As blockchain technology matures - in tandem with financial market (and public) perceptions - the time may be right to consider how blockchain (and other digital technologies) can resolve particular "TradFi" challenges with respect to efficient settlement and collateral management, writes Richard Baker, Founder and CEO of Tokenovate.

At a recent finance industry event (held under the Chatham House rule), one panellist observed  that “while trading is very much using 21st century technologies, post trade processes are still in the Victorian era”. While T+1 (and T+0) ambitions are noble, the reality of today’s T+2 environment is that it remains hamstrung by inefficient, inaccurate, incomplete — and largely manual — processes and workflows. These cost money, tie up liquidity, impact profitability and limit commercial opportunity. Despite technological advances in financial market infrastructure development, legacy mindsets, dated technologies, data silos and non-interoperable systems are still very much the order of the day.

End-to-end transaction processing is a complex series of actions triggered by different ‘lifecycle events’ performed by different stakeholders to satisfy different “end destination” requirements and obligations. While counterparties to an ISDA-documented trade, for example, may be fully aware of the commercial terms of any transaction, a host of associated actions and obligations triggered by changing market conditions or other lifecycle events may not be as transparent to all counterparties/stakeholders. There is also the challenge of efficient movement and management of collateral which remains costly and cumbersome, locking up assets and liquidity, and increasing transaction costs (and monetary risks).

At the same time, disparate and disconnected software stacks, often ripe with technical debt and coupled with disjointed databases and operational infrastructure inefficiencies, contribute towards a set-up that is increasingly not fit-for-purpose.

Addressing the digital transformation challenge, one step at a time

As we embrace an increasingly digital world, there is growing acceptance of (and interest in) “modern” solutions like cloud hosting and “as a service” delivery models. However, blockchain-linked transaction processing solutions are, as yet, far from universal. It is also unrealistic to expect that the entire transaction lifecycle, including settlement and collateral, can be transformed in one ‘big bang’ effort (like front end trading for many assets) – nor is it necessary.

In September 2023 ISITC endorsed a short paper “The Ten Pillars Of Digitalization” which outlines high level ‘requirements’ for — and challenges in — achieving digital transformation of financial market infrastructures, observing that one of the key benefits of T+1 is “to compel players in the market to introduce new technologies and innovate solutions…..the interoperability of Blockchains hold the most hope for the development of new international Capital Market structures.” This paper also notes that tokenisation (and fractionalisation) is “likely to be a [transitional] mechanism” allowing issuers and market participants who service assets for investors to make the switch from traditional book-entry systems to more modern and less costly digital solutions.

The transformation of collateral, custody and settlement through virtualised microservices, linked to a blockchain, can significantly reduce costs and risks for trading counterparties. Custodians and clearing houses in particular should be looking at the opportunities presented by tokenisation, fractionalisation and blockchain-linked system automation to generate significant cost efficiencies from more integrated workflows and dynamic liquidity management.

Tokenisation of assets isn’t a new thing, of course — it’s been around for hundreds of years (and the concept of a cash-ledger is older still). Digital tokenisation using a blockchain is, however, a reasonably nascent phenomenon.

Nonetheless, many financial institutions and organisations are predicting that tokenisation (and fractionalisation of assets using the blockchain) presents significant cost-saving and money-making opportunities.  In a report published in March 2023, Citi GPS forecast “$4 trillion to $5 trillion of tokenized digital securities and $1 trillion of distributed ledger technology (DLT)-based trade finance volumes by 2030.” In December 2022, BNY Mellon CEO Robin Vince noted that “With a majority of institutional investors interested in tokenisation, distributed ledger technology may represent the next financial frontier.“

Twinning is winning

The concept of digital twinning — creating an identical digital representation of an underlying asset — is an essential element of tokenisation. Tokenisation of financial assets is just one of many use cases.

Digital twinning solutions exist already in a multitude of industry sector applications, including predicting footfall in retail outlets, visualising traffic flows in smart cities, tailoring individual healthcare plans and simulating planning scenarios. In short, digital twinning helps to make smarter decisions, faster, and this is no different in financial markets applications.

There are a few different approaches to digital representation of collateral assets. One is to replace custody databases and vaults, and to create a blockchain-native asset. Another is to maintain existing custody vault functions for a period of time and to create a digital twin of the underlying collateral assets. Both cases require a token that encompasses legal definitions, rights management and economic value.

A digital twin (represented as a token on a blockchain) of a financial asset that fuses law, regulation, rights and permissions management and trading economics within the asset itself would be beneficial both to market participants and regulators. Beyond legal and regulatory compliance, and at a minimum, such a token must be able to synchronise states continuously between “real” and digital worlds. Achieving the full benefit of a digital twin system also depends on the design of the custody ledger, and approach to fractionalisation, transaction management and settlement predictability. Throw into the mix a smart legal contract, and it’s possible to envisage an end-to-end solution with integrated workflow that can operate to the highest standards of credibility, security and operational performance.

This approach also supports increasing demands and mandates for more and better regulatory reporting. Many organisations have been hit with huge fines for non-compliant transaction reporting in line with many and varied markets’ regulations. The regulatory  reporting challenge will be further exacerbated with the global roll out – in the next few years – of new Digital Reporting Regulation (DRR). By implementing a blockchain-based solution (and associated single source of truth) organisations will be able to build highly effective reporting engines that function within existing infrastructures to store, collect, monitor, verify and share accurate, immutable transaction data in a timely and compliant manner.

Despite the accelerated pace of digitisation, standardisation and collaboration between financial market participants have lagged behind. This disconnect has resulted in many gaps throughout the financial system, as well as highly siloed infrastructures, not least in respect of the separation and movement of money and assets on separate rails. Leveraging blockchain/DLT technologies, and digital solutions like twinning and tokenisation, offers the potential to manage money and assets on the same rail, making it possible to streamline processes, achieve efficiencies and reduce time to settlement.