Thoughts on how securities and derivatives are an opportunity to integrate digital currencies to real world financial markets.
Bitcoin and cryptocurrencies are something most entrepreneurs have probably given up on. Investors most definitely have. Not all regulators have positively treated them. So, when it comes to a topic such as digital assets or digital currencies, it is probably not the flavour of the season.
However, broadly speaking, if we add up the financial assets we hold in digital form including shares and fixed deposits for consumers and many more financial products for businesses such as bonds, these financial assets held in digital form probably far exceed the value of physical assets we hold. If we add non-financial digital assets such as assets that are sold in digital form such as content and advertising and assets that provide digital access to utilities such as e-commerce, the numbers would be even bigger.
Speaking of currencies, we certainly do not use digital currencies the way we use cash or cards, but if the definition of currency was to include anything that represents cash and is transferable, the value of currency derivatives in trading again far exceeds the physical cash in circulation in most major world economies.
Yet, when it comes to discussing digital assets and digital currencies, the first term to pop up is bitcoin. Sigh. The really large opportunities in the digital asset and currency space are ahead of us.
Let’s look at the numbers.
Although the numbers above are somewhat dated, we can see that as far back as 2007 itself, global financial assets were four times that of global GDP. And global derivatives were four times that of equities and bond market capitalization. What this indicates is that digitization of financial assets and currency equivalents is already a very large market.
But, what are the opportunities ?
Before we go into that, we need to appreciate that the single biggest contribution that peer to peer electronic cash systems like Bitcoin and blockchain technology have made is that they have shown that it is possible to create trust worthy transactional systems without the need to have an intermediary. Using game theoretic and cryptographic techniques, it is now possible to prove or disprove a transaction that is claimed to have taken place between two parties, even when each party makes a different claim on the transaction. While this is technically brilliant innovation, the creators of bitcoin and the developers of blockchain platforms failed to bring about a link between the digital world that could clear transactions without the need for centralized intermediaries and real world financial markets, that is acceptable within prevailing regulation and provides value to current market participants. And this is where the future opportunities lie.
Take the case of investments in alternative assets.
Although investments in public stocks and bonds are a $100 trillion plus category, investments in alternative assets are now reaching $10 trillion. Investments in alternative assets are not exchange traded like stocks and bonds and are mostly all bilateral trades over the counter (OTC). Among alternative asset classes, investments in private debt, real estate, and infrastructure is growing fast. However, being private in nature, such investments do not provide a level of visibility into risks and returns as publicly traded company stocks do. Hence, the opportunity here is perhaps for blockchain applications to digitize private assets (eg, high yield debt to Small and Medium enterprises), provide visibility into the risk profile of the assets (eg, make SME loan underwriting data visible to investors), and offer a secondary market platform where bilateral contracts between investors can be cleared. Blockchain technology can lower counter party risks in such cases where the value of assets invested in, the risk profile of assets invested in and the risk of a default in a secondary market trade can be reduced.
When it comes to digital currencies, the term itself deserves some attention. A currency, digital or not, needs to be a stable unit of value that is transferable and is used to denominate assets. As crypto currencies such as bitcoin or ether do not have a price stabilization mechanism, they have merely traded as commodities (and very rightly classified as commodities by the US CFTC) while assets that are denominated by them (eg, ERC-20 tokens) are mostly all securities that provide the holder of the security a beneficial interest in the underlying asset (eg, revenue stream from a project).
Blockchain based systems have a large opportunity in the securities offering space itself.
source : Deutsche Borse Group
In the illustration above, we can see that while a lot of securities are exchange traded, there are many that are OTC traded such as credit linked notes and certificates. These are examples of financial instruments that blockchain applications should be able to issue while being compliant with existing regulation. Market making, price discovery, reporting and compliance are largely well understood for such securities rather than ill understood and un/under-regulated crypto token offerings aka ICOs.
As far as digital currencies are concerned, price stabilization mechanisms and ability to integrate to existing financial markets are key. Price stabilization mechanisms observed in so called stablecoin projects are based on a mix of fiat currency backed digital tokens. However, such stabilization mechanisms, whether successful or not, are ill suited for integration to global liquidity pools and financial markets. Fortunately, the global derivatives market where 85% of outstanding positions have fixed income streams and other currencies as underlying asset classes perhaps provide us with clues on innovation in design and operation of price stabilization mechanisms in digital currencies.
Since a large majority of derivatives are OTC traded as the somewhat dated figure of 83.7% in 2007 above shows, digital currencies have a regulation compliant framework to operate in.
We will certainly see the emergence of digital financial instruments, asset categories and currencies that are not just technically brilliant but integrate well within global regulatory and operating environments. Valued in trillions of dollars and not in billions of dollars, this disruption will probably be the largest one that we have ever seen. The question now is who does it first and how.
Originally published at yourstory.com on January 10, 2019.
Disclosure : I am working on the design and implementation of a digital currency protocol at Verified AG called the Via that imbibes some of these ideas in the article. The Via is a fiat collateralized digital currency that is designed for transferring value between applications running on different blockchain platforms, hence the name Via. Please feel free to connect with me on twitter and subscribe to developments on Via.