As regulation of digital assets looks set to begin in earnest, a Funds Europe panel of industry experts discusses its potential impact on investment and more.
Laurent Marochini (Head of innovation, Societe Generale)
Chris Brodersen (Global head of digital assets, Apex Group)
Adam Belding (Chief technology officer, Calastone)
Darren Wolfberg (Founder, chairman and CEO, Blockchain Triangle)
Funds Europe – The term ‘digital assets’ covers a range of asset classes with extreme variations in risk and return, so how can the investment world better educate investors to distinguish between these and identify suitable long-term investments?
Laurent Marochini, Societe Generale – Education is crucial, not only asset management but for all the value chain shareholders. Since the inception of bitcoin, we now have more than 20,000 cryptocurrencies around the world, we witnessed a big volatility in the different digital assets, and for me it’s very, very important and key to understand.
Firstly, digital currencies have suffered from bad press since the beginning. Just remember one of the biggest CEOs in the world in 2016 said: “Bitcoin is a fraud,” while others said bitcoin was used for bad reasons. Maybe they did not or do not want to understand the rationale behind digital currencies. Misunderstanding the digital world is very dangerous and the way we manage the digital assets in a digital world is totally different to conventional assets.
Finally, all digital currencies are different with different business values. If I want to be an asset manager in the digital currency world, I really need to understand what protocol is behind the currency and what the business value is. I need to do my own risk assessment. Take the collapse of Terra Luna, a stablecoin which is not stable anymore. A stablecoin with a performance of 20% is not possible without considerable risk. So, to do your risk assessment you need to clearly understand the digital assets or currencies involved.
Chris Brodersen, Apex Group – The biggest challenge right now is educating people on what’s an investable asset versus what’s speculation. I see a lot of confusion in the market, especially when you start talking about things like non-fungible tokens (NFTs). An investor may say that they want to invest in an NFT fund, but what they’re actually describing is a security token or a utility token. So, the first thing to understand is what we are buying. For example, if one were to tokenise a piece of real estate, that’s not fungible. But even though it’s technically a non-fungible token, it is probably more a security token. You could call it an NFT, but it’s not [comparable to] a [well-known NFT collection such as] Bored Ape.
Adam Belding, Calastone – Digital asset is such a corrupted term. It means so many different things to so many different people and a lot of the terms are conflated. Until you can untangle all of that, you can’t really give sensible advice to anyone about any of these topics. If you were just investing yourself as an investor, to what your original question is, you are basically looking at investing yourself. It’s not dissimilar to me deciding to invest in global equity markets because I think I can make a good return on it, but the chances are you can’t, you’re not going to beat the market and you’re not going to be as capable at investing as professionals who are in the space. To be honest, there’s no difference, to my mind, between that and anything that’s cryptocurrency or a genuine token that’s not backed by something in the real world, because it’s very hard to ascribe value to that and there’s not decades of history of how markets go up and down and so on. There are tokens that are linked to underlying assets that are freeing up liquidity in those asset classes versus tokens that are actually entitlements to something virtual. There’s pretty much nothing there and the only reason people pay for it is because they believe that somehow there’s value there.
Darren Wolfberg, Blockchain Triangle – There needs to be better education but also continued follow-through on regulation, because I think regulation will bring education. And people need to move away from the ‘move fast and break something’ mentality because it is detrimental to the industry. People need to take responsibility for their actions as well.
Funds Europe – Arguably the greatest challenge in the emerging asset tokenisation and security token space is the lack of clear regulatory oversight, so where do you see this guidance coming from and when?
Brodersen – Just stepping into the United States for a moment, if you take a cryptocurrency and ask three different regulators, they’ll give you three different answers: the SEC [Securities and Exchange Commission] considers it a security, the IRS [Internal Revenue Service] considers crypto transactions to be barter transactions, so they consider it an asset, and then the CFTC [Commodity Futures Trading Commission] considers it a commodity, so how do investors navigate that? Who am I reporting to and what am I reporting? That’s really, I think, the main challenge, and that’s not just the United States, that’s around the world. There are certain jurisdictions that are aggressively out in front of this because they see the opportunity to become that crypto centre of excellence. Whereas in the US, we’re probably at least two years away from having anything meaningful come out of the crypto directive working groups.
Belding – There will be a fair amount of regulatory arbitrage and that will make it harder to implement any kind of regulatory passporting, because the EU, for example, will probably have a higher degree to, say, some other place where they’re trying to make it a lot more attractive to operate, so that could affect the ability to have truly global legislation.
Funds Europe – What impact will the EU’s Markets in Crypto-Assets (MiCA) have?
Marochini – MiCA is very important because it gives us more clarity about how to manage cryptocurrencies, utility coins, stablecoins and so on. It will allow us to start to work finally, because in Europe we are more shy than in the US or in the UK, because we are waiting for the regulations. We need to have the framework to start to work and see, for example, what would be the role of the bank in the world of cryptocurrency, who will be responsible for keeping the keys? Can we do record-keeping? What are the main exemptions? We still have a lot of questions to be answered, but with MiCA, we have more and more clarity about the roles and responsibilities of the different stakeholders of the value chain.
Belding – It feels like the EU is trying to create an environment similar to Ucits and MiFID where the primary purpose is to simply try and give some guard rails that are common across the EU, so that you have that kind of passportability for digital and cryptoassets and the way they’re treated within the EU’s policy framework.
Wolfberg – For this legislation, the most important thing is the principled approach towards crypto, utility tokens and security tokens, so that you have a regulated ecosystem that people need to qualify for. The decentralisation comment is inherent with the technology that we’re talking about, but there are a set of guard rails that are in place today in the regulated ecosystem, and every one of those regulations are in place because of something that went wrong before. So, let’s not start over at zero – we’ve got 120 years of case history, so let’s use that.
Brodersen – I totally agree with Darren that we very often get regulations after something goes wrong – regulating in the rear-view mirror. In terms of MiCA, I found it interesting that they took a somewhat narrow and prescriptive approach to this, which is probably a good thing. But when they talk about the asset reference tokens, they specifically mention that it’s one of three or a combination of three things which is fiat, commodities or crypto. It mentioned utility tokens and then also other asset type reference tokens, but it’s a broad swap. People being who they are, they’re going to test the limits and this is not MiCA’s first bite of the apple – I think they’re going to be coming back and refining these rules over time.
Funds Europe – What are the significant benefits and risks that digital assets offer institutional investors that can’t be found in other asset classes?
Brodersen – The benefit in terms of tokenising assets again falls to what is the underlying asset and what are the challenges around managing that asset. Very often what you’ll hear is, ‘We’re going to tokenise this illiquid asset and it’s suddenly going to become liquid.’ Well, that’s not always true. What does it represent? If it’s registered as an investment product, how is it registered? There are rules around when you can trade those assets, whether they’re tokenised or not. Then where is it going to trade? Most importantly, beyond where is it going to trade and who is going to trade it, who is holding the asset? He who holds the keys owns the asset. If we can answer all those questions first, then we can talk about an easier transfer of value. A token, if set up properly, should be easier to sell than a paper contract. The other thing that makes it interesting and unique is when we start tokenising assets, we have the ability to tie smart contracting language into those assets. That automation obviously offers some streamlining and some benefits.
Wolfberg – We are opening a chapter on what will be the plumbing that you need for all of this stuff to work; what I mean by plumbing, there are very large firms that are represented on this call, each of those firms are going to have a strategy on custody, a strategy on sec lending and leverage, and that plumbing is essentially the foundational pieces that you need for this velocity of money to work at a faster speed. Smart contracts allow you to do programmatic executions of dividend, of coupon, allow you to access a broader network of liquidity, whether that is in a regulated tokenised ecosystem or in a quoted perhaps non-regulated ecosystem. I tend to think that most of the trading will occur on regulated ecosystems just because of the confidence that investors receive from that participation, both from an AML perspective, a settlement perspective. There’s a reason why people trade with the biggest, because there is a confidence level that comes with that.
Marochini – We see and observe in the world of tokenisation of financial assets that we need to have a more industrialised process in order to validate all the benefits. The first one I see in terms of tokenisation of financial assets is definitely the cost reduction for the issuance and certification of transactions thanks to smart contracts. In our world, you have a huge amount of stakeholders and infrastructure that is working, but it is costly. But with smart contracts and a register on the blockchain, there should be a lot of cost reduction.
The second benefit is the time cycle in terms of settlement. Today, we are talking about T+2 and T+3, but in the digital world, it can be a question of minutes. Tokenisation of financial assets will also open a new channel of distribution and bring more liquidity on the private assets side. But we need to pay attention to the coding of smart contracts and not make any errors because as soon as it is embedded in the blockchain, it will not be possible to reverse it. Other challenges will be digital custody and cyber security and developing services that work on an industrial scale.
Wolfberg – All of those items speak to the operational stack of risk management at a large institution and there are now ways to perhaps make those processes more systematic, more programmable, which should reduce risk long term over this class of assets.
Brodersen – We have talked about the benefits of things like smart contracts, but that can be a double-edged sword. Have we considered all the variables that go into that contract that could force it to do something that maybe we didn’t intend it to do? And then how do we unwind it? Anybody who disagrees with that statement simply needs to look back at TheDAO hack of 2016 [when an attacker stole 3.6 million ether from a fund called TheDAO].
Funds Europe – How do we create an infrastructure behind these assets that can help mitigate some of these risks that we’ve talked about?
Belding – The concepts in digital assets slightly flip the way people think about constructing systems around financial services and investment from a client-centric view. There’s a big table with all the clients in it, but the asset itself is disparate around the system, where with digital assets the asset is at the core. This means you can construct systems and programmes in a way that you can’t with traditional systems – where you define the assets as the first-class citizen and everything else is interacting with it.
On the topic of the automation, most people in a typical operations team are used to backdating transactions, rolling things back, backing things out, coping with errors, and they’re absolutely terrified about any system where it looks like you can’t do that. A distributed ledger worries them a lot because their whole operational model is built around the probability of mistakes and having the ability to unwind them. That’s a big bridge to cross, because you’re already talking to people that are under threat from this type of technology, that it’s so automated, and now on top of that, it’s taking them away from their comfort zone.
In terms of infrastructure, there are two key challenges: the first one is, even if all 3,000 of the entities on our network were using this infrastructure and there was a common books and records for a given asset in between them all, if their actual systems they are using aren’t directly talking to that. This means there’s a common infrastructure, but everyone is using a separate system. So regulators will insist that you still have to reconciliations. Unless you start seeing the systems that run those business processes on top of this infrastructure, you won’t gain the full benefit and certainly not that dream of zero reconciliations that is often quoted as one of the ultimate benefits of digital assets.
Secondly, there are a lot of public infrastructures for tokens and cryptocurrencies and there are a lot of private infrastructures that you can use to build your own private networks, so if you’re in a world where you need to move cash one way and the asset the other way and you can’t do that all on one physical infrastructure, you’re still in a world where you need to integrate. Now, maybe because of the nature of the technology, you can cryptographically coordinate these systems, and there’s a number of ways that that can be done, but a lot of it depends on which system is being used for which part of the transaction. There’s a big integration story lurking here. If the big, post-trade settlement bodies are all running on separate blockchains and there are all these different central bank digital currencies, then we will have the same kind of problem that we have today. You have to crack that problem to gain that true flow of transactions in an automated and secure way as part of a complex overall transaction.
Brodersen – How do we avoid that Franken-network? How do we make sure that in the quest for digitisation and optimisation, that we’re not actually increasing our technical debt? Adam mentioned having this blockchain backbone for reconciliation, but what about the silos that each of those participants has to have on the back end? When we look at it from an operational perspective, there are all of these reference data models used by different asset managers and broker dealers. Yes, they’re technically looking at the same asset, but they’re ingesting and using that data in a different way, so you have to have data standards which we don’t even have yet. We’re really in the very first innings of having a truly digitised infrastructure that’s going to allow us to have truly digitally native assets in the future.
Marochini – The big challenge is to be clever in terms of infrastructure, because for the next ten to 15 years, we will have to keep our own infrastructure but also work with the digital one. We should avoid building an old world in a new world and making the same mistakes that we have made in the past where we build different infrastructures that are not interoperable. We just need to find the simplest and most secure infrastructure. It will take time, but we have to avoid the complexity that we have built during the last 40 years.
Funds Europe – Are we talking about a global utility?
Marochini – If we want to make a global utility, we will have the question of competitiveness, because as you know, today we all want to create our own blockchain and say, ‘This is the standard, just use my blockchain and we will all work together.’ But if we build hundreds of blockchain-based ‘utilities’, it will make no sense.
Wolfberg – That global settlement utility is something that we’ve been discussing with a number of prime brokers and custody banks. The central securities depositaries are not motivated to see T+0 settlement because of the amount of money that they make off of T+2 settlement, and from that perspective, this blockchain-based settlement utility could be a future state of clearing house where the community should be the stakeholders. If you can bring together custody, asset management, all the different banks and brokers and the roles that they currently execute in, there is a lot of common ground to be realised from an efficiency perspective. You can still offer the same services you currently offer in terms of client management, but you would have T+0 settlement.
Belding – Even if you have multiple different technical infrastructures, standards always plays a big part in success. The internet itself is a great example of something that defined standards for http and html, so that it didn’t matter what web surfer you bought or what browser you used, it would interoperate. And then there are standards which are achieved through dominance and power, so login with Facebook is one. There are precedents of things like Continuous Linked Settlement and Swift, where enough people got together and decided to do something and then it happens. There are not that many big, big players that would have to come together globally to make progress possible in some of these big, big areas.
Funds Europe – What significant development would you like to see in the next 12 months?
Belding – I want to see a genuine product that will use the technology specifically to create a digital asset representing a form of collective investment. Funds are already tokenisations of underlying assets anyway, but I want to see a much more streamlined model where all of the machinery of the existing fund will be brought together on a single infrastructure, and that will work. There are definite movements afoot to get to that kind of point. And if we get a group of asset managers to engage on how this thing would be regulated, that would be a pretty good outcome and it would move things forward.
Marochini – I strongly believe that tokenisation of financial assets and private assets will be a key topic in the future. The other use case is like a car: if you want to drive your car, you need to have fuel or electricity, and for me, if you want to drive the blockchain and the tokenisation, you will need to have a cash solution, so a type of digital currency or a type of stable supplement coin, whatever you want that you can have in Europe.
Brodersen – The message to the asset management community should be that crypto is interesting in and of itself, but really the larger opportunity is the broader digital asset space. To Jack’s point, that opportunity really presents itself as we look at the efficiency curve and which assets are the least efficient and ripe for disruption. There will also be less focus on crypto, but more on digital assets and tokens.
Wolfberg – The question of the technical utility of a digital asset is going to play itself out over the next 12 months in the climate market, with digital twins of existing asset ecosystems for reporting purposes. When you look at the challenge of delivering compliance with ESG reporting requirements, there is no way to achieve it using traditional corporate API solutions. Having a hash that can be a portfolio representation of climate performance information is a key tool to solving the problem of climate compliance in an efficient manner.
(First published Funds Europe July 2022: https://www.funds-europe.com/july-august-2022/roundtable-the-developing-digital-assets-marketplace–page5)