Crypto assets & smart contracts
Crypto currencies are facing difficult times at the moment… which is not helping the market participants to gain trust. However, the underlying assets are not at fault: it is the lack of corporate governance.
Rather than crypto currencies, we should focus more on the tokenized/crypto assets. Those are forming a big family, of which crypto currencies are part of.
All tokens result from the establishment of a legal link between the physical asset and its representative
digital token. Tokens are crypto assets representing a security (e.g. real-estate asset, debt/equity…) and are qualified as financial instruments under MIFID II. These are exchanged without the need for a financial intermediary, in a secured manner (channels are secured, and all stakeholders are KYCed by the participants)
The two main types of tokens:
Tokenized security: security that exists outside of a blockchain
Security token: security that is primarily issued on a blockchain
Some types of crypto assets:
Stable coins (backed by an underlying asset such as a currency, commodity, …). These can be considered as the tokenization of cash. Its digital form is then stored and transferred over a blockchain.
“Tokenization can be applied to pretty much any asset”
… tokenization can be applied to pretty much any asset, but some are more suited for it (i.e. those with constrained access, illiquid, restricted “investability”…)
Crypto assets are exchanged instantly and on a 24/7 basis (no T+1, T+2…) if of course the trade happens between e.g. a tokenized asset with tokenized cash.
There are however lots of challenges ahead for crypto assets, mainly due to the misconception/trust element. Bitcoin is playing a big role on this, while this is only one crypto asset amongst so many others.
Now, that being said, the tokenisation of investment vehicles and underlying portfolios have started to emerge.
What does it mean for the alternative investment industry, such as private equity?
The alternative investment industry is increasing its focus on tokenizing units and shares of investment vehicles. While the demand for financing remains robust, banks are reducing their lending activities amongst ongoing regulatory capital issues and substantial loan loss provisions due to the pandemic. As a result, the private debt market will have a steady and healthy grow to continue in the coming years. The digitalization and blockchain
technology is also to revolutionize the private debt market in the next few years, reducing the cost of loan origination, lowering barriers to entry, and increasing the asset class’s liquidity.
“The digitalization and blockchain technology is to revolutionize the private debt market in the next few years.”
On top of this, the private equity industry has record dry powder. Banks are retreating ever further from corporate lending. Currently, private debt investment involves multiple intermediaries, high costs and poor liquidity. Tokenization tackles these challenges by allowing economies of scale with disintermediation and increasing liquidity. In this respect, tokenization provides a technological advantage to asset managers, helping them become more versatile and competitive.
Tokenization offers natively digital, decentralized and peer-to-peer services accessible to all, challenging banks’ business models and the financial sector’s barriers to entry.
Smart contracts (programmable, software-driven business logic that enabless the automation of contract execution between multiple parties, with very limited human interaction) basically check if a pre-defined condition has been fulfilled, then executes a logic. They can also replace expensive functions like clearing and settlement and the use of transfer agents and intermediaries, such as distributors and placement agents. Removing these go-betweens can allow a direct relationship with investors, reducing costs and creating big economies of scale as a result. Smart contracts empower the blockchain technology and are therefore a key driver of success in tokenized assets.