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As you may have already read in my colleague’s recent post, institutional investor demand for exposure to crypto as an asset class grew by leaps and bounds in the first half of 2021, with no signs of abating.
According to the 2021 FIS Readiness Report, 38% of investment bank and 33% of broker respondents are prioritizing trading support for digital assets as part of their top three growth strategies over the next 12 months.
Moreover, a July 2021 report from Rosenblatt Securities highlighted that $3.5B of venture funding has been invested in crypto in H1 2021, more than 2X the total venture funding in the space in 2020. Rosenblatt also noted that 60% of the funding has been targeted at prime brokerage, lending and liquidity solutions.
To accelerate the transformation of the entire capital markets industry, it’s helpful to have a common understanding of the journey that starts with investing in crypto as a digital asset – and ends with the digitization of existing investment assets.
Here’s a five step thought process that you can use as a framework for this transformation:
Start with what you already know about Centralized Finance (CeFi) – the vast, regulated trading, investing and lending markets for traditional securities, derivatives and credit products, along with the ecosystem of participants in these markets, including investors, brokers, banks, custodians and exchanges.
These are big, established markets. For example, in equities alone, there are 137 stock exchanges around the world providing capital and liquidity for public companies. The products on just the top three exchanges have a total market cap of $53 trillion.
Familiarize yourself with the current state of crypto investing. To some degree it mirrors the CeFI world. It has many of the same participants, models and vocabulary. Buy-side and sell-side investors and brokers get exposure to crypto through exchange traded and OTC spot and derivatives markets or investment funds, and they may lend or borrow on underlying crypto balances used as collateral.
Currently, crypto is much smaller than traditional markets, but growing quickly; to put it in the context of the global equities figures above, the current market cap for all cryptos as of July 2021 is around $1.25 trillion.
Layer on Decentralized Finance (DeFI) – which are pools of trading, lending and borrowing liquidity for crypto assets, outside the confines of traditional banks, brokers and exchanges.
In the simplest use-case, DeFI investors move their existing crypto investment positions around these DeFI liquidity pools to enhance their returns or yields on their investments – something the industry refers to as yield farming.
These DeFI liquidity pools or “protocols” are pure technology-based offerings and part of an entirely new ecosystem of liquidity providers and investors. They’re separate from traditional centralized pools of liquidity such as exchanges, separate from traditional providers such as banks, brokers and market makers, and currently outside most of the regulatory boundaries that exist today.
These protocols are also very much traceable back to crypto investing, because DeFI expands the investment options and value for crypto assets. And importantly, both crypto and DeFI rely on the same underlying blockchain technology to manage transaction processing and value ownership transfer.
To put DeFI into context with the figures above, as of July 2021, $54 billion is “locked” in the DeFI protocol landscape – and continuing to grow.
As I noted above, crypto and DeFI protocols are based on common underlying blockchain distributed ledger technology that spreads the infrastructure and responsibility for the infrastructure across the Internet instead of being provided by CeFI. Much has been written about blockchain over the past few years, so I won’t delve deeply here, but it’s important to highlight that as investors grow comfortable with the public blockchains underlying crypto and DeFI, there will be greater comfort with and demand for applying blockchain technology to existing asset classes. Which brings us to my final point.
One of the key characteristics in both the crypto and DeFi ecosystems supported by blockchain is that value and ownership is represented by “tokens” within the systems. For example, nearly every cryptocurrency is a token and nearly every DeFI protocol has a token.
It’s these tokens that are then traded as cryptocurrencies – which may explain why there are more than 10,000 cryptocurrencies as of July 2021.
Tokens are also used as payment incentives for providing the decentralized technology infrastructure and cryptographic calculations required for transaction processing, commonly referred to as “mining.”
Tokens are important because they enable the decentralization of the economic incentives and governance of the infrastructure. We will no doubt one day see traditional CeFI providers generating new sources of revenue (tokens) by providing DeFI infrastructure.
What’s most exciting is that beyond supporting this world of digital assets, tokens can also represent the value of real-world non-digital CeFI assets – examples include Central Bank Digital Currencies (CBDCs), which are based on underlying sovereign fiat currencies, or even tokens representing stocks, bonds or real estate.
Digitization of these real-world assets through tokenization will allow them to be traded and settled using blockchain technology, significantly reducing the time it takes to trade, process and settle, but also reducing the cost and risk of the CeFI technology and human capital required to support the infrastructure.
The journey to digitizing real-world assets in the capital markets has only just begun. But with these tips, you can get a better understanding of how the rapid growth in institutional demand for digital assets will evolve into the complete digitization of CeFI investing and markets in the future.