The new abnormal: crypto and other challenges

As the asset management industry looks to a future beyond the Covid-19 pandemic, it is having to confront the dual challenge of navigating falling asset prices amid tough macroeconomic conditions, as well as the need to find ways to monetise investor interest in digital assets, even as prices for cryptocurrencies have sunk.

The AQR Asset Management Institute’s Insight Summit aims to equip asset managers with the key insights and strategies they need to successfully navigate these global market shifts. This year’s summit is themed ‘A New Abnormal: Disruptions to Financial Markets’. At the 7 December event, participants will hear from top speakers on the impact of central bank policies, the emergence of crypto, and the outlook and implications of the current macro environment.

• Find out more about the 2022 summit

Having emerged from the pandemic being propelled by market tailwinds, asset managers must now confront headwinds. As central banks around the globe hike borrowing costs to curb soaring inflation, and governments retract the fiscal stimulus they pumped into the economy during the pandemic, stocks, bonds and other asset classes have struggled this year.

“Quantitative easing pushed up the prices of all asset classes, but we’re now facing unprecedented times as [UK] inflation is at a 40-year high and interest rates are going up. That is reducing asset prices across the board,” says Anna Pavlova, Professor of Finance and Academic Director of the AQR Asset Management Institute at London Business School.

These are among the “megathreats” that Nouriel Roubini will tackle in his address to the Insight Summit. The economist, who predicted the 2008 financial meltdown, is expected to warn that soaring inflation and mounting debt will tip the global economy into a recession.

Richard Portes, Professor of Economics and Academic Director of the AQR Asset Management Institute, says asset managers should not be complacent just because they have experienced past financial crises such as the 1987 market crash, the 2000 dotcom burst, and the 2009 Eurozone debt crisis. “We are now in extreme uncharted waters,” he warns.

As an example, he cites the poor liquidity in the US Treasury market. Treasury yields have swung wildly this year, making it harder and costlier for investors to buy or sell Treasury bonds in this normally placid $24 trillion market. The Federal Reserve’s aggressive pace of interest rate rises has magnified the volatility.

“These weaknesses in the markets may be more widespread than we thought,” says Professor Portes.

Derivatives

He believes such fragilities are being amplified by complex instruments such as derivatives — a situation that played out in the recent UK pension funds crisis. Many pensions use derivatives to hedge against moves in interest rates, but the sharp fall in the price of government bonds — following Westminster’s “mini” budget — led to demands for more cash collateral.

To raise the funds, pensions were forced to sell assets, causing bond prices to fall even further, which prompted the Bank of England to intervene to avoid a financial meltdown. What concerns Professor Portes is the opacity of these complex arrangements. “We don’t have enough data on investor exposure to derivatives,” he says, highlighting potential hidden risks to financial stability.

Cryptocurrencies

Alongside the macro environment, crypto assets and decentralised finance are high on the Summit’s agenda. “Few asset managers have digital assets in their portfolios, but it is an asset class that is becoming difficult to ignore,” says Professor Pavlova.

At the Summit, Carlo Zaffaroni and Fabio Frontini from Abraxas Capital Management will discuss crypto investment strategies and Tether, a “stablecoin” pegged to other assets.

Institutional investors are warming to such assets. For example, BlackRock, the world’s largest money manager, is launching a spot bitcoin private trust for institutional clients, which will track the performance of the digital currency.

These offerings come despite the steep sell-off in bitcoin and other digital assets. However, Professor Portes believes that these assets do not yet represent a threat to global financial stability because of their limited interconnectedness with the traditional financial system.

“We needn’t worry about instability or shocks in the crypto and decentralised finance areas transmitting themselves to the banks and markets,” he says.

Regulation

Yet the industry’s growing ties to asset managers has led central banks and governments to increase their scrutiny of the market, following the crash in prices. The regulation of these markets will be a major Insight Summit theme, with Fabio Panetta, Member of the Executive Board of the European Central Bank, delivering his address on the subject.

The EU struck a landmark agreement this year to regulate the trading of crypto assets across the bloc. The rules aim to deliver much-needed protections to consumers, but without stifling the growth of the nascent market. “Investors often do not know what they’re getting into,” Professor Pavlova says. “And certainly, some regulatory oversight is overdue.”

Professor Portes thinks the US is falling behind the EU in drawing up new rules to govern the sector. “The regulatory environment is very vague and very limited,” he says. This is because US lawmakers have been unable to agree on how to regulate crypto. The Securities and Exchange Commission has taken a tough line on crypto exchanges, but digital assets themselves have limited oversight.”

“It is a global market and there are possibilities for regulatory arbitrage,” adds Professor Pavlova, underscoring the need for global rules to govern borderless crypto markets.

Please e-mail AQRInstitute@london.edu to be sent a link to register for the virtual event.