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What good are digital assets if they are all siloed?

A key promise of tokenization is the improved liquidity profile it offers to assets. Instead of a security listed on a single centralized exchange, a token representing the security can be traded across liquidity pools across a single blockchain and across different blockchains.


In order to make this happen, we need different blockchains and databases to be able to communicate and interact with each other. We need interoperability.



Interoperability is however in limited supply. It requires standardization of operating models and data across the industry otherwise it would be a case of every single blockchain system having to build custom communication channels with every other blockchains.


In this week’s newsletter, we will look at two well known examples of tokenization and their limitations/opportunities. 


Let’s dive in.


Case Study #1: JPM Coin




JPMorgan’s claim to fame in tokenization goes to its well known JPM Coin project. According to the official website, JPM Coin “is a permissioned system that serves as a payment rail and deposit account ledger, that allows participating J.P. Morgan clients to transfer US Dollars held on deposit with J.P. Morgan within the system, facilitating the movement of liquidity funding and payments in right time.”


Practically speaking, JPM Coin allows clients of its wholesale payments business to instantly transfer and settle payments with each other by using a private blockchain owned and operated by JPMorgan.


By Oct 2023, the network was handling more than $1 billion in transfer volume a day. 



In Nov 2023, Umar Farooq, Global Head of Financial Institution Payments at JPMorgan, and CEO of Onyx by JPMorgan, said he was looking for 5x-10x that number in a year or two.


At the first glance these numbers look impressive, the context that is missing is that JPMorgan actually moves about $10 trillion in daily transfer volume. So whilst $1 billion is a lot more than zero, it is but a rounding error in the overall scale of things.


Why aren’t we seeing more traction? There are a few reasons. But one of them is that while the JPM Coin private blockchain network offers 24/7 always-on clearing and settlement functions for JPMorgan’s own institutional clients who have accounts on the blockchain, it does not offer this benefit to other banks’ corporate clients who do business with the JPMorgan clients. 


Of course not all banks currently boast having a private blockchain enabled payment solution like this but what if they did?


Citigroup recently unveiled Citi Token Services that also offered a global cash management pilot, enabling clients to transfer liquidity between Citi branches on a 24/7 basis. Customers can easily send and receive funds between Citi accounts. It is a very similar product to the JPM Coin payment service.


However, there is no way for a JPMorgan customer who does business with a Citi Token Services user to instantly settle any payment terms, because there is no way for the two private blockchains to communicate or to bridge any value transfers. There is no interoperability between the two blockchain systems.


If the logic of using blockchain for instant settlement and value transfer is to hold true, then all customers must be able to take advantage of it. A lack of interoperability between JPM Coin and Citi Token Services means much of that promise remains unfulfilled. 


To put it in context, the cross-border payment market is $150 trillion+ in size and much of the transfers involve different banks and nostro accounts. If the plethora of bank’s blockchains remained separate instead of connected, then most of that market, perhaps at $100 trillion+, wouldn’t be unable to actually leverage the benefits of tokenization.


Case Studies #2: Hong Kong Monetary Authority


This week Hong Kong Monetary Authority came to the market with a $756 million green bond that is natively issued on the blockchain. The two year bond is issued according to Hong Kong law, listed on the Hong Kong Stock Exchange and rated AA+/AA-.



Natively issued onchain here refers to any and all onchain data regarding the bond having the same degree of legal enforceability as offchain regulated record keeping services. Traditionally a central securities depository (CSD) institution such as DTCC or Euroclear is tasked with the record keeping of any and all ownership data of a security. 


With the advent of digital assets, there have been cases where a bond is issued traditionally but is then moved onchain by recreating the same data onchain. Although the onchain data does not hold the same legal enforceability as the regulated offchain CSDs in these non-digitally native issuance cases.


The really interesting part of the HKMA’s green bond transaction is the linkage that allows liquidity from both onchain and offchain to seamlessly flow and participate in the trading of the underlying asset.


As you can imagine, most investors and capital reside in the non-blockchain world. So any onchain asset would be limited in size and depth without the traditional investors participation. 


As an illustration, just look at the current onchain private credit space. While there is much talk about this ever expanding asset class and hungry capital looking for yield, the onchain private credit space has barely seen its issuance volume surpassing $50 million in 2023. Why? Onchain private credit market is severely limited by a lack of participation from traditional investors. 


A lack of linkage between the two capital markets is telling about the importance of interoperability between the blockchain world and the offchain traditional financial rails.


However, the good thing is that the traditional investors could participate in the digital green bond via Euroclear and Clearstream accounts. 


The Hong Kong bonds were natively issued on HSBC’s Orion distributed ledger, which acts as the definitive record of legal title. Hong Kong’s Central Moneymarkets Unit (CMU) was the central securities depository (CSD) responsible for the issuance. It integrated HSBC Orion with its existing systems and enabled the linkage with Euroclear and Clearstream to allow both traditional capital and digital capital to participate in the bond. 


Conclusion

Blockchains offer the key benefit of borderless liquidity and instant settlement for financial market participants. However, just like in the offchain world, fragmentation due to siloed ecosystems hinders deep liquidity formation and realization of true potential. 


While recent advances in tokenization adoption in giant financial institutions are encouraging, siloed blockchains remain limited and handicapped in their capabilities. There are two important interoperability capabilities required:


  1. Blockchains to blockchains

  2. Blockchains to offchain existing infrastructures


The design space for the solution is wide open given the early stage of the technology adoption cycle. Before wide adoption of interoperability solutions come to fruition, we first need standardization of processes and data which would only come once there is social consensus on the best practices of tokenization.


The road ahead is a long one but also a necessary one. Interoperability is the key feature that will enable the full potential benefits of tokenization to be realized. 


Disclaimer: This content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.


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