The development of the digital financial asset (hereinafter, DFA) market just a year after its practical implementation is impressive. Although DFAs are still a new phenomenon, it is difficult to recall any financial instrument in the last 10 to 15 or years that has demonstrated similar growth in such a short period of time.
Current state of the market
The total number of DFA issues can be estimated at approximately 350, and the market volume for outstanding issues at the end of 2023 amounted to about RUB 60 bln. Given the limited access to centralized data for all data system operators (hereinafter, DSOs), actual market indicators may differ.
Figure 1. New DFA issues in 2023, monthly
Sources: Cbonds, ACRA
Issuers of DFAs in 2023 were both financial institutions and non-financial companies, including SMEs. We note a significant share of short-term issues: 25% of the total volume of issues were financial instruments with a maturity of up to three months. This suggests that DFA issuers are either still looking for their most rational application, or are testing the processes for issuing and servicing this class of financial assets and studying the investor base.
Figure 2. DFA maturities by issue volume
Sources: Cbonds, ACRA
In most cases, DFAs have fixed rates with coupon payment over the life of the financial instrument or when the debt is repaid.
The analyzed segment is currently dominated by the simplest DFA issues, which certify direct payment claims against issuers and are similar to bonds in view of their parameters. A small number of DFAs issued in 2023 had more complicated structures (for example, remuneration was tied to the cost characteristics of tangible assets, such as precious metals, etc.) or were secured by liabilities of third parties (for example, accounts receivable). Hybrid instruments, which besides simple claims to the issuer can certify additional rights, including utilitarian digital rights (hereinafter, UDRs), were practically absent.
The formation of the DFA market is currently in the final stage — the Bank of Russia’s register already includes 10 DSOs that technically carry out the issuance of the specified class of assets and operations involving these instruments. In 2023, an exchange operator was registered (the Moscow Exchange), work is being carried out to create over-the-counter platforms, and therefore the formation of a full-fledged secondary DFA market is not a distant prospect. Major financial institutions as well as relatively small companies act as DSOs.
Unresolved issues
The main problem facing the DFA market involves overcoming infrastructure risks. DSOs play a key role in forming and maintaining the register of data system users, and consequently, in storing data about all DFAs issued on the platform, conditions for servicing them, issuers and investors. In the event of a serious technological failure or bankruptcy of a DSO, issuers and holders of DFAs may lose access to the system, which jeopardizes the fulfillment of obligations for financial instruments, especially if their terms are determined by smart contracts. Although operational risks and measures to reduce them are regulated by requirements for data system reliability, cybersecurity and ensuring the uninterrupted functioning of systems and the implementation of these requirements is under the control of the Bank of Russia, the credit risks of DSOs are not yet hedged.
Let’s compare the situation to the ‘paper’ financial market — it has many intermediaries that to a certain extent duplicate all the relevant financial information, while a central depository in the form of the NRD, with minimal credit risk, carries out centralized accounting. Thanks to this, the realization of the credit risk of one of the intermediaries does not lead to disruption of schedules for servicing debt instruments. In the DFA market, all intermediary functions, as well as the functions of the central counterparty, are carried out by the DSO, to which, according to established practice, all the work processes of the data system are tied. If the system is not distributed, them the DSO’s creditworthiness directly influences all the DFAs issued using the system.
If an operator is excluded from the Bank of Russia’s DSO register, then the law1 requires information to be passed from the excluded DSO to a different one, and Ordinance 5828-U2 details this information. Obviously, bankruptcy or other cases of operational insolvency are grounds for excluding a DSO from the register. However, deterioration of an operator’s financial standing does not mean it is subject to pre-emptive exclusion. At the same time, direct interaction between two data systems is very difficult because DSOs employ different business processes and blockchain systems. As a result, the handover of information may not only be delayed, which in itself may lead to DFA payment schedules being violated, but may also require physical transfer of servers, which is not envisaged by the law.
The processes of finding and replacing DSOs can be simplified and streamlined by entering into contracts on reserve servicing that stipulate mandatory preliminary testing of information transfer before any concerns arise with regard to operator creditworthiness. However, corresponding regulatory requirements do not currently exist and DSOs are reluctant to cooperate with each other in the competitive environment. Distribution of a register, implying duplication of data system nodes among its participants, could compensate for the absence of an external central counterparty or mandatory backup servicing, but even in this case, the scenario of termination of the functioning of the central node of the data system represented by the operator requires testing to ensure the preservation of the system as a whole and the stability of its functioning.
As mentioned above, mechanisms for ensuring the rights of DFA holders in the event of a DSO’s bankruptcy have not been fully developed, but market participants are discussing the organization of reserve servicing and working on forming other mechanisms to mitigate infrastructure risks. A complete solution in this area should be expected in 2024.
1 Federal Law No. 259-FZ dated July 31, 2020 “On digital financial assets, digital currency, and making changes to certain legislative acts of the Russian Federation”.
2 Ordinance of the Bank of Russia No. 5828-U dated June 25, 2021 “On the procedure for the transfer by an operator of an data system who has been excluded from the register of operators of data systems, in which digital financial assets are issued, summary information stored in the data system about the persons who issued digital financial assets, as well as about the owners of digital financial assets issued in the data system, and digital financial assets belonging to them to the operator of another data system”.
Potential areas
The most widely used forms are simple DFAs that certify monetary claims against an issuer, which is not surprising at the current stage of market development. On the one hand, a significant part of issuers has been aimed at testing all stages of issuing and servicing this financial instrument: from registering an electronic wallet on a digital platform to making settlements with investors. On the other hand, simple DFAs are considered by many market participants as a tool for attracting short-term liquidity. Interest in this format is due to the simplicity of the issue process compared to issuing bonds, simplified requirements for both issue documentation, often generated automatically, and information disclosure. DFAs can also act as an alternative to bank lending, given that there is no need to interact with banks in terms of inspections, analysis of statements, credit decisions, as well as issuing collateral and guarantees. With a comparable cost of raising funds, the issue of DFAs is characterized by greater flexibility in terms of determining the amount of attraction and repayment terms. The combination of these factors makes DFAs an interesting tool both for SMEs and, partly, for larger non-financial companies. It is worth paying attention, however, to the obvious drawback of DFAs for investors — the limited information that would allow them to determine the creditworthiness of the issuer. In the short term, credit risk is reduced, but can be critical when making decisions in the case of long-term investments.
Some promising DFA forms have not yet been reflected in Russian legislation, and discussions on this matter continue. One of these areas is the use of DFAs in foreign economic activity. The preparation of relevant amendments to legislation was actively discussed in the media at the end of 2023, but the mechanism for implementing this idea is not yet clear and is due to a number of technical issues.
The specific nature of Russian DFAs is that the issue of these financial instruments, trading operations with them and redemption are possible only within the framework of Russian data systems (as this requirement is enshrined in law). Therefore, issuers and investors must have access to the system through an electronic wallet or personal account. UDRs, the most logical area of application of which is trading, including commodity trading, adds the need to use investment platforms. As a result, any economic activity that involves settlements for the supply of goods using hybrid DFAs associated with UDRs will require interaction between buyers and sellers exclusively through Russian data systems and investment platforms (regardless of the affiliation of trading participants to a particular jurisdiction). Even if we assume that legislative norms will be changed, interaction between users of different systems is technically problematic, since IPOs develop their own business processes and build platforms on different blockchain systems.
To resolve this issue, residents and non-residents, suppliers and buyers should be registered in domestic data systems, and non-residents should open accounts in domestic banks. This approach is more likely to be implemented on the platforms of the largest banks, which are also DSOs, since they can offer comprehensive cash settlement services to customers, including non-residents, and act as a DSO. The prospects of engaging a sufficient number of foreign companies to this form of foreign trade depend on the organization of business processes, as well as on the desire of non-residents to work directly with Russian banks, or on the availability of intermediaries. It is also necessary to assess additional risks associated with cross-border transactions. As an alternative option for connecting users in different jurisdictions, it may be reasonable to establish an international exchange operator capable of linking Russian data systems with foreign platforms. In general, the use of DFAs in international trade would certainly have a positive impact on the Russian DFA market and significantly expand the options for using these financial instruments.
Another notable area of market development may be the issuance of DFAs by regions and municipalities. Market participants are discussing the potential for issuing hybrid DFAs to finance capital construction and infrastructure projects. These secured instruments that are closely related to project finance or PPP projects can be issued today but to finance private investments. The new initiative will allow public partners to attract funding for the abovementioned projects. Use of collateral, including UDRs, in DFAs will allow regions and municipalities to manage their debt portfolio without prejudice to their development opportunities. Of course, for this initiative to be implemented, local authorities should have relevant powers, while the available investor base should be subject to regulatory expansion. A separate issue is the definition of requirements for investment sites and DSOs to reduce the operational risks of infrastructure.
Another issue is digital securitization, that is, issuance of DFAs secured by monetary claims to an underlying asset, generally, a portfolio of debt obligations. On the one hand, DFAs certifying claims to a third party other than the issuer are already available and used in the market. On the other hand, securitization has a number of specific features and requires certain mechanisms, the implementation of which in the current legal environment is fraught with difficulties. For example, DFAs cannot be issued by bankruptcy-remote SPVs that act as issuers in securitization transactions. This option excludes the contractual subordination of two DFA tranches secured by a single portfolio to ensure seniority of one tranche over the other. There is a lack of clarity on whether a DFA may certify claims for a portion of a collateral portfolio and not for a specific loan or debtor. The implementation of such mechanisms essentially similar to those listed above, but complying with existing restrictions, is theoretically possible but needs elaboration.
Factors of further growth
Further development of the DFA market may follow several scenarios. In accordance with the most conservative scenario, DFAs will remain a sort of niche tool, and their scope of application will be relatively narrow despite the development of new digital products. According to the most optimistic scenarios, DFAs will complement the common debt finance market or even attract some investors and issuers, as well as bank borrowers of certain categories, taking into account the emerging trend of using DFAs as an alternative option to short-term bank loans.
The development trends will mostly depend on the regulator’s position. The existing regulatory restrictions that allow qualified financial market participants to invest in DFAs but at the same time do not exclude individuals from the circle of investors, albeit to a rather limited extent, leave quite a lot of space for the gradual growth of the DFA segment in the near future. According to ACRA’s estimates, the DFA market volume in outstanding instruments may reach RUB 250 bln by the end of 2025. The limited investor base, as well as the current limits on the annual volume of investments for individuals, will curb more significant growth. ACRA expects that in the next two years, small and medium-sized issuers will gradually increase their issue volumes, while for large issuers, DFAs will be a tool for solving local problems. Since many large companies have access to the bond market, the rules and risks of which have long been clear to its participants, and given the availability of bank lending, large DFA issues will remain few for the time being due to the higher borrowing costs and the complexity of placement among a limited number of investors.
ACRA expects DFA market infrastructure to gradually concentrate around the DSOs who are the largest banks. First, financial institutions have extensive bases of retail customers who can be offered investments in DFA along with other banking products. Banking applications simplify new investors’ access to data systems. Second, large banks have well-formed portfolios of corporate borrowers that can become DFA issuers through the banking infrastructure they already use. Moreover, since existing borrowers undergo KYC and financial analysis procedures as part of credit decision-making, banks are aware of their creditworthiness, which can be broadcast to potential DFA investors. At the same time, ACRA believes that large DSOs will be more interested in ordinary DFA issues that are easier to scale up. Smaller DSOs will occupy the niches of hybrid, structural and structured DFAs that require a personal approach and specific settings of data systems and smart contracts.
An important factor for DFA market growth will be the formation of a secondary market. DSOs who have the largest investor bases can organize trading in DFAs within their own data systems, without involving third parties; however, for most market participants, the exchange mechanism is important. Currently, there is a single exchange operator in the market — the Moscow Exchange, and communication mechanisms with various DSOs are still being established. At the same time, market participants are exploring the possibility of using agency over-the-counter secondary trading arrangements that do not require an exchange operator.
Another important factor that will affect the vector of further evolution of the DFA market is the regulator’s position on a number of areas of development.
First, revision of restrictions on investments in DFAs; this includes a number of important questions, for example:
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Will institutional investors be permitted to enter the DFA market?
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Will investment limits for individuals remain unchanged?
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Will DFAs be included in the Lombard List and subject to repurchase transactions?
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Will the credit rating levels of DFA issues for certain categories of investors be included in the regulatory framework?
Second, diversification of DFA issue types:
- In particular, will various restrictions on investments apply to all DFAs equally or to certain types only (for example, hybrid digital rights)?
Third, expanding the application scope of DFAs:
- The key topics include the use of DFAs in financing regions and municipalities, DFAs and foreign economic activity, and digital securitization.
In the moderately conservative scenario, ACRA expects that at the current initial stage of development, the market has not exhausted its growth potential under existing constraints. The transition to the next stage can be discussed only after legal experience is accumulated (primarily in case of default of DFA issuers), infrastructure risks are excluded by creating and testing mechanisms for data transfer between DSOs, and the market practice for issuing various types of DFAs is established. In the Agency’s view, regulatory and legislative changes aimed at developing DFAs and expanding their application scope will be implemented no earlier than 2025–2026. Ordinary DFAs certifying cash claims to issuers will most likely receive greater support from the regulator, while structural and hybrid DFAs will be regulated separately and remain available for qualified investors and, possibly, unqualified ones — subject to certain requirements for the credit quality of such instruments, as well as certain limits. Part of the regulatory framework applicable to the bond market is likely to be extended to DFAs, including provisions on the use of credit ratings. According to ACRA’s estimates, the maximum volume of the DFA market in the moderately optimistic scenario may reach RUB 500 bln on the three-year horizon, but this figure will depend on general economic factors, including interest rates and macroeconomic stability. Today, it is also difficult to judge how much the circle of DFA investors will differ from the composition of investors in the debt market and whether certain DFA types will become an alternative for those who prefer bank deposits.
