We’re thinking about tokenization all wrong

https://blockworks.co/news/tokenization-standards-finance-crypto

Ever wanted to invest in stocks like you invest in crypto? 

Asset tokenization is already making that a reality. 

No more physical certificates, no more middlemen. Just a few clicks, and you’re a shareholder. This is the promise of tokenization, giving us new ways to transact, store and distribute wealth.

Bank of China International (BOCI) recently became the first Chinese financial institution to launch a tokenized security — issuing 200 million yuan in fully digital structured notes. This is a significant step in bridging traditional securities and crypto. And this, it appears, is a mere taste of what’s to come. 

The tokenization market is poised to explode in the coming years. According to financial giants like Citi and research firms like Bernstein, the market could be worth up to $5 trillion by 2030. 

But many institutions are still failing to grasp its full potential. Yes, you can digitize certain assets and put them on the blockchain. And yes, this may yield some boost in efficiency. But that’s not enough.

Tokenization should be more than just creating digital twins of real-world assets. It also needs to be more about capturing and standardizing all financial aspects of these assets — from their intrinsic value to their potential risks.

Current practices often neglect these dimensions, resulting in incomplete digital representations that fail to leverage the full potential of blockchain technology. 

The pitfalls of current tokenization models

Current failures in tokenization are more a result of a lack of innovation than a lack of potential. Most platforms only digitize the underlying asset, but they neglect to include liabilities or cash flows associated with those assets.

In this context, cash flows describe the payment obligations of the parties: In other words, the expected inflows and outflows of money generated from the asset, like periodic payments from a bond or rents from a tokenized property. Liabilities, meanwhile, refer to any obligations or potential risks tied to the asset, such as debts or other obligations that could impact the asset’s value.

Despite their importance, these key aspects are often overlooked. As a result, you get an asset-backed token on a blockchain — but the terms and conditions are often attached as a PDF. 

This requires human intervention to calculate cash flows, which is a major concern as it allows errors and discrepancies to creep in. A similar lack of transparency and verifiability around cash flows was one of the primary triggers of the 2008 banking crisis. 

To avoid another such crisis, we must ensure liabilities and cash flows related to underlying assets are tokenized, machine-readable and machine-executable, not just the assets themselves.

Existing standards are critical to a tokenized future 

The typical tokenized financial product today is essentially a digital representation of a document — a contract turned into a token. The true innovation, however, is in developing “Smart Financial Contracts,” which signifies an interplay between a well-established standardization framework and blockchain technology.

To start, implementing open banking standards which allow banks to share their data in a secure, standardized way would make it easier to track liabilities and cash flow across different institutions.

By applying these standards to Smart Financial Contracts, we can ensure that details of the tokenized financial asset and all financial obligations are machine-readable and executable. 

Using such smart financial contracts will lead to higher information quality and transparency. Due to their machine-readable and executable nature, they can also lead to greater efficiency in price discovery, analysis, trading and securitization. As a result, company-wide risk management also becomes simpler and more effective.

Given that the entire system would be transparent and machine-auditable, systemic risk management becomes a realistic possibility. This makes it easy to stress test for different market scenarios, offering a clear view of potential vulnerabilities and helping us prevent future financial crises.

Smart financial contracts go beyond simply being technologically innovative. They are about designing a more secure, stable and efficient financial asset tokenization ecosystem where all stakeholders can transact with confidence.

With blockchain-based financial infrastructure, most of the management or transfer of these tokenized instruments can be done automatically on-chain. This reduces the need for human oversight and the risk of fraud or error.

The ACTUS (Algorithmic Contract Types Unified Standards) is a grouping of open standards to represent financial contracts. ACTUS is already helping standardize tokenization for smart financial contracts. Banks, regulators, accountants and tech firms can use the framework to analyze and report on financial stability and define terminology, algorithms and data models used to describe cash flow patterns.

Read more from our opinion section: You aren’t thinking hard enough about digital art

Designed to represent a wide range of financial instruments, ACTUS improves regulatory reporting across all sectors and streamlines financial operations at the enterprise level. It serves as a foundation not only for traditional finance instruments, but also for the growth and adoption of DeFi by building new products based on a widely accepted financial structure. When built into blockchain-based smart contracts, ACTUS could enable a mutually beneficial relationship between distributed ledger technology (DLT) and tokenization.

The primary objective of ACTUS in standardizing tokenization is to provide an algorithmic representation of financial agreements, cash flows and the current and future states of risk factors (market risk, counterparty risk, and behavioral risk) that’s intelligent, machine-readable and machine-executable.

With a standardized language and taxonomy in place, smart financial contracts can be easily incorporated into existing banking and financial infrastructure. This taxonomy needs to define the terms, conditions and parameters of each financial smart contract type and cover a wide range of financial instruments; This can ensure consistency and interoperability in the tokenized ecosystem.

The promise of blockchain technology

Blockchain is undoubtedly a game-changer and the most disruptive innovation in finance since the advent of computers in the banks in the 1960s. But innovation in payments is not the same as innovation in finance, and that’s where the potential of this groundbreaking technology lies.

Blockchain could redefine finance, making it transparent, efficient and low-cost. Funds could be verified without custodians, and cash flows could be demonstrated without audits. The logic of the financial contract can be embedded in the token making pricing discovery far more efficient.

SME lending could also be streamlined if we conducted proper due diligence — shifting the focus from paperwork to knowing the borrower. With securitization, credit was made accessible to more businesses. 

But tokenization must be standardized, with the cash flow logic embedded in a machine-readable and machine-executable way. Otherwise, we’re just replicating the old system. After all, blockchain isn’t just about making payments easier — it’s about transforming finance as a whole.



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How Crypto Tokenization Can Go Wrong (and How to Make It Right)

https://www.coindesk.com/consensus-magazine/2023/08/10/how-crypto-tokenization-can-go-wrong-and-how-to-make-it-right/

Money doesn’t make the world go round; credit does. Credit predates any known form of currency and was in use at least as far back as the ancient civilization of Sumer around the year 3500 B.C.E. In Sumer, citizens could get loans for agricultural purposes, later paying these back via a percentage of their crop. By comparison, the oldest coin-minting operation ever discovered only dates back as far as about 640 B.C.E.

Ralf Kubli is a board member at the Casper Association.

Credit is the true foundation of finance. Not money or individual payments, but payments over time, aka cash flows. Cash flows allow entities to predict future financial states and develop strategies based on that information, which is why it’s often regarded as the lifeblood of the world economy. But if this is the case, why is the move toward tokenization and digitization so focused on money?

The credit landscape today

Today, credit remains the foundation of all finance. However, we are also navigating unprecedented times. There is a credit crunch looming in the U.S. as the broader economic outlook worsens. As a result, fewer loans are being offered and those that are have become more conservative resulting in a $2 trillion gap of unmet demand for finance.

This disproportionately harms small and medium enterprises (SMEs), which are generally in the most need of financial support as they get off the ground.

Part of the cause behind this is that large capital providers struggle to conduct adequate due diligence and risk management for their SME debt, resulting in the lack of options for borrowers. Instead, these lending platforms only focus on high-quality borrowers, ignoring many SMEs, even though they could generally charge much higher interest rates.

The situation stems from the fact that capital providers are stuck in a catch-22 situation. To provide opportunities for securitization on a larger scale, lenders would need to work with higher-risk borrowers. This would inevitably lead to higher default rates, which most capital providers won’t tolerate. Subsequently, the overall volume of credit remains relatively small, leaving many borrowers out of luck.

Fortunately, there is a potential fix here. The rise of blockchain technology is reshaping how many companies trade their financial assets. Blockchains allow existing real world assets (RWA) and capital to be “tokenized,” i.e., representing certain assets, be they tangible, intangible or financial, on-chain as digital tokens.

It’s relative easy for intangible and financial assets to trade because they effectively already exist digitally. Physical assets are a bit trickier, because what does it mean to own a token representing a physical good? With the right definitions and architecture, however, it is by no means impossible to represent real world goods on a blockchain.

The world is on the cusp of a tokenization boom. The tokenization industry is projected to reach a valuation of $3-$5 trillion by 2030, with big names like JPMorgan and BlackRock already signaling their interest.

Real estate and equities are currently the predominant forms of tokenized assets, according to a recent report from Digital Asset Research. Among the 41 centralized finance organizations focused on RWAs the researchers considered, 26 have established their own tokenization markets and 30 of them facilitate RWA fractionalization.

And it’s no surprise. The benefits of tokenization include increased liquidity, faster settlement, lower costs and better risk management of financial assets. A massive shift in institutional tokenization could easily bring enough liquidity into the credit market to address the current shortcomings, which would be a major boon for SMEs and economic development in general.

Imagine that, crypto having a real world impact.

However, there’s a catch. Currently, most tokenization of financial assets is just that: digital representations of reserves held by companies. But that doesn’t paint the whole picture of an asset. It misses the granularities of how various assets actually exist, like their financial obligations, liabilities or cash flows.

In some cases, companies merely encrypt the hash of a PDF containing their “terms and conditions,” while tokenizing. Even if that contract properly defines the full balance of assets and liabilities, it still requires a human to read the document and calculate the underlying revenue potential.

Such lackluster efforts certainly do not bring any new efficiencies to the market, or take full advantage of the level of transparency and finality that the blockchain presents. Let’s avoid the path where financial institutions merely upload financial statements to the blockchain and rethink the quality and types of information financial asset tokenization can provide, which will inevitably rewrite the rules on credit.

Otherwise tokenization will only provide the level of transparency and trust as in existing markets—which haven’t truly improved since the informational deficits that drove the housing market boom and bust in the late 2000s. Do we really want to recreate the conditions that led to the Great Financial Crisis in age of crypto and using crypto?

To bring about all the benefits of tokenization and ensure we avoid another recession caused by bad debt and leverage, all tokenized financial assets need to not only digitize the asset itself but also define its underlying cash flows and liabilities as well.

Further, this information must be standardized — I suggest using tried and tested financial asset standards like ACTUS, which can be implemented at a code level. This incidentally would have the benefit of making the entire on-chain credit system interoperable. Smart contracts aren’t truly smart, but smart financial contracts with certain definitional standards for tokenized assets would enable cash flows and liabilities to become machine-readable as well as executable and auditable.

This will open up many possibilities. Most notably, it will greatly boost efficiency and transparency, inherently making the economy operate much more effectively. It will also unlock a tremendous amount of liquidity across a wide array of industries, but most importantly, for our purposes, it will bring a wave of available credit options that SMEs can tap into.

This stands to boost innovation while simultaneously minimizing the risk that future financial meltdowns can ever again rattle global markets.

All this is precisely why the finance industry needs to tokenize correctly, with standardized definitions and the complete representation of cash flows. Until we see this, blockchain technology won’t truly bring about any meaningful evolution in finance, and we will still be at risk of the ongoing contagion that spreads when businesses collapse.

Worst still, SMEs will continue to bear the brunt, as the institutions that survive will only become more restrictive with their loans. If we want finance to truly enter the 21st century in a healthy way, thoughtful, standardized tokenization is the answer.

How standardized smart financial contracts could prevent crypto’s next black swan

https://forkast.news/how-standarized-smart-financial-contracts-could-prevent-web3s-next-black-swan/

At this point, most people are familiar with the collapse of cryptocurrency exchange FTX, but it is just the latest in a long line of “black swan” events that could have — and should have — been avoided. Mt. Gox, Quadriga CX, Three Arrows Capital, Celsius Network, Voyager, BlockFi, the list of hacks, fraud and resulting contagion goes on. Clearly, new practices are necessary to combat events like these from happening again. 

Regulators may need to step in to provide clearer guidance on cryptocurrency assets. But while regulatory clarity is essential, more is needed. 

This is especially true with the growing shift towards tokenization. Businesses that staffed up during last year’s crypto boom have faltered amid an uncertain regulatory landscape. Now, with regulators circling, many firms are opting for a relatively well-trodden and regulated route of tokenization. 

However, most current tokenization platforms have grave shortcomings. Some simply digitize the paper prospectus and hash it into the token. Others only tokenize the asset side and forget about the liability. Typically, a token gets created and has a PDF embedded that defines the terms and conditions without a liability side and without a clear definition of the underlying cash flows. This means that tokenized assets — designed to be more efficient and automated — still require human intervention to calculate cash flows, which requires reconciliation efforts and introduces discrepancies. This means we are still dealing with the same lack of transparency and verifiability around cash flows, one of the primary triggers of the 2008 great financial crisis.

The key to avoiding another crisis is ensuring that liabilities and cash flows related to financial assets are defined with machine-readable, machine-executable, and — perhaps most importantly — standardized data models and algorithms. This can be achieved by implementing open banking standards and introducing “smart financial contracts” that define the logic of the financial instrument in a token, that can be read and executed automatically and without error.

Building better contracts

The smart contracts that define tokenized financial assets need to describe the underlying obligations of the counterparties. In doing so, they become smart financial contracts. All parties who have a right to see the token, can then ascertain the current state and discover future expected cash flows with certainty. In the distributed ledger technology and blockchain-based financial infrastructure of the future, fulfillment or transference of these instruments can be largely automated on-chain. This can remove the need for human oversight and can eliminate the possibility of fraud or error.

Fortunately, standards already exist that can address these concerns, specifically, the standards outlined by the Algorithmic Contract Types Universal Standards (ACTUS) Research Foundation, a U.S.-based non-profit organization. ACTUS was established in the wake of the 2008 financial crisis to create clarity around the cash-flow patterns of financial instruments that were based on collateralization. The solution was an open-source standard that any business could use.

Traditionally, financial contracts acted as agreements between counterparties to exchange cash flows. However, these contracts were always written by humans (usually lawyers) and for humans (also usually lawyers), thereby introducing room for interpretation and clouding the fact that a financial contract indeed is algorithmic in nature. As one lawyer recently put it: “If you can not show me the calculation, then we do not have a financial contract.” ACTUS addressed this by deploying a global standard for the consistent algorithmic representation of all financial instruments. These algorithms focus on the cash-flow obligations of a given contract, not specific legal jurisdictions or terminology. This is possible because, in practice, all financial instruments can be built on a standardized data model and a translatable set of underlying cash-flow patterns.

Combining ACTUS with blockchain results in smart financial contracts. Such smart financial contracts as part of tokenized financial instruments and digital transaction rails would enable a much more efficient system for all parties — one that provides transparency and auditability. Better yet, this system can be implemented across all financial assets regardless of the infrastructure on which they live. This means that critical problems within the financial system such as reconciliation, systemic risk and regulation can be efficiently addressed. Reports on risk exposure can be generated with greater frequency and automatically in moments rather than slowly compiled over weeks by a team of analysts and accountants. 

The on-chain transparency of such a system would make it impossible for financial firms to hide massive shortcomings in liquidity. It would be relatively trivial for them to provide a verifiable audit of their complete balance of all assets and liabilities, and everyone could be independently confirmed by their counterparties. Given how simple it would be, any refusal to implement such a system could be seen as a major red flag for regulators and investors alike and could even be made illegal through legislation.

Beyond the next black swan

Digitally native financial contracts built on the ACTUS standard could be implemented into the architecture of any financial institution. For example, JPMorgan recently launched a pilot program to explore asset tokenization in Singapore. While it is currently exploratory, JPMorgan will need to adopt standardization and smart financial contracts if it is to provide real-time risk modeling and stay in line with regulations. 

While the benefits to trade finance and financial enterprises are clear, it doesn’t stop there. 

One of the biggest challenges in many economies is the availability of working capital for small and medium-sized companies. Factoring of payables of governments, government-owned entities and large companies that are outstanding to private companies, can be one of the key elements to inject liquidity on scale into local economies.  

Tokenized financial assets will enable liquidity and new forms of financing for critical parts of the economy, especially where established financial players have been unable to meet the financing needs due to their high-cost structures.  

Other industries, such as energy, telecommunications, healthcare and many others could see similar improvements in efficiency and transparency. The bottom line is, combining tokenization with clearly defined standards, like ACTUS, can bring a new level of efficiency, transparency and legitimacy to finance and businesses. This is essential if we want a future that deters otherwise preventable black swan events, but the upsides don’t stop there. Virtually all walks of life stand to be improved by embracing a clearly defined future for digital, blockchain-powered transactions.