Technology

What Digital Assets Bring To The Financial Landscape – An Overview

Dr Ian Hunt 7 June 2023

What Digital Assets Bring To The Financial Landscape – An Overview

This article unpacks the terms used for entities such as digital assets, sweeping away misunderstandings and problems to get at the picture.

This news service writes regularly about what goes under the moniker of “digital assets” (as in this feature here), and whatever the gyrations of markets, there’s little sign of them fading away. In some respects, interest is rising. To try and make sense of the terrain is UK-based writer and figure in the buy-side of financial services, Dr Ian Hunt (more detail on the author below). The editors are pleased to share these insights and invite responses. The usual editorial disclaimers apply. Email tom.burroughes@wealthbriefing.com


We hear lots about digital assets. There are loud claims of impending world domination. There are well-publicised instances of financial impropriety and fraud. There are demands from established investors for secure ways to access new digital asset classes. There are demands from Millennials and Gen Zs for a better way to invest. There are wild fluctuations in the value of cryptos.

In the background, there are agonised noises from regulators struggling to control new assets that are designed not to be controlled. They flip and flop trying, and often failing, to pigeonhole the badly behaved assets and entities that are crashing the conventional party.

To add to the noise, governments and central banks announce that they are pro- or anti-digital assets, without being specific on what digital assets they are talking about. In the UK, government ministers have claimed that the UK will be a world fulcrum for trading and managing digital assets, while the UK regulators are constraining any meaningful initiatives in the same space. It's a mess.

So what are digital assets and what do they really contribute to the landscape of finance? Under the blanket term “digital,” what kinds of digital assets are out there? How do they behave? What should we be promoting, and what should we fight shy of? This article tries to provide some answers to these questions.

The general public (1) (and general media) perception is that digital assets ARE crypto, and that they amount to the same thing: they are all dodgy. Better-informed commentators are aware that conventional assets of various kinds are being tokenized, and they call these “digital assets” too. However, there is an obvious flaw in each of these positions: the true cryptos, like Litecoin and bitcoin, are currencies, not assets as such, and tokenized conventional assets are conventional, not digital.

The only thing digital about tokenizsed conventional assets is the representation of their ownership in the form of a token on a digital ledger, rather than as a conventional share, unit or title deed. True cryptocurrencies, on the other hand, are purely digital, and don’t depend on any conventional assets or cash for their value: they are not marks of ownership of something else – they are the thing that is owned. There is no pool of conventional cash behind a holding in bitcoin. However, and despite their differences, cryptos and tokenized assets are both examples of tokens on a digital ledger.

So there are two basic kinds of token that we find on a digital ledger: those that reference conventional assets (or cash) outside the ledger, and those that don’t. We call the former “backed” or “collateralised” tokens, as they depend on something external for their security and their value. The latter we call “native digital” tokens, as they exist only on the ledger, and have no dependence on anything external for their value or security.

This may appear very worrying – there are digital tokens that have nothing behind them to underwrite their value and security? Yes, this is true, but it is a less unfamiliar idea than it sounds: pounds sterling, US dollars and euros are tokens (albeit of a different kind) and have virtually no reference to anything external to give them value or security: the gold standard disappeared years ago, and now less than 2 per cent of sterling is gold-backed: the rest is just a promise. 

Within the apparently new world of digital ledgers, we can recognise some very familiar faces: In the conventional world of finance, there is cash, and there are assets. In the digital world there is cash and there are assets too. Cash may be an investable (in both cases), but its role is as a means of exchange, denominating the value of assets, and intermediating transactions, rather than being strictly an asset itself. Reflecting this distinction between cash and assets, we can extend our basic categorisation of tokens on a digital ledger into four:

1.    Collateralised cash tokens;
2.    Collateralised asset tokens;
3.    Native digital cash; and
4.    Native digital assets.

Collateralised cash tokens
A collateralised cash token is a token on a digital ledger that gives its holder title to all or part of a pool of value outside the ledger. Prominent examples are Tether, USD Coin and Dai.  

That pool of value may be in the form of cash, near-cash assets (like Treasuries or gilts), or a combination of both. Such tokens are known as “stablecoins” because they aim to achieve stability against some reference currency or cash-like asset. The tokens can be used in on-ledger transactions, to enable digital versus digital settlement, which can be quicker, more efficient, and lower risk than conventional settlements.

As collateralised stablecoins depend on a relationship to external assets and/or cash, then there is the need for two service providers to manage that relationship: They are:

•    An issuer and redeemer of tokens, who maintains the strict one-to-one relationship between the tokens in issue and the external pool of value; and
•    A safe-keeper of the assets and/or cash which collateralise the stablecoin: it doesn’t help the stability of a stablecoin if the underlying collateral disappears!


Collateralised asset tokens
Collateralised asset tokens are tokens on-ledger that represent title to (i.e. ownership of) some off-ledger assets and derive their value and security from those assets: they are often referred to as “security tokens.” There is a very large number of projects tokenizing conventional assets, including equities, real estate, bonds, works of art and commercial paper. Some “non-fungible tokens” (NFTs) are in this category too, for instance where they represent title to a physical work of art.

Some apparently collateralised assets are not collateralised at all. For example, there has been a fashion for Initial Coin Offerings (ICOs – now often called Token Generation Events, or “TGEs”), where companies raise funding through token issuance, rather than share, bond, or loan capital. Generally, the rationale for an ICO is to avoid the heavy regulatory requirements of a standard capital raise. But the investor should beware: while apparently share-like, these tokens often confer no ownership, or other rights to the investor over the issuing company.

As we have seen, the only thing that is digital about a tokenized asset is the token itself: the underlying asset is unchanged, as are its operating model, controlling entities, cash flows, reporting requirements and regulations. So, tokenization doesn’t change the world, but it is useful: the point is that it makes trading and settlement easier, as managing tokens on a digital ledger is generally quicker and easier than managing shares, units and title deeds off-ledger.

A brief overview graphic:

Native Digital Cash
Native digital cash is currency that only exists on-ledger, and is not backed by a pool of off-ledger cash. Bitcoin and Litecoin are the most familiar examples of native digital cash, and are “true” cryptocurrencies, in that their use as a means of exchange is not limited to benefits within their own ecosystem.  Some cryptos, known as “Utility Tokens” are limited to private digital ecosystems, and can only be used as a means of exchange in that context.  There are very many other less prominent cryptos too, some of which are native digital cash and some of which are not.

Currencies, according the Bank of England’s definition, exhibit three qualities: they are a means of exchange (i.e. people accept them as payments when they buy and sell things); they are a store of value (i.e. people keep them between transactions, expecting that they hold value until they want to buy things with it); and they are a unit of account (i.e. they are a denomination of assets, used to measure the value of things and quantify the extent of profits and losses).  True cryptocurrencies satisfy all of these criteria, albeit quite badly, as a result of their currently high level of volatility.

The volatility of cryptocurrency values results in a frenzy of investment interest, as the opportunity to make large sums is well-publicised.  It also results in current suspicion and dismissal, as the opportunity to lose large sums is equally prominent.  But we should be kinder to crypto: most conventional currencies start their lives in a volatile state (2)  , and there are plenty of conventional currencies that have become worthless over time.  The familiar currencies that we use and trust have nothing much backing them either, as we have seen.

There are examples of stablecoins that are native digital cash too: these are called “algorithmic stablecoins”.  They are not collateralised into conventional cash or cash-like assets, but instead have their values stabilised by manipulating supply and demand: when the price goes up, more coin is issued, but when the price goes down, supply is throttled. Algorithmic stablecoins have acquired a tarnished image because of the tribulations of some prominent examples, including Terra, Basis Cash and SafeCoin.

The G7 have excluded algorithmic stablecoins from their decision to bring collateralised stablecoins within the regulatory perimeter: they are essentially beyond the pale. This is curious if you consider how our familiar currencies work. Their value and security is managed by controlling supply and demand too, but that controlling role is taken by central banks, whom we trust (despite periodic tendencies to print a lot of money), rather than by algorithms, which we don’t.

US Dollars, Pounds Sterling and Euros do not exist (yet) on digital ledgers, but they will do soon, according to our central banks.  When they do, in the form of Central Bank Digital Currencies (CBDCs), they will be native digital cash, and they will be very significant. And we will be no more concerned about their value and security than we are about any other form of conventional cash. CBDC will not suffer from the volatility and distrust that afflicts crypto (although they will share the inflationary pain and FX fluctuations of their non-digital equivalents), so they will be fully accepted as a means of exchange.  This will dramatically increase volumes in digital vs digital trading.

Native Digital Assets
Native digital assets are asset tokens without reference to, or dependence on any off-ledger asset.  The most significant are forward flow commitments (or ‘contractual liabilities’), and are likely to make a big difference to the way that we run finance, represent assets and funds, and manage transactions. 

In a purely digital financial world, the only representations of value are in token form, at addresses on a digital ledger. There are no pools of cash, and no conventional assets: only cash tokens and asset tokens. The only transactions taking place are token flows between addresses on the ledger. That is literally all that is happening. There are no payments moving between bank accounts along conventional payment rails, and there are no deliveries of assets between custodian vaults.  Everything is about tokens and the movement of tokens on-ledger.

In this context, then only things that a native digital asset can be is:

•    A token with current value as a purely digital entity; or
•    An entitlement to a future inflow of tokens, native or otherwise.

There is nothing else to own.

Uncollateralised security tokens and some types of NFTs are native digital assets of the first kind.  NFTs enjoyed a brief spell in the investment limelight recently, and became infamous after Damien Hirst burned some physical works of art, so that the only instances of them left were digital. Native digital NFTs may be investable, and entertaining, but are unlikely to change the investment world.

Much more significantly, future flow commitments allow us to represent any conventional asset in the formal of a cluster of tokens.  They release us from the limitations of current asset classes, and enable us to issue whatever is most useful to capital issuers for financing, and to asset owners for investment and liability-matching.  If we make the tokens smart, then they can implement their own commitments, delivering a very high degree of automation.  A single, simple digital operating model across asset types is within reach, and would open the door to a radically simpler regulatory environment.  

A fully financial digital world is a very different place from the world that we are used to.  To get the best out of it, we need to stop thinking of digitisation as a way of doing what we do now, but a bit better; we need to start thinking of digitisation as a wholly new way of representing and managing assets and transactions, in the form of native digital assets, that deliver dramatic benefits to the business of finance in simplicity and efficiency. The potential to create a more efficient financial ecosystem lives with forward flow commitments, not with tokenised conventional assets, crypto or NFTs.

Footnote:

1, With the possible exception of Millennials and Gen Zs, of whom around 59 per cent are believed to hold some form of crypto. 

2, Bitcoin has exhibited less volatility than Tesla in 2023.
About the author
Dr Ian Hunt is an authority on buy-side business process and technology. He is a frequent conference speaker and contributor to industry publications. Dr Hunt has advised many leading asset managers and asset owners on investment processes, operations and technology. He is particularly recognised for his work in promoting innovation in technology for investment. His clients include M&G, BNP Paribas, Legal & General, Insight Investment, Fidelity, Hiscox, Threadneedle, Royal London and Hermes.

Alongside his consulting and development work, Dr Hunt has acted as an investment management expert witness in a series of Madoff-related trials, and has provided expert investment evidence to a range of other fraud cases in the UK and Ireland.

Dr Hunt has supported the roll-out of liability-driven investment products at Insight, defined the business model for a new financial engineering and derivatives business for the BT Pension Scheme, structured insurance derivative funds at Hiscox and managed the derivatives components of an outsource for Threadneedle. He is recognised as an expert on investment process automation, and has led multiple system implementations in order management, asset allocation, trading, compliance and risk. He was central to the work of the global standards committee on Investment Book of Record (IBOR).

He is a recognised spokesman for the buy-side on distributed ledger technology. He provides expert input to leading DL consortia, advises asset managers on their blockchain strategies, and works with vendors as a design authority on ledger-based buy-side applications, including IBOR and TA platforms. He is the co-author of a paper on Buy-Side applications of DLT, which is a foundational research work supported by both the Investment Association and the Alternative Investment Management Association.

For seven years from 1997 to 2004, Dr Hunt was a founder director of the consultancy CityIQ. He was also global product director for DST International, and has held non-executive director positions at Xenomorph Limited (a derivatives and time-series data specialist), Catalyst Development and Shrap. Dr Hunt has a BA (Hons) in philosophy, an MSc in computer science, and a PhD in mathematical logic from London University. 

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