But perhaps most importantly, market participants now realise that developing this technology to completely revolutionise existing systems will only hinder its development. Rather, they are working to improve existing constructs to bring tokenisation to life.
Bringing tokenisation to life
The great benefits of tokenisation within market infrastructure are slowly starting to come to life.
A better understanding of what Distributed Ledger Technology (DLT) can do is pervading the financial ecosystem, as real life user cases – both in terms of deals done and new process – show the full potential of this technology.
The pace of change in recent years has been rapid. “We have come a long, long way in the last three years,” says Michael Coletta, Senior Manager, Emerging Technology Strategy and Development at the London Stock Exchange Group. “We now know that this technology allows us to unbundle the centralised, linear process of before.”
For Coletta, a key shift in the market’s understanding of DLT and tokenisation is that it can be used to fundamentally improve existing structures rather than trying to radically overhaul them. “We are building automation around the legal constructs of title and ownership,” he says. “A token is the exact same thing as before, except that transactions are decentralised and there is one centralised governance framework.”
For the post-trade environment this has huge implications that are no longer just theoretical. “DLT allows you to essentially transact without any settlement risk,” says Romain Dumas, Managing Director at Credit Suisse in London. In May 2018, Credit Suisse and ING undertook a trade that showed how this could be done. They swapped baskets of securities with a value of EUR 25 million using the HQLAX blockchain-based collateral lending application.
During the transaction, the two banks agreed to transfer legal ownership of Dutch and German government securities on the platform using HQLAX Digital Collateral Records (DCRs) while the underlying securities remained static within unique DCR-linked custody accounts held by Credit Suisse and ING at Credit Suisse (Switzerland) Ltd. “As there is no delivery versus payment, there is no settlement risk,” says Dumas. “It is a unique solution.”
As well as radically de-risking the post-trade environment, DLT can also benefit the primary markets. This was shown in another ground breaking transaction undertaken in August 2018 by the World Bank in Australia. Called Project Bond-i, the World Bank raised some A USD 110 million from seven institutional investors for a two year issue. This was the world’s first bond to be created, allocated, transferred and managed through its life cycle using DLT.
“This transaction shows the potential for the technology to collapse some registry, depository and custody functions, and perhaps increase efficiency,” says Paul Snaith, Head of Treasury Operations for Capital Markets at the World Bank in Washington DC.
Despite the success of this bond issue, there’s much still to be learned before tokenisation has a greater influence in financial market infrastructure, including in regard to regulations. For example, one of the institutional investors chose to not participate in the bond deal because it would mean holding the token directly, as opposed to in a custody account, requiring further study of reporting obligations under those circumstances.
Nevertheless, consensus is emerging that the most promising way to increase usage of DLT is to weave its benefits into existing standards and procedures, rather than try to create new regimes and new silos of information. One proponent of this policy of evolution instead of revolution is Charlie Berman, a 40-year veteran of the international debt capital markets. Since leaving banking he has set up a new firm called Agora Digital Capital Markets that uses DLT to digitise the end-to-end life cycle of a bond. This will reduce the prevalence of manual inputs in a traditional DCM transaction, greatly reducing human error and the need for reconciliations. “Everything we do is anchored in the real world,” he says. “You cannot expect to just take out the existing market infrastructure players. It is not about taking people out of the process. For DLT to be successful you need the reverse of silos.”
This view is echoed by those who are most active in the markets. “It is essential that market infrastructures such as central securities depositories are not disturbed or disrupted as they are good for everyone,” says Snaith at the World Bank. Others agree that if tokenisation can be centralised, it will enhance its applicability. “You need a central bank or a CSD to make this all work,” says Coletta. “The direction of travel is that we need to integrate with existing market infrastructure players.”
DLT developers are working away in nearly every corner of the global financial markets, trying to adapt the emerging technology stack to the business and user cases. Some areas stand out as being particularly ripe for tokenisation. Snaith at the World Bank believe one such is the OTC swap market. “All the OTC swap terms could be embedded on a blockchain and you will see a host of efficiencies,” he says.
Tokenisation could also help market players meet their increasingly demanding compliance obligations, which would, in turn, help the regulators. One such area is the upcoming Securities Financing Transaction Regulation (SFTR), which is going to radically change the securities lending business with its new transaction reporting burden. “With SFTR reporting, the regulators are imposing a specific messaging data standard and format”, says Richard Hay, UK Head of Fintech at law firm Linklaters in London. “Blockchain could be an alternative tool to allow market practitioners to achieve real consistency of data in this area”.
The key element to bring tokenisation to life will therefore be the degree to which all the differing DLT projects underway around the world become interoperable. The systems will need to talk to each other, recognise each other’s data and market participants will have to trust that this works. But, the end result will be dramatic. When regulators can see real time, complete data on a whole range of transactions, when settlement becomes automatic and when all market processes become seamlessly verifiable and trustworthy, then the DLT evolution will have become a revolution.