Banks and financial services are increasingly looking to leverage the technology behind cryptocurrencies to develop next-generation digital assets, products, and services. 

By harnessing this emerging technology, banks will be in a position to streamline services, reduce costs and deliver attractive new products for their customers. Yet for digital asset adoption to grow and truly thrive, they need a developed digital ecosystem in place. A gradual implementation of use cases is needed to build a sustainable and robust market, with a hybrid way of working expected in the interim period as the market collaborates and converges around the best path forward. 

There is often confusion between digital assets and crypto assets, stemming from the relative newness of the technology which has led to a complex patchwork of terminology with no clear classification framework. For this reason, it is important to pay close attention to how each institution defines their own digital assets, until a common taxonomy is agreed by the market.

The digital asset ‘umbrella’ covers a variety of assets, including digital currencies and tokenised traditional financial assets, such as bonds. We view digital assets as being the digital representation of an underlying asset. In the context of capital markets, digital assets we see holding particular promise include digital currencies and tokenised financial instruments.

The financial services industry has already come a long way since the inception of digital currencies with the introduction of Bitcoin in 2008. Since then, a range of different kinds of digital currencies have emerged and proliferated, including cryptocurrencies, stablecoins, and Central Bank Digital Currencies (CBDCs).

Originally advertised as a potential alternative to centralised money, cryptocurrencies exist digitally using a peer-to-peer network that has no central governing authority. Cryptocurrencies’ value is based on consumer (or investment) demand, which can lead to volatility, as seen frequently in markets and the press. This has prompted regulators to consider the frameworks necessary to safely regulate the use of cryptocurrencies, such as the MiCA bill in Europe and the HMT crypto asset consultation in the UK. Both aim to provide a more secure landscape in which to interact with digital assets, balancing the need for security and clarity with the need to enable innovation.

Stablecoins were developed in a bid to harness the decentralised nature of cryptocurrencies, whilst aiming to bring stability through asset backing. The value of stablecoins is pegged to a specific asset, whether it be a commodity like gold, or even other stablecoins. Not all stablecoins hold true to their name, and due diligence needs to be done when considering the backing asset and redeemability features of each stablecoin.

The popularity and potential of digital currencies has prompted many governments to consider how they could leverage the benefits of the technology whilst also protecting the sovereignty of their own currency through the implementation of a CBDC. These are a digital form of a country’s fiat currency, issued and regulated by its central bank. 

Almost 90 central banks worldwide are currently exploring the feasibility of a CBDC. Countries are at different stages of development, with each looking to research implementation based on its own economy’s needs and policies. China was one of the first to pilot a retail CBDC, rolling out their digital yuan (e-CNY) in 2020, with the intent of providing a more convenient and efficient payment solution. Meanwhile, the UK and the EU are both in consultation regarding their respective CBDCs, and the US have also announced the creation of a new taskforce to consider whether a CBDC would be beneficial.

CBDCs are uniquely placed as a digital currency as they promote trust in the soundness of the currency and could therefore promote more widespread adoption.

Tokenisation is the way in which real-world assets can be divided and turned into digital tokens. Each token has a unique identity that can be stored, transferred, and traded on a blockchain. As these tokens can be easily bought and sold on a blockchain exchange, transactions could become instant, efficient, and less expensive.

When it comes to traditional financial assets, their specific characterisation depends on the information within the token. Taking bonds as an example, you could either have a digitally native bond, where the tokens represent the bond itself and therefore the value lies within the token. Or, you can represent the bond in a dematerialised fashion on the blockchain, so that the token represents an ownership claim on the underlying asset, but there is no value intrinsically tied to the token. 

Digital assets could be transformational for banks and may disrupt several core business areas in ways that could improve security, efficiency, and data quality; reduce operational and transaction costs; and make it easier to comply with regulations. These improvements are made possible due to key characteristics that distributed ledger technology (DLT) enables.

Fundamentally, blockchain technology is a type of DLT, where data is validated into blocks onto a chain. Each block of information is cryptographically linked to the previous block. Once the data is validated onto the chain, it cannot be changed without tampering with the chain, which is what gives blockchain its immutable nature. Blockchain therefore creates a sense of accountability when validating the information as transactions are permanently recorded and are synchronised and updated in real time. This creates a golden source of data which can reduce duplicate processes and contribute towards building greater trust in the market.

The visibility of the data is dependent on the set up of the chain, particularly whether it is private or public. Although both have merit depending on the problem they are solving for, public chains would create an unprecedented level of transparency in the industry. An open source of data could have the potential to help banks comply with KYC/AML regulations without duplicating the information checks. Additionally, increased visibility would aid in the regulating and compliance of capital markets, as information is made available in real time to regulators.

The nature of tokenisation can introduce efficiencies and innovation through the programmability of the tokens via smart contracts. Smart contracts are built on a customisable set of rules that automate the execution of an action once certain criteria have been met, such as an agreed fee for the product, or a specified period of time has elapsed.

Given both a digital currency and a digital asset can be moved on the blockchain in tokenised form, atomic settlement can be programmed to accomplish DvP (delivery versus payment) or PvP (payment versus payment) finality, as opposed to the current minimum timeframe of 2 days. This not only creates efficiencies, but also mitigates settlement risk as the assets are instantly exchanged for one another. The speed of exchange also means that banks could benefit from holding smaller safety collateral and thereby use their assets more efficiently to promote liquidity.

Efficiencies gained from digital assets create the potential to lower operational costs in the long term. This overall reduction in cost could open up a wider range of capital pools for customers, removing barriers to access. Ultimately, cheaper systems mean that banks have the option of serving customers they may not have previously reached, while lower transaction costs make the new services more attractive.

The true benefit the technology has to offer will become transformational as a new digital asset ecosystem takes shape. But the level of innovation required to get there is significant, with solutions still needed to prove their value at scale to encourage participation and further development.

Digital bonds could enable the digitalisation of a wider set of banking assets. Traditional bonds are a relatively straightforward and mature instrument that will allow financial institutions to build the required capabilities to engage with digital assets more broadly.

We see digital green bonds as a way of introducing digital assets while simultaneously increasing our commitment to aiding our customers in delivery of their Environmental, Social and Governance (ESG) objectives.

Digital green bonds are issued by companies or, potentially, governments to raise funds for green projects – for example, linked to renewable energy, sustainable agriculture, and conservation. Enabling the traceability feature of digital green bonds at scale could be used for tracking use of proceeds or performance against set criteria and contribute to increased transparency of the green bond market.

In the future, the increased programmability of digital assets will facilitate more complex and innovative products that help achieve a broadening range of financial and non-financial objectives.

There are still challenges that banks will need to overcome in the adoption of digital assets, such as addressing fragmented platforms and understanding regulatory boundaries. However, in order to tackle these challenges, there is a need to move past piloting the technology, towards live use cases that will in turn provide the necessary learning to build on. Knowledge gained can be used as evidence to satisfy regulators, while acting as guardrails for future development.

Banks should continue to liaise with governments, regulators, and other financial institutions to ensure that the use of digital assets helps maintain and complement the deep levels of trust they have built up with their clients over the years.

Digital bonds have the potential to be the catalyst for large-scale collaboration between financial institutions over digital assets. 

Although digital assets are now pushing past the ‘hype’ and their benefits are becoming clearer, there is still work to be done before they can be successfully implemented at scale and market collaboration will be key to guide the direction of this innovation.

We are working closely with industry partners and customers to ensure the currency, capital markets, and payments systems we rely on can respond to the demands of businesses – and new business models. Get in touch to learn more about how we can partner for a more digital future. Speak with your NatWest representative and follow us on social media to learn more about the implications of these exciting financial innovations for your financial strategy.