For many years, certain parts of the financial markets have been burdened by unnecessary restrictions leading to inefficiencies in the free allocation of capital. The forthcoming broad uses of digital assets promise to change this. This article serves as an introduction to the topic of digital assets and describes some of the related opportunities and challenges for retail investors, institutional investors and financial service providers. Older markets have long faced obstacles due to restrictions on the availability of asset classes, the difficulty of cross-border transfers and minimum capital requirements, just to name a few. Given the potential and universal applicability of digital assets, all market participants can benefit from at least becoming familiar with the subject and possibly even developing a strategy for tomorrow’s capital markets.
Like “Blockchain”, “Digital Assets” is another term that is sometimes misused as a buzzword. Nevertheless, it is important to understand the implications of digital assets, as they will undoubtedly play a huge role in the future. It all started with Bitcoin and its underlying technology that enabled the creation and transfer of digital value without intermediaries. Several years later, Ethereum, an asset management platform, was introduced. Since then, Ethereum has evolved into the largest blockchain ecosystem in the world. The Federal Government of Germany, together with the Federal Ministry of Finance and BaFin (Federal Financial Supervisory Authority), has introduced several laws and regulations in recent years with the aim of building a solid foundation for digital assets. One of these rules specifies how institutions should keep digital assets in their custody. In addition, the Electronic Securities Act and recently the Fund Investment Act were introduced. Although Germany is not at the forefront, while smaller countries such as Switzerland are even more agile and progressive, the German state is making progress in building a solid regulatory base for tomorrow’s capital markets. This is particularly remarkable given the struggles Germany has faced in the past with digitization: the slow digitization of schools and universities and the mess of paperwork in vaccination centers are just two examples.
At the same time, Europe as a whole is also making great progress. While the aforementioned legal and regulatory initiatives are being implemented in Germany, Europe as a whole is seeking to implement the MiCA (Markets in Crypto-Assets) rules. MiCA represents a universal legislative work that is advancing with a speed and determination rarely seen in European bureaucracy, which is likely to be adopted by the European Commission by the end of 2022. This legislation covers all possible types of blockchain-based assets and applies uniform regulation applicable to all 450 million EU citizens. This is particularly noteworthy given the struggle that regulators in the United States have had to determine which agencies have jurisdiction over cryptocurrencies. Of course, there are some aspects of the MiCA regulation that are handled suboptimally. However, given the speed with which this regulation is being implemented and its universal relevance, it may well be worth it, given that companies require security and protection before they are willing to make investments.
One thing is for sure, the German laws as well as the forthcoming European rules reduce risks for companies so that they can make better financial decisions for the future. In addition, the legitimacy offered through government regulation signifies the importance of topics such as blockchain and digital assets, especially for the financial sector.
Use cases for digital assets
But what exactly are digital assets? At their core, digital assets are digital representations of all kinds of objects and their associated value. They allow issuance and change of ownership without the need for paper documents. It may no longer be obvious, but even today, when you buy shares through a broker or an online bank based in Germany, a paper document with a notary stamp is kept somewhere in a safe on German soil. This old way of doing such trades is ineffective. For example, issuing traditional securities costs time and money, and trading across borders is typically very complicated. These inefficiencies lead to high fees and cause delays as transactions cannot be completed or completed in the immediate vicinity.
Widespread use of digital assets will lead to easier and faster issuance of new securities, while cross-border transactions will be streamlined. These benefits apply to already existing types of securities, e.g. Bonds, fund shares and in a few years shares. In addition to simply improving the efficiency of existing types of securities, digital assets will allow entirely new types of securities.
Here are some examples: startups in Germany have started working on creating digital assets based on real estate. Finexity, Exporo and others allow retail investors who would not otherwise be able to participate in the real estate market due to lack of capital to invest in real estate. Digital assets allow investors with as little as 5,000 euros, for example, to invest in real estate. In addition, investors can divide their investment between several different objects, allowing for diversification of their investment. One problem with this approach is that it can be considered an investment in debt capital. Market participants worried about inflation, 3.8% in Germany and almost 5% in the US, may rightly be skeptical about investing in debt capital. Equities will address these concerns when introduced. We are likely to see companies introduce such instruments in the fall of this year, giving investors excellent protection against inflation. Digitized real estate is just the first step other companies are working to offer investable stocks in antiques, art and other fixed assets. Not only as debt capital investments, but also as inflation-resistant equity instruments.
Therefore, digital assets make new investment categories possible and accessible even to retail investors. Apart from equities, parts of large bundles of assets representative of companies, digital assets will enable focused, inflation-resistant investments in individual real assets. From 2022, this use of digital assets, currently focused on real estate, antiques and art, will be applied to industrial goods, making them available to investors.
Financing industry 4.0
The concept of leasing is well known, but who – apart from institutional investors and car manufacturers – can profit from the returns of thousands of leased vehicles? Currently none. From 2022 onwards, unique industrial goods will be invested in retail investors: industrial plants, machinery, tractors and more. The way it works is that these assets are typically associated with a large upfront cost and the ongoing consumption of resources – an operating expense. At the same time, they create an output, which in turn creates profits. In short, this allows for an investment opportunity that is similar to how leasing works but is open to retail investors. Manufacturers of industrial equipment will be able to continue to produce their equipment unbound by capital restrictions. The companies that use the machines no longer buy them for a large upfront amount, but rather pay for their use. This model is also called “pay-per-use”. Under this model, the capital market finances the first purchase of the machine via digital assets, and investors make returns each time the machine is used. The company CashOnLedger is already working on this concept, starting with tractors, but with plans to soon expand to all types of industrial goods, making them investable.
Digital assets are the future. The diversity of investable asset types will increase significantly in the coming years. Companies in the financial sector, but also in industry, should become familiar with the new opportunities to take advantage of this next phase of digitalisation. At the moment there are already some projects and prototypes, but in a few years there will be thousands of digital assets available to everyone.
Conclusion – The diverse world of digital assets
The financial sector should not underestimate this future development, but rather embrace the challenges and opportunities of the coming digital transformation and start developing a strategy. Competition from cryptocurrency exchanges is growing rapidly, and as Coinbase has shown, they have the necessary funds at their disposal in their war chests to develop and quickly execute successful business models. In addition, these platforms are quick to expand the range of assets their customers have access to. As more and more traditional assets are digitized, these platforms, apart from cryptocurrencies, will start offering digital stocks, tokenized real estate, art and more to their users. Institutional and retail investors are likely to use the platform that offers the largest range of services and assets. Older financial service providers will therefore have to adapt to this new world of digital assets in order to avoid losing relevance.
When it comes to using digital assets, this just scratches the surface. There are many more categories of it that would go far beyond the scope of this article. Decentralized protocols, utility tokens, non-fungible tokens, DeFi protocols and more. The digital future promises to enable extreme diversity in the capital markets.
Authors: Prof. Dr. Philipp Sandner has founded the Frankfurt School Blockchain Center (FSBC). From 2018 to 2020, he was ranked as one of the “top 30” economists by the Frankfurter Allgemeine Zeitung (FAZ), a major newspaper in Germany. Since 2017, he has been a member of the FinTech Council of the Federal Ministry of Finance of Germany. He is also on the board of directors of Avaloq Ventures and in Blockchain Founders Group, a Liechtenstein-based venture capital firm focusing on blockchain startups. Benjamin Schaub is project manager for INTAS.tech, a consulting company within digital assets.
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