Digital Assets on the Road to Institutionalisation

“There are limited investment opportunities available today in traditional markets. Furthermore, institutions now recognise that crypto-currencies are an interesting asset class, and they are increasingly incorporating them into their portfolios,” said Peter Hofmann, CEO at Custodigit, a joint venture developed by Swisscom, one of Switzerland’s leading telecommunications and IT companies, and Sygnum, the world’s first digital asset bank to be formally recognised by FINMA (Swiss Financial Market Supervisory Authority). Although digital assets are still fairly nascent, financial market infrastructures (FMIs) and global custodians have recognised that client demand for these instruments is accelerating. As institutional investor inflows into digital assets increase, FMIs and custodian banks will need to develop solutions in order to ensure that their clients’ needs are met.
 

Digital assets are not homogenous but diverse in nature, spanning across a number of different financial instrument types, a point made by Tim Grant, Head of SIX Digital Exchange (SDX). “To me, a digital asset is a regulated security whose value is derived from a real asset, be it an equity,  derivative, fund structure, commercial real estate or even a piece of art,” said Grant. So how do they work? In the case of tokenisation, an asset is converted into a digital token, which can be divided into many smaller units. As tokens are divisible, they are cheaper and easier to trade, helping to shore up liquidity, particularly in illiquid markets. “With tokenisation, all kinds of assets can be digitally represented on the blockchain, making them more widely accessible, affordable by fractional ownership, easily tradeable and more efficiently serviced. Investors can now profit from unique investment opportunities across different verticals including Venture Capital, Mid Cap, Real Estate, and Art & Collectibles, which were previously seen as hard-to-access and illiquid,” said Fabian Dori, acting Group CEO and Head of Asset Management at Sygnum.

Not only does tokenisation make it simpler for investors to purchase securities, it can also help SME businesses access the capital markets. “70% of Swiss SMEs do not participate in the capital markets. The process of raising equity can be very complex and expensive. Tokenisation could open up new opportunities for these SMEs to raise funding,” said Johannes Höhener,Head of FinTech at Swisscom. Dori concurred. “Issuers can profit from reduced costs, increased automation, in particular in the area of asset servicing, as well as new ways to access potential investors,” he explained.

Beyond tokenised assets, there are also crypto-currencies. “Crypto-currencies are typically un-regulated, traded on a public Blockchain network and are not underpinned by a hard asset,” said Grant.  Bitcoin, Ripple and Ethereum are perhaps the most well documented of the crypto-currencies. However, crypto-currencies also include StableCoins. StableCoins are effectively crypto-currencies whose market value is pegged to a fiat or several fiat currencies, or even a specific commodity. Central banks are increasingly taking a firm interest in crypto-currencies with a handful even launching CBDCs (central bank digital currencies), namely  digital versions of their own fiat currencies. In fact, the Swiss National Bank (SNB) is currently developing its own proof of concept aimed at supporting the issuance of CBDCs. Binding all of these digital assets together is that their issuance, trading, custody and settlement is made possible by distributed ledger technology (DLT).
 

What was once a niche and heavily retail-orientated market is now becoming more institutional with asset managers, family offices and HNWIs (high net worth investors) starting to make investments into digital assets, said Grant. Others agree. “In the cryptocurrency market, key participants include miners, crypto (hedge) funds and foundations, as well as private and professional investors. Increasingly, traditional institutional investors, such as Tudor Investment Corporation, or corporates such as Square and MicroStrategy are also entering the space and making significant investments into cryptocurrencies,” said Dori. MicroStrategy announced in early December 2020  the intention of raising $400 million to invest even more in Bitcoin. Höhener argued this was reflective of the changing demographics at investors with allocators now being younger and more open than their predecessors to digital asset trading. However, he added most of the investment was concentrated in crypto-currencies as opposed to security tokens as issuance volumes in the latter are still at very low levels. Liquidity is therefore absent in digital assets. A study by Fidelity Digital Assets found that 36% of institutional investors are currently invested in digital assets.¹ Meanwhile, 91% of the respondents who were open to investing into digital assets told Fidelity that they expected to have at least 0.5% of their total portfolio exposed to the asset class within five years.

Although there is more widespread institutional interest in digital assets, Fidelity identified a number of impediments precluding investors from trading these instruments. 53% of investors said volatility was an obstacle, whereas 47% cited market manipulation, and 45% the absence of proper fundamentals underpinning their value and pricing. “Complexity is also an issue for a number of investors insofar as many institutions do not understand how they can access digital assets. There are very few service providers giving investors a gateway to digital assets, ” said Hofmann. Other factors have deterred investors, not least counterparty risk. Having seen a number of crypto-exchanges suffer outages and cyber-attacks, investors feel the infrastructure supporting the digital asset market is vulnerable. Unless providers are subject to thorough regulatory oversight and adopt industry best practices around risk management, the market will struggle to institutionalise itself.
 

Clear-cut and effective regulation will also play an integral role in driving institutional capital into digital assets. A paper produced by the International Securities Services Association (ISSA) highlighted that regulations governing crypto and digital assets were inconsistent across a number of different markets.²  Although ISSA said many regulators were creating frameworks for digital assets designed to protect investors and safeguard market integrity, it also meant that FMIs and custodians were developing crypto-services in a very uncertain legal environment.³ It is vital that securities laws – as they apply to digital assets – are harmonised. However, some markets – most notably Switzerland – are ahead of the curve in developing digital asset regulations. For instance, Switzerland has introduced basic requirements for digital exchanges and pushed through insolvency rules which will give added protection to digital assets being held at third-party custodians.⁴ “More and more regulators are amending or adding to existing laws to account for cryptocurrencies (e.g. the passing of the “Blockchain Act” in Switzerland) which provides greater regulatory clarity,” said Dori. This Act will help cement Switzerland’s reputation as a leading market for DLT development.

Just as there is a patchwork global regulatory approach towards supervising digital assets, there is also a copious lack of industry-wide standards. Efforts to promote standardisation of both digital assets and the DLT solutions supporting them are ongoing, said Höhener. He said domestic initiatives such as the 4T-DLT and the BCP Framework for the assessment of crypto-tokens were playing a key role in creating standards to encourage mass adoption of digital assets. Most significantly, Höhener said there needed to be industry-wide consensus on digital asset issuance, transfers and custody. Without standards, the ability for market users to interoperate with each other will be difficult. “One problem we face is that there are a lot of white papers being circulated about standards in DLT and digital assets. The pursuit of common standards should be a market-led initiative,” added Höhener.
 

The Swiss Stock Exchange recognises that markets are undergoing an unprecedented transformation, which is why it has developed the SDX, a fully integrated issuance, trading, settlement and custody infrastructure for digital assets. The Swiss Stock Exchange is continuing to expand on its existing product suite and is evolving its business in line with client demand. In December 2020, the Exchange announced that it would make a major strategic investment into Custodigit. As part of this, SDX together with Custodigit will provide an institutional digital asset market gateway, which will support the investment value chain for banks from trading, smart order routing, settlement, custody/storage, AML to the secondary markets. This partnership will give banks fluid access to crypto-currencies and digital assets with differentiated price discovery capabilities. 

Beginning in Q1 2021, the Institutional Digital Asset Gateway will enable banks to access digital asset markets in a seamless manner. It will also allow the building of financial services and products around crypto-currencies and digital assets for its customers. “The Swiss Stock Exchange is a trusted provider and market infrastructure which works on behalf of institutions to provide them with access to markets all over the world. The exchange is a traditional FMI and runs the Swiss national payment network. Swisscom is the country’s leading telecoms provider whereas Sygnum Bank⁵ which already offers digital asset services to banks via its sub-custody solution, is one of the most advanced players in the digital asset banking space and subject to strict FINMA regulation. However, we recognise markets are changing and we want to be a leader. This is why we set up SDX to provide a digital market infrastructure to support digital asset trading,” said Grant. 

This latest collaboration comes almost ten months after the Swiss Stock Exchange made a significant investment into Omniex in a partnership which will provide a gateway to digital exchanges (including crypto-currency exchanges) and OTC markets for both the Exchange and its clients. That the Exchange – a leading FMI - is developing solutions to help facilitate trading in digital assets will be of a huge reassurance to traditional banks and conservative institutional investors. Grant said SDX was fully regulated while adding that its DLT infrastructure is now enterprise ready and capable of operating at  scale, milestones which will provide ample comfort for banking clients. He explained that  SDX’s ability to provide services such as asset safekeeping, AML and KYC (know-your-customer) would mean that banks could now access digital assets securely and frictionlessly. “If institutions are to move into digital assets, the intermediaries and infrastructures providing access need to be robust,” said Grant.
 

Without regulation or industry standards, digital assets will struggle to get institutional investor buy-in. At the same time, these very same investors want assurances that the market infrastructures supporting digital asset trading are strong. It is here where SDX believes it can make a big difference.
 

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_{¹ Pensions & Investments (June 9, 2020) Institutional investor interest in digital assets rises - survey}

_{² ISSA (November 2019) Crypto-assets: Moving from theory to practice}

_{³ ISSA (November 2019) Crypto-assets: Moving from theory to practice}

_{⁴ Coin Geek (October 21, 2020) Swiss parliament approves raft of digital asset regulations}

_{⁵ Platform integration will be provided via Custodigit, while sub-custody is available now through Sygnum Bank.}