How the Digital Assets Space Needs to Change to Integrate with the Wider Financial System

The digital asset space has grown rapidly, but how does the space need to change to match speeds with the wider financial system?

Gunnar Jaerv Published by Gunnar Jaerv on 31 December 2019 (Updated 31 December 2019)

The digital asset space has grown rapidly, facilitated by tech-friendly governments and powered by increasingly wide, flexible and use cases for digital assets. But how does the space need to change to match speeds with the wider financial system and achieve the effective regulation, professionalism and off-chain security needed to attract institutional investors and establish itself as a viable long-term asset class?

What is an asset? Currencies, assets, and others

The first step is to establish that digital assets really are assets. The initial intention behind Bitcoin and other first- and second-wave digital assets was that they should replace currencies: consumers would make purchases in them, and they would circulate. Instead, people largely don’t buy with Bitcoin, they buy Bitcoin itself. Digital assets have become an asset class, a transition most obvious in two of the highest-value digital assets, BTC and ETH. (The majority of actual transactions take place in BTS, a lesser-known coin with vastly lower aggregate transaction value which is still being used as a currency.)

Digital assets as an asset class depend upon scarcity rather than inherent value. The price is set in the market, and with BTC it is set without reference to any other indicator than the market price itself — in contrast to stocks, where a company’s performance might change stock prices, for instance. As a result, BTC is highly price-volatile. But if it has no inherent value, can we call it an asset?

As the central focus of traditional investment — stocks and bonds — slides into negative yield, many investors and investment professionals seek ways to diversify their portfolios. This can include interest in so-called "alternative investments," which can include artworks as well as real estate and other opportunities outside the traditional area of focus. As Larry Fink, Blackrock CEO, said in 2015, "[one of] the two greatest stores of wealth internationally today… [is] contemporary art," emphasising that "I don’t mean that as a joke, I mean that as a serious asset class."

How far have we already gone towards integration?

Yet art’s main claim to value is its irreplaceability. Aesthetic considerations are trumped by rarity and non-duplicability — just as with BTC. Seen in this light, it’s clear that BTC is an asset. And the issue is no longer encouraging uptake: 6.2% of Americans own BTC, while a further 7.3% plan to invest, yet retail investors are not the powerhouse driving the digital assets space forward. Crypto data firm the TIE presented analysis suggesting that retail investment in BTC has levelled off and the driver of the most recent price rises was in fact institutional investment.

Look closer and this picture — digital asset prices driven up by investment from HNWIs and institutional investors — becomes clearer and more certain. Led by client interest, financial institutions like Goldman Sachs, whose CEO, David Solomon, told Bloomberg in June last year that "we’re listening to our clients, and trying to help our clients as they’re exploring those [digital asset] things too."

Wyoming released draft state legislation for banks custodying digital assets in May 2019, and Japan’s SEC has imposed strict new rules on exchanges, including a requirement for third-party custody.

(You can see a constantly-updated guide to digital assets regulation around the world here: [hyperlink to our guide].)

What stands in the way of deeper integration with the wider financial system?

Scalability

Scalability is one of the largest underlying obstacles to wider digital asset adoption. The Bitcoin blockchain is slow, hugely expensive to produce and maintain and capable only of supporting the BTC currency, though some technical innovations have made inroads on this. The Ethereum blockchain is more versatile and forms the basis for the majority of tokens through its ERC20 standard, but its progenitor Vitalik Buterin warns that the underlying blockchain is "almost full." Scalability impedes wider adoption of digital assets, reducing incentives to integrate the digital assets market into the wider financlal market. To make digital assets acceptable to the traditional financial world this barrier must be overcome.

Regulation

Initially digital assets were created to escape or thwart regulation. However, as the space evolves, the need for regulation to protect investors and consumers becomes clearer. The rapid growth in the value stored in digital assets has been matched by growth in hacks and thefts, deterring some institutional investors and contributing to trepidation as onlookers associate the space with risk and bad actors. Anonymity raises concerns about money-laundering and makes AML and KYC more difficult.

How are legislatures and regulators approaching these issues?

In the United States, the principal approach has been to pull digital assets into the purview of the SEC as much as possible, addressing the issue through existing regulations and the courts as Congress considers legislation for the entire space. This approach has been mirrored by many other common law countries including the United Kingdom and Hong Kong, where the SFC has released guidance for digital assets trading companies, requiring the appointment of a compliance officer and imposing capital and custody requirements.

In the Eurozone, legislation is being considered, though the current regulations focus largely on AML. In every case, the challenge is to provide sufficient regulation to match both the regulatory burden and the regulatory protections under which the traditional financial world operates.

Professional Structure

The digital assets space is largely the brainchild of technologists rather than financial professionals. While the space has professionalized rapidly with the addition of digital assets staff to major financial businesses, and an increasing realization that the blockchain doesn’t ameliorate all potential risks, it still does not approach the professional standards of the traditional financial world — yet.

However, the digital asset space is moving towards a recognition of the kind of separation of powers that makes traditional finance secure and reliable — and which itself represents hard-won lessons from history. The unwisdom of leaving custody to investors, and of having one person or entity in possession of the keys to every lock, was learned by traditional financiers as the space grew in the 20th century: the same structured governance and regulated custody roles will be a major part of the solution to the persistent security and safety issues the digital assets space faces.

Technical integration

The blockchain-based digital asset space has suffered from its own inherent security: the inviolability of blockchain has militated against efforts to improve security off-chain where attacks actually happen, and a preponderance of ad hoc technical solutions has tended to obscure the need for structural answers to security and safety questions. At the same time, there is also a real need for technical solutions to problems of custody, of transfer and of trading.

Protection against recessions?

Global debt is forecast to reach $264trn by 2020, and $430trn by 2030 — unsustainable levels when compared with underlying economic growth:

Global Debt & GDP

Source

In addition, global economic growth is forecast to slow over the coming years.

Against a background of soaring debt, increasingly-common negative yields in traditional asset classes, there’s a clear risk of recession. Goldman Sachs put the risk of a recession next year at 24% — not an impending danger, perhaps, but sufficiently serious to warrant preparation.

How can digital assets help the financial system navigate a recession? Partly by providing a form of value storage and exchange that doesn’t degrade over time. It’s easy to to focus on the volatility of Bitcoin and not see that over time, its value tends to rise; by comparison the US Dollar has lost over 97% of its value since 1900, and a dollar of 1980 money was equal to $2.91 in today’s USD. When stocks and bonds underperform and money loses its value the search is on for something whose value is stable, which is one reason why digital assets have become such a sought-after store of value.

Stores of value such as gold, which has been the traditional hedge against currency variability, for instance, are popular with institutional investors but not with retail investors. Iain Wilson, Advisor to NEM’s new venture and investments arm Ventures, says, "whether Bitcoin performs [well] in a recession will be heavily dependent on the reaction function of Central Banks. The consumers’ experience to date of zero/negative interest rates has tended to be from higher asset price inflation (stocks, houses and government bonds), rather than an explicit negative cost to their savings. With many developed countries failing to normalise rates post the financial crisis, we now potentially face entering a Global recession with very limited room to cut nominal interest rates."

"Consumers face the prospect of Central Banks applying aggressive monetary easing," Wilson continues, "with explicit costs to holding cash deposits in banks and restriction of high value banknotes in circulation. Assets such as Gold, which has traditionally been held by large investors as an uncorrelated asset hedge, are harder to access as an individual and lack portability. Hence we see this economic environment as being highly positive for digitally scarce crypto assets."

Conclusion

The digital assets space was conceived as a kind of solution to the wider financial system: money, but without banks, governments, taxes, regulations or finance professionals. At the same time, one of the core functions of government is being eroded by digital assets: they want burgeoning economies and rapid, secure value exchange — but without anyone printing their own money. Both sides are going to have to compromise, and treating higher-value digital assets as value stores rather than as means of value exchange is a part of that compromise. So is accepting that blockchain by itself isn’t enough to be truly secure: governments have decided, for the most part, to regulate blockchain-based digital assets rather than to legislate them out of existence (read: to the black market). The digital assets space needs to willingly accept advice from finance professionals whose years of KYC, AML and professional separation of powers will help slash the risk of hacks and thefts, rescue the reputation of IXOs and secure the space as a long-term component of the world financial system.

Disclaimer:

Disclaimer: This publication is general in nature and is not intended to constitute any professional advice or an offer or solicitation to buy or sell any financial or investment products. You should seek separate professional advice before taking any action in relation to the matters dealt with in this publication. Please note our full disclaimer here.

Insights and industry perspectives delivered to your inbox

Subscribe to our newsletter for news updates and useful resources. You can unsubscribe with one click at any time, but we don't think you would want to.