Hello World — Wholesale CBDC, e-ID, Onboarding!
Preface
After involving in blockchain for 7 years, I think I’ve developped a strange synchronicity with the market. While I was almost finishing with this article, ECB announced that they are ready for the preparation phase for digital euro (retail CBDC) last week.
I felt it’s urgent to learn. In the past month, I’ve been studying over 1000 pages of documents from regulators, central banks, and market participants, also interviewed 2 platforms that tokenized private assets. It requires me to perceive blockchain, economic and finance knowledge as a whole. When it comes to digital world, the technical contents are impossible to avoid. I tried to extract and summarize the key points that may influence our understanding of future investment system. Hope it helps people to learn this subject in a more intuitive way.
Bitcoin was introduced in 2009 right after the sub-prime crises, since then, the new world was ready to update into its new infrastructure. Recently, tokenization of RWA (Real World Asset) has becoming a new hype. It uses distributed ledger technology (DLT) to fractionize ownership. These tokens can be representations of traditional tangible assets (such as real estate, commodities, artworks), financial assets (equities, bonds), etc. You may heard these noises in blockchain event: You can be the owner of part of a Rolex! Part of a Picasso painting! Part of vintage Porsche! However, while tokenising physical assets still face many obstacles, tokenising financial assets would be more crucial and realistic, and it will be eventually connected to the new fiat money system — CBDC.
I would analogise Tokenization as a christmas gift that is delivered by Santa. Once upon a time, Santa rode reindeer sleigh for 2 days (T+2) to deliever a teddy bear under your Christmas tree (settlement), even no wrapping paper for the gift. Then your parents will put it directly in your Christmas socks while you are sleeping. Nowadays, Santa bought a Tesla, so he can deliver the teddy bear directly it in your socks in the same day (T+0)! However, All the conditions of how you use the gift are written on a beautiful wrapping paper (tokenize) with Santa’s language (smart contract), he stipulates that you can only hug the bear in weekend (programmable). Your parents’s (financial intermediaries) responsibility is only to make socks (open wallet) and embroider your picture and name on the socks (KYC).
On the technical side, I would say that the main changes are the faster settlement process (DLT), programmable token (smart contract), and privacy designs (permissioned/permissionless blockchain).
On the financial side, understanding the main underlying assets is important. Fixed income is an instrument rather simple, transparent, and less volatile — common examples such as government and corporate bonds; However, Private assets is obviously more sophisticated, as the information is uaually more asymmetric compared to public market. Investors are supposed to have good sensitivity of the market, enough in-depth knowledge of a specific industry, understanding the due diligence documents, etc. Personally, I would not invest in a VC fund before speaking to the fund manager in person. Without a certain level of training, it could be challenging for general public makes proper investment decisions. For the moment, nearly all the toeknization asset platforms only accept accedited investors, even if the minimum ticket lowered down to $5000. The head of CAIA also expressed his concerns in his article: Democratization Without Education. Can we have Alpha and scalability at the same time?
This also alerts the Financial Advisor/CGP community to be better trained in blockchain and alternative investment field. In France, I think the education of these subject are far from sufficient. Moreover, the professionals should demand regulation to be more transparent with the underlying assets, individual investors should examine the quality and sutability of a financial instrument before giving in their personal information.
After all, fear and greed never fails financial market. Eden garden’s story never changed. With the veil of cryptography, things could be more wild. Be well prepared!
Main Subjects
Basics
- What is Tokenization?
- Why it comes to financial assets first?
- Why it’s about wholesale CBDC?
- Tokenisation Infrastructure (DLT, Blockchain, token standard, etc)
- KYC/AML & Digital ID
Fractionalized asset classes (Fixed income, Private Equity)
Tokenized fund investment platforms (Interview)
Historically, Token money is a form of money which represents a greater value than its intrinsic value. In Ancient Greece and the Roman Empire, copper coins were used for small transactions and were issued a monetary value greater than the value of the metal itself. This established the principle of token money, which is the nature of coinage in contemporary society. [1] From the hand-made coinage from 500BC, to machine coinage and paper money, until digital currency nowadays, the cost of producing token money diminished through out the time. That is to say, the sovereign credit that backs the value of the token money is the only grass that we can grasp.
Tokenisation of Real World Asset — Does it mean that we are on our way of adopting a new digital version of token money?
What is Tokenization?
Tokenisation refers to the process of generating a digital representation (token) of traditional assets on a programmable platform (distributed ledger) (FSB (2023)). [3] Another similar definition by HSBC — Assets are issued as tokens (programmable assets) on the network based on smart contracts. [4]
The information stored in tokenised form can include asset type, ownership details, valuation, legal framework, optionality, and settlement requirements, etc. [5]
Why it comes to financial assets first?
Tokenisation will be considerably more challenging in cases such as real estate and arts, as it involves complex legal framework, manual procedure, and less autonomous tokens. On the other hand, the assets in digital already such as financial assets, mostly automated systems with streamlined processes, and clear legal and regulatory frameworks. These assets will be more amenable to tokenisation. [3]
Why it’s about wholesale CBDC?
The whole financial market infrastructures is changing towards on-chain direction. If assets were issued or represented on a DLT platform, then issuance, trading, clearing, settlement, asset servicing and custody may also need to change. [7] A wholesale CBDC (wCBDC) is a CBDC available to commercial banks and other licenced financial institutions, which means they could be avaliable to a much wider range of intermediaries. It could represent a claim, either on a specific issuer or on underlying assets or funds, or some other right or interest. [8][9]
On 28 April 2023, the European Central Bank (ECB) also announced exploratory work on the settlement of tokenised financial assets in central bank money, which could begin as early as 2024. The aim of this exploratory work is to test different wholesale CBDC solutions, including DLT-based ones. [6]
Tokenization Infrastructure
The process of tokenisation contains three key elements: assets, ledgers and tokens. [3]
Assets — resources with inherent economic value owned by an individual or an organisation.
Ledgers — record information about ownership. “Programmable ledger (platform)” executes pre-agreed transaction standard such as fund transfers, locking of assets as collateral, etc. (Graph 1)
Tokens — Digital assets comply with the platform’s standards and the rules of its smart contracts. (Graph2)
- Core layer contains the information to uniquely identify and define the asset and its owner.
- Service layer specifies the rules and logic governing a token’s use on the platform (eg in smart contracts).
Tokenisation is the process of recording claims on real or financial assets that exist on a traditional ledger onto a programmable platform.
Programmability — the ability to embed code in the token, and the ability of the token to engage with smart contracts — enabling higher degrees of automation.
More about technical terms
1. What is Distributed Ledger Technology (DLT)?
It is the consensus of replicated, shared, and synchronized digital data that is geographically spread (distributed) across many sites, countries, or institutions. A distributed ledger requires a peer-to-peer (P2P) computer network and consensus algorithms so that the ledger is reliably replicated across distributed computer nodes (servers, clients, etc.). [10]
2. What’s the relationship between blockchain and DLT?
Blockchain (linear data structure) is the most common type of DLT. Other types of DLT include directed acyclic graph (DAG) and hybrid data structures. [10]
3. What is permissioned and permissionless DLT ? — About privacy
- Permissioned DLT: a form of DLT whereby only a pre-defined group of trusted institutions can act as a validating node, only select users that meet eligibility requirements can obtain access.. Ex: permissioned version of Ethereum (Hyperledger Besu), which was used for testing cross-boarder CBDC transactions by Project Mariana. [9][11]
- Permissionless DLT: a form of DLT where any participant can act as a validating node, members ca freely join the network and participant the consensus, and it provides a certain level of anonymity. .Ex: Bitcoin, Ethereum. Permissionless is incompatible with a system based on real names. [11][12]
Since the decentralisation has to be accomplished using real names, rather than using private keys as in cryptocurrencies, safeguarding privacy is an essential design element. Achieving both goals — of respecting privacy while using real names — can be accomplished by using public key cryptography.
Hence, wCBDC will be built on decentralisation and permissioned DLT. This has raised privacy concerns. Cryptographic techniques such as zero-knowledge proofs (ZKP) as a solution has been explored. [11] But clearly it will against fully anonymous accounts.
4. Token Standardisation- ERC-3643
Luxmburg based tokenize platform, Tokeny, proposed T-REX Token for Regulated Exchanges. It is designed for transfer security tokens. Basicly it’s ERC-20 (ERC-20 makes each Token be exactly the same as another Token) token works in conjunction with an onchain identity system that allows regulation and compliance checks. [13]
5. e-ID — KYC/AML
In order to engage trading on the plateform, investors have to go through rigorous KYC process, by uploading passport, electricity bill, biometrical info, etc. Such process is called“onboarding”.
Singapore government explains what is Digital ID and e-KYC: It is mainly used for On-boarding of new customers, Authentication of customers, Digital authorisations and signatures.
An e-ID system is also developed in Europe — European Digital Identity Wallets . In 2018, European Commission studied on eID and digital on-boarding. In 2021, ECB experimented integrating the Estonian and Spanish eID systems and certificates with the CBDC system and exchanging €-CBDC tokens in peer-to-peer transactions both within one single jurisdiction and across two EU countries. [14]
Financial Asset Classes on tokenization platforms
I. Fixed income
1. Experiments — French Government bonds:
In 2021, A consortium of banks led by Euroclear was selected to assess the potential of post-trade capital market settlement operations in CBDC for French Sovereign Debt Securities (real OAT ISINs issued in 2017). [15]
Bank de France managed the CBDC process by making available a permissioned blockchain platform — “DL3S” (Distributed Ledger for Securities Settlement System).
The test inclueds primary/secondary market issue/distribution, auto-collateral, coupon payment, etc.
Here we see details for coupon payment as it is more related to end user. The fixed rate coupons was handled by smart contracts. The payment of the coupon went from the AFT (the public Debt Management Office of the French government) CBDC wallet straight to the CBDC wallets of the OAT holders, without transiting via the CBDC wallet of the CSD (Central securities depository) or other intermediaries.
New system: Bond Issuer CBDC Wallet — Bond holder CBDC Wallet
Old system: Bond Issuer account— CSD — Bond holder cash account
In late 2021, HSBC also executed its experiments with the Banque de France using a wholesale central bank digital currency (CBDC) to settle digital bond transactions.
2. Backed Finance (coinbase): US short term treasury bond
In October 2023, Backed’s bIB01 crypto token issued under the Swiss tokenized securities law. It is a blockchain-based version of BlackRock’s short-term U.S. Treasuries exchange-traded fund (ETF). The underlying assets is iShares $ Treasury Bond 0–1yr UCITS ETF. Till September 2023, the ETF’s YTD is 4.4% (also tradable in public market). The product is denominated in Swiss Francs. The Underlying base currency is US Dollar. (KID) [16]
3. Goldman Sachs & HSBC: European Investment Bank Bond
In 2022, The €100 million, two-year bond was issued, recorded and settled using private blockchain-based technology (BIS Project Venus), and represents the inaugural issuance on Goldman Sachs’ tokenisation platform — GS DAP™ , with anual Coupon of 2.507%. [17] It is removed the need for a CSD and sharply reduced the settlement time. [18]
In February 2023, EIB issues £50m GBP tokenised bond using HSBC Orion tokenization platform, for registration and issuance under Luxembourg law.
II. Private Equity
1. ADDX (Singapore)
Private market exchange ADDX is the first financial institution in Singapore to recognise cryptocurrency assets for the purposes of onboarding accredited investors. The platform reduces minimum investment sizes from USD 1 million to USD 20,000. ADDX is backed by the Singapore Exchange (SGX), and is regulated by the Monetary Authority of Singapore (MAS) as a digital securities exchange. [19]
2. Securitize (US)
Securitize is the only SEC Registered Transfer Agent integrated with multiple regulated US-based marketplaces with a working protocol and live issuers. The company also offers KYC/AML and capital management services. [20]
Interview: I interviewed ADDX and Securitze as a financial advisor. Here are my findings and comparison:
1. Transparency: Overall, Securitze has better customer-service, they are more openly share the information of their funds. With ADDX, the retail investors can’t view the funds details before completing the rigorous KYC process, while financial advisors have to sign a confidential agreement to receive the funds materials. Both customer services are CFA practicioner.
2. Wallet: Securitize adopts web3 wallets such as Metamask, coinbase, and walletconnect. Investors could also open a “whitelable wallet” directly on their platform. However, They were not able to answer the question of “how can Metamask wallet and KYC exist at the same time, as one is anonymous one is not?” On the other hand, ADDX will open the wallet directly from their platform. Interestingly, they compared the tokenized funds as asset-backed stablecoin.
3. Funding process: ADDX could be funded directly with Singapore local banks; Securitize only accepts wire-transfer. Both of the platforms has to fund/defund by wire-transfer for overseas investors. This has no different than traditional PE/VC funding process, which is surprisingly heavy human-driven process.
4. Funds quality: Both platforms emphasis their predigious PE funds as selling point — ADDX tokenized Partners Group Global Value SICAV (was launched in 2007 and totals €5.5 billion). Investors could access the fund with minimum ticket size of $10,000 rather than the typical $100,000 minimum; Securitize carries KKR Health Care Growth II Securitize Fund, which was managed by Securitized Captial Feeder Fund, and deployed on Avalanche blockchain. It has a minimum ticket size of $100,000. Both of platforms also carry private debt funds.
5. Atypique Alternatives: ADDX carries a French wine portfolio; Securitize made available a tokenized art fund from Artory and Winston Art Group. The $25 million closed-end fund is actively managed and is on the Polygon blockchain.
5. Liquity: Theoretically, the tokens could be liquidated on the secondary market but the counterparty has to be in the market as well; the NAV will be caudated by professional accountant.
In Europe, we didn’t find similiar investment platforms like ADDX and Securitize. There are tokenization infrustructure providers such as Luxumberg based Tokeny. In terms of legal frameworks, Switzerland, Luxembourg, France and Germany are the most favorable European destinations . Both the UK and the EU are launching DLT sandboxes to potentially update laws. [21] In 2023, Euroclear aquired fund administration platform Goji, That may potentially lead to broader tokenization for the private market funds in EU. [22]
Final thoughts
Some web3 projects such as Hedera is exploring tokenization with other interesting DLTs such as hashgraph. We would pay attention to its further development, expecially the degree of the centralization between different solutions.
Rail CBDC and Wholesale CBDC would be eventually merge in the end user’s wallet with different form. (token money/token security) We would follow closely with the upcoming reports from the regulators.
Reference
[1] Tokenization: A digital-asset déjà vu https://www.mckinsey.com/industries/financial-services/our-insights/tokenization-a-digital-asset-deja-vu#/
[2] Token money https://en.wikipedia.org/wiki/Token_money
[3] BIS: The tokenisation continuum https://www.bis.org/publ/bisbull72.pdf
[4] HSBC: The 10x potential of tokenisation https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=&ved=2ahUKEwjzmc7O_v-BAxUXQ6QEHU8VBX8QFnoECAsQAQ&url=https%3A%2F%2Fwww.gbm.hsbc.com%2F-%2Fmedia%2Fgbm%2Finsights%2Fattachments%2Fpotential-of-tokenisation.pdf&usg=AOvVaw3txggcPoyig2CJV_2IzYQH&opi=89978449
[5] The Financial Stability Risks of Decentralised Finance https://www.fsb.org/wp-content/uploads/P160223.pdf
[6] Bank de France: Wholesale central bank digital currency https://www.banque-france.fr/en/financial-stability/financial-stability-mandate/supporting-digital-transformation-financial-sector/wholesale-mnbc
[7] BIS: projects Helvetia https://www.bis.org/publ/othp35.pdf
[8] BIS: Wholesale digital tokens: https://www.bis.org/cpmi/publ/d190.pdf
[9] Project Mariana: Cross-border exchange of wholesale CBDCs using automated market-makers: https://www.bis.org/publ/othp75.pdf
[10] Distributed Ledger https://en.wikipedia.org/wiki/Distributed_ledger
[11] BIS annuel economic report III. The future monetary system https://www.bis.org/publ/arpdf/ar2022e3.pdf
[12] Distributed Ledger Technology (DLT) — A Primer https://www.youtube.com/watch?v=VWAHxi9XAnA
[13] ERC-3643: T-REX — Token for Regulated EXchanges https://eips.ethereum.org/EIPS/eip-3643
[14] Work stream 3: A New Solution — Blockchain & eID https://www.ecb.europa.eu/paym/digital_euro/investigation/profuse/shared/files/deexp/ecb.deexp211011_3.en.pdf
[15] Experimenting settlement of French government bonds in Central Bank Digital Currency with blockchain technology https://www.euroclear.com/content/dam/euroclear/news%20&%20insights/Format/Whitepapers-Reports/settlement-french-government%20bonds-in-cbdc-with-blockchain.pdf
[16] Tokenized U.S. Treasuries Arrive on Coinbase’s Base with Backed’s RWA Token Issuance https://www.coindesk.com/business/2023/10/06/tokenized-us-treasuries-arrive-on-coinbases-base-with-backeds-rwa-token-issuance/
[17] EIB innovates further with Project Venus, the first euro-denominated digital bond on a private blockchain https://www.eib.org/en/press/all/2022-448-eib-innovates-further-with-project-venus-the-first-euro-denominated-digital-bond-on-a-private-blockchain
[18] Digitizing Bonds on the Blockchain https://www.goldmansachs.com/intelligence/pages/from_briefings_10-june-2021.html
[19] ADDX is first Singapore financial institution to recognise crypto assets of accredited investors https://addx.co/files/News_Release_ADDX_is_first_Singapore_financial_institution_to_recognise_crypto_assets_of_accredited_investors_2ca7c8d418.pdf
[20] Securitize https://www.crunchbase.com/organization/securitize-inc
[21] HSBC to launch Orion blockchain bond tokenization platform https://www.ledgerinsights.com/fed-dlt-wholesale-cbdc-fx-settlement/
[22] MODERNISING PRIVATE MARKET FUNDS: THE EUROCLEAR AND GOJI PARTNERSHIP https://www.securities-services.societegenerale.com/en/insights/views/news/modernising-private-market-funds-euroclear-goji-partnership/
More Reading
- CFA® Level I Portfolio Management — Distributed Ledger Technology (Blockchain) https://www.youtube.com/watch?v=wtglk_na1FU
2. Commercial Bank blockchain platforms:
