How a common platform or unified ledger could unleash network effects in the token markets

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What additional costs are created by the status quo in the capital markets?

At present, the money, securities and funds markets exist in separate siloes. This is partly a function of the fact that every jurisdiction has its own laws, regulations, taxes and customs. But the siloes are mainly a legacy of previous institutional and technological eras.  The multiple intermediaries needed to settle and custody financial assets - banks, brokers, inter-dealer brokers, asset managers, wealth managers, exchanges, order-routing networks, payments banks, correspondent banks, central securities depositories (CSDs), central counterparty clearing houses (CCPs), automated clearing houses (ACHs) and Real Time Gross Settlement Systems (RTGSs)  – have accumulated over time. Their existence means that data about transactions and assets must be moved between proprietary computer systems. Though standard message types are used to carry the data, these come in multiple versions and vary between asset classes, which means they must always be backwards-compatible. Private message types are also used, as are emails and even faxes, which inhibit the automation of data exchanges. The infrastructures on which market participants trade (exchanges), clear (CCPs) and settle (CSDs) are not always open at the same time either, imposing a further delay in settling transactions. For market participants, the costs of operating within such a complicated inheritance are immense. The intermediaries all charge fees, including fees to reconcile their accounts of the same stocks and flows. Cross-border transactions incur further costs in foreign exchange fees and spreads. Regulators impose capital allocations on the operational risks. Cash remains idle to cover the risks of settlement failure. The collateral needed to satisfy clearing houses and borrow money to raise cash is trapped in siloes and expensive to source.

How could a common platform or unified ledger help?

In theory, if digital money and assets were issued, traded, settled and custodied to a common design - effectively building interoperability into the design - the siloes that exist in traditional markets could be eliminated, with commensurate cost savings. Blockchain technology has provided traditional markets with a valuable opportunity to embrace a common approach of this kind. On a common platform, regulated and approved participants of any kind can build and deploy an application to do anything, and be confident it can interoperate with any other application built to the same design. Blockchain can also replace settlement on trade date plus one day (T+1) or two days (T+2) with atomic settlement in real-time. It can replace bi-lateral data flows to reconcile accounts of the same asset or transaction with a single source of truth that can be shared between all the parties. Finally, if both the asset and the cash are tokenised, the sequential steps in any transaction – trading, matching, settlement, custody, asset servicing – can be collapsed into a single integrated process.  These benefits are already being achieved within financial institutions, notably in the repo markets, but have yet to be extended to transactions between financial institutions.

Are blockchain protocols creating siloes?

At present, there is a danger that the proliferation of blockchain protocols that cannot interoperate is reproducing the siloed approach - and therefore the costs - of the traditional markets, because they cannot exchange data or value seamlessly. The siloes (being based on blockchain protocols) are not the same as their traditional predecessors (which are based on asset classes) and the differences between blockchain protocols may not be as meaningful as their creators would like the marketplace to believe. But they undoubtedly inhibit the progress of tokenisation by creating complicated risk management challenges as assets are issued and traded on many different blockchain protocols. Proliferation, however, reflects the prevalent incentives. Blockchain protocol entrepreneurs have an incentive to monopolise any value they create by building a “community” of users that are loyal to their vision because they have a stake in its success (so-called “tokenomics”). The rise of blockchain protocols that specialise in a particular field are another instance of this incentive at work. Incumbent financial institutions, on the other hand, are incentivised to compete. They are building proprietary tokenisation platforms of their own to reduce the risk of clients defecting to innovative competitors. Lastly, positive incentives are also at work. Competition between protocols to attract decentralised application (dApp) developers creates incentives for protocols to support start-ups and innovators. It also means that blockchains can develop, say, different settlement models to accommodate the fact that some transactions and asset classes will always be more urgent than others. It will be important to retain an element of competition for talent and by transaction type and asset class as the current fragmentation of business across multiple blockchain protocols consolidates - as it likely will - into a smaller number of protocols. This is why a common or unified platform should not be allowed to degenerate into a single blockchain protocol but must instead take the form of a common design that spans a constellation of separate but inter-operable blockchain protocols.

Are inter-operability tools the solution?

The market has developed multiple inter-operability techniques, including intermediated and un-intermediated cross-chain, sidechain and token bridges, token swaps and networks of routers united by common, open protocols. The FinP2P open protocol created by Ownera, for example, enables financial institutions to buy and sell digital assets peer-to-peer between applications hosted on different blockchain protocols by updating records of digital assets they hold on the blockchain they prefer to use. In principle, any financial institution can connect to any other financial institution that uses the same protocol. The principal alternative - bridges between protocols – became and remains a focus for hackers and creates a risk of theft by insiders.

What role do standards have to play in the creation of a common platform?

Standards work in blockchain is under way but is fragmented across the International Organisation for Standardisation (ISO), the Institute of Electrical and Electronic Engineers (IEEE), the Internet Engineering Task Force (IETF) and the Ethereum Enterprise Alliance (EEA). As a result, the work is poorly coordinated and backward-looking. Established standards, such as ISO 15022 or ISO 20022, offer partial solutions only. Because users can deploy standards in different ways or use different versions of the same standard – in short, the operational implementation of standards is not standardised – any use of standards must be supplemented by agreement on market practices. One less discussed standard that could contribute to the development of a common platform is Algorithmic Contract Types Unified Standards (ACTUS), which reduce all financial instruments to standardised sets of cash flows. It is attracting attention from regulators as a useful tool in managing systemic risk. ACTUS could be useful in understanding new financial products created by “composability” and in feeding accurate data into self-executing smart contracts.

Who are the enemies of progress towards a common platform?

Clients dictate the pace of change and incumbents are always willing to meet clients where they are rather than where they would like them to be. Some market participants still rely on fax machines and have no appetite to accept data even via Application Programme Interfaces (APIs), let alone share it via a blockchain. Despite their Luddism, and the operational costs of supporting it, their service providers are content to continue to service such clients because it gives them assets to broke or manage or custody. Incumbents can feign interest in blockchain but are unlikely to adopt it. Established businesses that provide a service that works, at however high a price and however low a quality, remain confident that they will not be disrupted by blockchain technology. In their view, innovative businesses have understood that their real opportunity lies not in the cryptocurrency markets but in the securities markets and will adapt to that reality rather than seek to supplant it. Even there, the immediate impact is likely to be limited. Large incumbent businesses are never going to be impressed by use-cases that, however brilliant in conception and effect, lack the scale to transform their costs or revenues.

Are common platforms being built?

Ethereum is a common platform but is proving too slow and expensive and not scalable. It also places applications in a silo. The Global Layer One project, launched by the Monetary Authority of Singapore (MAS), is a public-private collaborative venture that aims to design an open ledger with an Ethereum-like architecture capable of accommodating tokenised central and commercial bank money, bonds, equities and derivatives, verifying counterparties via digital identities and providing wallets capable of holding digital assets of all kinds. It envisages the “common” platform as an infrastructure for multiple applications to use and as a means of enabling sub-networks to interoperate. The Regulated Liability Network (RLN), initially conceived as a way to settle inter-bank claims in tokenised commercial bank money, has expanded into tokenised assets via experiments conducted as part of a Regulated Settlement Network (RSN). Other private sector initiatives to develop common blockchain platforms include the Canton Network (curated by blockchain vendor Digital Asset) and Partior (which originated within J.P. Morgan but has evolved into a shared interbank payment infrastructure). Public common blockchain platform initiatives include Alastria (Spain), LACChain (Latin America) and the European Blockchain Services Infrastructure (EBSI, an initiative of the European Commission and the European Blockchain Partnership). But the most seminal public blockchain project is likely to be Project Agora, an initiative led by the Bank for International Settlements (BIS) in which the central banks of France, Japan, Korea, Mexico, Switzerland, the United Kingdom and the United States are testing the practicability of a common platform. It puts tokenised commercial bank money and central bank digital currencies (CBDCs) on a programmable public-private platform that uses composable smart contracts coded into tokens to settle transactions in any digital asset (Payment versus Payment and Delivery versus Payment) instantly and atomically. Ultimately, all such projects need, at least in the short term, to fashion links between assets issued on to blockchains and assets issued via legacy technologies into traditional markets. This is essential to enable institutions to capture assets of both kinds on their balance sheets.

Which matters more: the platform or the applications?

Some argue that solving inter-operability through a common or unified ledger (“inter-operability by design”) does not understand how blockchains and applications on blockchains work. On this view, blockchain ledgers perform a limited set of functions. They store who owns which assets, and record changes in ownership by making sure transactions in the assets are immutable. The interesting and complicated work is done by the applications that sit on top of the ledger, such as the applications that tokenise assets, service assets and move tokenised collateral. It is these applications that must interact with multiple parties, including buy-side and sell-side firms and service providers such as custodian banks and central securities depositories (CSDs), and not through the underlying blockchain protocol. In short, inter-operability happens at the application layer, not the blockchain ledger level. According to this view, the applications that sit on top of blockchains are analogous to the on-line products and services – also applications – that sit on top of the Internet. It is true that blockchain-based applications, like all Internet applications, rely on software running at the point of interaction with the users. That software can be made inter-operable with the software running other applications. But believing that inter-operability matters at the application layer only means taking a sanguine view of how the Internet has evolved since it first became widely available in the 1990s. Services owned by a small number of technology companies (Facebook, Instagram, YouTube, X, TikTok, WhatsApp and especially the Apple and Google app store duopoly) have become the gatekeepers that consume the advertising revenues generated by users of Internet applications and tax (at 30 per cent) the applications published by other businesses. If blockchain consolidates in the same way as the Internet did, it will close and become the province of a small number of giant, application-based rent-collectors that determine which applications are published on the platform and what they pay to be published. The idea of a common platform is therefore not a technicality about blockchain versus application layers but a design from first principles that aims to ensure blockchain technology reopens a currently closed Internet for application publishers and consumers.

Would the mutual fund industry benefit from a common platform?

In theory, mutual funds could be issued, distributed and redeemed (even traded in secondary markets) on a unified platform that accommodated all the necessary services, including order-routing, issuance, purchase, registration, valuation and servicing. The platform would enable them to work together seamlessly because they conformed to a common digital design. But the current fragmented and competitive structure of the mutual fund industry militates against this possibility. Mutual funds are currently issued and redeemed by the managers, rather than traded in a secondary market, so they are “traded” in a primary market only. The industry is also far from homogeneous globally, with every market where funds are issued and sold having different operational infrastructures and distribution networks. In the United Kingdom, for example, mutual fund distribution is dominated by independent financial advisers (IFAs) while in continental Europe banks and insurers are the dominant fund distributors. The market is also highly intermediated, with fund distributors using order routing networks to contact fund platforms to transmit orders to transfer agents, which request fund shares from asset managers and collect cash payments from banks. With the downward pressure on operational costs exerted by asset managers under pressure themselves from the growth of less profitable passive products and greater institutional awareness of the impact of costs on investment returns, the various intermediaries are starting to compete with each other. Transfer agents are launching fund platforms and fund platforms are launching transfer agencies. Asset managers, which until recently were content with leaving retail customers to fund distributors, are rediscovering the benefits of selling directly to retail investors.

Do public authorities need to build directly or encourage the private sector to build a common platform?

Private sector actors have multiple visions of what a common platform is. Some see it as a harmonised blockchain platform, while others see it as a set of interconnected sub-platforms, while a third group likens it to the Internet model of a network that is indifferent to the blockchain technology each participant chooses to use. Private sector actors also have a multiplicity of opinions on whether a common platform is needed. Some are for and some are against. Those that are engaged already in collaborative projects with central banks, regulators, policymakers and competitors such as the Global Layer One and RLN clearly reckon common platforms will enable them to do more business with a greater range of counterparties in a wider spectrum of asset classes at lower cost. Others believe that blockchain platforms can continue to proliferate and all that is required is inter-operability at the application level. Regulators also need to clarify legal, regulatory and governance issues before they can build a common platform or encourage the private sector to build one. First, they need to decide if a common platform is purely a technology platform or a financial market infrastructure (FMI). If it is an FMI it will be subject to existing regulations such as the Principles for Financial Market Infrastructures (PFMIs) published in April 2012 by the Committee on Payment and Settlement Systems (CPS) and the Technical Committee of the International Organisation of Securities Commissions (IOSCO). IOSCO has already published recommendations that indicate it believes digital asset infrastructures such as common platforms are subject to the PFMIs. But if regulators conclude common platforms are just technology, they can be agnostic: regulators do not regulate technologies. Either way, only when the regulatory status is clear can regulators agree the technical standards that will govern the operation of the common platform – the protocol as opposed to the platform. They will of course be reliant on private sector input for guidance on the protocol that is chosen. Lastly, regulators must settle the governance mechanism that will enable the technical standards to be enhanced and augmented over time. Governance is already a live topic of discussion within the common platform projects currently in hand, as is the choice of legal jurisdiction when liability arises, as it will when a transaction fails or the service suffers an outage. However, there is a useful precedent for common platforms in that the development of the open protocols that govern the Internet and the Worldwide Web (HTTPS, HTML, SMTP, TCP/IP and DNS) are steered not by public law or private owners but by stakeholder groups.