4 Trends Impacting Exchanges – and 5 Building Blocks They Need to Base Their Strategy for the Future On

In the world of financial exchanges, there are two potential drivers for far-reaching changes: the emergence of digital assets, and cryptocurrencies. Institutional demand for cryptocurrencies is steadily on the rise. Bitcoin, for example, has exhibited a massive 313% compound annual growth rate since 2018, with the number of worldwide cryptocurrency wallet users increasing from 6 million in 2016 to over 64 million in 2021 [Source: WEF, Statista, Bain, BIS, and YouGov]. By 2027, approximately 24 trillion US dollars of financial assets are expected to be tokenized, with 10% of global GDP being stored and/or transacted on distributed ledger technology (DLT) infrastructure up from about 1.3% in 2021.

Successful evolution and growth of digital asset markets face a classic “Cold Start Problem”. How do we simultaneously introduce digital assets, liquidity, and a dedicated digital market infrastructure (DMI), all of which are mutually interdependent?

The development and direction of four key trends in the digital asset and cryptocurrency space will likely affect the shape of things to come in the “traditional” exchange space, and lead to the evolution of digital markets and DMI:

1. A Shift to On-platform Trading for Digital Assets and Cryptocurrencies
   
   There are two steps in the creation of digital assets: securitization, and tokenization. The process of securitization can vary depending on the asset under consideration. Different jurisdictions also have different regulatory frameworks around securities issuance and tokenization, and this will impact the process as well. In some jurisdictions, it is possible to issue fully digital securities. Others do not recognize these and require the issuance of a traditional paper-based security which can then be tokenized. Whilst tokenization is primarily a technical process, there are also design choices to be made that can significantly influence the development of a DMI, such as interoperability, and use of standards.
   
   The resulting digital assets may be traded on public or private markets, with different considerations – regulatory, liquidity, ease of access – around each. The key, in either case, is ensuring a migration of transactions from off-platform trading to on-platform trading, enabling the exchange of value and transactions in a more efficient, transparent, and economically optimal manner, and realizing the benefits of a governance structure that encourages adoption of digital assets.
   
   
2. Governance, and the Optimal Organization of Transactions
   
   Ronald Coase’s transaction costs approach, introduced in his seminal 1937 work, “The Nature of the Firm”, has been influential in the development of modern organizational economics. The role of an exchange, as a cost-effective means of transacting and of transferring financial value between companies, can in part be explained through Coase’s work. Changes to existing governance and transaction cost structures, the model predicts, can be expected to affect the structure and organization of how economic actors – in this case, financial market participants – organize the exchange of value.
   
   The introduction of smart contract-enabled digital assets provides the ability to automate, within the digital asset itself, events occurring throughout the lifecycle of the security, such as compliance monitoring, regulatory reporting, collateral and margin management, and corporate actions. In addition to offering huge opportunities for efficiency gains and cost reduction, digital assets also open-up a wealth of opportunities for tokenizing different types of value, and for creating more liquid markets for historically illiquid assets.
   
   
3. Decentralization and Modularization
   
   Cryptocurrencies such as Bitcoin and Ethereum, and the emergence of Decentralized Finance (DeFi) architectures and applications, built on DLT, also represent a harbinger of a more mainstream trend towards decentralization of the web in the form of Web 3.0 and the Internet of Value. At its heart, DeFi is about a different way of organizing transactions, through the introduction of automated and decentralized exchanges and market makers. The current financial market infrastructure world is built around a limited number of key incumbents who have established their position over time. It is not difficult to envisage a future in which their roles are replaced by trusted DeFi systems. That is not, however, to say that there won’t be a role for traditional, “centralized” finance, or CeFi, in this future.
   
   
4. Regulation – Keeping Up with the Joneses
   
   Regulators globally are grappling to understand potential ramifications of new forms of digital assets and new types of trading venues, particularly those built on DeFi infrastructure and principles. For example, regulators are wary of fully decentralized systems in which there is no market operator to be held to account. To avoid regulatory arbitrage, there is a need for global coordination in regulating DLT, smart contracts, decentralized applications, and organization.
    

We do not claim to hold a crystal ball – the trends identified above are shapers, not predictors, of the future. Awareness of these trends, however, can enable savvy operators to identify opportunities in time to effectively act on, and monetize them, moving fast, and solving for commercial outcomes. To maximize the likelihood of success in the brave new world of digital assets and markets, companies need to base their strategies on five building blocks:

1. Identify a diversified portfolio of strategic options that provide good coverage of future eventualities and outcomes.
2. Pursue an approach capable of solving the “Cold Start Problem”.
3. Put in place a team that has the right background, skills, and capabilities to maximize the success of the venture.
4. Establish a corporate culture and mindset that can deal with volatility, uncertainty, complexity, and ambiguity.
5. Ensure that incentives are aligned with desired outcomes at all levels of the organization and ecosystem.

A great change is underway, and, as with any paradigm shift, it will take time for things to fall into place. The key characteristics of this new paradigm are the speed of change, volatility, uncertainty, complexity, and ambiguity faced by markets. It is not a time for complacency; for those exchanges and market participants who are bold and forward-thinking in their approach, it is an opportunity to shape the future that is to come, and to pro-actively engage in writing the next chapter in the story of global capital markets.