Digital Assets: A Catalyst for Change in Investment Management

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Ten years ago, the consulting world was abuzz with the phrase 'digital transformation.' Radical change was coming, huge disruption would be experienced, and firms were being advised to appoint a Chief Digital Officer to help embed 'digital' at the heart of everything. Fast forward to today and what do we see in our industry? Well, for sure, we have experienced some meaningful and long-term change. Technology has undoubtedly altered the way we communicate and collaborate across the spectrum (albeit with a COVID accelerator), how we enable tighter control of workflows and, most impressively in my view, how we import, generate, interrogate, present, and manage immeasurably greater volumes of data and analytics. Paperless work is now the norm and we work on multiple devices largely in a remote capacity. All made possible to a greater or lesser extent by 'digital.'

But, would we really class this as digital 'transformation’ of asset management, or is it better described more modestly as digital ‘utilization’ or ‘adaptation’? Where the dictionary definition of transformation is “extreme and radical change,” it could be argued that what we’ve actually witnessed in the sector to date is simply an improvement on the way we have always done things.

Equally, while there has indeed been huge investment in a plethora of APIs, apps, and websites, many of these are now no more than obsolete cyber-clutter. There is evidence to suggest that many asset management businesses invested in ‘digital’ without fully understanding the potential benefits or drawbacks of specific projects. The result? Tools which were not aligned with core business objectives failed to take off and now lie idle in cyber-bins, or, worse, are being gainfully maintained in the forlorn hope that one day they may suddenly become useful.

In my view, the fundamentals of business and operating models across the asset management supply chain have barely changed in the past 30 years or more. Compared to other industries such as retail, telecom, entertainment, transport, travel, and even retail banking, asset management, especially institutional asset management, has yet to see true transformation. So, despite all the buzz, we industry operatives have not yet experienced the revolutionary disruption which many promised.

Why is this? Well, there are arguably three key conditions which need to be in place for digital transformation to truly occur in a particular sector, and these have not hit asset management en masse…yet:  

  1. the digitization of the products and services themselves, i.e., the replacement of legacy goods or services with a purely digital representation of the same which, critically, offers greater benefit, greater value, and a better experience to the end consumer;
  2. a sustained, disruptive level of disintermediation in the supply chain, radically changing the roles and priorities of various entities in the supporting eco-system;
  3. engagement of key regulators and a strong political will to enable change to take root and sustain.

So, the big questions: what’s changing now? And, what’s the catalyst for transformation in asset management? In two words: Digital Assets.

For one reason or other, there is still much confusion around this holistic term. Maybe it’s the ambiguity over the ‘d’ word, maybe the strong word association between blockchain and Bitcoin, maybe the perceived dominance of cryptocurrencies over other DAs, but more likely, to my mind at least, it’s because the innovation and new thinking in this space is emanating from outside the traditional drivers of change in the industry–and this is itself a key sign that disruption is coming.

The acceptance by institutional asset owners of fully digitized assets as viable investment choices meets the first condition set out above and provides sufficient incentive to the rest of the industry for the other two conditions to be met, by pushing forward the following disruptive new practices:

  1. direct access for asset owners to newly digitized products, where the entire value and projected lifecycle (entitlements, expiry dates, collateral obligation, etc.) of that product is held within an encrypted file or ‘smart token’ with an enriched profile comprising, for example, future cash flow information and ESG evaluation;
  2. instant trading and settlement of these products through trusted DLT blockchain technology; and
  3. full engagement from regulators and governments, driving mainstream adaptation, acceptance, and legitimacy.

By 2030, according to a combined report by BCG and private markets exchange ADDX, the value of digital assets is projected to be $16 trillion, or approximately 10% of global AUM. Once the market reaches that size, it arguably becomes mainstream and, with that sort of trajectory, we may be looking at seismic shifts and true transformation a decade or less from now. The drivers for this include both technological and socio-economic factors such as:

  • Growing maturity and acceptance of decentralized finance (DeFi), blockchain
    technology and atomic settlement;
  • Atomic settlement refers to exchanging assets between two parties in a single transaction, typically instantaneously and without intermediaries. The blockchain world eliminates the risk that one party hands over the money or the asset, and the other party fails to deliver.

    Stablecoins are digital currencies which are is pegged to a “stable” reserve asset such as the U.S. dollar or gold. Stablecoins are designed to reduce volatility relative to unpegged digital currencies like Bitcoin.

    Emergence of new purely-digital asset classes, i.e. non-fungible tokens (NFTs) representing investments in both traditional equity and debt plus numerous other private and alternative classes (made possible by tokenization and fractionalisation), cryptocurrencies and stablecoins;
  • A growing desire to invest with purpose and promote higher ethical standards, made possible through the transparency and democratization inherent in digital assets;
  • Expectations of low fees and greater willingness to switch providers;
  • A distrust of the status quo, fueled not least by nervousness in the banking sector and fiat currency sustainability.

The rise of DeFi, in particular, will increasingly challenge traditional models, as it enables investors to manage their assets without intermediaries, such as banks or asset managers. Total value locked into DeFi increased from $601 million at the start of 2020 to $239 billion by April 2022, a massive 40,000% rise, according to blockchain data provider Amberdata. While there are still limitations with what it can do, the concept is becoming established and new entrants to the market are developing at speed.

So, you may ask, what should asset managers and their service providers be doing now to prepare for digital assets and the now tangible radical disruption of traditional business and operating models which will result? Well, other than emerging from any lingering slumber and sensing the aroma from a nearby Nespresso machine, there are a number of areas to be addressed:

Asset managers first need to get to grips with the technology behind these assets and the risks and opportunities associated both with investing in them and supporting them. The disintermediation risk presented by DeFi and blockchain makes it imperative that they will need to proactively seek to engage with DLT, i.e. they need to go and look for it and learn it, rather than having it come to them (it won’t happen by default!). Having done this, they need to start to carve out digital assets’ investment products and solutions which will operate on DLT, alongside their traditional products. To this end, we expect to see more examples along the lines of the recent tie ups between BlackRock and Coinbase, Schroders and Forteus, or CoinShares and Invesco.

About Tokenization

The world of digital assets is rife with new jargon, largely imported from the fintech world. The term ‘tokenization’ is a good example. For those of us who have been brought up in traditional funds administration, there’s nothing really new about the concept – its simply, in my view, an alternative word for unitization, referring to the breakdown of a highly-valuable asset (or Fund) into tradeable single units or ‘tokens’. Units in mutual funds & REITS and shares of ETFs are obvious examples of this in the traditional space.

That said, where the blockchain technology brings radically greater capability and greater opportunity in this space (and therefore admittedly, provides some dubious justification for renaming ‘units’ as ‘tokens’), is in:

  • A far greater application of the concept across many more asset classes including (critically) private markets, and
  • The radical removal of barriers and operational headaches associated with the traditional use of unitisation (think of the manual, slow and opaque transfer agency processes today for example, plus limited liquidity, deal cut-off times, prolonged settlement cycles etc). In the new world, issuers (or their agents) provide or ‘mint’ the digital units or ‘tokens’ directly onto the distributed ledger (i.e., blockchain). Since the chain itself is the single record of truth, the ownership of each unit is transparent, instant and immutable as a result.
  • Through the huge potential of ‘smart’ tokens’, where all of the terms and conditions and therefore future cash flows are an intrinsic part of the token itself. In other words, the token is akin to a digital file capable of contractually settling all of the conditions of the contract on the blockchain automatically

It's these three factors which enable us to completely reimagine the end-to-end process of finding and matching investors with investment opportunities, both in primary and secondary markets, opening-up previously restrictive practices and providing significantly more investment options to the end investor.

Operationally, asset managers need to adjust to support new concepts and practices, such as tokenization, being adopted by the new digital platforms and exchanges, and to design cohesive operating models, potentially eliminating some middle and back office functions such as reconciliation, income and corporate actions processing (all inherent in the DLT and smart token functionality), but introducing others such as issuance management. Moreover, they need to be able to flip seamlessly between digital and traditional solutions alike and accommodate client requirements for consolidated pricing, data management, reporting and valuation solutions, as asset owners will likely move first to hybrid models. (Note, the notion of hybrid models is itself worthy of further discussion. Digital purists would likely argue that the whole notion of interoperability between traditional and DLT models serves only to limit the advantages of the new world since, by definition, it necessitates a degree of point in time valuation and reconciliation of disparate systems and ledgers, where DLT alone negates the need for both as it provides real time access to a single source of truth!)

Custodians and asset servicers will similarly need to develop solutions to provide for secure storage and facilitation of digital asset transfers, including support of token management, and fractionalisation. As mentioned earlier, alternative asset classes such as private assets and real estate lend themselves naturally to the digital medium and so custodians will need to enhance their support of these areas further.

Operations also needs to adapt to perform in both digital and traditional environments concurrently in support of asset owners moving to hybrid asset allocation models. The work currently being done by SWIFT and others to support the coexistence of tokenised assets and traditional assets is a case in point here. Interoperability between platforms and the ability for financial market participants to access them will likely become a differentiator for service providers. Like asset managers, they will likely see that the future operating model no longer accommodates a need to reconcile disparate ledgers or to scrub and resolve conflicts between diverging sources of data, but will see other functions such as cross-chain compliance (looking across multiple blockchains for evidence of potential fraud) and AML risk management come more to the fore.

Custodians should also consider establishing VASPS (Virtual Asset Service Providers) status, if they haven’t already. These are now a focus for regulators looking to strengthen controls around cryptocurrency exchanges, digital assets, and virtual currency on blockchain/DeFi. Gaining familiarity with the new world of Digital Asset Entities (DAE) and Digital Asset Customers (DAC) will become increasingly important in this space. 

Fund administrators and transfer agents similarly need to engage with DLT and move their service propositions along the value chain, away from the cumbersome maintenance of unitholder registers and payments processing, towards platform provisioning. For example, they may choose to facilitate seamless transfers between asset issuers and asset owners, manage respective nodes in the chain, and the associated token management. Some have already begun to make this move.

Innovative FinTech continue to actively develop solutions for digital assets to prosper. I’ve highlighted just a few here, but there are many, many more vying to be a part of the brave new world of digital asset management. They should be looking for established players in the industry to facilitate deeper cross pollination, and develop transformative new end to end strategy:

  • BitGoa digital asset custodian that provides institutional-grade security for digital assets. They offer a suite of products and services for digital asset management, including custody, trading, and settlement.
  • Coinbase Custodya digital asset custodian that provides secure storage solutions for institutional investors. They offer cold storage solutions, multi-signature wallets, and a range of other security features.
  • Fireblocksa platform for digital asset custody, transfer, and settlement. They offer institutional-grade security and support for a range of digital assets, including cryptocurrencies, stablecoins, and security token and claim to be able to support the build and running of multiple digital asset businesses at scale.
  • TokenSofta platform for digital asset issuance and management. They offer a range of services for tokenization, including compliance, custody, and investor management.
  • Templuma platform for digital asset trading and fundraising. They offer a range of services for digital securities, including issuance, trading, and settlement.
  • Ellipticcross chain transaction screening for crypto compliance, claim to cover 100 billion + data points across 98% of the crypto market.
  • CoolBitXa leading digital wallet provider.
  • ComplyAdbvantageAI-driven fraud detection and AML risk solutions.

Further collaboration between traditional players and fintech is clearly required if firms across the existing eco-systems are to avoid disintermediation, stay relevant and prosper in the new digital world. Some may choose to establish or acquire ring-fenced groups focused on and seizing the opportunities offered by this truly transformative advancement. Others may choose to try and go it alone. Either way, the Nespresso machine is brewing away, are you smelling the coffee?