Blockchain Short Story 003: Moving Traditional Assets On-Chain

Blockchain has brought us a new architectural paradigm, which allows us to frictionlessly collaborate with other legal entities in a shared data- and process-model and at the same time maintain our sovereignty. (See also “Episode 001 — Flattening the Hierarchy” and “Episode 002 — On the Paths between the Old and the New World.”)

How fast investors, issuers, service providers, and regulatory bodies can move to the “new world” and profit from the benefits of this new architecture, not only depends on the new asset classes and products appearing directly on blockchain (cryptocurrencies, tokens, …), but it also depends on how fast we can migrate large volumes of traditional assets (shares, funds, bonds, …) to it. It is for sure that this migration can not be done overnight, so it will be a long-running process, which most probably will take a decade or longer.

Technically, the most comfortable way would be to build the “new world” at the edge of the “old world” from scratch, and step-by-step redesign the laws and regulations (e.g. removing the requirement in Germany for the physical existence of a global note) to allow direct on-chain emission and management of assets. Some jurisdictions, like for instance Lichtenstein, are going this route already, however, most other countries, Germany including, will need few years more to get to this point.

Another popular way is the tokenization of the traditional assets. Basically, the assets get “immobilized” by a trustee in the old world and a token representing the asset is issued on-chain. However, here it is not yet clear if the token inherits all the properties of the asset or if it creates a new asset, which is only a representation of the underlying.

Although tokenization of traditional assets is a hot and trendy topic right now, the question arises, why is it needed at all? In fact, the book entries in the back office systems of the custodians are already a perfect digital representations of the assets in question. Furthermore, custodians, as strictly regulated entities, enjoy the trust of their customers. So the issue is not the digital representation of the asset itself or lack of trust, but rather the slow, error-prone and fragmented settlement infrastructure connecting the custodians. Fortunately, blockchain comes to help. It gives the custodians means to span a network and transact with each other frictionlessly based on a common protocol. Positions and settlement data can be instantly shared on a need-to-know basis as the transaction happens. This eliminates expensive and error-prone reconciliation processes.

In order to work, the approach sketched here would require mutual sub-custodian agreements, which would create a matrix of nostro/vostro depots between the participating custodians, i.e., we would extend the custody chain by an additional thirdparty depositary. Using traditional technologies to handle all possible relations in this network most probably would end in a reconciliation-hell, but with the help of blockchain/DLT it is a feasible approach for taking the first step to the next-possible and at the same time being compliant with the existing laws and regulations.

Moreover, having a shared position keeping and settlement layer between the custodians as foundation, it becomes possible to build other financial modules on top of it. For instance: collateral pools, liquidity management, securities lending, fund management, etc.

Finally, since power in the blockchain network can be equally distributed, the hurdles for new participants are lower than with the centralized platform models. At some time in the future, the chances are good that we will have a global network of custodians that allows us to transfer values across the globe in a ubiquitous, instant, and fail-free way like we transfer the data via the internet.

Further Reading

• Michael Cyrus, Introducing the Digital Collateral Protocol: the right blockchain for global settlements
• Stephan Mögelin, Demystifying the phenomenon of STOs (Security Token Offerings) in Germany
• Stephan Mögelin, Tokenization — What’s it good for?