaller institutions to obtain coverage.

“When you go downstream to the smaller entities, you find lower premiums and lower retentions,” says Jim McCue, managing director and U.S. financial institutions industry leader at Aon. “Finding digital asset coverage gets to be more difficult. They’re not as high-profile with these insurers, they don’t have as much premium in the bank or the relationship history with the insurers and their foray into digital assets could be a larger proportion of their exposures overall.”

In many cases, digital asset service providers are helping the smaller institutions overcome those issues. Those relationships can allow a smaller bank to offer digital asset solutions to customers, while a service provider maintains responsibility for custody of the digital assets.

The Impact of Regulatory Risk

Regulatory uncertainty might be the biggest obstacle for banks and other financial institutions entering the digital asset space. In the U.S., the Securities and Exchange Commission and the Commodity Futures Trading Commission have both claimed to have purview over different aspects of digital assets, McCue notes. There have been positive signs recently as the current administration issued an executive order in March for the “responsible development of digital assets” and subsequently a comprehensive, bipartisan “crypto bill” was introduced in the U.S. Senate.

“The recent executive order from the current administration encouraging regulators to develop more clarity has been welcome just in itself, as it has given insurers comfort that this industry is here to stay,” McCue says.

Other countries have been more receptive to digital assets. “We do see some financial institutions that are setting up subsidiaries in Switzerland, for example, because of the more friendly stance on crypto,” says McCue. “And the U.K. is a bit ahead of the U.S. in terms of being proactive towards crypto as well.”

The regulatory uncertainty is also contributing to a supply-demand gap for insurance products to cover digital asset business — both for traditional financial institutions and businesses created in the digital asset space, otherwise known as digital asset natives. While the insurance capacity supply has been slowly increasing, it has not kept up with the growth in demand.

“In the native space, we have done a lot of good work with some of the bigger native digital asset players to help them address limited insurance market supply and capacity through the development of captive programs to supplement limited market capacity,” says Sulkes.

Embracing a Digital Asset Future

As the digital asset market continues to grow, it will become increasingly interwoven into various aspects of the economy. To meet customer demand and maintain relevancy, traditional financial institutions are exploring their adjacencies with the evolving digital asset ecosystem. As they do so, it’s essential that these institutions understand the emerging risks they will face correlated to the services they’ll be providing along with the risk assessment and mitigation tools being developed in the insurance industry.