How many routes to interoperability does digital money need?

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In theory, blockchain is an ideal technology for driving interoperability in financial markets because it puts digital money and digital assets on a single ledger shared with all parties at all times, ending the cost and complexity of coordinating multiple, siloed ledgers through complicated data exchanges between multiple intermediaries, each using proprietary systems, and it operates 24/7. 

However, blockchains as they exist today do not conform to this promise. There are dozens of blockchain protocols, each seeking to capture and retain activity within their own network, whose users are unable to share data or value easily with users on other networks. There is a lack of fiat currency on-chain to make cash payments, necessitating recourse to the existing banking system. Nor can blockchain networks interoperate with existing financial networks. 

This lack of interest in interoperability is not peculiar to blockchain, but the default setting in the digital technology industry, as a series of conflicts ancient and modern (IBM versus UNIX, Microsoft versus Linux, Microsoft versus Apple, Apple versus PC, Apple versus Android) can testify. But in blockchain, the lack of interoperability risks reducing the whole idea of Web 3.0 - an open, decentralised network in which users interact peer-to-peer using data they control directly in their own digital wallets – to a cipher. 

The eventual outcome might even be worse than that. Just as Web 2.0 has seen a small number of centralised technology platforms undermine the original promise of the Internet with monopolies funded by mass data surveillance and collection, the current fragmentation of blockchain protocols might be overcome not by interoperability but by consolidation into a handful of giant corporations. Some are already predicting a narrowing of interoperability solutions through consolidation. 

The cryptocurrency industry which spawned the digital money and asset industry has not solved the interoperability challenge but relied instead on a series of workarounds. These include cross-chain bridges (an intermediary blockchain that keeps score), token bridges (that Lock and Mint, Burn and Mint or Lock and Unlock tokens on different blockchains), sidechains (two-way channels between blockchains) and atomic token swaps between blockchains via Automated Market Makers (AMMs). 

These do not provide comprehensive coverage of all blockchain protocols and many market participants worry about security, especially the vulnerability of “bridges” to being hacked. Meanwhile, technical solutions to interoperability (“routers” and “decoders”) continue to proliferate and blockchain standards initiatives by the International Standards Organisation (ISO), the Institute of Electrical and Electronics Engineers (IEEE), the Internet Engineering Task Force (IETF) and the Enterprise Ethereum Alliance (EEA) are poorly co-ordinated. 

In this context, with multiple vendors and industry bodies contending to solve the inter-operability problem by using technical tools or standards to link disparate systems, the idea of a “unified” or “common” platform has emerged as an alternative route. Although a “common” platform is not in principle incompatible with interoperation between multiple platforms – a “virtual” common platform – a single model can in theory overcome the risk and cost of adapting an interoperability solution to the particular systems, processes, governance procedures and risk appetites of individual market participants. 

The need for a solution to the interoperability conundrum is nevertheless urgent. It is easy to forget that interoperability is not just about connecting blockchain networks to each other, and connecting blockchain networks to traditional networks, but connecting the demand for capital to its supply (or, more plainly, issuers to investors). Without interoperability, the network effects that will drive growth and liquidity in digital money (and digital assets) will never acquire momentum. 

Benefits

• Inter-operability will drive market interest and adoption once delivery versus payment for digital assets, payment versus payment in the FX market and trade versus payment in the supply chain using tokenised orders and invoices can trigger payments programmatically using digital money. 

• Designers of new networks in both the digital money and digital asset markets should build interoperability as a design principle into their models from the outset because ease of connectivity is the fastest route to generating the network effects and the liquidity needed for growth. 

• Technically, adoption of digital money is hampered not by the need to support different forms of money - cash, bank accounts, cryptocurrencies, Stablecoins, tokenised deposits, central bank digital currencies (CBDC), public money, private money – but by the need to enable them to inter-operate. 

• Digital wallets can play a role in interoperability because they equip every owner with a unique but universally accessible address (akin to a web address) in which digital data or value can be held on any network and to and from which digital data or value can be moved on any network, including SWIFT. 

• One route to interoperability is programmable “primitives” that enable users to move data, or move value, or move data and value together using different types of transfer mechanisms, such as bridges, atomic swaps and Mint and Burn, to provide a wide range of interoperability solutions. 

Issues

• Initial expectations that a single blockchain protocol would prevail were disappointed, and activity is now fragmented across hundreds of protocols and private, public and public permissioned networks, and expectations that a single interoperability solution will prevail will also be disappointed. 

• The need for inter-operability is not confined to different forms of digital money but encompasses digital assets, which are purchased with digital money, and the need to link the financial institutions, such as custodians, transfer agents and central securities depositories, that support digital asset transactions. 

• Although digital assets and digital money will sometimes co-exist on a single platform such as the Regulated Liability Network (RLN), inter-operability must also facilitate transactions between digital monies and digital asset classes hosted on different platforms. 

• Interoperability solutions must find a replacement for the trust conferred by financial intermediaries in terms of validating counterparties, assets and transactions and this can be found in cryptographically impregnable and mathematically proven techniques such as zero knowledge proofs. 

• One reason for the slow adoption of blockchain solutions by established financial institutions is fragmentation, with the proliferation of vendors requiring bespoke adaptations of systems and processes to accommodate their services, or reliance on vendors to run nodes in blockchains on their behalf. 

Regulation

• If central bank money, in the form of CBDCs, was the only form of digital money on-chain, and a wider range of financial institutions had access to central bank settlement systems 24/7, application programme interfaces (APIs) could enable interoperability with other forms of tokenised and non-tokenised money. 

• Traditional financial message standards such as ISO 20022 are widely used, so it makes sense to adapt them to blockchain networks, and their history of securing user-led agreement and adoption of standards provides a model that the currently disparate blockchain standards initiatives could usefully follow. 

• The “common” or “unified” ledgers advocated by the Bank for International Settlements (BIS) and International Monetary Fund (IMF) risk suppressing innovation, but are compatible with interoperability between multiple platforms, creating a “virtually” unified ledger that maintains diversity as well.