Blockchain has ushered in a new era in the finance world but perhaps one of the most interesting innovations blockchain has introduced is the rise of digital assets.
One of the key advantages associated with digital assets is the ability to lower costs, remove intermediaries in their distribution and tackle counterparty risk. This process occurs when financial or real assets are digitised on the blockchain.
As a result of this, a hype formed around initial coin offering (ICO), which particularly attracted those who had missed the mark on cryptocurrencies such as Bitcoin.
ICO, however, is highly risky. GMEX Group’s chairperson and CEO, Hirander Misra, explains that the ICO bubble burst because there was a lack of regulation and trust resulting in many investors being burnt.
The burst ICO bubble prompted a move towards asset backed tokens with security token offerings (STOs) being undertaken in regulated environments so that the underlying companies/ assets can be properly vetted, according to GMEX Group’s CEO.
Misra notes: “We expect these to be increasingly on regulated digital exchanges with regulated digital custody taking into account existing processes relating to the underlying assets.”
This is aligning the old world of traditional assets with the new digital world with fewer intermediaries and lower cost. Misra explains: “There will be more digital funds set up that tokenise assets in a way that traditional professional investors can invest.”
As the rise of digital assets has changed the game of how the industry interacts with money, several digital custody services have popped up in recent years, including the partnership between Archax and Unbound Tech, for example.
This year, industry experts expect there will be more investigations into the economic advantages of digital assets, stronger demand for digital capital markets solutions, alongside increased advances in blockchain interoperability. Additionally, the development of regulation on digital exchanges is suggested to become more prominent. All of these things are set to bolster the digital asset space.
The digital demand
Digital assets are flying high in the asset servicing world and are becoming increasingly welcomed by institutional investors. Digital assets require enterprise-grade market infrastructure that can be integrated with existing technology and processes to run properly in regulated environments. This is so they can trust and align digital assets with the existing business.
Misra explains that as the potential impact of blockchain technology on financial markets - new and old - becomes more readily apparent, institutional investors are increasingly engaging with digital assets, whether directly or through service providers.
To back this up, Misra refers to a survey conducted by Fidelity Investments, published in May last year, which found that around 22 percent of investors already have some exposure to digital assets, while 40 percent say they are open to diving into this exciting market over the next five years. The survey findings also showed that, of those that have exposure, most investments were made in the last three years.
Discussing the changing attitudes towards digital assets across institutional investors, Myles Milston, CEO of Globacap, identifies that there is still a scepticism towards pure crypto assets such as Bitcoin, but that’s shifting as institutions like Fidelity and Nomura start to provide custody for those assets.
The scepticism around crypto stems from the 2018 cryptocurrency crash, which occurred after an unprecedented boom in 2017, when the price of Bitcoin fell by approximately 65 percent during the month from 6 January to 6 February 2018.
However, Milston notes that people are showing an “increasing understanding of the many benefits that blockchain brings, especially in automating workflows and making existing manual work more efficient and cost-effective”.
In terms of what is being done in the custodian community to service digital assets, Ralph Achkar, managing director, digital product development and innovation at State Street, identifies that they are actively monitoring demand from clients to understand the exact needs of solutions for digital assets.
Additionally, State Street are working with the market and regulators to “understand how existing rules, regulations, and constructs apply to digital assets, as well as conducting pilots to try new approaches and ideas for the custody of digital assets and ongoing work with existing wallet providers who have been servicing the digital asset space for some time”, Achkar notes.
As attitudes towards digital assets are becoming increasingly positive, more work is being carried out to devise the market standards and tools that will enable crypto-asset services providers to interoperate with each other – floating towards the exciting second generation of blockchain in financial services.
Misra suggests: “It’s going to lead to a bigger future. The second wave of blockchain now looks at much more multi-node activity across tiers, across jurisdictions and across business activities as well.”
Archax’s chief marketing officer, Simon Barnby, has observed that there are a number of initiatives around interoperability standards, but none has really established itself as the leader yet.
Barnby says that over time there is likely to be a “somewhat of a shakedown” reducing the number of different technology standards/providers.
He adds: “Projects such as the Archax Exchange, effectively normalise the differing standards for institutions and insulate them from the multitude of underlying technologies, standards and platforms being used.”
A need for regulation
To encourage future advancement to further shape attitudes towards digital assets, regulators are working towards increasing regulation on digital assets after a lack of regulation was one of the main causes for the cryptocurrency crash back in 2018.
While regulators are at different stages of forming views on digital assets and how the different types of digital assets fit into their regulations, Nelson Macchi, head of operations at Finoa, a German-based fintech company, says that Europe is at the forefront of regulation with Germany leading the way.
Backing this statement up, Globacap’s Milston notes that ‘crypto assets’ are currently unregulated, but Germany was the first country to introduce legislation around custody.
“This was a big step forward in allowing institutions to potentially invest in these types of assets more widely since it gave investors a framework by which regulated custodians could be used. That’s a key requirement for institutional investors,” Milston says.
Meanwhile, the current direction is consideration into how to fit existing regulation to the digital asset space, and how to bridge differences resulting from the use of distributed ledger technologies, observes Achkar.
“The initial focus is on private networks with a defined governance structure before considering public networks”, Achkar says.
In jurisdictions such as the UK and the US, for example, Misra notes that increasingly, security tokens are seen as securities and will be subject to securities laws.
The time for unregulated digital exchanges is limited, according to Misra, as credible investors, whether they are retail or institutional, want to trade on a platform they can trust. He says: “It’s inevitable that we will see a shift from unregulated exchange platforms for regulated ones not only on the securities side but also in the case of crypto derivatives that really need to be supported by a properly regulated clearing house to protect against potential events of default.”
“In some jurisdictions where the prevailing laws do not support certain types of digital asset activity, regulatory Sandbox structures have been introduced so that the feedback within a two-year period of activity can then lead to policy changes at national level followed by regulatory changes, which can see the introduction of new types of licensed activity such as digital custodians, challenger banks and robo-advisory on the wealth management side,” Misra explains.
Digital deployment
Predicting the 2020 landscape, Misra suggests that the key trends in the digital capital markets space will be based around: properly regulated digital exchanges and custodians go live; more assets tokenised and increased institutional involvement, demand for digital capital markets solutions; advancements in blockchain interoperability, the convergence of artificial intelligence (AI) and blockchains.
In terms of convergence of AI and blockchain, Misra predicts that there will be “greater application of AI in mainstream capital markets underpinned by blockchain immutability this year whether it is in investment management for robo-advisory, market surveillance or to drive smart contracts underpinned by the right data and analytics with self learning feedback loops”.
Milston believes that a few large exchanges or banks will have deployed blockchain technology by the end of this year to replace at least some of their existing processes. He says: “The greater awareness this brings should kickstart a longer-term transformation in the capital markets industry.”
Going back to regulation and how it will come into play for the year ahead, Macchi emphasises that infrastructure providers (as well as market makers and participants) “will have to close the gap” with standards in the existing in the traditional finance industry and current processes. For example, compliance, bringing trust to the overall industry and therefore a consequent overall growth.
Macchi highlights that the regulated security-token exchanges going live in 2020 will be SIX Swiss, Deutsche Boerse, and the London Stock Exchange.
Oz Mishli, vice president of products at Unbound Tech, suggests that most of the big players in the custodian community are “testing the waters” in terms of providing custody for digital assets, however, “few of them are actively moving forward into that direction and actually offering a service now or in the near future”.
