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June 2022
 

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Why Crypto Is Just the Start of Digital Transformation of Finance

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It is hard to imagine financial services, let alone any industry, without the internet. Yet that was the case a few decades ago. The internet is the single underlying layer to everything we do today. It not only is how we “work” it is also how we spend our time off.

Life became faster, scalable and “easier,” we learned more, communicated more and took advantage of it to transform finance.

Blockchain technology is primed to do the same thing. It will affect everything: WHAT we invest in, HOW we invest and even WHO we invest with.

The conversation around theadoption of blockchain technology in financial markets has, for the most part,been centered around cryptocurrency and its rise as an asset class. Whilecrypto is an important development, it is just the start. Blockchain technologycan support the digitization of any financial asset.

The reason blockchain is so attractive is at its heart blockchain verifies and confirms ownership as well as value in a way that is both immutable and seamless. It allows for value exchange that previously was unattainable for electronic transactions. Once the data is “validated” it cannot be changed, making it far more powerful than most technology in place today.To understand why, start with what blockchain is. Blockchain is a distributed ledger and cryptocurrencies like bitcoin are just one use of the blockchain technology. Blockchain technology is over a decade old and what may be surprising is that blockchain already exists in many industries today. For example, both Walmart and the shipping company, Maersk use blockchain to monitor supply chains, solve logistic issues and improve performance. Other industries such as healthcare and public transportation also use blockchain technology. We expect blockchain to cause a dramatic shift across all sectors of the financial industry including the buy side and sell side. For the buy side this not only means incorporating new asset classes into portfolio models for purposes of return, but more importantly it means taking advantage of blockchain technology to reduce the costs of IT, labor, compliance and overhead.Since financial services is a dynamic and fluid industry, it has amassed a large amount of “technical debt.” Technical debt is the result of applying short-term solutions to improve or implement processes rather than taking the time to implement a new technology or a longer term solution. In the past, technological innovation in finance often meant developing new layers on top of old ones. That will not be the case with blockchain though, as it requires an entirely new infrastructure. This is likely to occur as tokenization transforms traditional assets into digital assets.
 

The promise of tokenization
It is essential to understand what tokenization is, not only as a new form of asset investment, but also how it has evolved in the last five years.

Tokenization is best described as the process of taking a tangible “asset” and replicating it on a blockchain in the form of a “token.” That “token” represents the asset but in reality, it is a surrogate or proxy for the actual “asset.” It is important that the network on which it is represented recognizes it and treats it as the actual asset. These “tokens” can then be used to move that asset, settle and exchange it for another token representing another asset and so on. While blockchain has been around since 2008, the idea of using it for tokenization is only a recent use case, however it has evolved rapidly in the past few years. A review of all blockchain based businesses that existed in 2017—well over 200 companies including custodians, trading firms, exchanges, developers and more—shows that none of the firms at that time specialized in tokenization. Today there are at least two dozen firms whose business model is mostly, if not entirely, built on tokenization. For example: Securrency, Tokeny, Texture, Paxos and Symbiont. We have seen illiquid assets like real estate and art being digitized, but none of these early experiments gained much traction; they really were tokenization of assets that were for the most part not attractive to institutional investors. Today the digitization of private assets has accelerated, particularly equity and debt, along with traditional assets like public equity and fixed income. The future also holds the promise of true multi-asset trading. Our current trading universe involves almost every asset—bonds, gold, stocks, real estate—all trading on different platforms. There are multiple settlement cycles and multiple intermediaries and the movement from one asset class to the next or even between single assets (equity to equity) is not at all seamless.

But what if all assets were represented as tokens and could move between blockchains? The tokens themselves, instead of being represented by their conversion rate to a currency, would have a conversion rate to another asset. For example, we could move from a gold “token” into a bond “token” almost immediately; We would offset the tokens and net cash on the blockchain and do so with little risk of errors or settlement failure. The possibilities this creates are astounding and will lead to seismic shifts on the asset management business model.The most interesting ideas take tokenization a step further. That is where tokenization is starting to create entirely new asset classes, which will ultimately segue into the mainstream. For example, the tokenization of data is a particularly interesting area. Tokenization could allow companies to share their data securely with third parties, but more importantly allow them to value their data in a way that was previously unattainable.

Finoa, a European digital assets management platform, researched tokenization markets and projected developments (Figure 1). Overall, it projected tokenized assets would grow from US$500 billion to US$24 trillion by 2027 not including intangible assets1. The advantages of tokenization are well beyond simply digitizing assets. The utilization of blockchain technology at some point in the lifecycle of the asset can create a better experience or even eliminate a process such as transfer Agency or T+0 settlement. Advantages of tokenization include:

  • Increased sources of capital – Accredited investors will be able to access more private investments. Eventually the market for private assets will be democratized as they will be easily accessible to a wide and diverse set of investors.
  • Liquidity – Tokens can easily and securely be exchanged on a secondary over-the-counter market using blockchain. As mentioned above, the bar of entry is lowered and the opportunity to create a retail secondary private market that does not yet exist.
  • Fractionalization – Assets can be split into far greater amounts than traditional methods, lowering barriers to investments. Also, through fractionalization tokens can offer greater investor diversification and targeted portfolio construction.
  • Data transparency – Data is stored and accessed securely on the blockchain, providing credible insights to investors.
  • Shorter settlement time – Tokens are traded 24/7 with a record that can be updated in minutes, compared to T+3 day settlement times. We have proven this in equity markets and our thesis is that it will hold for all markets.
  • Operational efficiency – Mostly manual processes such as compliance and corporate action, can be “automated” via smart contracts.
  • Flexibility – Tokens can be customized with unlimited share and debt
Projected tokenized market volume until 2027

The challenges of digitizing assets
Of course, as with any new technology, there are challenges to overcome. First, cryptocurrency’s environmental problem raises concern about the sustainability of blockchain technology more generally (Please see “An ESG Assessment of Crypto” in this Digital Digest). However, the industry has already introduced multiple blockchain protocols that rely on proof of stake for a more “greener” way to validate transactions on the blockchain and recognizes the need to continue to address environmental impact. Second, regulatory frameworks are largely lacking and need attention by major economies such as the US, Europe and Asia (Please see “The Developing Global Regulatory Landscape for Crypto Assets” in this Digital Digest). Third, security concerns surrounding the blockchain technology need to be addressed especially around public vs. private and permissioned vs. permissionless. Fourth, legacy technology issues need to be tackled. For example, can older systems be refined in a way that allows them to interact with blockchain technology?
 

Towards a new financial architecture
So what does all this mean? Today’s global financial infrastructure is not built to support a world where all assets are bought, sold, held and serviced on a blockchain. While an argument can be made that transforming that architecture is years away, in some ways it has already arrived. For example, we founded, State Street DigitalSM in 2021 not only to support our clients’ investment in cryptocurrencies but to accelerate the digital transformation of our firm.Industry leaders are now exploring business use cases for digitizing assets. This is especially true when it comes to regulators. The Fed is exploring creating a digital currency (Please see “The Digitization of Money” in this Digital Digest). The SEC in its FinHub initiative has carved out a space to explore using blockchain in securities markets.We are exploring numerous proofs of concepts to advance the use of blockchain to improve our clients’ experience. Our approach is not to create a product or service that is just available to State Street, but we are looking at ways to improve how we interact with third parties. These include:

  •  Using tokenization to allow for settlement of any asset atomically (i.e., T+0)• Facilitating the movement of cash geographically between wholesale banks
  • Using fractionalized assets to increase distribution or even to represent a portion of an underlying asset
  • Providing digital representation of underlying collateral

Traditional buy-side firms are beginning to understand that the need for specialized assistance is imperative. Some are acutely aware that they will need to re-think their approach to both investing and managing digital asset. However, others are just beginning, asking about what blockchain is and what they need to know. While some firms are innovators, looking to expand their business and transform their business model, others are comfortable with a business-as-usual approach that protects their long-term business models.

It may no longer be possible for the industry to ignore blockchain technology. Many financial firms are realizing that exploring blockchain solutions cannot be done in a vacuum using a traditional ROI model that yields finite returns. Instead, they must be evaluated bilaterally to understand how a new ecosystem can benefit the industry as a whole—an ecosystem that holds the promise of being more productive, more democratized and ultimately more valuable.

The advantages of tokenization are well beyond simply digitizing assets. The utilization of blockchain technology at some point in the lifecycle of the asset can create a better experience or even eliminate a process. 

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