Despite the immediate economic and financial threats posed by the COVID-19 pandemic, European banks and asset managers must not lose sight of the overall disruptive potential of new platform technologies, such as blockchain and distributed ledger technology (DLT), and the increasing potential of digital assets to disrupt traditional bank and asset management firm business models.
In January 2009, when the global financial system was on the brink of collapse, Bitcoin was launched anonymously by Satoshi Nakamoto. As a "peer-to-peer electronic cash system" based on DLT in its special form as a blockchain, the first crypto currency promised decentralization, immutability and pseudo-anonymity of rule-based transaction data storage on an encrypted, open-software, permissionless database. Ethereum, a next generation blockchain proposed by Vitalik Buterin in 2013 and launched in 2015, added a smart contract, decentralized application layer which enables the pre-programmed, automated execution of coded contracts. Nearly all technical components of the open-source Bitcoin and Ethereum protocols, such as linked time-stamping/Merkle trees, proof of work, Byzantine fault tolerance, public keys as identities and smart contracts already originated in the academic literature on cryptology, network computing and game theory in the 1980s and 1990s.
Crypto currencies as a new digital asset class
Today, more than a decade after the launch of Bitcoin and five years after the launch of Ethereum, the European financial system is more stable, but its fundamental vulnerability to banking crises and bursting asset price bubbles remains unchanged. Although not yet established as a cross-border means of payment, Bitcoin has asserted itself as the leading crypto currency with a market share of around 70 percent at the end of 2020. It is used in particular for speculative purposes and, as digital "gold", as the de facto lead currency of the crypto currency universe. Ethereum, with 60 billion EUR market cap as at the end of 2020, is the second most valuable crypto currency. It has established itself as the global open-source permissionless enterprise blockchain of choice. At the end of 2020, the total market capitalization of all 8,100 crypto currencies amounted to USD 725 billion. In January 2021, the value of all crypto currencies surpassed USD 1 trillion for the first time, still tiny compared to the value of asset classes such as real estate, bonds, stocks or gold.
The most dynamic and innovative segment in the blockchain universe is "decentralized finance" (DeFi). DeFi is an experimental form of finance that does not rely on central financial intermediaries, and instead utilizes smart contracts on blockchains, in most cases on Ethereum, to provide banking and lending services. As of the end of 2020, crypto currencies worth USD 19 billion have been “invested” in various decentralized financial applications. At the beginning of February 2021, already, the level of USD 40 billion was surpassed.
Despite significant volatility and technological and legal risks, the demand for crypto currencies from investors, initially from crypto enthusiasts, but increasingly also from retail clients, primarily millenials, high net worth individuals, family offices and institutions, keeps growing. These investors require new crypto exchange, trading and custody services that most banks and asset managers currently are not offering.
Stable coins have the potential to disrupt payments
So-called stable coins have established themselves as the second crypto category. Examples are Tether or USD Coin. Stable coins are crypto currencies designed to minimize price volatility relative to some "stable" asset or basket of assets. A stable coin can be pegged to a cryptocurrency, fiat money, or to exchange-traded commodities such as precious metals. The most prominent example of a stable coin is Libra, the global project proposed by Facebook, which would be backed by a basket of major currencies. Libra or Diem, as it has been called since the latest relaunch as a simpler, US dollar backed stable coin, could reach 2.5 billion Facebook users worldwide and call into question the sovereignty of smaller central banks. Stable coins, in the absence of central bank digital currencies (CBDC), have the potential to disrupt payments as they allow for the immediate transfer of value over the internet.
Security tokens will disrupt the securities industry
In addition to crypto currencies and stable coins, so-called security tokens are also gradually taking hold. These are property rights in assets such as securities registered on a blockchain/distributed ledger. The tokenization of securities will allow for direct ownership and remove barriers to trading. The elimination of brokers, clearinghouses and other middlemen would eliminate commissions and other charges, thereby reducing transaction costs. Instant settlement via DLT/blockchain will free up liquidity and eliminate the need for back-office reconciliation. Market observers assume that the penetration of security tokens can quickly reach several percentage points of the gross domestic product. Not only securities can be tokenized, but also the fractional property right to any type of real physical or intangible asset such as a piece of art, real estate, or intellectual property rights and identity. As such, the trend toward tokenization is a broader disruption paradigm that could significantly reduce transaction costs for economic activity well beyond the securities industry. The World Economic Forum has recently forecasted the volume of assets stored on blockchain/DLT to reach a volume of 10 percentage points of global GDP by 2027.
European banks and asset managers falling behind US peers in digital asset adoption
All three categories of digital assets – crypto currencies, stable coins, and security tokens - can be held outside of the banking system in electronic purses called wallets. A traditional securities account is not required. So far, developments in these three categories have largely taken place without the involvement of European banks and asset managers. Although the underlying blockchain/distributed ledger technology was used in application-related experiments in consortia with competitors, due to the anonymity (keyword: money laundering and terrorist financing risks) and volatility (keyword: consumer protection), traditional banks and asset managers have largely avoided crypto currencies. The US asset manager Fidelity was the first large asset manager to launch its own institutional digital asset servicing platform. Due to massive political resistance and considerable regulatory uncertainties, no banks have participated in the Libra stable coin consortium to date. So far, US bank JP Morgan remains the only bank that has developed its own stable coin, the JP Morgan Coin, as part of its Open Banking API Platform for cash management and treasury services. JP Morgan Coin was realized on the self-developed, Ethereum-based, open-source Quorum blockchain, which is now owned by Consensys. Goldman Sachs, another Wallstreet giant, has gained access to the crypto universe through investments in, among others, the crypto custodian Bitgo and the crypto financier Circle. Circle, in turn, has launched USD Coin, a USD-backed stable coin.
European banks and asset managers should build a digital asset service offering for their customers
However, the wait-and-see attitude of European banks and asset managers could soon change for two reasons. On the one hand, crypto currencies, security tokens and stable coins are slated to be integrated into the existing financial market regulation with the plannedEU directive Markets in Crypto Assets (MiCA). The ECB, driven by developments in China (keyword: Digital Currency Electronic Payment (DCEP)) and the Libra project, has further specified its preliminary considerations on the Digital Euro and has announced a project start for mid-2021. The combination of a stable legal and regulatory framework as well as the Digital Euro could help digital assets make a breakthrough in the European financial system this decade. European banks and asset managers should therefore increasingly invest in practical digital asset know-how, whether by setting up specialist teams, cooperating with crypto fintechs and/or directly investing in start-ups. Specifically, they should concentrate their investments on three interfaces to the digital asset universe:
- the private and corporate customer interface, i.e., the development of programmable wallets and embedded finance solutions;
- the institutional interface, in particular the development of crypto exchange, asset management and custody services, such as the partnership between BNP Paribas and the cloud-based wallet platform Curv; and
- the interface to the payment system, i.e., to SEPA or the TARGET system. Larger European banks should permanently occupy these interfaces in close collaboration with the infrastructure operators.
Otherwise, they risk being beaten in the race toward a more open, user-friendly and efficient financial system by crypto fintechs like Binance or Coinbase, neo-banks and brokers like Revolut, Robinhood or Bitpanda, online payment service providers like PayPal, and social media giants like Facebook. The advantage of the incumbent banks and asset managers is the trust of their clients and regulatory protection. If they quickly recognize the disruptive potential of blockchain and DLT, they still have an opportunity to shape the future of finance.
By the first week of each month, a new article is published in the series of "How Bitcoin and Co are changing the traditional banking world". More articles published so far:
Tips for practitioners
- Recognize the transformative power of DLT/blockchain based digitization of assets!
- Invest in practical digital asset know-how by setting up specialist teams, cooperating with crypto fintechs (via open banking and open asset management interfaces) and/or directly investing in start-ups.
- Follow your customers and offer programmable wallets, digital asset services and build digital asset on- and off-ramps.
- Also seek cooperation with peers and infrastructure providers to drive digital asset adoption.
- Harness technology to build a more efficient, more resilient and more inclusive financial system.
- Buterin, V. (2015): Ethereum White Paper, A Next Generation Smart Contract & Decentralized Application Platform, found at: https://whitepaper.io/document/5/ethereum-whitepaper, last accessed on February 7, 2021.
- Narayanan, A./Clark, J. (2017): Bitcoin´s Academic Pedigree, in: ACMqueue, Volume 15, issue 4, found at: https://queue.acm.org/detail.cfm?id=3136559 , last accessed on February 7, 2021.
- For market data compare CoinMarketCap, found at: https://coinmarketcap.com/de/ , last accessed on February 7, 2021.
- For DeFi market data compare DeFi Market Cap, found at: https://defimarketcap.io/ , last accessed on February 7, 2021.
- Compare Diem (2020), White Paper, found at: https://www.diem.com/en-us/white-paper/ , last accessed on February 7, 2021.
- Compare World Economic Forum (2015), Global Agenda Council on the Future of Software & Society, Survey Report: Deep Shift: Technological Tipping Points and Societal Impact, 2015, p. 24, found at: http://www3.weforum.org/docs/WEF_GAC15_Technological_Tipping_Points_report_2015.pdf ; last accessed on February 7, 2021.
- Regarding MiCa please see European Commission (2020): Proposal for a Regulation of the European Parliament and of the Council on Markets in Crypto Assets, September 2020, found at: https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A52020PC0593, last accessed on February 7, 2021.
- Regarding the Digital Euro compare ECB (2020): Report on a digital euro, October 2020, found at: https://www.ecb.europa.eu/pub/pdf/other/Report_on_a_digital_euro~4d7268b458.en.pdf , last accessed on February 7, 2021.
Professor Dr. Axel Wieandt
Axel Wieandt - former DAX 30 bank CEO/CFO, Global Head of Corporate Development, FIG banker and McKinsey consultant - is a senior financial services professional with a focus on banking, fintech and finance. Axel is currently advising US and European private equity/venture capital funds and real estate companies on their investments and value creation plans. He is also serving on the ad-/supervisory boards of German fintech and real estate investment companies. Axel is an early fintech investor himself and has teaching assignments with top-ranked international business schools, e.g. WHU – Otto Beisheim School of Management. Over the years he has published over 70 research papers, op-eds, and interviews; he is a frequent conference speaker/panelist. Axel is the author of "Unfinished Business: Putting European Banks (and Europe) Back on Track" (2017).