Embrace this digital future or die – Summary

This is the summary of a discussion hosted by Future of Finance in London on 20 September. A presentation by Dr Ian Hunt on his recently published paper, Digital Issuance – An Optimal Model for Digital Assets and Transactions, was followed by a discussion with an expert panel and the members of an invited audience, moderated by Future of Finance co-founder Dominic Hobson. 

• Margin pressure exerted by institutional investors and passive investing means asset managers must cut costs but the methods used over the last 30 years – computerisation, outsourcing and offshoring – are no longer sufficient, partly because of rising regulatory costs. The asset management industry needs to move on to a new operating model. 
• If the asset management industry fails to adopt a new operating model, it risks being displaced by the Decentralised Finance (DeFi) industry. Despite reputational issues and a recent loss of value, DeFi protocols have experimented successfully with alternative models of capital-raising, trading and investing, and are attracting interest from asset managers.
• A further challenge facing the asset management industry is set by unavoidable generational change. Baby Boomers which saved via pensions, funds and housing are being replaced by Millennials and Gen Z, which are not only digitally native but alienated from all existing financial services providers, as their enthusiasm for tokenised forms of finance proves. 
• Tokenisation offers a new operating model. Instead of assets (such as securities) and cash (as payment) being moved between buyers and sellers by a complex eco-system of exchanges, brokers, clearing houses (CCPs), custodians, central securities depositories (CSDs), registrars and paying agents and their computer systems, tokens move between nodes on a network.
• Ultimately, finance is about the transfer of value through time. Its essence can be reduced to flows of value in which an asset is a purchase of future flows of value (an investment by investors) and a liability is a sale of future flows of value (an issue of equity or debt by an issuer).  Financial services exist to facilitate exchanges between investors and issuers.
• It follows that intermediaries that facilitate exchanges of futures of flows of value between issuers and investors must add value or they will become vulnerable as forms of transactions costs only. In principle, tokenisation can dispense with intermediaries altogether, with issuers and investors holding self-servicing tokens on their nodes only. 
• Tokens differ from conventional financial assets. A conventional equity offers an uncertain promise of capital appreciation and dividend income. A fixed rate bond offers a certain income and a promise of redemption. Mutual funds are more like bonds than equities. What tokens offer is something simpler: a pledge to deliver a particular flow of value in the future.
• These pledges of future flows of value are made by token issuers to token investors. There are two variants. The first is a “native” token that exists in digital form only (as Bitcoin does). The second is a “title” token or a tokenised underlying analogue asset (such as a company share or a building or, in the case of a Stablecoin, cash and near-cash financial assets).
• Fulfilment of pledges of future flows of value can be automated by building intelligence into a token, making it a “smart token”. For example, when the date arrives to make a transfer of value such as a dividend or interest payment or rights issue or redemption, it triggers the token to deliver other tokens of the requisite value to the node of the holder of the pledge. 
• Tokens can also be fractionalised (broken into ever smaller pieces for sale to investors with smaller needs or less wealth to invest) and clustered (simulations of future flows on conventional assets such as bond coupons and redemption payments or bespoke groups of tokens designed to achieve a particular set of exposures that suit a particular investor). 
• The ability to combine smart tokens in any way means they can used to create the equivalent of any conventional financial instrument – equities, bonds, money market instruments, options, loans, mortgages, margin calls, complex derivatives and structured products, and so on – at much lower cost than existing forms of issuance. It creates a single operating model.
• Smart tokens can replace not only the process by which conventional financial assets are issued but the processes by which they are traded. Indications of interest posted on a node are matched with orders from other nodes. Reducing conventional instruments to clusters of tokens enables holders to trade some of the tokens (or fractions of tokens) separately. 
• Smart tokens also alter the process by which conventional assets are serviced. Payments of dividends or interest or other forms of value can be made by the transfer of payment tokens between issuers and investors. Other corporate actions (such the issue of rights) can also be fulfilled by the transfer of tokens between nodes.
• Tokenisation of issuance, properly conceived and implemented, will not make existing processes more efficient. It will replace them, because the existing, duplicated and reconciled data flows between exchanges, brokers, custodians, CCPs, CSDs, trade repositories, SWIFT, CLS, Omgeo and computerised databases are needlessly complicated and risky. 
• The optimum model of digital issuance is drastically simplified. Issuers that wish to sell pledges of future flows that they have “minted” make the unissued tokens visible at their node in the form of smart tokens, along with an indication of what they expect in return. Being visible, these minted but unissued “pledges” can be searched and found by other nodes.
• The matching process is also simplified and automated. Issuers that indicate they want cash tokens in exchange, for example, can be found directly by other nodes whose unissued smart tokens pledge to transfer cash tokens when they find a suitable investment. Alternatively, both sides can send their unissued pledges to a matching node. 
• When an issuer and an investor find a match – whether it is done directly or anonymously via a matching node – different tokens (not the smart tokens) are exchanged to fulfil the pledges. From that point, the holder can trade them in whole or in part until all pledged future flows have settled, at which point the tokens are returned to the issuer. 
• One consequence of a simplified issuance model is a reduction in the burden and cost of regulation. This is partly because smart tokens can incorporate compliance with regulatory obligations (for example, avoiding mis-selling of products) and partly because there will be a reduction in the number of entities involved in issuance, trading and token servicing.
• But the major benefits of a simpler system are a reduction in the costs of issuance and liability servicing for issuers; more choice and tighter asset/liability matching for end-investors; lower execution, systems and operational costs and faster product development for asset managers; and elimination for all three parties of the costs of third-party service providers.
• Because the digital issuance model in principle reduces the operating system to token transfers between issuers and end-investors, existing third-party intermediary service providers must develop new roles. Candidates include running matching and net settlement nodes and providing assurance of the integrity of smart tokens.