This article was written by Nicholas Mitsakos : Chairman and CEO at Arcadia Capital Group.
Digital Assets, Distributed Ledgers, and the Future of Capital Markets
“Distributed ledger technology and digital assets have the potential to dramatically disrupt global equity and debt markets.” (World Economic Forum, May 2021)
Distributed ledger technology (DLT), otherwise known as Blockchain technology, will radically simplify financial markets and, more importantly, fundamentally change the market’s infrastructure. Specifically, distributed ledger technology decentralizes critical data and enables an entirely new financial system where capital flows without the need for traditional intermediaries.
While there are challenges and numerous detractors, DLT is an irreversible disruptive force transforming capital markets and the global financial system.
Regulators (a potential obstacle) are increasingly comfortable with this technology. Distributed ledgers, decentralized finance, and Blockchain-based platforms are creating products and services evolving from exploration and experimentation to commercialization. DLT will be transformative to the world’s largest industry and represents an unprecedented opportunity.
Reshaping Global Capital Markets
Market forces are inexorably pushing capital markets to digitize, and distributed ledger technology will be the standard.
- Growing institutional and regulatory comfort with Blockchain technology
- Potential central bank digital currencies in China, the US, and the Eurozone
- Cost efficiency and client pressure
DLT solves capital markets’ inefficiencies from legacy processes, complex technology systems, opacity, and fragmentation across markets. Distributed ledgers have a meaningful impact on costs, market liquidity, and financing capacity, significantly improving operational efficiency and balance sheet management.
Smart contracts improve existing capital market processes in numerous asset classes or re-create value chains, causing disintermediation and digital transformation.
Competition remains fragmented and has not scaled significantly yet as this market emerges. Development will take many forms, but the opportunity to create substantial value as a new market participant is indisputable.
Greater digitization is inevitable. But incumbents are hesitant from uncertainty, operational restructuring, legacy systems, and regulatory uncertainty. Decentralized finance and digital assets, therefore, create a unique opportunity for new market entrants.
New digital platforms created by decentralized finance companies integrate securities and other digital assets comprehensively. The platforms enable market participants and intermediaries to issue, trade, settle, and provide custody services for digital assets, usually consisting of digitally native equity tokens (ICO’s).
These digital asset and financing platforms exist in parallel to existing market infrastructure and securities markets, in many cases offering an alternative digitized version of a standard asset class. Fundamentally, what is disruptive is that this new technology disintermediates all parties, creating effectiveness and efficiency in the transfer and recording of transactions that is unprecedented in legacy infrastructure.
Digital platforms created with distributive ledger technology accomplish several things quite effectively:
- Introduce a single, verified source for all aspects of the security, including ownership and trading activities
- Enable digital securities (ICO’s)
- Settle trades on a shorter and more flexible timeline
- Investors and issuers interact directly with market infrastructure or each other
Why bother disrupting a global industry that seems to be working fairly well? Some of these benefits can make all the difference and create substantial value:
- Greater transparency for all parties
- Significantly simplified operations
- Automating all securities clearing, settling, and compliance
- Better balance sheet management (e.g. reduced funding requirements for risk capital or liquidity)
- Issuers can list directly and have greater transparency of ownership without relying on intermediaries, lowering the cost of capital significantly
These developments are still in their infancy, and many uncertainties are yet to be resolved.
- A supplemental market infrastructure could introduce additional operational complexity
- Mechanisms are needed to verify smart contracts when issued
- Revise regulation regarding responsibilities in securities’ transactions
“Equity tokens issued on a blockchain platform are potentially the most disruptive threat to existing equity markets.” (World Economic Forum)
- Equity markets
Operations and infrastructure in public equity markets function effectively, but the prospect of digitizing the entire process, including smart contracts enabling transactions and settlements immediately with greater flexibility while eliminating settlement risk while accessing a global base changes the game for public equities.
In addition, privately held equities – which do not benefit from the central infrastructures, standardized processes, and liquidity of the public markets – will be fundamentally changed because the efficiencies of public equity markets will be delivered to the private markets using Blockchain and tokenization.
It is disruptive because distributed ledgers will replace most of the traditional intermediaries and processes in equity markets. By listing securities directly on public blockchains – either on their own or with the help of banks – issuers eliminate many of the processes associated with an offering. Security tokens via DeFi (decentralized finance) through decentralized exchanges enable global and decentralized reach. This is possible with both public and private shares, potentially eliminating fragmented markets and manual processes by creating standardization and automation. Tokenized shares will blur the lines between traditional publicly listed equities and private company shares creating a larger global market for all equities at a significantly lower cost.
- Debt Markets
The bond market will be significantly transformed by Blockchain-based fixed-income securities. Specifically, it can significantly reduce inefficiencies in issuance and trading; illiquidity in secondary markets; and limited primary market access – mostly due to high minimum transaction sizes.
Bond markets are fragmented and mostly over-the-counter. They are more likely to benefit from distributed ledger transactions, and decentralized digital transformation will probably be easier.
The opportunity is enormous. Globally, the notional value of bonds outstanding totaled $106 trillion at the end of 2019, with an average of approximately $20 trillion issued annually.
- Asset Management
Perhaps the single most disruptive long-term development from distributed ledger technology may be in asset management. Asset management is central to the capital markets ecosystem, representing a large share of investment dollars globally. In addition to being very actively involved in the broader markets that may be transformed by DLT and other technologies, asset managers face inefficiencies and other challenges for which distributed ledgers and smart contracts offer solutions, including:
- Streamlining client investment by allowing it directly via a liquid digital token
- Enhanced liquidity for all investors – redemption no longer requires fund management approval and prices are established by an independent market providing immediate liquidity for each investor without needing the approval of the asset managers
- Improving data sharing among all investors and advisors enabling immediate access to all information
- Transformation of back-office operations
Fund assets tokenized or issued digitally will transform asset management. Tokenized fund shares will be tied directly to underlying asset pools via smart contracts, and traditional fund structures will be replaced by fully customizable portfolios.
Given the central role of asset managers in allocating capital globally, asset management firms and the ecosystems that service them will be affected by digitization. Faster or more flexible trade settlement, shared sources on securities or derivatives transactions, and operational simplification will all have implications for fund managers, custodians, and fund administrators. Shared, real-time data on all underlying portfolio holdings greatly simplify valuation, accounting, and liquidity, especially from new digital-native asset classes or fund ownership.
Once in a Generation
Creating actual efficiency for “efficient markets”
Fundamentally transforming markets requires new ways of thinking. Existing inefficiencies and limitations create an unprecedented opportunity for new thinking in the global financial markets by applying distributed ledger and smart contract technology.
New competitive entities can create an opportunity to fundamentally reimagine how capital markets operate, and this may be a once-in-a-generation opportunity.
- Distributed ledger technology can eliminate unnecessary complexity and redundancy in capital markets. Important applications regarding debt and equity enable efficient business operations and client interaction and access. Global financial markets can become substantially more efficient enabling global access to investment opportunities and financial products.
- New business models using DLT-based solutions can exploit existing inefficiencies and deliver new products or existing products more efficiently to a broader range of investors and financiers, and connect the sources of capital to users of capital much more effectively. It is one of the greatest potential opportunities world’s largest industry.