By Robert Nanni
Digital Assets Are Revolutionizing Traditional Investing
A decade ago, plans to build wealth were rooted in traditional investment approaches such as long-term real estate acquisitions, exposure to the S&P 500, private equity, bonds, or even hedge funds. Some of these vehicles had high barriers of entry and were not open to most of the investing public. Flash forward ten years, and in 2022, the dawn of DeFi (decentralized finance) has revolutionized the way people seek to build wealth with digital assets providing a new investment category.
As the world of finance continues to evolve, stronger transparency and regulation around digital assets is driving wider adoption among investors. Research by Nickel Digital Asset Management found that 29 percent of professional investors interviewed cited growing transparency as a reason for institutional investors to move into this new asset class.1
What Is Considered a Digital Asset?
Digital assets are not limited to cryptocurrencies (i.e., Bitcoin and Ethereum) or non-fungible tokens (NFTs) but can also include digital securities that represent fractional ownership in a variety of assets ranging from collectibles and art to energy and real estate. As a result, the digital asset ecosystem continues to expand, and many participants are beginning to structure new securities represented with digital instruments.
Why are Digital Securities Relevant?
While the decentralized nature of cryptocurrency and NFTs has allowed for global access and democratization, the lack of regulatory infrastructure concerning these products has also turned many potential investors away from the asset class due to the inherent risks, mounting fraud, and potential for manipulation. Further, the regulatory uncertainty surrounding these products (i.e., are they securities or commodities) has also limited their widespread adoption. Enter digital securities. The concept of digital securities has been welcomed by many as a middle ground to attempt to capture some of the efficiencies that blockchain can provide, while also allowing for the same investor protections, and regulatory certainty, as traditional securities marketplaces.
Contrary to popular perspectives, not all digital assets exist in an unregulated space. Specifically, digital securities are digital assets that that are offered and traded pursuant to SEC regulatory requirements. Digital securities are no different than traditional securities but for a token being used to track share ownership as opposed to a certificate or electronic record typically seen with traditional securities. Market participants trading these products receive the same investor protections and are subject to the same securities laws as participants in traditional securities markets. For these reasons, larger investors have been more open to considering digital securities as opportunities for investment.
Why Do Digital Assets Continue to Proliferate?
The market capitalization of digital assets—for example, cryptocurrencies and NFTs—was valued at $1.95 trillion in mid-August 2021; just a month later, it was valued at $2.14 trillion and is still growing.2The success of digital assets, specifically cryptocurrencies such as Bitcoin and Ethereum, has shaped the minds of forward-looking individuals and firms. However, the digital asset space continues to expand beyond cryptocurrency and NFTs as more people try to utilize concepts of DeFi and blockchain and apply them to the traditional capital markets.
In the United States, issuers are able to construct their digital asset offerings in a manner that clearly makes them securities, and thus regulated by the SEC (U.S. Securities and Exchange Commission). The underlying regulatory certainty in traditional securities markets sets the stage for explosive growth in digital securities, because issuers and market participants operate through a known regulatory regime. As more tokens launch that are classified as securities, investors will be able to gain exposure to alternative assets such as real estate offerings, art and collectibles, equity and debt offerings, and commodities.
By providing unbound and global access, cryptocurrencies provide people worldwide with more freedom in storing, transferring, and accruing value. Digital securities attract a different type of investor, which allows the addressable market for all digital assets to reach far beyond its current size.
As mentioned earlier, digital assets are gaining popularity with institutional investors, but already have mass appeal to retail investors and more technologically focused market participants. Mainly, certain proprietary trading firms and portfolio managers have allocated a portion of their capital to cryptocurrencies, and cryptocurrency and NFT trading platforms are popular among younger retail investors.
The digital securities subsector is far more nascent, and the tokenization/digitization of securities is still evolving. For this reason, many institutional investors have not yet embraced the space, rather they watch diligently from the sidelines. As more issuers embrace digital assets, digital securities may become the new industry standard if the blockchain based efficiencies around clearing, settlement, payments, and immutable cap table management can be realized. Institutional investor participation will likely occur at that time, and it will mark a new milestone for the space. However, some investors are interested in digital securities, not only for the merits of the investment characteristics, but also because of the potential efficiencies to be created in the future. There have been multiple successful digital securities offerings to date with the anticipation that digital securities offerings will bring much needed infrastructure to private capital markets.
Support And Education for Investors
Digital asset investments, whether cryptocurrencies or securities, will continue to grow and gain popularity if investors have a runway to educate and confidently explore digital assets as an investment type. While the lack of professional support and education for digital assets has been a challenge for many investors, this is slowly changing in the industry. Many new investors do not understand where to start when seeking to invest, or how to identify high quality opportunities. Financial advisory firms are stepping in to fill this role.
As the market matures, more educational materials and professionals who understand digital assets will be available, and investors are likely to become more comfortable with digital assets. Registered investment advisors have already taken the step to manage digital security/alternative assets in portfolios for clients as traditional security allocations begin to evolve. Eventually we will see the same traction in other digital asset subsectors as more advisory firms guide their clients through the exciting world of digital assets.
What's Next for Digital Assets?
Digital assets may have graduated from their infancy, but there is still much room for growth in this market. When analyzed by investors and market participants, the differences between cryptocurrencies, NFTs, and digital securities will continue to move regulated digital securities into a differentiated category. While some people may be hesitant to invest in digital assets because of perceived volatility, others see this as an opportunity to tap into a new asset class that is quickly revolutionizing mainstream investing. Further, digital securities are slightly different because there is an underlying investment/asset driving the price fluctuation (real estate, for example), and these securities are more comparable to traditional asset classes. We are likely to see an intersection of each subsector of digital assets. For example, the market has already shown demand for cryptocurrency to be used as a payment method for digital securities transactions. Digital asset investments are certainly still evolving, and it will be interesting to see what comes next for the space.
Digital Securities Infrastructure and Marketplaces
Long-term sustainable growth of digital securities heavily depends on institutional-grade infrastructure for pre-trade services like research and analytics, comprehensive execution support, and post-trade services like clearing/settlement or securities lending. Institutional investors (pension funds, endowments, foundations, corporate treasurers) will require scalable and compliant solutions if they are to begin allocating capital to digital securities. . As innovative firms build out infrastructure solutions for the digital asset and digital securities marketplaces, investor demand will grow.
Digital securities face the largest hurdle when it comes to infrastructure deployments. The current complex regulatory environment, especially when looking cross-jurisdictionally, does not allow for the efficiencies of tokenization that are hyped in less regulated crypto markets. The need for compliant infrastructure and SEC regulated entities to maintain control is crucial for digital securities to succeed. To launch successfully, broker-dealers, custodians, transfer agents, and ATS (Alternative Trading System) providers are often required.
Technology firms such as Templum can address and resolve these challenges by providing next-generation capital markets infrastructure for traditional and digital securities along with the regulatory approval sets to operate these markets in the United States. When firms partner with Templum, they can launch marketplaces to enable the issuance and trading of digital securities, while bringing standardization and market control to enhance the investor experience.
Digital assets are moving from fringe to mainstream, and there is no turning back. In the coming year, we will see a growing number of institutional and retail investors move from simply sticking their toes in the water to jumping into the deep end. We expect this to translate to the digital securities space.
With the (r)evolution well underway, we can expect to hear more about alternative digital assets in the coming months as they merge with traditional investments and become part of the foundational investment landscape. The future of digital assets is bigger than crypto; a mature digital securities industry is coming.
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