2024 Digital Assets Study: A regulatory assessment

State Street’s 2024 Digital Assets Study revealed several notable trends in the use of digital assets and related technology in the institutional investor marketplace. Many of these trends are consistent with the evolution of the regulatory environment, and are supported by ongoing global efforts to foster responsible innovation with effective risk management.

In this article, we highlight three trends revealed by our study and explain how they align with regulatory developments. We start with an analysis of respondents’ propensity to increase their allocations to digital assets and digital asset technology over the next five years, and evaluate whether the current regulatory landscape supports that activity. Then, we discuss the increasing interest in the use of permissioned digital networks and explain how this is supported by regulatory guidance. Finally, we examine a trend identified by the study that validates our hypothesis that we are entering a hybrid world where digital and traditional assets will coexist.

Study results indicate that while one-third of respondents increased their allocation to digital assets over the past 12 months, a whopping 69 percent globally expect to increase their allocations in the next five years. How can this be accurate in light of the calls for more regulatory clarity? The answer lies in the fact that regulatory clarity, particularly with respect to tokenization efforts, has slowly but surely been building.
 

Increasing clarity of regulatory and legal frameworks

Over the past year, a range of jurisdictions have taken meaningful steps not only to develop appropriate frameworks addressing the nuances and variety of digital assets and distributed ledger technology (DLT), but also to support responsible innovation in tokenization.

In January, regulations promulgated by Britain’s Treasury came into effect, establishing the framework for the UK’s Digital Securities Sandbox (DSS) to be operated by the Bank of England and the UK Financial Conduct Authority (FCA).¹  The stated purpose of the DSS is to support the development of trading and settlement of securities by leveraging novel tokenization technology. Sandbox participants can seek to provide the following services with respect to tokenized securities:

• Notary, settlement and maintenance activities for tokenized securities for which it would need to register as a digital securities depository (DSD) instead of as a central securities depository (CSD)
• Trading venue services of an organized trading facility or a multilateral trading facility, or both

This April, the Bank of England and the FCA published a consultation describing their proposed approach to the operation of the DSS, including the proposed rules and fee regime, as well as guidance for prospective applicants.²  The consultation notes that the overarching aims of the DSS will be to facilitate innovation while protecting financial stability and market integrity, noting specifically that:
 

“The application of new technology, such as distributed ledgers, could materially improve the efficiency of “post-trade” processes that take place after a trade is executed. By making these processes faster and cheaper, the adoption of these technologies could, if successfully implemented, lead to material savings across financial market participants, such as pension funds, investment firms and banks.”³

While the regulatory environment in the US has not been particularly welcoming for cryptocurrencies, tokenization is looked upon more favorably. In February, the US Office of the Comptroller of the Currency held the Symposium on the Tokenization of Real-World Assets and Liabilities,⁴  bringing together legal experts, academics, regulators and representatives from the industry to discuss various aspects of tokenization and its use cases. In testimony before the US House Financial Services Committee on May 15, Acting Comptroller Michael J. Hsu noted:
 

“In contrast to crypto, tokenization is driven by solving real-world settlement problems and can be developed in a safe, sound, fair and competent manner … The symposium sparked robust discussion on these issues and highlighted the innovative potential of tokenization.”⁵

Additionally, there have also been some encouraging developments on Staff Accounting Bulletin 121 (SAB 121)⁶  issued by the Securities and Exchange Commission (SEC). The developments require an entity that safeguards crypto assets (including tokenized securities) for customers to provide certain risk disclosures, and to recognize the fair value of the custodied assets as both a liability and an asset on its balance sheet.

The SAB 121 position represents a marked departure from the historical treatment of custodied assets as off-balance sheet items, and disproportionately impacts those crypto asset custodians who are subject to prudential capital requirements, such as banks, which are required to maintain capital based on assets included on their balance sheet. To date, the SEC has been unwilling to modify SAB 121 to address this disproportionate impact, which effectively makes it uneconomical for banks to provide custody for crypto assets. However, in May, both houses of the US Congress approved a resolution to disapprove SAB 121 on a bipartisan basis.

Although the President has indicated that he will veto the resolution, the bipartisan Congressional action demonstrates growing support for the use of DLT and may help persuade the SEC to modify SAB 121 to remove the balance sheet treatment for banks.

This February, the Hong Kong Monetary Authority (HKMA) issued a number of regulatory guidance documents, including the “Sale and Distribution of Tokenized Products”⁷ and the “Provision of Custodial Services for Digital Assets.”⁸ The HKMA noted that financial institutions should conduct appropriate due diligence and implement relevant risk management protocols and controls when pursuing tokenized asset activities, and further set forth expected standards for entities safeguarding client digital assets, including tokenized assets. In framing its guidance, the HKMA stated that it was:
 

“… providing the banking industry with regulatory clarity to support continued innovation and realization of benefits that may be brought by tokenization, with appropriate safeguards from a consumer/investor protection perspective.”⁹

In addition to regulatory support for tokenization, achieving legal clarity as to the property and transferability rights embodied by a token is another focus area for further adoption of tokenization. This clarity is on the horizon in the US, following recent updates to the Uniform Commercial Code (UCC) by the Uniform Law Commission (ULC) – the organization responsible for drafting uniform laws such as the UCC for consideration by the states.

The commission proposed a new Article 12, which introduces the concept of a “controllable electronic record” that is “a record stored in an electronic medium that can be subjected to control” as defined under the act.¹⁰ As with other assets under the UCC, Article 12 also makes controllable electronic records subject to the so-called “take free” rule, which stipulates that a good faith purchaser who acquires control of a controllable electronic record – without knowledge of any competing claims of a property interest in that controllable electronic record – acquires it free of any such competing claims that may actually exist.¹¹

This is the same treatment that applies to a negotiable instrument. In addition to the creation of Article 12, the ULC also proposed a number of amendments to incorporate the concept of controllable electronic records into other relevant parts of the code, such as those governing security interests and securities intermediaries.¹² As of this May 7, 20 states have adopted these amendments, with many other state legislatures in the process of reviewing them.

Similarly, in the UK, the Law Commission, a statutory independent body created to keep the law of England and Wales under review and recommend reforms, published a consultation on digital assets¹³ that provisionally proposed the explicit recognition of a "third category" of personal property under English law (distinct from "things in possession" and "things in action”) to govern digital assets. Like the UCC, this proposal also incorporated the concept of a “take free” rule for data objects. Moving from a report to execution, the Law Commission published a consultation on a draft bill in February to amend English and Welsh property law to explicitly reference a digital component.¹⁴
 

Increasing interest in permissioned networks in line with regulatory expectations

While a large percentage of study respondents indicated their intention to conduct digital asset activities on permissionless networks, a significant percentage indicated that they also planned to conduct activities on some form of permissioned network (46 percent for private permissioned and 35 percent for public permissioned). This increased focus on permissioned networks is in line with regulatory expectations and the increasing involvement of institutional investors in digital asset markets.

In the US, the prudential regulators clearly stated in a January 2023 joint statement on crypto asset risks that “the agencies believe that issuing or holding as principal crypto assets that are issued, stored or transferred on an open, public and/or decentralized network, or similar system is highly likely to be inconsistent with safe and sound banking practices.”¹⁵

Similarly, the Basel Committee on Banking Supervision (BCBS) stated in December 2023, when they declined to allow more favorable capital treatment for assets traded on permissionless blockchains, that “[t]he Committee has … concluded that the use of permissionless blockchains gives rise to a number of unique risks, some of which cannot be sufficiently mitigated at present.”¹⁶

In addition, the HKMA noted in their guidance in February that the risks associated with permissionless networks were heightened as compared to permissioned networks and would require “extra caution” and a need to “critically assess the implementation,” including whether it is appropriate to outsource custodial functions.¹⁷

These concerns are understandable, particularly when viewed in the context of tokenized securities. Regulation of the securities markets is conducted largely through the regulation of market intermediaries, a core aspect of which relies on the intermediary knowing exactly who their client is and with whom they are transacting. This knowledge is leveraged to protect against illicit finance, market manipulation and other market disruption activities. When operating on a permissionless network, by definition, there is a level of anonymity built in by default. This anonymity extends beyond counterparties and includes parties facilitating the transaction, such as entities validating transactions to be added to a blockchain.

By moving to a permissioned network, and especially a private permissioned network, the transparency and control over who is involved in a transaction facilitates the ability to effectively regulate and supervise the market and protect investors much the same way as is done today. While a permissioned network does give significant control to the party administering the permissions, that control can be regulated and supervised, similar to how a market intermediary is monitored today. While the evolution of permissionless network technologies may allow for a similar level of control in the future, for now, permissioned networks will be the primary home of tokenized securities. As such, it is no surprise that the majority of tokenized security issuances to date have occurred on permissioned blockchains,¹⁸ including the recent US$756 million equivalent multicurrency issuance of a digital green bond by the HKMA.¹⁹
 

A hybrid world awaits

Building on the tokenization trend, nearly 70 percent of study respondents indicated that they are prepared to transfer assets from traditional custody and trading ledgers to tokenized form and back again. This is consistent with our hypothesis that the financial markets will exist in hybrid form, implying that digital assets and traditional assets will exist side-by-side in the marketplace for years to come.

One of the primary applications for this type of hybrid traditional/digital environment is collateral. Current processes for transferring collateral include a number of manual steps that introduce operational risks and create inefficiencies for capital management as a result of the time it takes between identifying the exposure to be collateralized and actually transferring the collateral to the collateral receiver.

For example, collateral may need to move from a custodian through a central securities depository to a collateral agent and then to the relevant secured party. Each of these steps requires coordination and introduces the potential for delay. Delays in moving collateral indicate that exposures remain unhedged for some period of time, which can impact capital optimization for trading counterparties.

By creating tokenized versions of securities held in traditional custody, those tokenized versions, referred to as “digital twins,” can then be used to transfer collateral between counterparties using a shared collateral ledger while the traditional securities are immobilized at the custodian. There are a number of systems currently in existence today that leverage DLT and smart contracts for such activities, including a distributed ledger repo solution for repurchase transactions, a solution for tokenized US treasuries and others. The market has also developed industry frameworks to help these systems grow, as reflected by the publication of tokenized collateral model provisions by International Swaps and Derivatives Association (ISDA) in December 2023 for use in standardized ISDA credit documentation for over-the-counter derivative transactions.

Over time, as a widely accepted digital cash instrument becomes available, tokenization will begin to extend its reach to the entire lifecycle of an instrument, helping to bring increased operational efficiencies to the marketplace. We are seeing progress being made on the development of an institutionally robust digital cash instrument. For example, Fnality International, which is supported by a consortium of financial institutions (including State Street), is working to develop a cross-currency network of digital payment systems for wholesale market participants through accounts held at relevant central banks. Governments and international financial standard-setting bodies are also actively investing in this area, such as the recently announced launch of the Bank for International Settlements’ (BIS) Project Agorá (Greek for "marketplace").

This project brings together seven central banks²⁰ and a group of interested private financial firms to investigate how tokenized commercial bank deposits can be seamlessly integrated with tokenized wholesale central bank money in a public-private programmable core financial platform.²¹ This could enhance the functioning of the monetary system and provide new solutions using smart contracts and programmability, while maintaining its existing two-tier structure.

The advent of a widely accepted digital cash instrument will definitely help to accelerate the development of digitization of the financial marketplace. The breadth and interconnectedness of the existing systems within the financial market will require time to transition to a fully digital market, making a hybrid world the likely outcome for the foreseeable future.
 

Conclusion

Many of the trends revealed by State Street’s 2024 Digital Assets Study are consistent with the evolution of the regulatory environment. Over the past year, regulators have concentrated more on supporting responsible innovation through tokenization efforts, noting the potential benefits to the financial system from tokenized securities, which is consistent with study results identifying that institutional investors intend to increase exposures to digital assets and more widely embrace the use of permissioned networks. In addition, the high levels of preparation to operate in a hybrid world, moving between traditional and digital assets, align with the burgeoning collateral use case and the longer-term hybrid environment.