Can Britain move decentralised exchanges into the mainstream?

The still-nascent market for tokenisation and decentralised exchanges received a boost in November, when the UK Government announced plans to issue digital versions of its bonds.

Chancellor of the Exchequer Rachel Reeves said in her Mansion House speech on that the Government was planning to issue a ‘digital gilt instrument’ (DIGIT).

Economic Secretary to the Treasury Tulip Siddiq later explained that a pilot issuance will take place in the Digital Securities Sandbox, which the Bank of England and the Financial Conduct Authority launched in September.

This sandbox offers a controlled environment for firms and others to create, trade and settle securities using distributed ledgers.

Speaking at the Tokenisation Summit in London, Siddiq said the DIGIT plan was part of the Government’s aim to make the UK “a global hub for securities tokenisation”.

If it goes ahead, Britain could become the first major economy to issue government debt on a decentralised exchange. And it could help to bring the technology further into the mainstream.

How token trading can revolutionise DEX

To date, cryptoassets are the only thing traded at volume on decentralised exchanges. But there is no reason why the market should be so limited. In theory, any asset can be traded on such a platform although, before that can happen, it first needs to be tokenised.

This process of splitting an asset into many smaller parts which can be bought and sold is similar to the way a company’s ownership can be divided into shares and traded on a traditional stock market.

Tokenisation is simply a way of creating a digital representation of a real asset. Stablecoins, for example, are a token of a real-world currency, typically the US dollar.

In principle, anything can be tokenised. In the future, we might see other financial assets like stocks or exchange traded funds being tokenised.

Some large US asset managers such as BlackRock and Fidelity International already run tokenised money market funds on public blockchains.

Such instruments typically invest in short-term US Treasury bills and other low-risk, interest-bearing securities.

The idea could be extended to cover physical assets too, and could be particularly useful for high value items such as real estate or art, where the existing market can often be illiquid.

The lower unit cost of a token means barriers to entry fall away and many more investors can get involved.

It could also apply to business loans. At the moment, if a company wants to borrow, say, £100,000 it has little choice but to go to a bank.

But if the corporate loan market was fractionalised, the debt could be split into many smaller pieces and attract a wider range of lenders – meaning companies would have a much bigger potential pool of investors to tap into.

There are other advantages too, beyond liquidity, not least the higher security that a decentralised system offers.

Under the digital model, a user retains control of an asset until it is sold, rather than having to hand custody over to an exchange or other intermediary.

Can DEX make trading quicker and safer?

For well-regulated exchanges that is not usually a problem but, as the debacle at the failed cryptocurrency exchange FTX showed, that situation is open to abuse if the proper safeguards aren’t in place.

On the security front, it is also much more complicated to hack a decentralised system which sits on numerous servers around the world, than to target the infrastructure of a traditional exchange.

Digital platforms could also offer far speedier settlement. This is particularly useful in volatile market conditions – such as when interest rates are high or asset prices are prone to large swings.

It would certainly be a notable improvement on the existing system, where settlement on major stock markets is usually T+2, meaning it takes two business days for a transaction to be completed.

In the 21^st century there’s no reason for such a slow process. With everything becoming digitised and computerised, we should aim for far quicker settlements.

At the moment, the idea of simultaneous payment and transfer of ownership – sometimes called ‘atomic settlement’ – can only really be achieved using stablecoins.

But in the future this role could also be fulfilled by tokenised versions of central bank or commercial bank money.

On top of all this, the blockchain operates on a 24/7 basis and many elements can be automated, such as the payment of bond coupons or company dividends – meaning activity does not need to stop at the end of a business day. Cross-border trading is also far simpler.

What are the obstacles facing decentralised exchanges?

However, there are also plenty of challenges when it comes to decentralised exchanges and tokenisation, particularly when the market is still at such an early stage.

In an ideal world, everything would be traded in one place to maximise liquidity. But as the decentralised platforms grow, there is the danger of so-called liquidity fragmentation, when assets are partly traded on decentralised exchanges and partly on traditional exchanges.

In addition, blockchains are not free. Users must pay ‘gas fees’, which can be costly, particularly at times of high activity. There is a trade-off here, with greater security coming with higher costs.

There is also the fundamental issue of regulation. For fractionalisation and tokenisation to take off, you need to have a large degree of trust in the system. But currently it's not clear what should be regulated and who will step in to do that.

The European Union is leading the way on this with its Markets in Crypto-Assets (MiCA) regulation, which came into effect at the end of 2024. The US is lagging behind, while the UK is somewhere in between.

Everywhere though, regulators are moving quite slowly, so it is unlikely that the market will take off any time soon.

Many investors will be understandably wary of committing funds to a still poorly-understood system. Even so, the direction of travel seems clear and momentum is building.

This article was first published by Finextra as part of its series of insight articles by academics at the Gillmore Centre for Financial Technology at Warwick Business School.

Further reading:

How decentralised should DeFi platforms be?

What does DeFi need to go mainstream?

Why AI could transform peer-to-peer lending for investors

How stablecoins will impact foreign exchange markets

Olga Klein is Assistant Professor of Finance and a member of the Gillmore Centre for Financial Technology. She teaches Investment Management on the Undergraduate programme. 

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