Native digital assets—a Kodak moment for financial services

The financial services industry is approaching a Kodak moment.

A wholly new business model for investment products, assets, transactions and asset servicing is emerging. Just like the digital photography model that supplanted traditional film, the new model in finance is enabled by the latest innovative technology and it is the business model, not just the technology, that business leaders need to embrace.

Kodak experimented with, and invested in, the technology of digital cameras. At one point, it had competitive products in development. But it failed, and its business evaporated frighteningly quickly.

Kodak’s problem was not the technology. It was the failure of business leadership to recognize, embrace and drive forward the seismic change that was happening in their market: that their customers increasingly preferred digital photography to physical film, and that sharing, editing and mass storage opened up new user experiences. Printed pictures were dying, however quickly and efficiently they were produced. Hi-res phone cameras completed the execution, and everyone became a photographer. Kodak filed for bankruptcy.

Financial services are in the same position today.

The emergence of digital ledgers and blockchain, and the tokens that they naturally support, offer an opportunity for a new financial ecosystem that is much simpler, cheaper and safer than the current labyrinth. It offers the flexibility to deliver financial products that meet customer-defined outcomes, rather than arbitrary returns from assets that asset managers choose to buy. Investors can have an experience that is very different from, and very much more attractive than their current experience.

A single, simple digital issuance model and operating model across assets is entirely achievable: This will enable a rollback of the inexorable growth in complexity of regulation and technology. Hard boundaries between asset classes can be dissolved, and new asset classes defined and implemented quickly, without operational complexity, and without extended delays while technology and regulation catch up.

The opportunity for radical new products and a new financial ecosystem is being overlooked. The Kodak moment is approaching

As with Kodak, the problem is not the technology. The problem is that business leadership in financial services in Europe, the UK and the US has not yet perceived—let alone embraced—the real business opportunity. Digitization, tokenization and blockchain are seen as technologies that may (or may not) help us to make current operating models a bit more efficient. The perception of our business leaders in finance is that we should carry on doing what we do now, delivering the products that we deliver now, and deploying the assets that we deploy now, but just a bit better and with sexier tech. The opportunity for radical new products and a new financial ecosystem is being overlooked. The Kodak moment is approaching.

Current initiatives in tokenization focus on the creation of tokens that are backed by “real assets”—“real’ in this context meaning off-ledger, conventional assets, like loans, bonds, real estate, funds and equities. This form of tokenization does not create digital assets; it just gives us a new, digital way of representing the ownership of conventional assets. It replaces shares, units, title deeds and the like.

There are some benefits in this. Tokenization gives us one common way of representing ownership across asset classes, and simplifies the maintenance of the ownership register. If we have access to digital cash on the same ledger, then we can achieve perfect delivery versus payment (DVP), and eliminate a key component of settlement risk. There is the standard blockchain benefit of immutable history too, and the standard distributed ledger benefit of aligned data across participants, eliminating much of the need for messaging and reconciliations. The programmability of the tokens through smart contracts offers the prospect of useful automation.

This is all fine and worthwhile, but is not really changing the current process, let alone changing the world. The deep problem is not how we own the assets, but the complexity of the assets themselves, of their diverse operating models, of their burgeoning regulations, and of the labyrinthine ecosystem in which they exist.  

The Man from Mars is Shocked

In the current financial services ecosystem, there is a multiplicity and diversity of asset classes, a wide range of elaborate investment strategies, a universe of financial products and outputs, and a plethora of entities engaged in their delivery. The multiplication of all these factors leads to a firestorm of regulation. We keep on adding to this complexity, inventing new entities, processes, reports and regulations, to patch over the frailties of the tottering structure. The man from Mars (and any other objective observer looking from the outside) would be perplexed and astonished by this.

Funds, despite their explicit role in the democratization of investment, are similarly hyper-complex in structure and operation. Take, as an example, an equity individual savings account (ISA), the UK’s most straightforward tax-efficient savings structure. The delivery of this commonplace product requires up to 16 regulated entities, including the wrapper provider, the fund, the fund manager, the fund’s broker-dealer, the fund custodian, the payment bank, the authorized corporate director, the fund depositary, the transfer agent, the fund accountant, the fund auditor, and the rest. Each adds risk, cost, time and regulation to the ecosystem. The man from Mars would be dumbfounded.

It is easy to believe that the world of finance is very complex and largely impenetrable—the preserve of the highly experienced and the highly qualified. Fortunately, this view is totally misguided.

What we actually do in financial services is very basic and very simple: We just reengineer current pots of value into and out of future flows of value. That’s all. Investors are people or organizations who have a pot of value now that they are prepared to forego, in order to receive (hopefully larger) flows of value later, when they need them more. Borrowers are people or organizations who need a pot of value now, and are prepared to commit (usually larger) outflows of value later, in order to receive that current value. Investors and borrowers are the only parties who really matter; everyone else only deserves their place in the ecosystem if they make it easier, cheaper, quicker or safer for investors to invest and borrowers to borrow.

In contrast with the current financial ecosystem, a purely digital ecosystem is a thing of great simplicity. It is a network (or “digital ledger”) on which participants have addresses (or “nodes”) at which they hold tokens. Those tokens are the sole representations of value owned by the participants. The participants are issuers and recipients of tokens, or, in other words, borrowers and investors. The tokens may be backed by conventional cash or assets, or they may be “native” to the ledger and have no external reference. Token movements between nodes are the sole representations of the transfer of value between participants. That’s all.

As there are only two things happening on the ledger—static value or value flowing, both in the form of tokens. So in the context of a purely digital ecosystem, a native digital asset can only be one of two things: value held statically at a node in token form, without external backing; or an entitlement, held in token form at a node, to a future flow of tokens.

As entitlements to future flows of value are themselves represented as tokens, then clearly they can be exchanged for current value, or vice versa. So there is a natural mechanism for reengineering between current value and future flows. It will be crystal-clear to an objective reader (and to the man from Mars) that the structure of this digital ecosystem is perfectly aligned to the objective structure of financial services: Both comprise just pots of current value, future flows of value, and a mechanism for transforming one into and out of the other.

Native digital assets in the form of future flows, and entitlements to receive them, are powerful constructs. A bond, for example, is not really a single atomic asset, but rather is a collection of commitments to future value flows as coupon and redemption payments—like a fistful of promises or IOUs. A loan is similar. A swap is just two sets of flow commitments defined by rate relativity. An option is a contingent flow commitment. All of these assets and derivatives can be represented as a cluster of flow commitments, and therefore represented by native digital assets on the digital ledger.

It is not just financial assets that can be represented by native digital assets. Asset servicing processes are flow commitments too. Income is a committed flow of a fixed or rate-adjusted variety, corporate actions are contingent flow commitments, and a collateral arrangement is just a set of flow commitments scaled by the value of a net exposure. Even the objects deployed in trading are representable in this way: An order is really just two back-to-back flow commitments, and an execution is just the delivery of those flows. An indication of interest, or any other invitation to trade, is a flow commitment that the issuer would like to make, but has not made yet.

So across assets, across transactions, across products and across the processes that deliver them, we can have a single form of representation, and therefore a single issuance model and a single operating model. This is the key to a massive operational simplification, and to a massive increase in product flexibility.

Keep it simple

In summary, we need to recognize and embrace three simple ideas: that all assets, asset services, cash and transactions can be represented in the form of tokens and token flows on a digital ledger; that a digital, token-based ecosystem should reflect the real purpose of financial services, representing entitlements to future value flows alongside current value, and not just ownership of conventional assets; and that the tokens that represent those flow commitments should be smart and potent, and be able to implement the value flows that they commit.

If we embrace these principles, then the world really can and will change. We will have a single, simple digital issuance model, and a single simple digital operating model, across all assets, transactions and products. If it works for one, it works for all. When we create a new asset class, which we can do easily from flow commitments (and therefore represent in native digital assets) then it will work for that, too, immediately and without change.

Fund types like pension funds, insurance funds, investment fund and endowment funds become the same things structurally and operationally, distinguished only by the terms on the smart tokens that define and implement their flow commitments. Therefore, they can operate under the same issuance model and operating model as their underlying assets. Fund managers, fund platforms, distributors and advisors become part of the same model too.

The model is self-executing, and requires no intervention. Investors can hold tokens that both represent and can implement the flows they want to receive. So investments can become outcome-oriented, rather than purely speculative, and the operations that support those investments can be wholly self-executing. Asset servicing melts away. Entitlements, reconciliation and settlements become things of the past.

The ecosystem is simple. Everything is built from one construct, there is one issuance and operating model, and not much is happening: Transparency is a natural consequence. With greater transparency, and without a plethora of entities and processes, regulation can be much smaller in scale, and much less intrusive, but also much more effective.

The visionaries of digital photography were the men from Mars as far as Kodak management were concerned. Kodak was sure that printed pictures would always be with us; it was just a matter of using the new technology to produce them more efficiently. But that is not what happened.

Business leaders in financial services think that our current asset classes and products, and the labyrinthine ecosystem that delivers them, will always be with us, but may be upgraded a bit by digital technology.  They need to wake up to the real potential of digitization before their own Kodak moment arrives.

Dr. Ian Hunt is a well-known industry advisor and author on digital assets. He was the design authority for the FundAdminChain ledger, on which the first tokenized fund was launched in the UK market.