Digital assets and their mainstream adoption are hot topics. How market infrastructures should support digital assets is a related theme which is also being discussed – it was, in fact, the subject of interesting debates at the last Sibos conference. The historical role of financial market infrastructures (FMIs) has been to ensure financial stability through the mitigation of risk, to promote industry standards and to eliminate siloes that inhibit liquidity and market access. This crucial role will likely remain unchanged for digital assets, particularly as we see them increasingly proliferate.
Related: DTCC's Jennifer O'Rourke on bridging the gap between TradFi and DeFi
While there are many different functions that market infrastructures perform for traditional assets, we’ve explored two potential benefits in the digital asset space that FMIs can provide.
Delivering Interoperability across Tech Stacks and Asset Types
First, in order to realize the benefits of reduced operational processes and increased automation – a key promise of DLT and smart contract technologies - interoperability between technology stacks and assets (i.e., composability) will be crucial. Since FMIs are neutral entities, typically heavily regulated and sometimes industry-owned, they are optimally placed to develop and drive the adoption of standards that can ensure this interoperability within the digital asset ecosystem.
In addition to interoperability between blockchain solutions, FMIs are also well placed to provide connectivity outside the digital ecosystem, linking digital and traditional assets. It is worth considering that there is a $100 trillion (USD) global market capitalization of traditional assets, and the question remains as to whether these assets will ever become digital and, if so, how? FMIs are well placed to enable the convergence between digital and traditional assets by facilitating the connection between conventional and new asset types. What will be significant to retail and institutional investors is the ability to interact with traditional and digital assets in a consistent way – an approach that FMIs are well placed to facilitate as digital assets become more mainstream.
Putting Assets to Work
Second, market infrastructures could potentially provide solutions that allow traditional assets and digital assets to be put to work for each other. Beyond the simple notion of technological and operational efficiency comes an opportunity for greater capital efficiency. Long before the emergence of bitcoin or DeFi, financial institutions have looked to FMIs to provide solutions that allow for more efficient use of capital through netting, collateral optimization and cross-margining. As the digital asset ecosystem continues to grow alongside the traditional environment, the desire for these types of solutions will only increase.
Whether there is value in leveraging traditional assets as collateral in a DeFi lending protocol, cross-margining bitcoin trading activity against public equities, or performing end of day settlement to alleviate the need to pre-fund every transaction, the industry will continue to evaluate and pursue solutions that put assets to work to enable effective strategies. And while some assets and rails might be new, the outcomes that market participants are seeking, and the risk management capabilities required to make it a reality in a responsible and resilient manner, are not. FMIs sit at the crossroads of our financial markets and are well-positioned to usher in a new era of capabilities while upholding the safety and soundness of our markets.
Through the creation and adoption of industry standards, the facilitation of interoperability and the creation of solutions that enable capital efficiency, FMIs have a unique and crucial role to play in the increasingly decentralised world of digital assets. Ultimately, standards are necessary, the prevention of silos can drive growth and the financial stability of both traditional and digital markets is paramount. In order to preserve today’s robust risk management environment while fuelling the growth of new markets, financial market infrastructures must continue their essential role in traditional finance and apply their capabilities and expertise to the flourishing digital asset ecosystem.
This article was originally published to FundsTech on January 19, 2023.