He said “What do you mean blockchain? I’m talking about bitcoin!”. The conversation about how to reduce market inefficiencies in cryptocurrency trading had gone on for a while when I realised: a significant part of actors in the cryptocurrency arena, this Wild West of speculative markets, does not think much about the underlying technology. The promise of blockchain gets forgotten over the daily swings in markets, sensationalism and overly technical analyses. Not just by little-informed media outlets but by the people dealing with this technology every day. Even in the narrow use case of cryptocurrencies, it is a miracle that millions of people exchange billions of US Dollars equivalent every day, relying on secure transactions without involving any of the traditional institutions as a trusted intermediary. This development would have been impossible at today’s scale just a few years ago; for most, it was unimaginable and science fiction, at best. Blockchain made all of that possible — yet as a fundamental technology, it goes far beyond this application. Looking at it from a capital markets perspective, it has the potential to become the new infrastructure of financial services, the next generation of pipes facilitating the global flow of value exchange between economies and people. We are in the early days of this massive transformation which is both inevitable and for us to shape and propel.
How can cryptocurrencies be understood from a financial markets angle?
Let’s get the semantics out of the way. ‘Financial services’ — with its growing definitional grey zone at the fringes — is one area of application for distributed ledger technologies. Financial markets are an area of financial services. Digital assets or cryptoassets are one asset class within financial markets, complying with the fundamental requirement of ‘investability’. Cryptocurrencies are a type of cryptoasset created typically for storage of value or transaction of value. They exhibit distinct qualities different from other asset classes across several characteristics, such as politico-economic features, correlation of price movements, and risk-reward profiles.
There are three material strands of discourse in the context of cryptocurrencies as an asset class: taxonomy, valuation and relevance. Each of these is subject to heated and sometimes unnecessarily complicated debates. A radically simplified perspective is one way of moving forward.
The ongoing debate about what cryptocurrencies actually are in the traditional taxonomy of financial markets is meaningless to most people actively using these instruments today but is a relevant topic for making them a broadly recognised asset class in financial services. The academic discourse about traditional asset classes leads to conclude that the demarcation lines are not as unequivocal as we would like and would be practical. There are grey zones and fuzzy borders between classes.
The use of Cryptocurrencies as, well, a currency and form of payment mechanism is a secondary use case in today’s reality but still a quality of the instrument per se. From the perspective of a capital markets practitioner and looking beyond the various definitions of cryptoassets by regulators, cryptocurrencies behave like commodities, predominantly used for their ability to store value, not much unlike gold. This observation is limited by the fact that they are not consumable and the caveat that the high volatility in cryptoassets reduces their store of value property. Nonetheless, the over-the-counter character of the market structures, the mechanisms of price discovery, the nature of ebb and flow of volumes, the impact magnitude of market sentiment and even market operational elements like ‘post-trade’ and ‘settlement’ all point to this conclusion. Consequently, the existing naming convention of calling this class ‘cryptocurrencies’ is imprecise and incorrect. Of course, capital markets practitioners can be wrong — and in the interest of general understanding, we shall continue to use this term.
In effect, cryptocurrencies in their contemporary manifestation span two asset classes as they are academically defined, leading to knock-on complications for their acceptance as capital markets instruments.
In the academic tradition, there are different ways to gauge the fair value of any instrument in any asset class. The complication with discussing the fair valuation of cryptoassets is the abovementioned challenge of classifying them correctly.
Taking the above examples into consideration, it is evident that we have not arrived at a clear concept of cryptocurrency valuation yet. Different methods have their place and reasoning, and they all lead to entirely different fair value opinions. Emerging from that are the loud and many voices worried about overvaluation or baseless valuation in cryptocurrencies. Let’s try to oversimplify the discussion of that concern: since our economies moved away from the gold standard, it can be argued that at its heart, any currency (and, arguably by extension, any commodity) holds a unit of value which is agreed between people. The official, undebatable and fair value of bitcoin and any others, in the same vein, is the price that two actors decided in the last transaction in this instrument. Just as much as the exchange rate of USD to RMB is, ultimately, agreed between the entities dealing in these currencies, though influenced by state and non-state forces that encompass the markets. According to this logic, there is no reason for bitcoin prices not to surge to 100,000 US Dollars or more or drop back to 10 US Dollars. It all depends on the value the involved actors see in it.
The current number of different cryptocurrencies including tokens is well above 1,000. Unlike traditional asset classes, they have in common to be subject to significant network effects created by users and, equally important, the developer community. The result is a strong force of concentration that we do not see in other asset classes like equities or fixed income. Ultimately this drive leads to an oligopoly of a few cryptocurrencies dominating the entire market. Realistically, a significant share of the smaller instruments will fade away in the next few years and become virtually worthless. A few will survive, grow in size and may provide their users with meaningful utility.
The fundamental importance of cryptocurrencies, surviving or dying, is in their function to lead the way, to open the debate and function as experiment fields and testing grounds. They are trailblazers, beating the path to the new, broader asset class of digital assets and emerging new categories.
Disclaimer upfront: FinFabrik is involved in several projects building on digital real assets and as old school capital markets people, this topic gets us excited.
Another asset class in the group of digital assets, next to cryptocurrencies, are digital real assets. A digital real asset is the digital representation of an ownership fraction in a tangible asset on the blockchain. Imagine 100 people owning a valuable painting collectively, each holding 1%, represented as a token that contains the ownership right and other rights and obligations in binary form.
A real asset is defined as a physical object, anything which can be touched and derives its value from its substance. The group includes assets such as real estate, precious metals, commodities, oil or alternative categories such as wine, jewellery or classic cars. As an investment instrument, real assets fulfil the requirements to store wealth and retain a form of economic value.
The process of digitising ownership and other rights in real assets is called tokenisation, the representation of a physical asset on a distributed ledger, applying a unique and immutable identifier, validated and authenticated by the collective effort of nodes on the blockchain. You may think ‘securitisation’, but that is only part of the way. Securitising an illiquid asset turns it into a transferable financial security. Tokenising attaches another quality by making this security immediately digitally tradeable. Tokenisation of any real asset hence adds fundamental attributes to the instrument. For example:
What makes digital real assets particularly interesting is their nature as an asset class. There are three fundamental superclasses of assets and cryptocurrencies span two types, as established above. Digital real assets widen this span even more to cover the third class. Via tokenisation, we are creating assets that are potentially all at the same time,
store of value assets (holding value over time), consumable and transformable assets (providing utility to the holder), capital assets (ongoing source of value and rents and tradeable).
It will be interesting to see how this new class emerges, not fitting ordinary classification boundaries and as a consequence, not working within the well balanced regulatory frameworks that rely on clear-cut asset classification.
In contrast to that, the difficulties of valuing cryptocurrencies as examined above are not applicable in the same way to digital real assets. Each ownership token represents a respective fraction of the total value of the tokenised asset. It is reasonable to assume that digital real assets stand a better chance of long-term sustainability compared to cryptocurrencies, not least because they always hold a clearly defined and derived value. They can be connected back to the ‘real’, the physical world.
Given all the above, the process of creating, sharing, trading, investing in or collateralising an asset changes entirely and creates a different dimension of relevance of this asset class for our economies.
A major factor is how we invest and transact in real assets. The ownership and transfer of tangible assets come with significant complexities, including deal discovery, legal procedures, price determination, paperwork, title transfer, post-transfer settlement or secure holding and exchange of funds. Consider how investment in a building works today. Creation and transfer of ownership are full of friction and hurdles. Access to this investment class for average citizens is limited, mostly due to inefficiency in the traditional processes and minimum investment tickets based on high operational costs. Digital real assets radically break down these complexities by representing all rights and duties in a smart contract which allows reducing the friction to a minimum. Ownership in most any physical asset can be established in infinitesimally small units, transfer of units and exchange of value across tangible assets is low-cost, immutably recorded and secure.
That results in formerly highly illiquid and hard to transfer assets like real estate, gold or art becoming accessible to anyone, easily and freely tradeable, and available as asset classes to create portfolios with diversified exposure. Beyond that are a multitude of additional uses. For example, digital real assets can be used in real time as collateral and utilised for barter with any other asset.
This exciting development is what we call the emerging Digital Real Assets Economy — and it needs broad participation to make it a reality.
People, even with comparatively little funds, will be able to broadly participate in investments and trading in physical assets that were not accessible before. With a number of early projects live and gaining traction, the emergence of this new asset class is real. We are gradually forming a better understanding and a founded opinion on the underlying mechanics and dynamics in digital real assets. Clearly, there will be a significant amount of hard problems to solve along the way to creating a legitimate new class of investable assets. Not least, there are numerous open questions around regulatory frameworks and the bridging and interoperability of the established operational processes with a binary world of digital tokens.
Given the vast potential of this space, we decided to engage and develop solutions to power this next chapter in capital markets. The fundamental spirit of the cryptoassets movement is not to be deterred by perceived or real hurdles to implementation and regularisation of new approaches and services in financial markets. It is all about picking one’s moon and going for it.
We choose to go to the moon,
not because it is easy, but because it is hard,
because that goal will serve to organize and measure
the best of our energies and skills,
because that challenge is
one that we are willing to accept,
one we are unwilling to postpone,
and one which we intend to win.
(This is redacted. Find the full remarkable speech here. Yes, watch the whole thing.)
Be in touch if you choose this path as well or are just interested in the topic. We are always interested in exchanging thoughts and exploring joint opportunities. There is much more to be said and discussed on all of the above. Please share your opinion here or engage directly with us at FinFabrik.