Digital assets – Cutting through the noise

Jannah Patchay, founder of Markets Evolution assesses the digital asset landscape and the benefits it can bring to market participants.

Last year was all about digital assets. Bitcoin continued its volatile journey, Paypal launched a cryptocurrency service, the Bank of England and HM Treasury joined a growing trend by governments and central banks to explore central bank-issued digital currency. Meanwhile, Meta (formerly Facebook) is (still) planning to issue a digital currency via its Diem Association, plus we saw the rise of non-fungible tokens and the world’s first tokenised digital house. Just a few of the abundant digital asset headlines in 2021.

Amongst all this noise, it’s been all too easy to overlook some of the important developments with respect to digital assets and their adoption in traditional financial markets.

The term “digital asset” represents a diverse range of instruments. Cryptocurrencies are one component, and while they remain a source of innovation (and inspiration), their legacy has a wider reach. Digital money – in the form of central bank-issued digital currencies (CBDCs), or privately-issued, fiat-backed stablecoins such as JPM Coin and Circle’s USDC – has the potential to transform post-trade processing in wholesale markets through atomic, instantaneous settlement capabilities.

Other forms of digital assets – such as non-fungible tokens (NFTs) – exist on a spectrum ranging from platform-specific utility tokens through to fully regulated security tokens, equivalent to existing financial instruments.

On the 18th November 2021, SIX Digital Exchange (SDX) announced the world’s first issuance of a purely digital bond on a fully regulated environment. It comprised two parts – the digital issuance on the SDX platform, and a traditional issuance on SIX Swiss Exchange. It is remarkable not only for bridging the traditional and digital worlds, but also in being digital-native – the digital issuance was not based on an underlying traditional issuance.

For other jurisdictions and markets, this represents an example of what can be achieved when legislators, regulators, and the central bank work with market infrastructure providers and market participants towards a clear goal and destination. In this case, the establishment of a legal and regulatory framework to support the development of digital asset markets. But why does it matter? What benefits can digital assets bring to financial markets, and why should we embrace their potential?

There’s all too often a tendency to see regulated digital assets as a gimmick, a play by financial institutions to show their understanding of emerging technologies and paradigms – such as distributed ledger technology (DLT) and decentralised finance (DeFi) – without any real grasp of their transformational potential for financial markets.

Yet they have much to offer, and forward-looking institutions such as Archax – the UK’s first fully FCA-regulated digital securities exchange – are taking the first steps towards developing the infrastructure to support these markets.

DLT, in this instance, is inextricable from the financial instrument; it allows for the creation of unique digital assets that are cryptographically secured, and for which ownership can be fully transferred without risk of copying or duplicate entries.

A digital asset is a representation of value which is an asset in and of itself. It could represent an underlying physical (or digital) asset – a traditional security, for example, or a basket of securities, or a derivatives contract.

Digital asset transactions – when executed on a platform that supports settlement with CBDC or private digital money – can also be instantaneously settled, reducing or even eliminating counterparty and settlement risk, and allowing for streamlined post-trade processing.

In addition, these assets are governed by programmable ‘smart contracts’, which can carry data about the asset, its issuer and its valuation, along with rules and processes to determine applicable regulation and compliance obligations, automatically perform regulatory and tax reporting, or undertake suitability checks on transfer of ownership. It’s far beyond the capabilities of the technology stack needed to support valuation, due diligence and regulatory compliance with respect to traditional assets and instruments today.

There is nothing inherently radical about creating digital representations of traditional securities. Most would likely accept that it’s the next stage of their technological evolution. Looking beyond existing asset classes, though, things become a lot more interesting. Illiquid assets today tend to be illiquid due to their complex legal documentation, the high degree of due diligence involved, and the challenges of valuation.

They can also reference a number of underlying assets, all of which must be included in any transfer of ownership, and all of which require valuation and risk assessment as well, culminating in significant, onerous paperwork to effect a transfer of ownership.

Digitisation of these illiquid assets can lead to a host of benefits. It can enable more streamlined valuation of assets, as the assets themselves can carry valuation logic and links to valuation data sources. It can provide the ability to build in verifiable linkage to any underlying assets and to ensure that ownership of all of these is transferred successfully.

The list also includes the ability for fractionalisation of the new digital assets, helping to create new liquidity and new investment opportunities, where these previously did not exist. This opens up previously inaccessible assets for asset managers and buyside firms seeking alpha, while firms like banks can leverage the opportunities created to offload risk and to free up balance sheet capacity.

Programmability introduces new opportunities for automation of trade or instrument lifecycle events, or integrating the capabilities of other frontier technologies such as AI / ML or the internet of things (IoT), so that the performance of an asset can be monitored and reflected in factors affecting its valuation in real-time. This leads to the ability to monitor, measure and report on other factors as well – such as performance against environmental, social and governance objectives.

Performance of sustainable, green and impact investments is notoriously difficult to measure and report with any degree of consistency, accuracy and reliability. This is where programmable digital assets can really add value that goes beyond financial measures. Indeed, given the complexities of measuring and integrating ESG metrics into instrument pricing, digital assets may be the only solution to the challenges of transitioning to a more sustainable financial system.

©Markets Media Europe 2022

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