8 December 2023

Even for the most seasoned of fund managers, digital assets can be an overwhelming subject to wrap their heads around. And those that take a deep dive into the topic risk becoming exponentially more confused even after doing some basic desk research. The terminology is confusing, to say the least.

In its recent paper on fund tokenisation, the Investment Association (IA) announced that the Investment Fund 3.0 era has now arrived and the UK is uniquely placed ‘to take a leadership position in the continued development of this important ecosystem’. This also follows calls from UK ministers to turn the country into a global crypto hub.

Digital assets and the benefits they can bring are clearly gaining traction, so I thought now is a perfect time to explain what we mean by digital assets and look into their potential future impact, focusing specifically on investment funds.

To begin, let’s demystify some commonly used terms. ‘Digital assets’ is a broad descriptor covering anything of value created and stored digitally. While this can span all sorts of things including videos, images and data, in the finance universe, digital assets often relate to crypto-tokens (aka cryptocurrencies and Non-Fungible Tokens), collateralised stablecoins, Central Bank Digital Currencies, and everything in between.

The crypto landscape, often synonymous with terms we hear like cryptocurrencies and cryptoassets, relies on digital security through cryptography. Most cryptos operate on decentralised networks utilising blockchain technology – a distributed ledger underpinned by a network of computers or nodes.

Bitcoin remains the most well-known cryptocurrency and has the largest market capitalisation of approximately $810 billion at the time of writing. The crypto realm has expanded in recent years, with the introduction of novel asset classes i.e. Non-Fungible Tokens (NFTs) that represent unique digital items such as artwork.

Recent market activity saw Bitcoin reach new highs in 2023, partly fueled by speculation surrounding potential approval from US regulators for traditional stock market funds to directly invest in cryptocurrencies. Also, traders are anticipating the approval of a Bitcoin ETF by the Securities and Exchange Commission. These developments would enable investors to gain exposure to Bitcoin without direct ownership, having a significant impact on the overall investment landscape, including that in the UK.

Prominent financial institutions, including BlackRock, Fidelity, Ark Invest and Invesco, are actively pursuing Bitcoin ETFs. BlackRock’s iShares Bitcoin ETF recently made its appearance on the DTCC clearing body’s website, and its approval would undoubtedly encourage others to follow suit.

While mainstream adoption of digital assets will take time, there are obvious (and potentially enormous) benefits that the industry will gain down the line. Just think of lower costs, improved trading, settlement, liquidity and transparency, as well as easier and quicker access to new products and markets. Almost sounds too good to be true, right?

The full realisation of these benefits is most pronounced in native digital assets existing solely on-ledger (not collateralised or backed by off-ledger assets), and this is where complexity and any restrictions tied to conventional assets are significantly reduced.

However, a shift of this magnitude from current investment practices poses significant challenges, namely the wide acceptance of moving away from traditional financial instruments and infrastructure to a new, decentralised digital world.

Some advocate for a transitional approach, tokenising conventional assets to capture part of the benefits. Tokenised assets, in the shape of digital tokens issued and held on-ledger, represent ownership of conventional assets held off-ledger, potentially replacing traditional shares and units in fund registry and trading. The key difference here is that these tokens can be traded on digital, rather than conventional markets.

Initiatives like tokenised cash will also help boost confidence and foster innovation in various financial products. Tokenised cash, in the form of digital tokens issued and held on-ledger, represents title to conventional cash or cash-like assets held off-ledger. These are commonly referred to as ‘collateralised’ stablecoins, with USD Coin being a good example. The G7 has already expressed interest in bringing collateralised stablecoins into the regulatory perimeter, and it’s the first asset class being looked at by the Treasury in the UK as it considers oversight measures to strengthen regulation in this area.

It’s worth noting that these differ from algorithmic stablecoins like DAI and Ampleforth. Algorithmic stablecoins are digital assets designed to maintain stability by adjusting the supply to control their price. An algorithmic token and tokens backed by “baskets” of multiple other cryptoassets maintain a one-to-one exchange rate with pegged assets. This is achieved through an algorithm that adds (“mints”) and removes (“burns”) tokens from circulation.

Central bank digital currencies (CBDCs) are a somewhat contentious form of digital asset that would be created and regulated by a nation’s central bank – but they are gaining momentum, too. By February 2023, 11 countries had already introduced CBDCs, while over 100 others, constituting 95% of the global GDP, were investing in research for CBDC pilots and white papers. This marks a substantial increase from 2020 when merely 35 countries were actively exploring issuance of CBDC.

By the end of the decade, the Bank of England is exploring the introduction of a Central Bank Digital Currency (CBDC), commonly known as the Digital Pound and nicknamed “Britcoin”. Jon Cunliffe, the Deputy Governor for Financial Stability, sees the UK developing its digital currency in collaboration with the private sector. Describing an ongoing consultation in coordination with the Treasury, Cunliffe calls it being a “platform model,” wherein the Bank of England supplies the central infrastructure, and private firms provide wallets and payment services.

It’s not surprising that the extreme volatility associated with cryptocurrencies and cryptoassets has contributed to skeptical views around digital assets. Nevertheless, there is optimism that new initiatives and regulations could improve public perceptions, especially when the benefits of the new model are being recognised more and more by the industry. It’s still early days for this fledgling technology but innovation fueled by effective collaboration in this area is gaining pace and certainly not going away any time soon.

The original version of this article was published on FT Adviser.