25. April 2022 By Nehir Safak-Turhan
Crypto assets and crypto currencies in the age of digitalisation
Disruptive innovations have the power to fundamentally change the tried and tested and make room for something new. Basic innovations, such as the invention of electricity, the steam engine or information technology, have demonstrated this many times. Thanks to their power of ‘creative destruction’ (the famous term coined by Austrian economist Joseph Schumpeter), they have the ability to completely replace the ‘old and familiar’ with something new or to force it into a niche existence, albeit in the course of a transitional period.
This is the exact form of innovation-triggering transformative power that we observe in distributed ledger or blockchain technologies. Even though these technologies don’t place themselves on the pedestal of basic innovations and usher in Schumpeter’s famed ‘creative destruction’, they nevertheless clearly show how they can change the tried and tested in the realm of monetary transactions as well as in the traditional world of physical currencies or book money. Crypto currencies and digital payment methods have been fuelling the emergence of new trends and developments in the financial sector for several years; and they’ve gained significant impetus. Regulatory bodies are also reacting to the phenomenon by bringing order to the system. In this blog post, we’ll take a closer look at what consequences these developments have for the banking market and what the future of crypto currencies and digital assets might look like.
What are crypto assets and crypto currencies?
The term ‘crypto’ comes from Greek and means ‘to conceal’ or ‘to hide’. ‘Crypto asset’ is the collective term for all digital assets, such as crypto currencies (‘tokens’ or ‘coins’). These are financial instruments that represent digital assets and asset classes that are mapped in a blockchain.
A ‘token’ can represent things such as a financial asset, a tangible asset or a commodity. ‘Coins’ are digital coins whose basic purpose is to function as cash – but in a digital manner. These currencies are purely digital representations of values that aren’t issued or guaranteed by any central bank or public body. Accordingly, they aren’t legally considered currency or monetary units.
Crypto currencies are among the most popular crypto assets and refer to digital payment methods that are based on a blockchain system and encrypted using a complex algorithm. These are not regulated currencies in the proper sense, and they don’t exist in physical form as we know them, for example, in the form of paper money and coins. They don’t constitute national legal tender and usually aren’t issued by a central authority or supervisory body. These currencies aren’t necessarily stored in banks, but rather in the form of ‘wallets’, which are offered by numerous service providers and traded on stock exchanges. They can be accepted by natural or legal persons on the basis of an agreement or as a means of exchange or payment, or for investment purposes. A central bank, clearing houses or the traditional SWIFT network are no longer necessary when using crypto currencies. They aren’t controlled or regulated by state institutions, such as central banks or other official administrations.
Bitcoin is one of the most popular crypto currencies. This digital currency is already widely accepted in certain circles of investors and is hands down one of the most well-known crypto currencies. Much like gold has been a store of value for many generations, experts now believe that in future, Bitcoin could be a globally recognised asset for the younger generation.
All crypto assets and crypto currencies are generally technically based on distributed ledger (DLT) or blockchain technologies, which use a form of asymmetric encryption to prevent unauthorised interference with the system. These technologies form the technology pull that made it possible for this innovation to emerge in the first place.
How is the market developing and what does it mean for banks?
The market for crypto assets is experiencing incredibly dynamic developments and is characterised by remarkable growth figures. Crypto currencies in particular have been a hot topic for several years and are gaining more and more importance and attention in the financial market. According to CoinMarketCap, a leading platform for crypto currencies, over 18,600 crypto currencies are currently being traded on over 489 stock exchanges around the world. The market capitalisation for crypto currencies is approximately 1.94 trillion (as of 31 March 2022). Crypto currency is a remarkable market whose best-known securities include Bitcoin, Etherium, Tether, BNB and USD Coin.
It’s important to bear in mind that this market is highly volatile: official interventions, environmental concerns or tightened tax audits, as have been reported by the press, have led to considerable price fluctuations, especially in recent months. But sometimes, statements by Elon Musk are enough to influence the crypto market: when Musk tweets, the crypto scene is all ears. He doesn’t even have to provide in-depth analyses or background information; the gleeful conviction with which he expresses his opinion is all it takes to trigger price fluctuations. Nevertheless, these values have recovered faster than other forms of investment and have continued the impressive growth trend, even if there were a few setbacks.
This opens up a wide range of opportunities for banks and financial services institutions to come into contact with crypto currencies. In doing so, they can do things such as engage in proprietary trading using crypto assets, trade them on behalf of their own clients, set up their own trading venue or act as custodians of these assets. Knowing the obligations and necessary frameworks that come along with these endeavours is a basic prerequisite.
Crypto assets and regulation
Crypto assets are often characterised by a feature that isn’t always simple and understandable. The corresponding investments are to be classified as highly speculative and risky, as they can imply a threat to the stability of the financial market due to their high volatility and fluctuating prices and the amount of risk they involve. Accordingly, the the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, BaFin) supervises the service providers in Germany that actively engage in activities that deal with crypto assets. Examples of these providers include, crypto trading platforms, crypto cash point operators and companies that work in the crypto custody business. Therefore, the custody, management and safeguarding of crypto assets are regulated as part of the crypto custody business. This means that if the above-mentioned characteristics are present, the financial services are subject to authorisation.
New legal frameworks must also be taken into account in the securities business sector: the German Electronic Securities Act (Gesetz zur Einführung elektronischer Wertpapiere, eWpG) was enacted by the BaFin in June 2021 as a new regulatory guideline. This act reflects the increasing demand for digital asset classes and modernises German securities law and securities supervision. Under the eWpG, bearer bonds, mortgage bonds and certain shares in special assets can now also be issued purely electronically. By doing this, the BaFin is on its way to dematerialising securities law.
Legislation is intervening in an increasingly regulatory manner at the European level as well. For example, the European Commission proposed the directive to regulate ‘Markets in Crypto Assets’ (MiCA) to set EU-wide rules for trading in crypto assets. The MiCA legislation aims to provide EU member states with a regulatory framework for digital assets.
As digital assets become more widely accepted, it’s to be expected that regulation and legislation will enforce additional regulatory measures.
How can banks set themselves apart?
Trading in crypto assets is no short-lived hype. An increasing amount of private as well as institutional investors have shown serious interest in the new digital asset class in recent years. The new sector promises high return potentials and points to attractive growth impulses in the overall market. Now that there’s well-founded knowledge and experience in dealing with crypto assets, it’s realistic to postulate that the new business field could experience exponential growth in the next few years. It’s even predicted that 2022 will become the year in which crypto assets are considered to be a legitimate asset class. However, it’s also obvious that a sort of natural selection will play out in the market over the long term: according to estimates, only about one per cent will have a long-term chance of success and establish themselves in the market. When viewed in perspective, however, these few could then effectively increase their value by leaps and bounds.
As a result, it’s to be expected that digital assets remain viable in the long term, and that financial institutions begin to focus on them more and more. Numerous fintechs and exchanges have already recognised the signs of the times and positioned themselves on the market with various business models. For example, Bitwala, a fintech from Berlin, is already being called the ‘crypto bank of the future’. Bitwala is partnered with SolarisBank AG, a credit institution that allows them to link a traditional financial service provider’s bank account with Bitwala’s crypto wallets. Traditional financial service providers, such as the Stuttgart Stock Exchange/BSDEX, are also getting involved in the market and provide a trading venue for crypto currencies.
Although they won’t be among the first, attractive business models are also emerging for universal banks, in which they offer financial services related to the custody and trade of crypto assets as well as related consultancy services. This is because the market for crypto assets not only requires that the new asset class be actively managed, but it also requires operational and technical expertise, as well as a deep understanding of the financial market and how to handle regulatory challenges the right way. By implementing these business models, there’s no doubt that banks can make a name for themselves in the overall market and differentiate themselves from fintechs. They usually enjoy a higher level of trust from their clients and are well acquainted with the technical and regulatory specifics of the custody business and securities trading. Offering digital asset classes and securities accounts would be both obvious and lucrative, especially since a large part of traditional securities accounts are managed by banks.
There are also opportunities in the consultancy sector. As financial intermediaries, banks are experts at evaluating, analysing and providing risk management for asset classes. They can proactively participate in developing a digital investment division as a new business unit and draw on a broad portfolio of digital asset classes.
Because blockchain technology will permanently change the capital market for digital asset classes, being able to understand and use innovative technologies as well as map bank-specific use cases will be a basic requirement. Banks can create competitive advantages by using an appropriate technological foundation based on DLT and blockchain.
To sum it all up, banks are able to distinguish themselves as ‘connoisseurs’ and ‘experts’ in this growth market, as they not only understand the complexity of the financial system but are also able to maintain regulatory compliance as well as investment interest and manage them reliably. With the right technology and strategic direction, the benefits of the impetus generated by crypto currencies and digital payment methods are within reach.