The Bitcoin white paper introduced a new perspective on money and highlighted blockchain technology’s potential to power a new financial paradigm. Enabled by blockchain, digital assets have been the proof of concept (POC), demonstrating how the technology can streamline and enhance processes in the U.S. financial markets. Despite 2022’s volatility, the POC matured, illustrating how digital assets can revolutionize the approximately $100 trillion U.S. securities market ($50T in equities, $52.9T in fixed-income securities).
A POC assesses the feasibility of an idea or technology to determine the value of further developing a thesis. The past decade of digital asset experimentation has provided critical learning that can help improve financial services infrastructure and products. Using blockchain technology and smart contracts, securities can be tokenized to create digital asset securities. These digital representations of traditional assets can significantly expand the securities market and help solve current challenges like laborious back- and middle-office processes and the auditability of financing activity. The securities market can incorporate insights from the digital assets POC to enhance existing workflows and avoid pitfalls on its way to digitization.
Seizing the Opportunities
Blockchain has enabled the digitization—or tokenization–of physical assets like real estate and art. At first glance, the digitization of assets in financial markets can look like today’s online banking, whereby owners view, trade, and document their assets electronically via smartphone or laptop, but an important distinction exists between electronic and digital. While computerized access is convenient, the underlying mechanics of capital movement still operate on centralized, sleepy, and vulnerable legacy financial rails. Alternatively, tokenizing real-world assets secures existing assets on the blockchain with added benefits: transferability of ownership, fractionalizing assets into smaller units, the potential to increase liquidity, and reducing settlement processes and costs.
In the background, traditional financial firms have been exploring how digital asset securities can improve antiquated systems to facilitate more seamless capital movement. For example, KKR tokenized a portion of several private funds, offering a tokenized share class and reduced minimum investment. Additionally, JPMorgan, SBI, and DBRS conducted a live cross-currency transaction involving tokenized JPY and SGD deposits.
While tokenizing real-world assets utilizes blockchain for the traditional financial system rails, decentralized finance (DeFi) is an original application of distributed ledger technology (DLT). DeFi is an emerging model of financial organization implementing encryption and programmable smart contracts to displace centralization and streamline processes. It is building a future version of the financial system with transparent and decentralized creation, exchange, and investment of assets.
In 2022, DeFi showed sustainability during volatility. While DeFi’s centralized counterparts had many points of failure that contributed to their demises, DeFi—with its automated processes embedded in code—operated as expected. In the wake of collapsed centralized companies like Celsius, Genesis, and Voyager, decentralized companies like Aave, MakerDAO, and Compound remain. Further, in strong contrast to the defunct FTX exchange, decentralized marketplaces like dYdX and GMX are operational. The DeFi use case for the lending sector exhibits how digital assets can successfully operate in a decentralized world.
Identifying the Distinctions
Since the advent of digital assets, the unwritten understanding of custody at your own risk highlights that funds not held in a secure custodial solution can be lost indefinitely, commingled, misappropriated, or locked up in bankruptcy proceedings. The SEC’s recently proposed custody rule would require a “qualified custodian” to hold clients’ digital assets. Digital asset securities would be largely unaffected, as they already follow traditional security laws, including safeguarding client assets with a qualified custodian. The proposal is a reminder to the securities market and blockchain initiatives; hot wallet custody can be unsound, and off-chain solutions may be preferable for institutions. The harm caused by FTX to individuals and entities with assets on the exchange underscores why custody rules must be a regulatory priority.
However, cold storage qualified custody presents limitations for operational efficiencies, as it is more cumbersome to trade assets off-chain. A great appeal of blockchain is the ease of transferability, but cold storage custody curtails the instant settlement feature of blockchain-native assets. Understanding the rationale for feature tradeoffs—asset protection versus T+0—may be the insight the securities industry needs to make informed blockchain development decisions or innovate.
The roadmap for digitizing the securities market is incremental. Just as digital asset securities may not have T+0 settlement today, other interim hybrid solutions are necessary to achieve blockchain’s full benefits. Distributed ledger technology’s inherent programmability and automation can eliminate intermediaries for more cost-effective and seamless movement of funds. However, the nascency of blockchain and the estimated 20% of bitcoin that is irretrievable due to lost or stolen wallets and forgotten keys creates the need for an imperative role—a transfer agent.
Considering the notional values at stake and the potential risks of holding and transferring digital assets, regulatorily compliant solutions for recovering them are needed. One solution common in digital asset securities is Securitize’s digital securities protocol, whereby a centralized agent—a transfer agent—can research, freeze, burn, and replace tokens if they are compromised. Feasible protection and recourse can provide comfort for owners, users, and blockchain builders.
The Opportunity Going Forward
Digital asset securities are a technological advancement of traditional securities, modernizing legacy structures with blockchain. The widespread adoption of digital assets can allow faster, more efficient securities issuance and enable new types. Ultimately, we believe all securities will be digitized, and there will eventually be no differentiation between securities and digital asset securities. Further, digital asset securities will likely become more mainstream in traditional financial institutions and see a rapid increase in product variety, depth, and complexity. Projects will address public and private capital market inadequacies and continue developing solutions with meaningful use cases.
While the building blocks of progress have been established, the main event has yet to begin. The ecosystem setbacks and developments represent the first stages of a pilot testing the viability of blockchain solutions in traditional markets. The experimentation has yielded valuable insights about the capabilities and limitations of blockchain solutions, which the industry can leverage to bolster the ecosystem and transform the securities market.
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