For the financial and especially for the wealth management industry, it is time to look at blockchain technology. Three concrete application scenarios seem particularly promising now: investing in cryptocurrencies and digital assets, tokenization of non-bankable assets (nBA) and decentralized finance (DeFi).
Blockchain or distributed ledger technology makes it possible to create new, digital business and investment models. At the centre of this are digital tokens that can represent very different types of assets – traditional, alternative as well as completely new – or even rights of use. Blockchain technology is suitable for promoting digitalization, driving automation, and streamlining processes. In this way, it can make a significant contribution to reducing costs in financial institutions. Blockchain-based transactions can be carried out more efficiently and costs for the lifecycle management of financial products can be reduced. Ideally, both the investment object and the means of payment are available in digital form on the blockchain – and are thus practically protected from manipulation.
With the help of smart contracts, completely digital processes are thus possible, which, among other things, allow atomic “delivery-versus-payment”. This brings enormous advantages, such as the reduction of counterparty risks and deposit reserves, as well as near real-time settlement. Financial institutions can use blockchain technology to optimize and simplify processes – and to increase efficiencies and reduce costs, especially in the back office.
Although the technology generally offers advantages in terms of security, robustness, transparency, and traceability, it is not suitable for every application. It is important to always check and plausible its use according to the requirements. Sometimes blockchain is brought into play for scenarios in which classic technologies, central approaches and databases are better suited. In the following three areas of application, however, blockchain technology provides an answer to already existing or emerging challenges. With promising prospects – for financial institutions as well as for their end customers or investors.
Investing in digital assets and cryptocurrencies
It is important for investors to have a broadly diversified portfolio, especially in times of low interest rates and global disruption in the financial markets. In addition, the digitalization of assets opens significant opportunities for new ways of wealth creation for the masses. In addition to cryptocurrencies, digital assets also include digital representations of alternative investments in the financial world that were previously inaccessible to many investors or at least associated with high barriers to entry.
However, this requires education about the potential returns and risks of digital assets, for example about the volatility of cryptocurrencies and other alternative investments. The complexity of digital assets is also a barrier that should not be underestimated. It is not only necessary to convey the nature and characteristics of the underlying assets. Financial institutions also must create a basic understanding of crypto technology itself among their customers to establish trust.
The step towards an investment in a digital property – in principle with the same opportunities and risks as a direct investment in this property – may in principle still require relatively little explanation. The situation is considerably different for digital investments in works of art (for example in the form of a non-fungible token, NFT) or intellectual property. Digital assets will bring about profound changes.
New technological solutions allow financial institutions to enter the field of digital assets with little effort. The same applies to their customers. Ideally, their financial institution offers them all investment options from a single source, from traditional investments to cryptocurrencies and other digital assets. For example, shares in non-regulated funds can also be issued in the form of digital assets. Technical hurdles and security concerns are thus reduced to a minimum – for the financial institution and its customers.
Through digital assets, financial institutions can offer their clients new investment opportunities and portfolio diversification options. At the same time, the denomination options that digital assets open give them the opportunity to tap into new customer segments. It is quite conceivable that the industry is at the beginning of an explosive growth of financial products based on digital assets. It will be important for banks or asset managers to offer seamless integration of digital assets to their clients. This significantly lowers the barriers to entry for investors, whether it is cryptocurrencies or other digital assets.
Tokenization of illiquid assets/ non-bankable assets
- Challenge: Around one-third of all global assets are now illiquid assets, so-called non-bankable assets (nBAs). These include, for example, works of art, exclusive real estate, valuables, or classic car collections. Dealing with nBAs is often more challenging for banks than dealing with traditional, liquid assets such as shares and bonds. On the one hand, this is since the investment of money is often associated with high entry barriers for investors. On the other hand, pricing, risk calculation and return forecasting are often more complex for alternative assets. Works of art, for example, are rarely traded, are very heterogeneous and difficult to compare.
- Solution: Thanks to blockchain technology, it is possible to offer nBAs in the form of tokenized assets. This lowers such entry barriers as minimum investments and creates liquid markets for these assets. The technology thus allows financial institutions to open up nBAs to a broader investor base.
- Prospects: Tokenized assets allow financial institutions to drive the democratization of asset management and make alternative asset classes accessible to a wider audience. Tokenization will enable clients to trade fractions of a classic car collection, a luxury villa, or a Picasso painting like traditional shares. This should result in both an increasing demand for nBAs and new advisory services.
In this way, financial institutions are tapping into new sources of revenue, expanding their portfolios, and addressing new customer segments. In the case of a tokenized Picasso, for example, proof of ownership may be required, as well as a guarantee that the physical asset is well stored and, if necessary, insured. Both could be part of the service portfolio of financial institutions in the future. Tokenization of nBAs represents a growth strategy – often even without additional acquisition costs for the institutions, as they can most likely fall back on an existing customer base. In any case, the potential of the nBA market is immense. If estimates at the end of 2020 still spoke of around 18.1 billion US dollars, experts expect a market volume of around 24 trillion US dollars in 2027. The long-term potential will certainly be many times higher if one considers the total volume of all illiquid assets.
Decentralized Finance (DeFi)
Decentralized Finance (DeFi) is an approach that counters centrally organized financial services with a decentralized model. To put it pointedly, a peer-to-peer approach replaces the intermediary. In addition to the existing advantages, conventional centralization also brings with it the usual disadvantages: the system may be controlled by a few institutions, their quasi-monopoly position leads to a dependency of the other participants and exposes them to bureaucratic obstacles and inefficiencies. This can be seen, among other things, in the formation of central financial centres with regional specifics, for example in the form of regulation, language and laws, to which consumers often must adapt.
Blockchain technology allows the decentralization of financial services – in the form of smart contracts that not only store transaction data in the distributed ledger, but also the rules for transactions. Investors interact directly with each other, as the smart contract replaces the trusted intermediary. In addition to the blockchain, other modern technologies such as the Internet of Things (IoT), artificial intelligence and big data also play an important role in the new DeFi concepts. Decentralized Applications (Dapps) allow access to a wide variety of DeFi services, from peer-to-peer payments to loans to decentralized exchanges, directly through the Blockchain and without the usual need for a financial intermediary.
Prospects: DeFi opens great possibilities for economic life. Especially also because it can financially include the people of the world who until now have not had access to banking services. Even though DeFi has set out to make intermediaries obsolete and increase inclusion, financial institutions can certainly open new business models in the DeFi context: whether it’s the safekeeping of private keys, innovative insurance solutions or the automated verification of identities. The dollar value of DeFi applications has increased fifty-fold within a year. It therefore seems sensible to look at the issue and identify business opportunities.