How banks are opening the market for DLT and digital assets

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Interest in cryptocurrencies has plummeted. Contrasted with this is the accelerated development of other forms of digital assets and the development of DLT-based infrastructures in the financial industry. DLT is the abbreviation for “Distributed Ledger Technology”, the principle of decentralized data management, which is also the basis for e.g. blockchain. The disruptive potential of this technology is supported by the supervisory authorities by creating suitable framework conditions for the development of corresponding business models. This increasingly opens up the market to institutional investors. So is “buy the dip” the motto?

One thing is certain: the developments in DLT and digital assets are more than just hype. Looking at the venture capital market, for example, there has been a sharp increase in investment volume in blockchain companies. In 2021, 26 billion euros were invested worldwide, bringing the annual growth rate of this sector to an average of 44% since 2018. In addition, the EU regulation called MiCAR (Markets in Crypto Assets Regulation), which is expected to apply from 2024, create new requirements for crypto service providers in Europe. New rules of the game for financial institutions are emerging.

The financial services market in the German DLT ecosystem is becoming increasingly mature. Nevertheless, the number of players in this market environment is still small, which is why banks and fintech can still realize early mover advantages. Three interesting business models are presented below.

First business model: crypto depository and brokerage

Cryptoassets have been part of the German Banking Act (KWG) since January 1, 2020. The underlying private keys are secured and managed as part of crypto deposit as a financial service. However, like the traditional securities custody business, the crypto custody business tends to have low margins. This financial service can only be run profitably by using the mass of stored private keys. Nevertheless, the crypto depository is an important starting point for further business models for digital assets, as it provides the technological basis for further use cases.

The combination of crypto depository and brokerage services is particularly interesting for crypto brokers and exchanges. There are currently two main business models.

  • On the one hand, institutions can act as financial brokers and get crypto assets executed on a crypto exchange or against a liquidity provider on behalf of their clients. The institution does not assume any market risk here, but is bound by the counterparty’s pricing.
  • Another option: Institutions can supply their own trading on a crypto exchange and sell the crypto assets (e.g. cryptocurrencies) from their own trading book directly to their clients. The institute can set the price more flexibly. However, it also assumes the market risk itself for the period from purchase to sale.

Second business model: Introduction of a registry for crypto-securities

In addition to the crypto depository, the introduction of the crypto securities registry has also made it an entry in the KWG. This means management of bonds or fund units that are issued and made tradable via DLT. Basically, we are talking about managing crypto-securities in a decentralized registry system that is protected against counterfeiting. So far, only crypto-securities have been issued in the form of bearer bonds on the capital market. Transfers are made through reservations in the respective custody account, without the recipient having to participate in the infrastructure of the crypto-securities registry and create a so-called “wallet” (or other new accounts) for this purpose.

It is to be expected that the first shares in the crypto fund will follow from 2023. Similar to crypto deposit, the earning potential of this service can be assessed as low. However, new crypto-savvy customer groups can be opened up through crypto fund shares, who want to realize the benefits of wallet booking and the associated real-time portfolio changes compared to conventional, more time-consuming transactions.

Third business model: asset tokenization

The so-called “tokenization” of assets is another service in the DLT ecosystem. Traditional assets, such as bonds or shares, but also illiquid assets are digitally securitized on the blockchain. A corresponding “token” can be issued in the form of securities regularly subject to the rules for classical securities (MiFID II, etc.), or in the form of non-fungible tokens (NFTs). The latter is enjoying increasing popularity, especially among private investors, as this type of investment can generate unique assets. However, how NFTs should be treated from a regulatory point of view depends on the individual case, as there are many possibilities for their specific design.

Various platforms are already trying to make assets accessible to small investors by splitting them into denominations. An example: the Picasso painting worth 4 million Swiss francs, which was auctioned as an NFT in 2021, in the form of 4,000 fragmented tokens. However, the market for tokenized assets faces a central problem: the lack of liquidity, which often leads to high spreads and difficult tradability. However, this problem of liquidity in this still young market will be gradually solved by the regulator from 2023, at least for security tokens, because that is when the DLT pilot regime comes into effect in Europe. This creates a regulatory framework for the establishment of trading venues for security tokens that can make them tradable from multiple issuers in a centralized manner.

What should you pay attention to when creating new business models?

Challenges in building a business model for DLT or digital assets must be identified and mastered. Financial institutions primarily face the following four challenges:

  1. Continuous development of know-how: This is necessary to recognize the relevance of the topic at an early stage. Crucial here is an emphatic commitment to dealing with DLT and digital assets at a strategic level.
  2. Slow innovation, legacy issues with existing systems, a cost base that is too high: Institutions should start with an MVP approach, “minimum viable products” (e.g. with crypto-custody) and gradually expand this. Partnering models can be a sensible solution here.
  3. Complexity in mapping digital assets in compliance and risk systems: It is recommended to raise awareness of the topic and build skills through regular training of relevant stakeholders on the risks, compliance and money laundering obligations associated with these business models. Outsourcing of compliance and risk management software for digital assets may also be considered.
  4. Lack of knowledge of the approval procedures in Germany: In the event of a decision being made, it is often necessary to apply for a license from Bafin. Early processing of the approval process at Bafin and the exchange with it is an important success factor. A project approach can also be pursued, and external know-how can be purchased.

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*The authors Julian Schmeing (Senior Manager), Philipp Kerber (Senior Consultant) and Christian Rößler (Consultant) work for zeb. The strategy and management consultancy is one of the financial scene’s first-class partners. You can find out more about our partner model here.

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