The rise of the adoption of institutional digital assets and decentralised finance

A recent Era of Convergence panel debate between TradFi and DeFi industry specialists to debate on whether 2024 would be the year that institutional digital assets would really take off – was a timely reminder of how the financial industry narrative has evolved since the early days of the crypto ‘Wild West’, to a more measured approach to the opportunities presented by new digital assets and technologies within traditional financial markets ecosystems.

Traditional assets are being expressed increasingly in digital form – for example, in the form of tokenised assets such as stablecoins;  and an estimated $7 trillion in traditional assets is estimated to be targeted for transformation over the next five to seven years. This might be as a result of cash instruments being presented as stablecoins, bonds being presented as registered tokens, or a myriad of other digital forms.

It is clear that the conversation around the convergence of traditional and decentralised finance has moved on, from how traditional finance firms might look to adopt and embrace digital assets, to how this trend is affecting real transformational change. There are, however,  steps that still need to be taken to improve institutional investor understanding of this market.. One of these is greater public-private sector cooperation; this is particularly important since public sector organisations cannot compete with fintechs when it comes to hiring people with a track record of success with respect to new digital technologies and assets.

There also needs to be an educational drive across the financial services sector. There is a lot of discussion about “real money” investment in  digital assets , but there is also a case to be made that the application of blockchain technology has been under-analysed on the basis that investors who utilise blockchain technology to hold digital assets or tokens are also participants in wholesale markets.

Increasing awareness of how to apply decentralised finance principles to traditional assets is an exciting development – especially among firms that don’t have strong views on digital assets (including crypto) as an investment thesis, but hold these assets as a result of something else they’re doing. One particularly interesting example given to illustrate this might be an energy firm using electricity that it cannot sell to mine Bitcoin.

There are also very large asset owners that have never been able to put these assets to use properly who could create a digital twin of these assets to represent the value of the underlying asset that could go into custody and be traded in a new set of trading rails. This raises an interesting point about how trades could be executed in the future. Just because the option for new payment rails exist, it does not mean that RTGS or any other existing payment rail is going to disappear overnight, which suggests that there are a lot of questions still to be answered around interoperability across networks, protocols, and smart contracts.

In terms of settlement, it is likely that market participants will eventually want to settle trades on-chain, avoiding the high operating costs and failure rates of traditional settlement systems that are a general drag on business performance.

Automating the lifecycle of a trade and taking a significant amount of cost and complexity out of the transaction lifecycle also makes it possible to mobilise new asset classes much more quickly.

In any discussion of decentralised finance, the subject of regulation is never far from the surface. For regulated firms to feel comfortable about investing in digital assets and technologies  they will want  legal clarity and regulatory certainty, particularly when  operating in and across multiple financial markets..s. The encouraging news here is that a lot of work has been done this year in the regulatory space in multiple jurisdictions in the form of consultations and frameworks.

That said, not all markets are moving at the same pace. While Europe has become something of a flagship regulatory environment with the enactment of the Markets in Crypto Assets Regulation (MiCA), the US by contrast has been hamstrung by the lack of consensus between the Fed, the SEC and the CFTC.

The pace of regulatory reform in the US is, however, set to accelerate in 2024  amid speculation that US financial regulators will sign off on Bitcoin spot exchange traded funds. This is expected to result in a significant increase in capital flow into this asset class as heavy hitters such as Blackrock put their considerable distribution resources behind such funds.

This move would lend further credibility to crypto as an investment and could incentivise the FCA to be more open to regulated crypto in the UK (where the Financial Services and Markets Act 2023 passed into law at the end of June). The FCA publication of a discussion paper on the regulation of stablecoins in November is seen as a positive development in this regard. Elsewhere in the US, the outcome of a consultation by the US Treasury and IRS on the taxation of digital assets will be eagerly examined.

So what needs to happen to accelerate the pace of  convergence of traditional and decentralised finance over the next 12 months? Many factors could be considered here, with the use of blockchain in the real world economy just one development that would add impetus to this era of convergence. Proponents of this trend are understandably keen to see wider institutional adoption of digital assets, although it is not easy to be precise about the timeframe within which critical mass will be achieved.  For example, many market participants are bullish about the prospects of institutions paying more attention to this asset class, while also acknowledging the transition that will need to take place, for example, to new stablecoin  payment rails.

There are undoubtedly positive signs from a regulatory, technological infrastructure and investment perspective, with even the most  conservative asset managers and pension funds now  looking at the opportunities presented by digital assets and how these might sit within investment portfolios.  

To go back to the original question of whether 2024 will be the year that institutional adoption of digital assets will really take off, the signs are very positive, albeit subject to legal clarity and associated regulatory frameworks to assure appropriate and proportionate market  and consumer protections.  

Watch our recent Era of Convergence panel debate here.

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