TAKING THE LID OFF CRYPTO.

Jannah Patchay delves into the world of cryptocurrencies and how it is progressing.

In the future, financial historians may well look back on 2019 as the year in which crypto-assets went mainstream in Europe, if not the world, in the context of being taken seriously by regulators as financial participants including investors and market infrastructure providers.

This is the year in which Switzerland’s SIX Exchange announced its plans to issue security tokens on its imminent blockchain-based SIX Digital Exchange, while the London Stock Exchange, one of the world’s oldest and most venerable examples of its type, played a key role in the UK’s first tokenised primary equity issuance process.

Both the Financial Conduct Authority (FCA) and European Securities Markets Authority (ESMA) have identified three broad categories of crypto-assets. First are exchange tokens, used as a means of exchange, including cryptocurrencies. Second are security tokens, which confer an equity stake, represent a debt or a return based on future income. And, last are utility tokens, which are not necessarily transferable outside of the application or platform whose functioning they enable.

Many financial institutions see value only in security tokens, although it’s worth noting that there are also valid use-cases for exchange and utility tokens even if it is confined to the traditional asset management sector. However, security token offerings (STOs) are grabbing the limelight because they are seen as the more legitimate, regulated sibling of initial coin offerings (ICOs). They offer a host of potential opportunities and benefits to both issuers and investors.

Avtar Sehra, CEO of Nivaura, a firm specialising in the automation of both traditional and tokenised primary issuance processes, says “Just like the world is moving to a cashless society, it’s also moving to a document-less society. Financial instruments are not documents – the documents contain information on what the instrument is, what the terms and conditions are, and how these can be legally enforced.”

He adds, “this information can just as easily be digitised – the contract should still be standalone and enforceable. This is essentially what we do – we say that if you get that right, then the performance of the contract can happen via a traditional clearing system or on the blockchain, it doesn’t matter.”

20:30, the firm that recently tokenised its own primary equity issuance, sees tokenisation and the associated automation as creating greater efficiencies and cheap, fast access to markets for issuers. Ubiquity is their goal, and it is an inevitable one, according to Jack Thornborough, 20:30’s Chief Compliance Officer. “We’re first working with equity but then we are looking at other financial instruments as well,” he adds. “We have a clear vision of how our offering will be built out – using smart contract technology in the future to support lifecycle events and corporate actions. That means working with fiduciary service providers and law firms to determine how this will all work and what legal documentation is needed to support it.”

Overcoming hurdles

There are, however, obstacles in the path to ubiquity. Not only does full tokenisation of primary equity issuances face legal barriers, but there are also challenges to liquidity in secondary markets trading. Specifically, the European Union’s Central Securities Depositary Regulation (CSDR) mandates that securities that are admitted to trading on an MTF or OTF must be registered with a CSD. At present, the inability of any to demonstrate control over blockchain-registered tokenised securities means that no CSD will undertake this activity.

As a result, there is currently no capability for security tokens to be traded on a regulated secondary market trading venue. They can be traded OTC, but the lack of venue trading inhibits liquidity and price discovery; both blockers to greater institutional take-up of these assets. As in many other cases, collaboration between market participants is key to overcoming these challenges.

“This is why the work that Nivaura is doing in the 5th FCA Sandbox cohort is so important,” says Stuart Davis of Latham & Watkins, a law firm which is advising on this project. “By partnering with a CSD and a leading exchange, Nivaura will demonstrate for the first time that a digital equity security can be traded on an EU trading venue in a manner which fully-compliant with CSDR.”

In the shadows

By contrast, exchange and utility tokens have garnered less attention and interest from the institutional sector, partly due to the perceived taint associated with Bitcoin and its fellow cryptocurrencies. Moreover, there is also a view that this is an unregulated sector or a kind of wild west frontier. Many market participants such as Obi Nwosu, CEO of Coinfloor, a voluntarily-compliant cryptocurrency exchange offering trading in Bitcoin and Ethereum to fiat currency pairs, baulk at this stance.

He notes that “there are three main blockers to more wholesale institutional adoption of crypto as an asset class: volatility, regulation and availability of products. Volatility will decline as more institutional investors enter the market. Regulatory certainty will help drive innovation and product development. There aren’t currently many product offerings available to either retail or institutional investors that are sophisticated, well-structured to meet client demands and requirements, and that are easy to access.”

Nwosu believes that as long as there is sufficient demand and supply, then “the number one-use case for Bitcoin and other cryptocurrencies is as a speculative asset, due to intrinsic properties that make them an exceptional store of value.” He foresees a future in which an ecosystem of products and services develops around cryptocurrencies, both legitimising them as a viable asset class, and attracting a greater range of investors.

George Zarya, CEO of BeQuant, a crypto-asset exchange and prime broker aimed squarely at the professional and institutional market, is working hard to make this vision a reality by trying to bridge the gap between the traditional financial markets and crypto-assets. “The crypto market is still very fragmented, and as a prime broker we offer a one-stop solution to institutional investors,” he says, adding the company works with exchanges to build out FIX connectivity, and offers services in the post-trade space. In the future, it hopes offer algorithmic execution tools.

Although there has been a lot of hype in the industry, three things have become increasingly apparent over the past year. Firstly, a lack of legal and regulatory clarity creates barriers not only to wider demand-side adoption by institutional investors, but also supply-side barriers to the firms that want to launch new products and services. Secondly, that even where there is a clear legal and regulatory position, the constructs of the existing legislation are not necessarily relevant to digital tokens. This creates unnecessary layers of indirection and intermediation in this nascent market structure. Last, but certainly not least, the market structure developing around crypto-assets is not so very different, after all, from that of traditional financial markets.

©Best Execution 2019
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