Digital Assets: The Future Of Capital Markets

Digital Assets: The Future Of Capital Markets

For many years, certain parts of financial markets have been burdened by unnecessary restrictions leading to inefficiencies regarding the free allocation of capital. The upcoming broad applications of digital assets promise to change this. This article serves as an introduction to the topic of digital assets and describes some of the associated opportunities and challenges for retail investors, institutional investors, and financial service providers. Legacy markets have long faced obstructions stemming from limitations on asset class availability, the difficulty of cross-border transfers, and minimum capital requirements, to name a few. Considering the possibilities and universal applicability of digital assets, all market participants stand to benefit from at the very least becoming familiar with the topic and possibly even developing a strategy for the capital markets of tomorrow.

Introduction

Similar to "Blockchain", "Digital Assets" is yet another term that is sometimes misused as a buzzword. Nevertheless, it is vital to understand the implications of digital assets as they will undoubtedly play a tremendous role in the future. It all started with Bitcoin and its underlying technology enabling the creation and transfer of digital value without middlemen. Several years later, Ethereum, an asset management platform, was introduced. Since then, Ethereum has evolved to become the largest blockchain ecosystem in the world. The federal government of Germany, along with the federal ministry of finances and the BaFin (Federal Financial Supervisory Authority), has introduced several laws and regulations in recent years intending to build a solid foundation for digital assets. One of these regulations specifies how institutions are to store digital assets in their custody. Furthermore, the law for electronic securities and, more recently, the fund location act were introduced. While Germany is not quite leading the pack, with smaller countries like Switzerland being even more agile and progressive, the German State is making progress in building a solid regulatory foundation for the capital markets of tomorrow. This is especially remarkable considering the struggles Germany has faced with digitalization in the past: the slow digitalization of schools and universities and the mess of paperwork in vaccination centers are just two examples.

At the same time, Europe as a whole is also making great progress. While the aforementioned legal and regulatory initiatives are being implemented in Germany, Europe as a whole is looking to introduce the MiCA regulations (Markets in Crypto-Assets). MiCA represents a universal regulatory work progressing with a speed and determination seldomly seen in European bureaucracy, which will likely be enacted by the European Commission towards the end of 2022. This regulatory framework covers all possible types of blockchain-based assets and applies uniform regulation applicable for all 450 million EU citizens. This is especially noteworthy considering the struggle regulatory bodies in the United States have had in determining which agencies have jurisdiction with regards to crypto assets. Of course, there are some aspects of the MiCA regulation that are being handled suboptimally. However, considering the speed at which this regulation is being implemented and its universal relevance, this may very well be worth it considering businesses require security and protection before they are willing to make any investments.

One thing is certain, the German laws as well as the upcoming European regulations reduce risks for businesses, allowing them to make better financial decisions for the future. Additionally, the legitimacy offered through governmental regulation signifies the importance of topics such as blockchain and digital assets, especially for the financial sector.

Use Cases for Digital Assets

But what exactly are digital assets? At their core, digital assets are digital representations of all kinds of objects and their associated value. They allow issuance and transfer of ownership without the need for paper documents. It might no longer be obvious, but even today when you buy stocks via a broker or an online bank based in Germany, a paper document with a notary stamp is held for you somewhere in a safe on German soil. This legacy way of executing such trades carries inefficiencies. For example, the issuance of traditional securities costs time and money, and trades across borders are typically very complicated. These inefficiencies lead to high fees and cause delays as transactions cannot be fulfilled or finalized anywhere near instantly.

Widespread adoption of digital assets will lead to easier and faster issuance of new securities, while cross-border transactions will be streamlined. These benefits apply to already existing types of securities, like bonds, fund shares, and in a few years, stocks. Beyond just improving efficiencies of existing types of securities, digital assets will allow completely new types of securities to be created.

Here are some examples: startups in Germany have begun working on creating digital assets based on real estate. Finexity, Exporo, and others are making it possible for retail investors, who otherwise would not be able to participate in the real estate market due to a lack of capital, to invest in real estate. Digital assets allow investors with as little as, for example, 5,000 EUR to invest in real estate. Furthermore, investors can split their investment among several different objects, allowing for diversification of their investment. One issue with this approach is that it could be considered a debt capital investment. Market participants who are concerned about inflation, 3.8% in Germany and almost 5% in the USA, might justifiably be skeptical about debt capital investments. Equity instruments will address these concerns when they are introduced. We will likely see firms introduce such instruments in the fall of this year providing investors with excellent protection from inflation. Digitized real estate is just the first step, other companies are working on offering investable shares of oldtimers, art, and other real assets. Not just as debt capital investments, but also as inflation-resistant equity instruments.

Hence, digital assets are making new investment categories possible and accessible even to retail investors. Aside from stocks, portions of large bundles of assets representative of companies, digital assets will enable focused, inflation-resistant, investments in individual real assets. Starting in 2022, this use of digital assets, which is currently focused on real estate, oldtimers, and art, will be applied to industrial goods, making them accessible to investors.

Financing Industry 4.0

The concept of leasing is well known, but who - aside from institutional investors and car manufacturers - can profit from the returns generated by thousands of leased vehicles? Currently, nobody. From 2022 onward, singular industrial goods will be made investable to retail investors: industrial plants, machines, tractors, and more. The way this works is that these assets are typically associated with a large up-front cost and the ongoing consumption of resources - an operating cost. At the same time, they create an output which in turn creates profit. Put simply, this allows for an investment opportunity, similar to how leasing works but open to retail investors. Producers of industrial equipment will be able to continue producing their equipment unbound by capital limitations. The companies using the machines no longer purchase them for a large upfront sum, but rather pay for their use. This model is also referred to as “pay-per-use”. Under this model, the capital market finances the initial purchase of the machine via digital assets and investors make returns each time the machine is used. The company CashOnLedger is already working on this concept, beginning with tractors, but with plans to soon expand to all types of industrial goods, making them investable.

Digital assets are the future. The diversity of investable asset types will significantly increase in the coming years. Businesses in the financial sector, but also in industry, should become familiar with the new opportunities to take advantage of this next stage of digitalization. Currently, there are already some projects and prototypes, but in a few years, there will be thousands of digital assets available to anyone.

Conclusion - The Diverse World of Digital Assets

The financial sector should not underestimate these future developments, but rather embrace the challenges and opportunities of the coming digital transformation and begin developing a strategy. Competition from cryptocurrency exchanges is growing quickly and as Coinbase has shown they have the necessary funds available in their war chests to develop and quickly execute successful business models. Additionally, these platforms are quick to expand the offering of assets their clients have access to. As more and more traditional assets are digitized, these platforms will, aside from cryptocurrencies, begin offering digital stocks, tokenized real estate, art, and more to their users. Institutional and retail investors are likely to use whatever platform is offering the greatest variety of services and assets. Legacy financial service providers will therefore need to adjust to this new world of digital assets to prevent losing relevance.

Regarding uses of digital assets, this is just scratching the surface. There are many more categories thereof that would go far beyond the scope of this article. Decentralized protocols, utility tokens, non-fungible tokens, DeFi protocols, and more. The digital future promises to enable extreme diversity in capital markets.

Authors: Prof. Dr. Philipp Sandner has founded the Frankfurt School Blockchain Center (FSBC). From 2018 to 2020, he was ranked as one of the “top 30” economists by the Frankfurter Allgemeine Zeitung (FAZ), a major newspaper in Germany. Since 2017, he has been a member of the FinTech Council of the Federal Ministry of Finance in Germany. He is also on the Board of Directors of Avaloq Ventures and of the Blockchain Founders Group, a Liechtenstein-based venture capital company focusing on blockchain startups. Benjamin Schaub is Project Manager for INTAS.tech a consulting company in the area of digital assets.

Source