The digital transformation of financial services is continuing apace. Digital technology, such as distributed ledger technology (DLT), is enabling any form of value to be transferred at low cost. This is not only opening the investment world to a wider client base, it’s also set to remove many of the complexities constraining the securities services industry.
Because of the speed of industry evolution, clear definitions of such new assets and solutions have yet to be cemented. The terms digital assets and crypto assets, for example, are often used interchangeably. And while the International Securities Services Association (ISSA) describes four classes of digital assets, the UK’s Financial Conduct Authority (FCA), defines three classes. As part of its definition, the European Central Bank (ECB) defines a crypto asset as one that “is not and does not represent a financial claim on, or a liability of, any identifiable entity”. That these assets lack an underlying fundamental value is the causation of both their novelty and inherent high volatility, according to the ECB.
Tokenisation – a growing phenomenon
The tokenisation of real-world assets into digital assets is a solution developed to address the risk profile of those assets. Tokenisation could also allow more efficient trading of all types of assets, including securities, bonds, private equities, commodities, real estate and fiat currencies, on digital asset exchanges. Assets are converted to digital tokens that are backed by the assets themselves – and are particularly useful for releasing trapped liquidity in otherwise untradeable asset classes.
According to ISSA, the number of digital assets issued and traded now exceeds 1,800, with a total market capitalisation of more than USD260 billion. The aggregate market capitalisation of digital assets skyrocketed from USD30 billion to more than USD800 billion at its peak in early January 2018, until coming down again to hover at around USD200 billion as of the end of last year. As ISSA includes crypto currencies, as the value of bitcoin and other top-five crypto currencies depreciated, the total market cap of digital assets subsequently fell, as these account for more than 60 per cent of the total transaction volume.
There are currently more than ten digital assets exchanges in the world, which are designed specifically for trading asset-backed tokens and encouraging token trading activities. In addition, there are more than 500 cryptocurrency exchanges – for which business models could easily be expanded to include asset-backed token trading.
Jurisdictions around the world are introducing regulatory frameworks for digital exchanges, these include larger jurisdictions such as Singapore, Thailand, Switzerland and Hong Kong. Smaller markets, too, are embracing digital assets and are introducing regulatory frameworks for digital exchanges. In Gibraltar, for example, the Distributed Ledger Technology Regulatory Framework (DLT framework), which was introduced on 1 January 2018, applies to activities (not subject to regulation under any other regulatory framework) that use DLT for the transmission or storage of value belonging to others.
Despite the growing interest in tokenisation, nothing of scale has yet been achieved. The ECB has observed that the combined value of digital assets is small relative to the financial system (and that linkages with the formal financial sector are limited).
Challenges for securities services providers
While there are considerable potential advantages in tokenisation, there are also challenges for securities services providers and their clients to overcome.
Foremost is a lack of standards and interoperability. The industry must reach a common view in terms of definitions of assets and how to make interoperability a reality. As industry participants introduce new concepts to the market, interoperability becomes even more important; without it, the additional liquidity that tokenisation offers will be limited to the size of the single exchange on which it is issued.
Several industry and regulatory working groups are looking to create standards around digital assets. Collectively, their work should help to identify and mitigate risks, enhance investor protection and ensure greater market integrity. The Tokenization Standards Association (TSA), for example, has issued due diligence standards for those engaged in the tokenisation of assets and token-generation events. The standards cover technology, blockchain regulation, legal and tax areas, anti-money laundering compliance, investor protection and trading.
Despite the attention garnered, institutional investors are reluctant to enter the digital asset market – given their fiduciary obligation, the risks currently associated with digital assets are untenable. Moreover, regulations require many institutional investors to appoint an independent custodian. Nascent and heterogenous regulations are also an impediment to adoption. Negative perceptions around such assets – particularly for cryptocurrencies such as bitcoin – continue to hinder their development. Perceived as volatile and vulnerable to hackers, regulating standards could help to alleviate such concerns.
While the combined value of crypto assets relative to the financial system is small, regulators continue to narrow their focus. Indeed, the ECB recently cited a requirement for “continuous careful monitoring,” of the sector.
This approach increasingly makes sense – ultimately, there could be policy inconsistencies if economically-equivalent assets are treated differently for regulatory or supervisory purposes. The rapid technological evolution of digital asset markets may also influence supervisory approaches, which if not done in consultation may give rise to regulatory gaps or areas that require further regulatory attention, says the FSB.
And given current variations in regulatory approaches, it’s also critical that regulatory infrastructure becomes more harmonised. Without this, the risk of jurisdictional arbitrage will increase, given the borderless nature of digital assets.
While the impact of digital assets on post-trade will be significant, industry participants will have to change the way they think about products, and how they bring them to the ‘borderless’ markets of the future. By experimenting now with the technologies, securities services providers can stand themselves in good stead for the road ahead. Tokenisation and digital and crypto assets are as significant an evolution as the movement from paper-based securities to electronic form was in the past. We all have to adapt.
By Margaret Harwood-Jones, Global Head of Securities Services, Standard Chartered
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