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WHAT ARE DIGITAL ASSETS?
Digital assets are digital representations of values that are not issued or guaranteed by a central bank or public authority and do not have the legal status of currency or money. They are accepted by natural or legal persons as a means of exchange or payment or are used for investment purposes and can be transferred, stored and traded electronically.
Which drivers will influence the market environment for digital assets in the future? An overview of a market that will reach the billions:
- Formats of digital assets
- Regulatory initiatives lower barriers to market entry for digital assets
- Assessing the market development of digital assets in Europe and Germany
- Key findings and required actions
FORMATS OF DIGITAL ASSETS
Digital assets exist on a blockchain in the form of cryptocurrencies or security tokens (crypto-assets pursuant to section 1 (11) sentence 10 of the German Banking Act (KWG)) and are deposited in so-called wallets (“digital lockers”). Currently, the market potential of digital assets is primarily driven by the two aforementioned formats until the conditions for crypto-securities (crypto-securities according to Art. 4 (3) of the German Electronic Securities Act (eWpG-E)) will be in place.
Differentiating these three digital assets and comparing them to traditional securities is important for analyzing the market environment in more detail.
CRYPTOCURRENCIES – HYPE OR RELEVANT ASSET CLASS?
Cryptocurrencies are cryptographic values that are based on a decentralized payment system and do not represent a currency in the strict sense. Apart from the increasing acceptance of some cryptocurrencies as an alternative means of payment to so-called fiat currencies such as the euro, more and more professional and institutional market participants are entering the cryptocurrency market alongside private investors in order to unlock new diversification and performance potentials.
After a strong rally at the beginning of the year, there is currently a new phase of euphoria for cryptocurrencies. The reasons for the renewed rise in investor interest could be the low interest rate environment, increasing market liquidity, occasionally high valuations for other asset classes and growing inflation expectations in Europe. The European market share for cryptocurrencies is gaining momentum as the degree of legal certainty for investors and financial services providers advances. Consequently, exciting times are ahead and we will see whether cryptocurrencies will make their way as an alternative asset class.
SECURITY TOKENS – USE CASES AND PROSPECTS
In addition to cryptocurrencies, standardized products for issue such as shares or bonds have so far been mapped and transferred via blockchain using security tokens, albeit to a limited extent. The tokenization of more illiquid and non-fungible assets (e.g. real estate) is currently being accelerated by some market participants due to the easier transfer of ownership via blockchain. Nonetheless, security tokens tend to be in a transitional phase until the conditions for the introduction of crypto-securities are in place. Crypto-securities thus enable the transfer of digital assets into the securities business and will thereby set the next milestone for digital assets.
CRYPTO-SECURITIES – TRANSFERRING DIGITAL ASSETS TO THE SECURITIES BUSINESS
The act on the introduction of electronic securities (hereinafter “eWpG”) by the German legislator is expected to come into force in the second quarter of 2021 and will allow the issuance of crypto-securities as an alternative format to securitized assets. The differences to traditional securities lie in the type of issuance (electronic versus securitized). Analogously to securitized assets, crypto-securities are classified as safe custody business pursuant to Art. 1 (1) (2) (5) of the German Banking Act, whereas the custody, management and safeguarding of cryptocurrencies and security tokens as a financial service are classified as crypto custody business pursuant to section 1 (1a) sentence 2 no. 6 of the German Banking Act (KWG). In a first step, the currently required securities certificate is to be replaced by an entry in a securities register for electronic bonds and stock certificates – in the future, this will also apply to investment fund units and stocks.
REGULATORY INITIATIVES LOWER BARRIERS TO MARKET ENTRY FOR DIGITAL ASSETS
The increasing openness to digital assets also benefits from the removal of investment restrictions. In particular, the DLT pilot regime adopted as part of the European Commission’s Digital Finance Strategy on September 24, 2020, is expected to enable instant trade processing via blockchain, intermediary-free investor admission and the elimination of central securities custody. This regime is described as the introduction of a “sandbox” approach to DLT-based market infrastructures to allow temporary exemptions from existing rules so that regulators can gain experience in dealing with digital assets. In addition, the Digital Finance Strategy also includes a regulation on markets for crypto-assets (“MiCa”), whereas crypto-securities are governed by the existing MiFID II regime.
ASSESSING THE MARKET DEVELOPMENT OF DIGITAL ASSETS IN EUROPE AND GERMANY
Figure 2 shows the forecast market development of digital assets in Europe compared to Germany in EUR billion. It reveals that the market volume of digital assets in Europe in 2024 is expected to be close to EUR 1.5 trillion. Germany’s share of the European market for cryptocurrencies and security tokens amounts to around 21%. The total market for all digital assets, including crypto-securities, in Germany is expected to increase to almost EUR 400 billion between 2021 and 2024, which means it will be more than tripled. With the introduction of the eWpG in the second quarter of 2021 and the subsequent creation of a new market infrastructure to enable the transferability of crypto-securities in Germany, their market value estimates increase to EUR 18 billion for 2022.
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KEY FINDINGS AND REQUIRED ACTIONS
Hence in the coming years, the market for digital assets will be growing into the billions, offering a wide range of earnings opportunities for new and established market participants. Five key findings can be derived from the current market dynamics:
- In the future, digital assets will be highly relevant for both private and institutional investors. Established institutions need to adjust their organization, processes and services along the entire capital markets value chain in order to meet customer needs.
- New market participants must deal in particular with the issue of applying for a license in order to be able to continue to provide their services under BaFin’s supervision. This transformation from a start-up to a regulated institution often presents challenges for these young companies, as a multitude of regulatory requirements must be met and documented.
- The German legislator would like to lead the way in Europe. As a result, digital assets in Germany are also becoming attractive for foreign fintech companies as well as established financial institutions that want to participate in this growing market.
- With the introduction of crypto-securities in the wake of the eWpG, the setup of a professional and high-performance market infrastructure for digital assets will become more and more relevant, especially in 2022. Established market participants need to observe the development and assess the impact on existing systems.
- Volume begets volume – the provision of liquidity on trading venues and platforms will be a major influencing factor for the market performance of crypto-securities.
 The word “fiat” originated from Latin and means “let it be done”.
 See “Markets in Crypto-assets, and amending Directive (EU) 2019/1937”.
 Markets in Financial Instruments Directive II.
 Forecast for cryptocurrencies based on current market capitalization incl. growth rate of 30% p.a. and for security tokens (STO) based on relevant asset classes (bonds, real estate, etc.) incl. a weighted conversion rate of 0.08% as well as a growth rate of 65% p.a.; Europe has a constant share of the global market volumes for cryptocurrencies and STO of 30%. Germany’s percentage of Europe according to GDP share of approx. 21% for cryptocurrencies and STO; forecast for crypto-securities based on new issues of bonds of domestic issuers incl. conversion rate of 1% in 2022 and a growth rate of 80% p.a. until 2024.