The past five years have ushered in a number of monumental changes across the industry. Most notably, financial institutions are now making abundant use of new technologies to support their clients’ evolving requirements and heightened expectations. Digital assets are one such example. With investors struggling to generate returns off traditional asset classes – namely equities and fixed income – many are now thinking more laterally about where they obtain their returns.
Digital assets: New instruments, better returns?
The investor appetite for digital assets has been around for some time. According to a State Street study in December 2019, only six percent of respondents said they had no digital assets in their investment portfolios and that they had no plans to invest in them in 2020 either. 69% of large institutions polled by State Street added that they intended to boost their digital asset allocations in 2020. However, the debate about digital assets has undergone a seismic shift over the past two years.
Historically, banks and infrastructure providers spoke enthusiastically of tokenizing conventional equity securities. Nowadays, however, experts believe that tokenization is of more tangible use in illiquid markets such as commercial real estate or private equity. This is because trading in traditional equity markets is already reasonably efficient so the argument for digitization or tokenization carries less weight.
This is not so with illiquid instruments. Through divisible, low-cost tokens, more investors – including retail – will be able to trade in illiquid assets which were previously unavailable to them. In addition to democratizing investment, tokenization could help generate more liquidity in illiquid markets while facilitating much better transparency and efficiency during the transaction lifecycle.
Is the market ready?
With investor interest in digital assets growing, it is vital that intermediaries – principally custodians and market infrastructures – evolve accordingly. This will require providers of post-trade services to implement wholesale changes to their platforms and technology architecture. A failure to do so exposes them to the risk of disintermediation from fintech companies. Increasingly, exchanges, CSDs (central securities depositories) and custodians are beginning to examine ways by which they can offer digital asset services such as safekeeping.
Providers such as SIX Digital Exchange (SDX) are actively participating in a number of industry bodies looking to promote standardization to encourage more effective innovation. These include the InterWork Alliance (IWA), an association entrusted with developing standards for tokenization, which also counts among its members leading technology firms such as Microsoft. As more trusted and regulated financial institutions roll out digital asset solutions, sophisticated investors will start increasing their digital asset holdings.
Although service providers have woken up to the potential commercial opportunities that digital assets may bring, the regulatory situation is muddled. While markets such as Switzerland have adopted an incredibly progressive approach towards digital assets, others are being far more cautious or even antagonistic. This lack of regulatory consensus – or industry-wide standards for that matter – is a major obstacle, which needs to be overcome. If digital assets are to become more ubiquitous, then market participants need to collaborate on standards and engage with rule-makers to develop comprehensive and homogenized regulations.
CBDCs – digitizing currencies for the 21st century
Central bank digital currencies (CBDCs) – as the name suggests – are an electronic form of central bank money, which can be used by households and businesses to make payments. Unlike a crypto-currency, a CBDC is pegged to the central bank that issued it. The emergence of CBDCs comes at a time when physical cash payments are in decline, something which has been accelerated by COVID-19. As with digital assets, the pace of adoption across different markets is not synchronized. The People’s Bank of China (PBOC) is widely expected to be the first central bank to unveil a CBDC, although SDX is working on a CBDC project with the Swiss National Bank (SNB). Trials have already begun in a handful of Chinese cities with a lottery due to be held in Shenzhen to distribute USD 1.5 million worth of CBDCs. With physical cash payments becoming less common, CBDCs could fill a void.
A digital future
Digitization – whether it be through tokenization or the adoption of CBDCs – will result in profound changes across financial services. If the traditional incumbents want to retain client wallet share, they will need to develop a strategy along with solutions to support the burgeoning digital financial market. Something that is easier said than done.