Digital Currencies and ESG: Strange Bedfellows?

By Martha Reyes, Head of Research at Bequant

ESG and digital assets have more in common than meets the eye. At first, they both faced rejection by incumbents and investors. They then gained popularity and finally recognition by politicians and regulators, having been nudged by public pressure. They are relatively new asset classes coming into their own, with key issues to resolve.

They also attract individuals with strong convictions. Today, politicians, and even some governments, are starting to embrace digital currencies and blockchain technology, realizing its potential and popularity amongst voters. Some of the main incumbents, financial institutions, have done a complete about face from outright rejection to providing access to the new technology for their clients.

Digital assets and DeFi may become more mainstream as more people understand the potential benefits, both social and financial. The idea that ESG has financial implications and can lead to better investment returns, in addition to the social and environmental goals, is now firmly entrenched. Studies show that investors can beat the index all while doing good for the planet and society. As a result, ESG investing has been expanding at 30% per annum over the last five years, on the back of strong client demand. Bloomberg projects assets under management (AUM) could climb to $50 trillion +, over a third of total investments.

Blockchain technology has the potential to help address some ESG goals. It should be nurtured by those espousing ethical considerations, while accepting that meeting ESG criteria is a gradual process, as has been the case in traditional assets.

The digital asset industry’s role

Given the importance of the issues, global awareness and the size of the addressable market, the digital asset industry would advance its adoption and sustainability if it worked towards transparency and self-reporting, engaging with the ratings agencies and data providers.

The decentralized nature of many protocols and the sheer number of projects in existence make this a challenge. It could also add extra costs and burdens to a nascent sector that may be already dealing with stricter KYC and tax reporting requirements, hurting start-ups and benefiting larger projects. There is a balance to be struck and the process will take time.

More than just an E

There has been so much written about the supposed conflict between ESG and digital assets. It helps to take a step back and define what is meant by ESG investing as it can mean different things to different people. In particular, ESG goes beyond climate challenges, and also addresses social impact and governance concerns. The overwhelming ESG concern amongst investors is climate risk, especially post-Paris Agreement (2015) and here is where crypto has faced the most backlash. On the energy front, only Bitcoin and Ethereum, as proof of work protocols, faced scrutiny. The community has responded well, with great strides made in a short period of time in terms of transparency and reporting. However, with the COVID-19 pandemic, there has been more of an emphasis on inequality and sustainable finance, both issues where digital assets have bragging rights. Less attention has been placed on the social inclusion and equality aspects of the digital industry. This will come as awareness grows and here is where the industry can shine.

Global remittances is the area that has received the most limelight, with billions to be shaved off transfer fees across the world. The World Bank currently suggests that fees are between 5-7% of transactions, a substantial amount given remittances are expected to hit almost $1 trillion in five years (Allied Market research). Given the security, faster transaction speeds and absence of banking account requirements, it is easy to see why we are seeing high adoption rates in the case of remittances.

Another powerful argument is that cryptocurrencies are used as a store of value. Though not universally relevant, it has been vital to many people in countries with failed economic models, namely Argentina, looking to preserve their wealth.

The technology has aided organizations in countries with repressive governments to find ways to source funding, Russia being a case in hand. Stablecoins have been used to transfer funds to those who do not have access to banking services. In the future, if technology extends to property rights, that would be a huge advancement in the developing world, where the rule of law can be weak and an important factor in economic development.

Perhaps in the developed world, some of the above issues may seem distant. As inequality has increased even in wealthier countries, the impact can be felt closer to home, where younger generations have a low net worth versus previous ones due to stagnant wages and runaway asset prices. DeFi has provided individuals with better rates on their savings, eliminated banking fees, and offered the opportunity to invest in fractionalized art or real estate, areas that were traditionally the preserve of the wealthy.

Governance is perhaps the Achilles heel of digital assets. This ranges from risks such as hacking and rug pulls to a lack of diversity within the community. That said, these risks are hardly exclusive to crypto. The development of DeFi and Decentralized Autonomous Organizations (DAOs) has posed new questions for us on governance, with degrees of centralization and the control of keys being debated across the community. The ability to choose the direction of a project through governance tokens opens new possibilities for governance and a new meaning to the term “democratized finance”. The shape that this will take, and the impact on the wider financial system is still not clear.

Despite the risks, demand will likely continue to expand as people become cognizant of the benefits of blockchain technology across many segments. The recent amendment debate in the US Congress has probably done a lot to ratchet up awareness even more. We have seen adoption of innovative technology in other instances where risks have not necessarily deterred uptake. As we see the industry mature, it will be able to focus on improving its overall ESG reporting standards and cope with additional regulatory burdens or taxation, drawing in more participants by doing so.

Read more from the report, Digital Assets: Laying ESG Foundations