Digital assets and traditional finance: Can two parallel lanes converge?

As the growth of digital assets continues at a rapid pace, Wesley Bray explores its influence on traditional finance, market structure and trading practices, and looks at what can be learned from the asset class.

In the ever-evolving landscape of financial markets, the emergence of digital assets has resulted in a paradigm shift as conventional notions have been challenged and new players have emerged along with a reshaping of the way in which financial systems are perceived and interacted with.

As the introduction of digital assets become increasingly common, their influence on traditional finance is becoming more notable, blurring the line between two seemingly separate, and arguably parallel, financial instruments.

Think of exchanges that now have a digital asset offering, banking giants which have dedicated units and the wave of experienced personnel who have made the transition from traditional finance to this burgeoning sector.

From the rise of blockchain technology to the proliferation of tokenisation – as well as the increased, yet still debatable, acceptance of cryptocurrencies as ‘legitimate’ assets – the impact of digital assets is evident across several facets of the financial ecosystem. The industry can now differentiate between ‘crypto’ and ‘digital assets’, while the old ‘Wild West’ comparisons for the former have now been replaced with opinions of ‘bad actors, not bad assets’.

What doesn’t seem up for debate is the potential of blockchain and how tokenisation will shape the markets of the future.

“For us, blockchain really is an enabler – looking from an infrastructure, product and a client facing perspective – to make processes in the long run safer, more efficient, while also reducing costs and enabling us to create accessibility, especially for retail investors, to additional products which are not tradable or fungible today,” says Christoph Hock, head of tokenisation and digital assets at Union Investment.

Blockchain, at the highest level, is about providing additional transparency, and with that, the opportunity for composability and less need for reconciliation, argues David Newns, head of SIX Digital Exchange (SDX). However, Newns also highlights the importance of regulation to improve and ensure investor protection within this specific asset class.

“The role that institutions play in this space is to find ways to enhance investor safety. When it comes to crypto assets, the notion that you have regulated institutions which are transparent and compliant with regulations will mean you trust them as a counterparty to provide services,” asserts Newns.

“That gives you the confidence that your assets are safe and that your activities are being conducted in the most fair and equitable way possible.”

The importance of regulation

In addition to helping foster investor protection, regulation in digital assets can help ensure market integrity and promote stability in an increasingly digitised financial landscape. Without appropriate oversight, digital asset markets can be left susceptible to fraud, manipulation and other illicit activities.

Regulators can also help facilitate mainstream adoption by bridging the gap between traditional financial and digital assets, contributing to the long-term sustainability and legitimacy of the digital asset ecosystem.

“Our key focus, as of now, is on crypto securities and that’s where governance is clearly required,” emphasises Hock. “All the negative issues around crypto, like FTX and Bankman-Fried which came up in the past, are based on human fraud. It’s not malfunction of the blockchain but human misbehaviour, in combination with a lack of regulation, for example in the US. Therefore, governance is key to ensure that the trust our investors have in us as an asset manager can be fulfilled.”

Impacts on infrastructure

Market infrastructure is being reshaped by digital assets through the introduction of new methodologies for ownership, transferability and transparency. Unlike traditional financial assets, digital assets leverage blockchain technology, enabling peer-to-peer transactions without the need for intermediaries.

The continued evolution of digital assets is helping catalyse the transformation of market infrastructure, shaping a way for a more inclusive, efficient and resilient financial landscape. However, there are still limitations as to how much can be gained in terms of infrastructure in the traditional financial landscape – one being the cost of any change.

“Typically, trading a digital asset requires new functionality such as a digital custodian, new post-trade integrations and/or trading connectivity – anytime a traditional financial firm has to put something like that in place, there has to be a really strong commercial case for why they do that because it’s timely, costly and expensive,” explains Duncan Trenholme, global co-head of digital assets at TP ICAP.

“The reality is if you are going to bring liquidity in from the traditional markets then the new digital trading experience has to be dramatically efficient or cheaper for clients to change their infrastructure.”

With developments linked to blockchain and digital assets surging and subsequently presenting various use cases and areas of improvement for the traditional finance landscape, the phrase ‘don’t fix what isn’t broken’ comes into mind. Traditional financial markets have existed for much longer than digital assets and because of that, any major shifts should be carefully considered.

“Looking at the intersection between blockchain and traditional banking, traditional banking has so much efficiently already in it, despite what you might sometimes hear. It’s highly optimised, it’s very efficient, but there are areas that we can certainly bring significant benefits through blockchain technology,” highlights Newns.

“To get the fundamental benefits, it’s hard work and it’s all about building and getting all the various participants comfortable. In crypto you’re taking traditional structures and you’re trying to accommodate a new asset class into them. In tradfi, however, we’re trying to get an existing asset class and then bring it into a new technology, which can be difficult.”

Where parallels meet 

Traditional finance and digital assets typically operate as two parallel and distinct markets at present, but increasingly there is overlap between the two. Settlement, something that tends to be instant within digital assets – particularly when it comes to cryptocurrencies – is something we see influencing the traditional financial landscape.

However, there is still a lot of work to be done on either connecting the two systems or uplifting the traditional financial systems to be able to support digital assets.

“In traditional finance, we’ve moved to shorter and shorter settlement times. Within securities markets we are currently discussing how to move to T+1 settlement from T+2 and make sure we avoid trades failing at scale,” says Trenholme. “Within crypto they’ve started with the premise of moving collateral within minutes or hours. Crypto challenges the way that traditional markets operate and have grown to operate over the years.”

Looking at what can be learned from digital assets, legacy systems and the need for increased modernisation to bolster efficiency comes into play. Limitations linked to message-based architecture is something market participants are fully aware of, and something that the seemingly parallel nature of digital assets emphasises even more.

“You just can’t do the sort of composable transactions and achieve the reduction in requirement for reconciliation when you’re still sending messages from one platform to another platform. We’ve optimised, but at the same time are inherently constrained by the fact that it’s not instantaneous,” says Newns.

Cryptocurrencies, specifically, have been viewed as attractive due to their ability to be traded 24/7, including on weekends and holidays. Unlike traditional financial markets, such as the equities space, cryptocurrencies are not limited by set trading hours and can operate continuously. Given that they are decentralised and traded across a range of global exchanges, they allow participants to buy, sell and trade cryptocurrencies at any time.

Whether traditional finance will mirror the around-the-clock model is yet to be seen, with varying arguments on whether demand for it exists and whether or not the shift is even feasible.

“You do see some discourse in the news about clients wanting to shorten market hours in certain asset classes, so we should challenge the assumption that just because we can operate markets 24/7, as we see with crypto, that we should operate markets 24/7,” argues Trenholme.

“Ultimately, if you think about the notional of assets that have been tokenised today, it’s still a drop in the ocean compared to the size of traditional finance. As such, it is easy to have a certain scepticism about how meaningful and relevant this could be if you are sat within a traditional business. There’s a lot of promise, and the technology could improve the market considerably, but it hasn’t reached a scale yet where it’s forced clients to alter the way that they trade. That tipping point has not yet been reached.”

Moving forward

Despite the current operation of digital assets and traditional finance as two separate parallels, digital assets’ influence is evident in the increasing integration of blockchain technology into financial infrastructure.

Institutions are exploring tokenisation of assets, converting traditional assets into digital tokens to enhance liquidity and improve accessibility. 

Hock tells The TRADE that Union Investment are one of the first asset managers in this area combining the traditional asset world with the tokenised world.

“For us, our view is that within three to five years of tokenisation of assets – not only of traditional assets but also of products which are not tradeable and are not fungible today – this will become a new normal. Important to highlight that we are not only talking about assets on chain, but also cash on chain, i.e. e-money. This consideration will be most powerful.

“Looking five years down the road, I’m sure tokenisation will become a key topic here for the entire ecosystem and has the potential to be a disruptor and a game changer for the financial industry.”

Digital assets are here to stay and their influence on traditional finance is undeniable. Although still a small fraction of the entire financial ecosystem, it’s clear that digital assets, the innovation linked with them, and the lessons learned from the asset class are influencing the way in which future developments within traditional will be approached.