The Chancellor’s Mansion House pledge to trial a ‘digital gilt’ within two years sets the stage for UK financial services to lead on new digital asset classes. In this article, Christopher Hinitt, PA Consulting’s Digital Banking and Operations Lead, discusses how distributed ledger technology (DLT) – the basis for the digital gilt – could reinvigorate the sector and drive economic growth. Put simply, this may be one of the most significant transformations in the 400-year history of modern financial services. But Hinitt believes that to make it a success, we need the right safeguards in place, with data analytics being key to achieving this.
What are the benefits?
DLT, DeFi and digital (crypto) assets have the potential to accelerate and reduce the cost of asset transactions. DLT essentially acts as a digital system for recording transactions. This means it offers ‘immutable records’ – unchangeable digital logs stored on a distributed ledger or Blockchain – and so every asset transaction or change in ownership is documented in a permanent, verifiable manner. This can ensure greater transparency and security, whilst simplifying due diligence and transaction costs.
By converting physical or illiquid assets into ‘digital tokens’ that represent ownership, DLT also enables currently illiquid assets to be traded on Blockchain-based platforms – opening up opportunities to establish entirely new asset classes. Illiquid assets could be traded in a similar way to high-frequency trading, with more dynamic, AI-enabled investing strategies. It also offers the possibility of fractional investment.
For example, gilts could be used to fund capital investments – such as UK critical national infrastructure – whereby previously illiquid large infrastructure projects are fractionalised using tokens and linked to a UK digital gilt. This would enable UK national infrastructure to be funded by a larger number of investors, including private equity and global retail investors. At the point of selling, the larger size of the capital pool and the liquidity available could support getting the target sale price of these assets, with a new range of DLT-backed instruments phasing the sale of assets and smoothing price volatility.
Risks remain
In short, DeFi could drive significant innovation and democratisation in the financial sector. Yet it’s important to be clear sighted about the operational, regulatory and technology risks. Having a digital gilt will require a wholesale digital pound – that is, a pound that is a cryptoasset and uses DLT platforms for its issuance and the control of money supply. This is because a digital pound could enhance the speed, efficiency and functionality of digital gilts, enabling frictionless transactions with orders-of-magnitude lower transaction costs when compared with TradFi and its much higher settlement times.
Transactions with the digital pound will be faster than those for a physical pound. Whilst the difference will only be fractions of a second, in foreign exchange trading, these small margins matter. If a digital pound is traded quicker, it opens the possibility of closing a trade, and then using the small-time difference to either hedge the trade using a physical pound or manipulate the market through liquidity constraints.
There is also the risk that a DLT-enabled digital pound could affect the value of money. The decentralised nature of DeFi means that no central authority controls a digital asset once it has been released. The owner of a digital asset could therefore opt to destroy it, deleting the data and digital representation of its physical counterpart, and a bad actor could try to influence the money supply by acquiring and destroying digital pounds in significant quantities. These potential unintended consequences will need to be thought through and addressed.
Role of data
While technological innovation creates risks, technology – in the form of data analytics – also provides a way to manage and mitigate those risks. At the heart of DeFi is transaction data. Creating a digital gilt – and a digital pound – requires new levels of data, with higher quality customer data views and cleaner data processing.
In a DeFi-enabled world, data analytics will therefore be better able to monitor and track transactions. This will involve using the data properties of ‘immutability’ to know precisely when transactions occur, with a clearer view on transaction patterns. There will need to be new thinking about how to ethically create and track DLT-enabled financial products, potentially by assessing each individual’s financial ‘DeFi data fingerprint’. AI-led automation will also be better able to identify and mitigate money laundering and sanctions evasion.
New DLT-led data assets call for informed discussion on the operational and regulatory approach. Much of the careful thinking has yet to be done. In particular, enabling a digital gilt will require a more consistent approach from UK regulators in the way they treat cryptoassets, although the UK’s Property (Digital Assets) Bill may partly address this.
The Government and firms should also embrace advice from digital asset leaders and data analysts who understand the underlying product innovation, technology platforms, DLT ecosystem and how the UK can lead globally.
Opportunity for the UK
Crucially, now is the time to act. Not only are the capital markets already moving towards DeFi, but there is a sizeable first-mover advantage for the UK. Once there are early mainstream use cases of DeFi, the cost and speed advantages will see a strong driver for traditional assets migrating to DeFi, and it will likely spread through the market quickly.
If the UK is not a centre for DeFi, its lead as a global financial centre is likely to be eroded. Failing to develop a digital gilt could see UK financial services stagnate and decline in the next three to five years. With the recent US election, we are also likely to see the SEC rapidly reducing crypto-service regulation, making it even more urgent for the UK to embrace these developments to maintain its current, more fragile lead.
The Government has given the green light to DLT and UK financial services must now focus on building the data foundations, regulatory certainty, and FinTech ecosystem partnerships for DLT financial products. With the right data analytics and input from digital asset leaders, there is every opportunity to seize the benefits ahead and transform economic growth.