• TECHNOLOGY, SECURITIES SERVICES, CASH MANAGEMENT

    Digital assets in 2021

February 2021

With more companies using digital assets, flow’s Janet Du Chenne hears from Deutsche Bank’s Regulatory and Securities Services experts on the game-changing initiatives that are driving their adoption in financial services

In January 2021, Elon Musk’s Tesla became one of the largest companies to invest in bitcoin1 with a US$1.5bn purchase. In a stock market filing, the company said it was trying to maximise returns on cash that is not being used in day-to-day running of the company and that it could "acquire and hold digital assets" and start using them as a form of payment in the future. The news sent bitcoin’s price up 17% to US$44,220, topping recent month highs after a rollercoaster ride over the last decade.

Spikes such as these have created volatility concerns2 with central bank regulators admonishing the cryptocurrency for its risk and unpredictability. In October 2020 Bank of England Governor Andrew Bailey commented that he saw little intrinsic value in bitcoin3 and cautioned against its use in payments. He is not alone in his concern. US Federal Reserve chairman Jerome Powell and Christine Lagarde, the European Central Bank (ECB) president, have both highlighted the risk to the financial stability of the existing monetary systems and the risk of fraud and theft of the so-called non-fiat currencies.

This has not stopped institutional investors showing their support for bitcoin. The world's biggest money manager, Blackrock changed a handful of investment mandates to allow some of its funds to invest in the currency in early 20214. “We are seeing many more institutional investors now allocating portions of their portfolios to crypto, and also large companies either building services around, or holding cryptocurrencies,” says Samar Sen, Head of Digital Products and Data in Deutsche Bank’s Securities Services team.

In this briefing, we highlight the initiatives on the road towards further adoption of digital assets in financial services.

State of play

For the financial services industry, digital assets such as cryptocurrencies are being lauded for having many of the elements needed in a digital and globalised financial market place. Their potential of real-time finality of transactions and frictionless cross-border availability are among the draws.

However, cryptocurrencies’ adoption as an efficient payment tool mechanism depends on regulators getting comfortable with them. In October 2020, Fortune noted, “governments are getting more concerned about both illicit activity and the threat to their monetary sovereignty" stemming from cryptocurrency”5.

This is why Facebook abandoned its proposed cryptocurrency launch of Libra and replaced it with a new digital currency named Diem6. Supported by the Diem Association, which consists of 27 members including Facebook, Coinbase, Spotify and Uber7, it is now set for launch in early 2021. Diem has a softer mandate in that it's meant to complement domestic currencies by creating a parallel means of payment and not replace or compete with them (Diem's monetary value will be tied to the US dollar – so one diem will equal one US dollar). Separately, Coinbase is planning to launch a long-predicted bitcoin exchange-traded fund (ETF) in 2021.

Since Facebook’s original Libra proposal in June 20198 and with further momentum among payment companies such as Paypal9, Visa and Mastercard, which are using digital currencies in payments, central banks and governments have understood that cryptocurrencies are here to stay. And that their benefits can only be unleashed when integrating cryptocurrencies into solid regulatory frameworks and financial systems.

Regulating digital assets

This acceptance, as flow’s Graham Buck notes in “Will digital currencies become mainstream?”, has moved several central banks to retain monetary control by launching central bank digital currencies (CBDCs) to complement or replace cash. A Bank of International Settlements (BIS) 2021 survey found 86% of central banks developing a CBDC, with 14% already running pilot projects and 60% experimenting proof-of-concept. Central banks representing one-fifth of the world’s population are likely to issue a general purpose CBDC by 2024.

Katharina Paust-Bokrezion, in Deutsche Bank’s market advocacy and regulatory affairs team, says that bringing digital currencies into mainstream needs further institutionalisation with “the establishment of a regulatory foundation followed by an at-scale participation of key members of the regulated financial ecosystem around the world”.

Deutsche Bank’s Sen lists the changing attitudes to digital assets that are shaping regulatory behaviours:

  • Cryptocurrencies: Institutional investors are now viewing some cryptocurrencies as a legitimate store of value, or a currency hedge during inflation, and are increasingly starting to allocate portfolios to this type of digital asset.
  • Tokenised assets: multinational companies are excited about new ways to raise financing beyond standard debt/equity, and various banks in partnership with exchanges and regulators have started to pilot new client issuances via tokenised assets. There is still a need for viable secondary markets, platform standardisations, and ecosystem maturity.
  • Stablecoins: Institutions recognise the enormous potential in having instant settlement, retail payments, and cross-border transfers via stable coins and settlement coins, but much work is needed in the regulatory space here to ensure that various countries’ capital controls are not circumvented.
  • CBDCs: China and Europe are currently leading the way in experimenting with and then rolling-out CBDCs. “I think that CBDCs will start to gain traction along with some approved stablecoins for use in settlement, payments, and remittances,” Sen adds.

Many central banks are considering measures to minimise the risk of disintermediation and the functioning of the two-tiered monetary system that provides the liquidity for the economic growth. Besides issuing CBDCs and defining standards, regulators’ key concerns around cryptocurrencies are consumer protection, financial stability and the fight against money-laundering and terrorist financing.

Regulators in various countries are starting to release frameworks and guidelines about how various types of digital assets and their services will be regulated to ensure MIFID continuity, investor protections and licensing.

Samar Sen, Head of Digital Products, Deutsche Bank Securities Services"Regulators in many countries are providing clear guidelines on how to offer digital asset custody in a responsible and regulated way"
Samar Sen, Head of Digital Products, Deutsche Bank Securities Services

Regulation in action

A boilerplate of these guidelines is expected in Q2 2021 when the ECB’s decision on a digital euro draws closer “and there is tangible view on regulatory activities in this year,” says Paust-Bokrezion. “2021 will be a game changer in this respect”.

In several jurisdictions, regulators have initially issued bans or warnings as an ad-hoc reaction to the increasing market capitalisation of crypto-assets, which increases the need for investor protection. However, that prohibitive approach is slowly shifting to proactively incorporating crypto assets in the regulatory landscape by issuing targeted laws or even regulatory frameworks that integrate crypto-asset related concepts.

In the EU, the Commission proposed a comprehensive regulatory regime for crypto-assets in September 202010 which is currently being negotiated amongst EU regulators and expected to come into effect at the end of 2021.

Similarly, the UK has launched its consultative process on crypto-assets and stablecoins in January 202111 and Switzerland, the jurisdiction where Facebook’s Diem has established its European home base, is expected to do so later in Q1 202112.

The US administration has issued numerous regulatory initiatives since early 2019, including the Framework for Digital Assets13. The Biden administration is expected to establish a collaborative and unified strategy to adjust the existing comprehensive regulatory framework and establish new regulations as needed to provide legal certainty.

In China, the approach is slightly different: the government launched targeted regulatory actions to support interest in establish and strengthen the digital Yuan. For example, in 2017, the government increased already strict scrutiny over cryptocurrencies in response to bitcoin peaks as the People’s Bank of China (PBOC) prepared to launch its CBDC. This was recently followed by the PBOC generally outlawing the issuance of privately-issued digital currencies.

Singapore has established itself as a hub for cryptocurrencies and the Monetary Authority of Singapore (MAS) enacted a revised Payment Services Act in January 2020 which provides rules and regulations for cryptocurrency exchanges and service providers to operate in the country.

In Japan, regulatory activity for crypto-assets kicked off in 2020 and is mainly focused on the adaption of the Payment Services Act and the Financial Services and Exchange Act for crypto-assets14.

The role of banks

In a two-tiered scenario for the issuance of a CBDC, banks and other regulated intermediaries will be distributors of the digital currency and provide payment services involving CBDC.

In addition, the banking industry continues to play an important role in the two-tiered monetary system: they facilitate the commercial bank money system by taking in deposits and granting loans on the basis of deposits and reserves.

As the digital agenda of the global economies progresses, an increasing number of industry processes are - or will be - based on blockchain/DLT technology, for example connected cars, pay-by-use concepts, and machine-to-machine payments. This creates a demand for compatible payment solutions where the programmability of money is a key feature. With this in mind, the financial industry shapes its digital strategy.

For commercial banks this includes the development of payment solutions to provide commercial bank money in a cryptographic infrastructure - complementary to the developments of CBDCs. These solutions are key to leveraging the benefit of cryptocurrencies in the regulated financial markets.

In addition to the payment infrastructure, the custody of crypto assets is another area where banks can play a role in the adoption of these assets in financial services. “Regulators in many countries are providing clear guidelines and licensing paths on how to offer digital asset custody in a responsible and regulated way with investor protection in mind,” says Sen. In the US, for example, the Office of the Comptroller of the Currency (OCC) announced that national banks can provide custody solutions for cryptocurrencies.15 “Institutional-grade custody and technology providers are more abundant, making hacks much more difficult.”

What’s next for digital assets?

With these initiatives paving the way for more digital asset use cases, further take-up hinges on a stable system to support them and the skills, knowledge and infrastructure, notes Sen. These include:

  • Knowledge, skills, technology: building services within this ecosystem often involves deploying new skills and technology stacks. Many institutions will need to invest in the right talent and technology to ensure they can participate.
  • Volatility and liquidity: cryptocurrencies still come with high volatility and limited liquidity. To get a fair and efficient market, all the various participants of this nascent ecosystem will need to bring the stability − from regulators, market makers, liquidity providers, to price discovery, brokers, exchanges, banks.
  • Regulation: although various digital assets bring exciting new features, some of these also allow for circumventing existing regulatory norms. Regulators will need to up-skill and legislate quickly to catch up with the innovation and yet maintain control. Some markets are taking the lead here by investing in talent and participating in the pilots with banks, clients and exchanges to learn and legislate on the go, while others fall behind.

Given the momentum and as appetite for digital assets accelerates, it does appear that robust partnerships between banks, central banks and payment system providers will be evolving quite quickly to facilitate their increasing use in financial services.


Sources

1 See https://bbc.in/3rHEhxZ at bbc.co.uk
2 See https://bit.ly/2MY7t54 at forbes.com
3 See https://reut.rs/3p6nyTz at www.reuters.com
4 See https://bit.ly/2Ojw0Su at markets.businessinsider.com
5 See https://bit.ly/3jEyqqs at fortune.com
6 See https://bit.ly/3743D1k at thisismoney.co.uk
7 See https://bit.ly/3rJn6MB at thisismoney.co.uk
8 See https://bit.ly/3pc39fC at diem.com
9 See https://bit.ly/2Z67VAR at newsroom.paypal-corp.com
10 See https://bit.ly/3tID0J7 at ec.europa.eu
11 See https://bit.ly/2LEKFXt at gov.uk
12 See https://bit.ly/3jFutBT at theblockcrypto.com
13 See https://bit.ly/3d37Ply at sec.gov
14 See https://bit.ly/2Z6gxrd at globallegalinsights.com
15 See https://bit.ly/372GRqB at occ.gov

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