Banks to Blocks: exploring TradFi/ DeFi collaboration

Simon Williams:

Hello and welcome to Ashurst Legal Outlook. Today we are talking about distributed ledger technology, DLT, and specifically operationalising DLT. I am Simon Williams, counsel in Ashurst's Digital Assets and Financial Innovation team. Ashurst is a global law firm with genuine world first global experience and expertise in the digital assets space, as well as a deep involvement in digital assets' future development and regulation.

For those less familiar with the digital assets ecosystem, here is a brief overview. If you need more detail, there's a link in the podcast description to Ashurst's Digital Assets 101 explainer.
So, a digital asset is any asset that is represented digitally or electronically. For example, stocks and shares, investment funds, sovereign debt, and money. They can all be created in a digital rather than a physical form.

One form of technology those digital assets use is called distributed ledger technology - DLT. It's a form of technology used to store and process data. I think that sometimes these concepts can be over complicated or over explained. We have a financial asset that is digital rather than physical. By analogy perhaps, think of an album on Spotify rather than a physical compact disc or vinyl on your shelf. And then there is some technology, the DLT, that enables the asset's digitalization. By analogy, think the internet and the Spotify app. That's the technology. Playing the Spotify album rather than, say, Amazon delivering the physical CD to your door to play on your home music system. Another important point to make is that one does not necessarily need to understand how the technology itself actually works, i.e. how the code works, as long as one understands the concepts. I couldn't code a website or an app, but I understand how to play music on Spotify or do internet banking.

Okay, so that's what it is. Now, why does it matter to you and why now? The very short answer is that DLT has many financial services use-cases. For example, record keeping, clearing, settlement, value storage, transfer, and ID verification. It has many advantages, for example, the speed of use, the potential for greatly reduced costs, and the ability to streamline many financial systems. The advantages are now widely recognised, including by governments, regulators, financial institutions, and end users. And of course there are risks. These are recognised and solutions or mitigants are being found.

And finally, why now? Well, DLT technology holds the capacity to transform the world to a greater extent than the internet. In the not too distant future, not using DLT could be as unimaginable as not using the internet today. We are at the tipping point. The digital asset train is fast leaving the station and financial institutions not on it will be left behind.

So we've split the podcast into two episodes. Today we'll be talking about the ways to operationalize DLT, and then in episode two we'll talk about some of the material risks and some ways to address those risks.

That's a very long introduction, but I thought it would be useful to level set.

To help talk through this topic, I'm joined by Thomas Hyun from Forensic Risk. Welcome, Thomas.

Thomas Hyun:

Thanks, Simon, and thank you for this opportunity. It's such a fascinating time to be in the space of digital assets, and we're seeing so many creative use-cases come to light, bridging the digital native world with traditional financial services. So I'm very excited to discuss some of these areas with you today.

Simon Williams:

Absolutely. Thomas, before we dive in, could you tell us a little bit about your organisation and your expertise in the DLT world?

Thomas Hyun:

Sure, Simon, happy to. For the past 25 years our firm Forensic Risk Alliance, or FRA, have been helping our clients across a number of investigations, disputes, corporate monitorships, and regulatory compliance matters. We're a London-based firm and balanced between a team of forensic accountants complemented by a specialised forensic technology team focused on e-discovery and data analytics. Specific to crypto and digital assets, we built a strong team dedicated to cryptocurrency compliance and investigative matters with a focus on partnering with our clients directly and their counsel on both proactive and reactive investigative work. Over the past year I've served as the Director of Cryptocurrency Compliance at FRA, leading our compliance advisory services with our digital asset clients. Previously, I've held several risk and compliance leadership roles at PayPal, supporting their crypto offering, MasterCard, and at the blockchain infrastructure provider Paxos in New York.

Simon Williams:

Thanks for that, Thomas. Let's get into the detail.

The huge potential of DLT for the financial services sector is now generally and widely recognised, including by central banks and regulators. As is the value that DLT brings to both digital natives and also to traditional finance. Whilst DLT operations are obviously baked into digital natives, a growing trend that Ashurst is seeing is the crossover of these DLT operations. So collaborations between digital natives and traditional finance, so traditional finance can leverage and operationalize DLT. And also vice versa, so that digital natives can utilise attributes of traditional finance. So for example, Ripple leveraging its on-chain technology and infrastructure to provide digital asset custody to support BBVA's cryptoasset services. And in turn, traditional finance institutions are providing support services to digital natives, for example, to mitigate the perceived digital native counterparty risk. BBVA is reported to be providing custodial services for clients' US treasuries, which Binance then accepts as margin for trading.

And we're also seeing collaborations between digital natives, so that one digital native can operationalize some aspect of DLT that it doesn't currently have. For example, Circle and Fireblock's collaboration, where Circle's stablecoin network will complement Fireblock's custody and payments infrastructure tools to provide cross-border treasury and tokenization asset settlement. And another example, Circle and Kraken expanding access to Circle stablecoin on the Kraken platform.
Those are just a few examples, and there are many, many more. And we're now seeing these collaborations, quite often world firsts, announced on what feels like a daily basis.
Thomas, could you talk to some of the instances that you are seeing?

ThomasHyun:

Sure, Simon.

I started my crypto journey over seven years ago, so I've seen many of these use-cases develop at the early stages. Historically, this space has been heavily dominated by crypto exchanges, your Coinbases, your Krakens, who are focused on providing customers the ability to buy, sell, trade, transfer, digital assets, whether it's retail investors or enabling offerings for institutional investors such as your market makers and providing institutional custody. Then we saw the rise of decentralised offerings starting to develop. Whether it's self-custodial wallets, venues of exchanges like DEXs, NFT platforms. All which typically sit outside of regulatory frameworks. Then given Bitcoin's volatility as a trading pair, we saw the rise of stablecoins, mostly as a trading use-case in its earliest form. But with unregulated less transparent stablecoins, we saw the rise of regulated dollar-backed stablecoins from Coinbase and Circle, for example, USDC. But utility has always been a challenge in this space, and now we're seeing unique ways to bring digital asset use-cases more mainstream. Drawing more partnerships, but also more competition between TradFi and digital and crypto natives.

The concept of chasing yield. We're seeing tokenized money market funds, tokenized treasuries by traditional asset managers, those who are more accustomed to regulation, easily able to track institutional investors. For example, we're seeing BlackRock's token, the recent token by Fidelity, increasing competition in this space, but also taking away market share from fiat-backed stablecoins like USDT and USDC. Now in the present day, those who've had a long runway of developing digital experiences leveraging DLT are now offering their backend capabilities for new TradFi entrants, really in a crypto as a service model.

Here in the US, we have a large regional bank PNC who's partnering with Coinbase to allow their bank customers to buy, sell, and hold cryptocurrency. Companies like ZeroHash have been around for quite some time, powering the broker's capabilities on interactive brokers and now partnering with Morgan Stanley. And in the payment space, those who ride on stablecoin rails like BVNK are enabling payment use-cases using stablecoins. Whether it's around send/receive, cross-border payouts, treasury management, or on settlement and pre-funding, enabling payment processors and merchant acquirers like Worldpay.

So yes, Simon, there are some examples that we're closely tracking and these are the collaborations we've been seeing in the recent months.

Simon Williams:

Thanks for that perspective, Thomas.

Building on what you've said, I'd also note service provision by outsourcing, i.e. whereby the service provision is more deeply integrated. We'll talk more about regulation in episode two, but I just wanted to mention regulation now in this context. Obviously, many of these structures we're talking about will have regulatory implications, for example, risk controls. In UK regulation, there are, for example, enhanced obligations for material or critical outsourcing. And then for another example, in the EU there is the Digital Operational and Resilience Act, or DORA for short, which imposes additional regulatory obligations.

Thomas Hyun:

Yeah, I think Simon, most of TradFi aligns to what you're saying - has an understanding that in order to enter the space, really trusted relationships, trusted partnerships are required. This space was traditionally reserved for digital natives who are more nimble. And now TradFi is seeing the fastest way to enter the market is through these outsourced frameworks, especially for initial use-cases around brokerage models or stablecoin offerings. Now with stablecoins, we're seeing more and more white labelled or branded offerings, drawing interest from companies wanting to launch their own tokenized offering. For example, companies like Paxos have issued a branded stablecoin for PayPal. Bridge and Stripe for the recent issuance of mUSD for MetaMask, a first for self-custodial wallet. And back to the regulatory point here in the US with the passage of the GENIUS Act and its focus on on-shoring stablecoin issuers to the US - we may see a rise in institutions wanting to become a permitted payment stablecoin issuer or providing white labelled offerings to foreign entities seeking to enter the US market. For example, Anchorage's announcements about issuing Tether's US-compliant stablecoin.

But given my compliance background, I'm really focused on how this impacts third-party risk management programmes. Given recent regulatory developments, having a strong understanding of your licensing and supervision requirements, and compliance and internal control processes of those offering DLT capabilities - these are going to be the most important factors on how and whether these outsourcing relationships will be established and whether they're successful or not. And often these arrangements can be quite complex. They can be omnibus offerings or simply servicing a technology provider. So having clear lines of responsibilities between each party, for example - who's going to handle the AML/ CFT obligations, and having sufficient due diligence oversight capacities. As failures in this process have been highlighted, and brought to attention, by recent enforcement actions coming out of the us, specifically with NYDFS in New York.

Simon Williams:

Thanks, Thomas. And picking up your point on white labelling. White labelling is a good example of something which could well be a UK regulatory material outsource. And topically, just this month, the EBA has issued a report on white labelling in financial services, noting cryptoassets as an area where this happens.

So pulling some of the strings of this part of the discussion together.

There's a lot of activity and a lot of possible routes for collaboration. One thing that I've found super interesting is where we are now essentially seeing a complete crossover between the worlds of TradFi and digital natives. For example, traditional FMI - financial market infrastructure - SWIFT payments system announcing a blockchain. And then a digital native, Circle, announcing the possibility of launching a blockchain with a layer capable of having reversible transactions. A key feature obviously of blockchain pioneers being the immutability of the chain.

And obviously the DLT value-adds manifest in many different ways. And each collaboration will have its own ambitions and targets and be structured accordingly. And each will present different economics, and importantly risks. And I mentioned earlier, risks is something we'll be talking about in episode two of this podcast.

So far we've talked about service provision and outsourcing. I wanted to also talk about corporate transactions too, i.e. mergers and acquisitions, M&A. There's been some activity here, for example, reportedly Ripple made an offer for Circle. And we just recently saw crypto firm GSR agreeing to buy a US broker dealer. So with the last example, a digital native reversing into a traditional finance vehicle.

How are you seeing this space, Thomas?

Thomas Hyun:

I think these strategic opportunities can be quite challenging at times, with global regulatory frameworks still in development and often in conflict across certain jurisdictions. These opportunities pose many questions and challenges.

For example, what are the new regulatory requirements I will be subject to with this acquisition? Is there a new customer impact and what are those challenges and risks? What's the compliance culture of the acquiring entity? And how mature are their internal controls? And how can this be integrated within our existing systems and technologies?

I think we're seeing more from digital natives in this space trying to really expand their reach; whether to offer new products, to new markets, or really see where their competitors go.

Around derivatives, for example, Coinbase acquired the option exchange Deribit earlier this year. Kraken just recently had an acquisition of a CFTC futures exchange.

And with new regulations, specifically here in the US with the CLARITY Act focused on classifying digital assets, potentially how digital assets would be regulated and supervised here in the US as well, we may see more of a buy-a-licence trend. Specifically for SEC-registered broker dealers. And we've seen an example with Ondo lately - a stablecoin issuer trying to enter the tokenized security space.

Simon Williams:

Yeah, absolutely. I agree on the digital natives M&A point, Thomas.

From my perspective so far, material M&A activity has largely been confined to digital natives with other digital natives. And I think TradFi and DeFi partnerships have generally taken the more prudent services and outsource route. That said, I would expect to see the corporate transaction space accelerating going forward - as happened back in the day between internet service providers and traditional media. With some DeFi market capitalizations now rivalling major banks, and further use-case rollouts, DLT collaboration will I think encompass material TradFi/ DeFi M&A activity in the short to medium term.

Thanks very much Thomas for your great insights. For me, the three key takeaways from our conversation today are:

• Firstly, TradFi/ DeFi partnerships are now a question of how and when, not if.
• Secondly, increasingly, these collaborations will become business as usual - BAU.
• And finally, cadence. Pace will accelerate and the collaborations will no longer be FT headlines.

Thomas, any other key takeaways from your end or anything else you wanted to add today?

Thomas Hyun:

Just one final point. And fully agree with you, Simon, here. I think we're seeing real utility, real use-cases, offering products which look and feel like traditional finance and providing these capabilities to the masses. However, this will be dependent on the growing collaboration across TradFi and DeFi - really stressing the importance of how these institutions evaluate and maintain these relationships.

Given recent regulatory sentiment, recent enforcement actions, the inherent need of these partnerships to exist, and the overall complexity around these arrangements - institutions really need to level up their due diligence and risk assessment processes on their outsourced arrangements to ensure that these are risk-based, they're fit for purpose, and specifically tailored for the digital asset offering.

Simon Williams:

Thanks, Thomas.

So that brings us to the end of today's podcast. Thank you again to Thomas for the conversation. And thank you to you for listening to our podcast. We hope that you found it informative. If you'd like further information on any of the topics raised, please do reach out to your usual Ashurst contact, to me, or to any of the other contacts listed in the podcast description. Please also feel free to share the podcast with interested colleagues.

As I mentioned at the beginning, this is episode one. Episode two, will continue our conversation with Forensic Risk's Meredith Fitzpatrick..

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For other digital assets content, see www.ashurst.com/digitalassets for our thought leadership. That is ashurst.com/digital, singular, assets, plural, all one word. And the link is also in the podcast's description.

So all that remains for me is to say goodbye.

Goodbye.