Distributed Ledger Systems have the potential to fundamentally change the way financial markets work. And although there seems to be consensus about this rather bold statement since a couple of years already, the industry is still in its infancy when it comes to tokenized securities, to which I will be referring to as “Digital Assets” in this article. If we look at assets without a “tangible” underlying such as Bitcoin and Ether, to which I will be referring to as “crypto assets”, one can see a far higher degree of market maturity when it comes to transaction-volumes, but a lower degree of harmonized regulatory oversight. This not only led to traumatic incidents such as the FTX-fraud but also prevented the crypto asset market from growing even more.
The rise of Digital Assets is challenging Risk and Compliance departments
When you look back on the development process of these two markets, a differentiation in phases seems possible. In phase one, regulated financial market participants were keen to leverage blockchain-technology, but did not want to have anything to do with crypto assets. They were experimenting with their own permissioned ecosystems, basically mimicking the traditional financial world. And from a risk-management-perspective, this approach is reasonable: If you are running the network, you can decide who is able to participate, you can make sure KYC is taking place and most of the time, the participants in these networks would have been able to change things if something would have gone wrong. And although this has not a lot to do with the basic concept of distributed systems to reach a consensus about a certain stage within the network, this phase was essential to learn about the technology. In phase two, more and more market participants realized that building just another permissioned ecosystem is not the way to go if you want to leverage the real power of truly globally distributed networks. In this phase, the EIB issued their first bond on the Ethereum-Network. With the EIB-issuance it felt like “Pandora’s box” was opened – and a lot if risk-management-professional still have a hard time wrapping their head around questions like settlement finality and the (not possible) necessity to make sure your transaction is not mined in a block from a miner in a sanctioned country, as this most probably would be deemed “interacting” from a legal perspective. In the current phase three, more and more securities are deployed on public blockchains and the mood from regulated financial institutions regarding crypto assets is massively changing. BlackRock, Deutsche Bank, DWS – everyone wants to have a piece from the pie.
This, of course, challenges not only the risk but also the compliance departments, as they must deal with a set of completely new risk factors. And although we are seeing some appropriate approaches, misunderstandings and bad reputation of crypto assets are still deeply woven into some departments. And to be clear: Yes, there have been illicit activities and scams out there and yes, there will still be illicit activities and scams out there. But with the proper skills and tools, blockchain-ecosystems offer far greater options to manage risks than classic financial markets and it oftentimes amazes me why so little is done. And every time I am catching myself thinking that way, I need to remind myself that the people on the other side most of the times are not blockchain-natives and think in classical structures or are trying to apply the rules and regulations that try to regulate the “old world”. This again is understandable, as they will be benchmarked by the auditors according to the same rules as in traditional financial systems, that were not adapted to the “new normal” as of now.