Truly Smart Financial Assets — Larry’s last Lego Block
It is easy to agree with Larry Fink. And somewhat “cheap” to harvest attention on social media when sounding the alarm bell around the tokenization narrative of the most successful financial services firm ever to exist. However, the implications of this technology on finance are so profound that a more in depth discussion is warranted.
Let’s consider the key points of Larry Fink in the Bloomberg TV interview and explore the respective implications. There is an entire preceding thought process by Larry Fink and Blackrock, which underpins each statement with respect to the functionality of shared ledgers, bearer instruments, efficiency and reconciliation (see links below to go down the rabbit hole of blockchain, tokenization, financial contracts).
Larry Fink’s key statements
In order to better connect the narrative and its implications, I have reordered the sequence of the statements made by Mr. Fink to illustrate how he sees the evolution of the global capital markets [added text for clarity in brackets]:
“Tokenization of Financial Assets [is a] technological transformation for financial assets [it will allow to] customize strategies through tokenization for every individual [and any investor. Blackrock will be] curating performance products [and] everything will be ETF’d”.
The impact on key players in the capital markets is going to be profound. Some are preparing well and are getting ready for the future (Franklin Templeton, Fidelity, KKR, Apollo). The straddlers seemingly completely missing the power of shared ledgers and characteristics of bearer instruments secured with private keys, will see their balance sheets shrink and lose the ability to compete in short order. The iPhone moment in Finance is very, very close.
Dumb tokens: The biggest threat in Finance
However, there is one key ingredient missing for Blackrock and other leaders in the industry to deliver this step change in the functionality of tokenized financial assets. In my opinion, the biggest threat to the financial system are dumb tokens. Without standardized machine readable and machine executable Smart Financial Contracts, the promise of the transformation of financial systems for the better can not be delivered.
Industry and technology leaders must first understand that a definition of the payment obligations to the parties, i.e. the logic of the underlying financial contract MUST BE included in the token when tokenizing a financial asset. Unless this logic is available in standardized, machine readable and machine executable form, asset interoperability, (nearly automated) reconciliation, efficient securitization, and the required analysis and risk management will not be possible.
Innovation is built on Smart Financial Contracts
The crucial component of finance is the financial contract. These financial contracts are agreements that the parties arrange among themselves with the purpose to exchange future payments or cash flows. These exchanges of payments follow well defined, universally applicable algorithms. The payments can be represented entirely by pure numbers, e.g. dollars, euros, francs, or bitcoin.
Although currently written in plain English, the cash flow obligations of all financial contracts can be fully and accurately represented by machine-executable code. Financial contracts are mathematical in nature.
Financial contracts can therefore be presented in digital form — in fact, this is the ideal scenario since they are completely and exclusively in digital form. The good news here is that financial contracts are much easier to categorize and understand than is commonly assumed.
Since financial contracts are by their nature digital, algorithmic and standardized, they can be optimally processed by machines. By defining attributes and algorithms for financial contracts, real innovations are possible again in traditional finance. Today’s chaos in the financial sector can only be overcome by putting the standardized algorithmic financial contract into the centre of any architecture.
Blockchain technology can only prevail with the same core architecture: real digitization of cash flows on which financial instruments are based. Standardized, machine readable and machine executable algorithms are indispensable for this new technology to compete with the established institutions in the financial sector
The ACTUS Standard as the solution
The ACTUS standard (Algorithmic Contract Type Unified Standard) defines terminology, algorithms, and data models to describe these patterns of cash flows.
This enables fully consistent digital processing of financial contracts in life-cycle management and analysis. The focus of this classification scheme is an intelligent, machine-readable, and machine-executable algorithmic representation of all legal financial agreements as well as a strict separation of the known from the unknown.
The legal agreements and, if applicable, the current status of risk factors (for example, with a view to the slope of the interest rate curve or the exchange rate of a currency) are known.
The unknowns are the future states of these risk factors; especially when it comes to market risk, counterparty risk, and behavioral risk.
Resources — Links
Larry Fink on tokenization — Technological transformation for financial assets: https://www.youtube.com/watch?v=HTveRlW7QPo
Introduction to Financial Contracts: https://www.nasdaq.com/articles/smart-financial-contracts-should-be-basis-for-innovation-of-financial-systems
The Actus Standard — Wikipedia article: https://en.wikipedia.org/wiki/Algorithmic_Contract_Types_Unified_Standards
How to avoid Disaster in Tokenization: https://www.youtube.com/watch?v=nMmxZYBf0Vg
The current problems in Tokenization and the Future of Capital Markets: https://www.globalinvestorgroup.com/articles/3698016/blockchain-and-the-future-of-the-capital-markets
Silicon Valley Bank Failure Reconstruction — What a Finance, Risk and Regulatory Functions could have seen with ACTUS: https://youtu.be/1OxFWdxF0LE?feature=shared
