By Florence Angles, CAIA, FDP is managing principal within Capco in charge of Finance, Risk and Compliance (including ESG).
ESG is no longer just an acronym, it becomes a reality, representing in 2025 a market of $53,000 billion, i.e., one third of global assets under management, with Europe and North America as its epicentre.
The environmental, social and governance (ESG) agenda has thus become a growing priority for the financial sector. This groundswell was reinforced during the COVID-19 pandemic, prompting institutions to prioritize their strategy, notably by integrating these three criteria into risk management and product development. Regulators have also made it their priority and we are far from the end of the regulatory wave; this is just the beginning!
The European Union is the leader in this field. The regulatory framework for digital assets is on the horizon: initiated with the 5th Anti-Money Laundering Directive that came into force in January 2020, which gives a legal definition of cryptocurrency and expands the scope of customer due diligence obligations, but it doesn't stop there. A future regulatory framework, called MiCA (Markets in crypto assets), is expected by 2024. It aims to harmonize the European framework for different types of crypto-currencies and its coverage is broad (issuance, trading, settlement, custody, and collateral management) for digital assets not classified by current regulations. In parallel to this development, a regulatory tidal wave is taking shape in Europe in the field of sustainable finance taking its source in the European Commission's action plan on sustainable finance published on March 8, 2018, and whose impacts on financial institutions will change their entire organization, including risk management. This is the current challenge for Europe's largest banks: how to integrate ESG criteria into governance, risk measures, stress tests, reporting and potentially the bank's own funds?
Sustainability concerns are spreading across the economy including digital assets. For example, the cryptocurrency market has reached a capitalization of $3,000 billion by the end of November 2021. Institutional investors, initially reluctant, are jumping into these assets, which are sometimes described as "sulphurous" given their volatility, regulatory uncertainty, and potential for fraud and money laundering. Their integration is now raising questions about their sustainability. Are they compatible with the ESG agenda of financial institutions?
Greening digital assets
Bitcoin, the first and most popular cryptocurrency with its proof-of-work (PoW) consensus mechanism, allows two parties who do not know each other to transact in a completely decentralised manner. Despite these many advantages, studies have pointed to the ever-growing energy appetite of this digital ogre, to the point where it has become uncontrollable as the number of miners has increased.
However, as technology evolves and adapts to its new environment, solutions exist. The first option is the use of renewable energy. The third global crypto asset benchmarking study shows that the share of renewable energy in the total energy consumption of PoW miners has reached 39% globally, with hydroelectricity being the most popular source. Geographical disparities exist: North America seems to use the most renewable energy from different sources.
The second possible alternative is a migration to other, more efficient consensus mechanisms. One example is the migration from PoW to Ethereum proof-of-stake (PoS). If successful, the Ethereum Foundation estimates that it could reduce energy consumption by 99.95%.
Greater inclusion and improved compliance under the weight of new regulation
Digital assets promise to break down socio-economic barriers by promoting financial inclusion. They can have a positive social impact, particularly in developing economies. This progress must be qualified by potential questions about respect for human rights and problems of fraud.
As the demand for digital assets increases worldwide, there are threats that are becoming more and more common. The characteristics of some digital assets make them attractive and exploitable by cybercriminals.
Encounter between two worlds - traditional and alternative - towards a hybrid governance
Digital assets offer a new and completely decentralised mode of governance. In traditional finance, small investors typically have limited decision-making power over strategic directions, which is no longer necessarily the case with community owners of digital assets. The rapid development of decentralised finance (DeFi) allows for innovation in the governance space by decentralising power rather than concentrating it. However, this vision is confronted with reality and must be integrated into the conventional financial and legal system.
Finance is reaching a new stage where central banks are entering the arena and have begun researching the suitability of issuing a government digital currency (CBDC) as an alternative to cash, an opportunity to reduce costs and the possibility of maintaining control over the money supply and interest rates. According to a 2021 survey by the Bank for International Settlements, 86% of central banks are actively exploring the potential of CBDCs. China has taken a lead in this area with the digital yuan issued and controlled by the Chinese central bank. With a preliminary test phase in many Chinese cities, its official launch is planned for this year. Its deployment coincides with the ban on Bitcoin and cryptocurrency mining in China. The aim is to export the digital yuan beyond China's borders and eventually compete with the dollar. Other countries are following the trend, the United States, the European Union, United Kingdom, and Switzerland with the Helvetia project.
Digital assets are therefore adapting to the new requirements by becoming aware of their impact on the planet, society, and the financial system. Faced with the development of alternative finance, central banks have stepped in and are now setting the pace with future governmental digital currencies: a new geopolitical and stability issue for the global financial system.
About the Author:
Florence Angles, CAIA, FDP is managing principal within Capco in charge of Finance, Risk and Compliance (including ESG).
During the last 3 years, Florence leads the ESG practice for Capco Switzerland including ESG mandates. Florence has 22 years of experience in banking and asset management, more particularly in the risk management field in Europe for Tier 1 banks, private banks, and asset managers, and was leading the Risk Management Practice of a big 4 in Switzerland. She has a strong knowledge of Swiss, EU and UK regulations including supervisory audit. she followed an engineering degree in France supplemented by an MBA in finance and a DBA in partnership with Georgetown University on the topics of ESG. Florence is also a certified ESG analyst from EFFAS.