Decentralized Natives and Asset Management
Blockchain uses cases and how you play a role
Do you still remember the headline that Binance exceeded Deutsche Bank’s revenues in Q1/2018? While Germany’s biggest bank recorded USD 146 million, Binance announced profits of USD 200 million.
Is this a fair comparison? Chinese exchange versus a German bank? It would be fairer to compare exchanges with exchanges. If you compared it to the profits of the second-largest American stock exchange, the NASDAQ, you would have seen USD 209 million in profits. Not really better, but at least comparing apples to apples. However, when you were looking at the revenue numbers of each financial institution, the deviations were quite heavy. The established institutions were far ahead of Binance of course. But what counts in the end is the profit and investor’s ROE.
So, does this mean the legacy financial system is obsolete?
In my opinion, this shows clearly that the new world around crypto and DeFi is at least much more efficient, innovative and better in meeting the demand of millennials than the old world. This should be the last wake up call for legacy financial institutions to adapt to new technology, educate and train employees, establish an entrepreneurial mindset and set the right incentives to reward innovation.
Born to swipe — Need to re-act
The financial evolution started with Finance 1.0 (double-entry accounting), moved on to Finance 2.0 (structure financial products aka Gordon Gekko era) and is now in the stage of Finance 3.0 (digital asset era). This development is accompanied by a simultaneous societal evolution. Investors used to be digital adopters (learned about online banking etc.), became digital natives (mobile-only via apps) and have now reached the era of decentralized natives. This last-generation has lived through the global financial crisis. They lost all trust in governments and institutions as well as the belief in long-term fiat value overall.
The average life expectancy for fiat currency is only 27 years! This is what happened to them:
- 20% failed through hyperinflation
- 21% were destroyed by war
- 24% monetarily reformed
- 12% destroyed by independence
- 23% still in circulation
But the remaining currencies are not a success story either. The British pound sterling is the oldest fiat currency, established in 1694 and has since then lost 99,5% of its value.
Older generations also see the dilemma and search for a better store of value. This applies to both retail and institutional investors. This manifests itself in the sell-off of Rolex watches in December 2019 in Munich as well as all-time highs in real estate, equity and fixed income prices.
New generations, often showing a high degree of technical and financial literacy, are looking increasingly for a decentralized store of value that is easy to use, has gamification components and gives them independence over their finances. They are characterized by
- Technical and financial literacy
- Master of social media
- Requiring personal and financial independence
- The joy of Gamification aspects
Established asset managers will not maintain their market share and client base if they fail to meet new customers’ demands.
Shortcomings of Legacy Systems — Need for DLT
A need to react does not only occur due to a changing mindset of investors but also their demand for innovative products and services. The technical infrastructure of legacy systems often also requires a significant need for improvement and adoption of distributed ledger technology.
Existing database systems often have a central operation structure, .i.e. a single source on which the data resides and therefore present a single point of failure. Cyber attacks can lead to the collapse of this data source, which results in the loss of huge amounts of data. The maintenance of old database systems and their IT landscape is often very expensive and shows a low degree of efficiencies across different departments. With a blockchain, you never have to deal with those issues again.
A blockchain is a distributed ledger-based on a growing list of records, called blocks, that are linked using cryptography. Each block contains a cryptographic hash of the previous block, a timestamp, and transaction data. By design, a blockchain is decentralized and resistant to the modification of data.
Private Blockchain:
A potential first step for an institution to test this new technology is the launch of permissioned blockchain. It is not public, owned by a central institution (e.g. bank) and can be built with R3 or Hyperledger for example.
Public Blockchain:
The ultimate goal should, however, be a decentralized database without any form of a central operator, a permissionless blockchain. This provides greater security and reliability of data. Moreover, it offers clients more integrity, authenticity, and robustness for their confidential data.
Blockchain technology could not be hacked so far. It is secure, fast, decentral and anonym. The consensus mechanism for creating new blocks can be based on “Proof-of-Work” (PoW) or “Proof-of-Stake” (PoS) mechanism. The differences are shown below:
Implementation — Need for full business integration
There are many ways in which blockchain technology and crypto can be incorporated in your business model:
The above-shown use cases for the asset management industry are quickly elaborated on.
Use Case 1: Crypto Funds
Previous generations are less tech-savvy and less open to learning complex new technology. However, they might have huge wealth and want to allocate some part of it into crypto for diversification reasons. Bitwise asset management, for example, has seen the potential and offers those solutions to family offices, wealth managers and investment advisors.
Another offer could be crypto ETFs, or so-called BTFs (blockchain-based ETFs). But as protection for retail investors is much stronger than for professional investors, regulators are still reluctant to approve them.
An attractive offering could also be crypto share classes. If an investor holds bitcoin for example and doesn’t want to switch back to fiat, it could be interesting for him to invest in a bitcoin share class of a mutual fund. Until the present day, this does not exist.
Use Case 2: Tokenized Securities
Traditional assets like real estate or art can be tokenized and traded by investors. This can also include traditional financial products like certificates. Vontobel has started to build tokenized assets on Ethereum.
Use Case 3: Digital Custody Service
To manage those crypto assets, it is important to have a robust digital custody service. Either by relying on an external party (like Coinbase) or by building one yourself (like Fidelity Digital Asset Custody Service).
Use Case 4: Smart Contract Platform
If an asset manager does not only want to have a product offering, but also programmable features, like distribution of staking yields or voting rights, a smart contract platform should be at the core of its business.
Use Case 5: Validator Node
To gain knowledge in the “proof-of-stake” technology, to establish a potential new business division that replaces the “legacy interest rate” and to attract new customers, an asset manager can set up a validator node to dig even deeper into the technology and become an integral part of the digital asset ecosystem.
Use Case 6: Decentralized Governance
For crypto, 2019 was the year of the DAOs (decentralized autonomous organizations). The idea is to replace a central authority and give the decision rights to the community. For an asset manager this means, that proxy voting on AGMs can be facilitated by equity holders, investors can have an influence on portfolio management decisions or in the extreme case even on the portfolio management team or the entire board of directors of the company.
The crypto world has proven that this mechanism works. Decred belongs to the leading DAO concepts, that combines PoW and PoS consensus mechanism. After miners have generated a new block in a first step, coin holders have to validate them by a pseudo-random selection mechanism in a second step. This process makes the system 20x more secure than bitcoin for example. Additionally, the stakeholders can engage in governance proposals, i.e. about the project’s funding or strategy for example by handing in own proposals via Politeia or voting on incoming proposals via that platform. Since the launch of the blockchain in 2016, the project is constantly evolving due to a very active community.
Decred can be considered as bitcoin with a better governance model, but also as an evolution of a concept of a company or even as a digital nation-state if you will.
Challenges for implementation
It is hard to imagine that an existing legal entity can switch to a DAO governance mechanism. But even if a company is building it up from scratch by forming a new legal entity (like Fidelity), many challenges have to overcome beforehand:
- Lack of knowledge: not the right people with the relevant knowledge
- Limited history processing large volumes of data: skepticism with regards to transaction volumes
- Lack of experience: for example in smart contract security, as no dev specialists in place
- Regulatory challenges: many initiatives no consensus
- High costs: to replace legacy systems and processes
- Lack of courage: towards self-disruption, managers often not risk-takers
Way to Market Leader — Company View
First of all, employees have to be trained to change their mind-set. To achieve that, external people with the right mindset and programming skills have to be hired. A company could then start to engage with start-ups, investors and industry leaders by attending conferences, hackathons or meet-ups. The next step would be a proof-of-concept testing phase, where asset managers analyze above-mentioned use cases and host own hackathons to find the best solutions. This process will be in constant iteration, but the path towards holistic business integration.
Way to Market Expert — You
What can you as a crypto expert or complete newbie do within the asset management space?
As an expert, you can always approach the respective digital teams to find out about potential collaborations or educational needs. As a newbie, you can start to educate yourself via the various social media challenges and chat groups, follow the leaders in the field and engage in the community. This can range from volunteering jobs (when you’re still learning) to active speaker activity (when you teach others about certain topics).
As the crypto space is by nature open-source and overall quite open to supporters, don’t hesitate to reach out to the projects that look interesting to you and where you think you can add most value!
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.
