Blockchain radically simplifies the custody of alternative investments
Blockchain adoption is gaining intensifying traction in the traditional finance industry. The technology was misunderstood as a mere synonym for crypto-currencies such as Bitcoin and Ethereum for a long time. Now, it is fundamentally changing many processes in the asset servicing sector. This includes, in particular, the secure custody of assets, which investment funds must regularly guarantee. Today, this duty is performed mostly by custodian banks, as defined by the regulator.
Blockchain leads to a paradigm shift
Blockchain technology offers vast opportunities, especially in the rapidly growing private capital market. For example, real assets can hardly be standardized and are therefore more challenging to securitize. This is associated with considerable administrative work for custodians and service providers, such as high issuing, distribution, and custody costs. The consequences for investors are high minimum investment amounts and management fees, as well as little flexibility in terms of liquidity. In other words: the current vehicles only function locally in the respective regulatory environment, and investors do not have permanent access to the funds and ability to trade them.
Blockchain technology promises a radically simplified solution compared to the widespread and costly practice of holding shares in real estate and other real assets. The decentralized structure of the blockchain cannot be emphasized enough here. This structural difference between a central custodian and decentralized self-custody on the blockchain is the "game-changer" per se. A central database, i.e., a solution using a custodian, always belongs to a central office and is administered and licensed locally. Decentralized databases have no owner and and investors are entitled to full ownership of their assets, via controlling their blockchain wallets. Thanks to the decentralized registry being digital by nature, processes can be automated and made paperless.
Most importantly: the overall custody and intermediation fees are lowered. These advantages of the blockchain infrastructure are especially decisive in times of low-interest rates and falling yields. Digital securities - also known as security tokens - enable asset servicing providers such as crowdfunding platforms, to pass on various advantages to their investors. Besides cost-efficiency, they include permanent tradability and global availability of investor's assets. In addition, due to the lack of need for intermediaries such as market makers, there is the potential to reduce transaction costs and the dependency from trading hours at individual marketplaces.
Security token: a real-world use case
The blockchain enables the digital securitization of every asset: all relevant framework data for the securitization are irrevocably written into the security token. The process of creating the digital representation of a real-world asset, is called tokenization. The security tokens created can then be traded and stored much more easily than traditional securities.
The non-custodial way of distributing and storing assets goes beyond mere tokenization, where the blockchain is only acting as a replacement for custodians. Even more so, a key management system solution allows for truly decentralized custody of assets by the investors themselves. Thus, providing a range of valuable benefits: decentralized, secure, paperless, and automated processes that cannot be corrupted and are independent of a central intermediary. Investors have permanent access on a global level and the ability for the transferring and trading of these assets. De facto, one can summarize that the technology manages to fulfill the "Magic Triangle": Security on the custody level, liquidity due to access availability and tradebility, as well as higher potential returns due to margin increase in the absence of intermediaries.
Up to 85% lower costs with core blockchain system
The non-custodial technology enables cost savings for investment platforms and funds of up to 85%. To put the technology into practice, a core blockchain system is needed. It is a solution to build the complete blockchain application: from non-custody wallets, asset recovery, fee management to the security tokens issuance and distribution. A core blockchain system is a "ready-to-use" toolkit that various financial services providers can use to offer their customers cost-efficient, decentralized investment opportunities, as for example real assets that are difficult to invest in - with entry tickets as low as one Euro. As a result, we can speak of no less than an old world and a new world in terms of financial infrastructure, which will shape the industry from today onward at an increasing pace. Anyone who has previously experienced the distribution of closed-end funds, as well as AIFs, knows that the investment decision often fails, due to the high minimum entry tickets and the inability to sell these assets prior to maturity.
At the same time, independence from a central administrator or depositary enables asset providers to distribute globally whereby tokenization opens up a completely new field for the securitization.
In addition, the independent administration by the investors via direct access enables continuous trading of the purchased assets, at any time and worldwide. The core blockchain system solution is thus not only accompanied by a paradigm shift on the cost side, but also by global democratization with regard to asset classes that were previously difficult to access, such as alternatives assets.
Using Upvest as an example, we're presenting a concrete design which goes beyond the previous market standard: The decentralized custody is carried out via so-called blockchain wallets owned by the investors. The information stored in the security tokens cannot be changed once created. These digital wallets on the blockchain are encrypted in such a way that only the investors themselves can access them, control the current value, and sign transactions. The access happens smoothly by logging in to the investment platform and keeping a private password for the wallet. Upvest ensures that access can be restored even when the password is lost. At the same time, this solution for B2B partners offers a smooth user experience for the end investor thanks to the simple API implementation: The user experience is not interrupted by "media breaks" or switching between applications, but takes place entirely within the provider's ecosystem.
Not a future vision, but already live
One example of a core blockchain system in use is the successful issue of token-based bonds by the crowdfunding platform Exporo AG. As the first EU-wide transaction of its kind approved by the regulatory authorities, the financing of a Hamburg property with a portfolio volume of almost EUR 3 million was completed within only a few hours in July 2019.
The underlying infrastructure, i.e., the digital wallets for self-custody, was provided by Upvest. Thanks to the implementation via APIs in the background, the investment process for Exporo customers continues to take place exclusively on the Exporo website. All transactions can also be carried out onto Exporo's platform in the usual manner, using username and password. The application's frontend or account experience remains unchanged, the core blockchain system and wallet infrastructure operate in the background.
The B2B solution for the asset servicing industry
In addition to crowdinvesting and fintech, blockchain technology will also become increasingly important in traditional asset management and bring lasting changes within the traditional supply chain of the industry.
One thing is clear: due to increasing cost pressure, the current business models will not be sustainable in the long term. An attractive solution for fund managers may be to fall back on already tested and established technologies via APIs, i.e., technical interfaces like Upvest, instead of investing massively in building up their own systems. This is because the blockchain technology itself is "raw" and very difficult to use. It can take years to build up a technologically competitive and compliance-compliant infrastructure yourself - assuming you have the technical know-how.