Is blockchain the future of finance?

The finance industry certainly hopes so, but it’s a complex undertaking that requires a global interoperable ecosystem and accompanying regulatory framework. DBS, Standard Chartered, KPMG, OCBC, SIX and HashKey Pro share their ideas.

"Blockchain In The Financial Industry" panel at the DLT Compass event in Singapore.

It has been a few years since Bitcoin and its underlying enabling platform – the distributed ledger technology (DLT) blockchain – captured the imagination of the financial world. Famously, 2017 was the year everyone seemed to go gaga for fintech, cryptocurrencies and blockchain, while 2018 was the “crypto winter” following the inevitable bursting of the hype bubble and subsequent regulatory crackdowns. Now, midway through 2019, banks and financial institutions are taking a more pragmatic and sober approach to evaluating what blockchain can do for them.

Payments and settlements are the more obvious use cases for blockchain – indeed, retailers and restaurants such as Whole Foods, Nordstrom, Baskin Robbins, KFC and Subway already accept cryptocurrency payments in select locations. But one use case that still generates a lot of buzz is tokenization – the concept of converting hard assets (like real estate and securities bonds) and illiquid assets (like precious metals or commodities) into digital representations of those assets that can be traded via blockchain to raise capital.

A panel session at DLT Compass – an event staged by blockchain incubator LongHash in Singapore in June – discussed the game-changing possibilities of tokenization enabled by blockchain, and the significant hurdles that need to be overcome before tokenization can go truly mainstream. Some are technical, but for the most part it’s about fostering the global interoperable ecosystem of banks, institutions, partners and regulators that’s required to make it all work.

Digital assets

The big attraction of tokenization is that it enables enterprises to transform assets into a digital token that can be used to raise capital. For the financial sector, that means opening up new asset types, said Neil Thomas, country head for Singapore and Japan and head of Sales (Asia) at Swiss Exchange (SIX).

“It’s a real game changer for our industry – 70% of the assets in the world can’t be traded. So for things that have value like property, wine or artwork, you can create a token around that, unlock that value, and then you can trade it,” he said.

“It’s very exciting, because people hold all these assets that suddenly can create this liquidity and capital in the market that just doesn’t exist right now.”

Amit Agarwal, product head for Open Account Trade at DBS, agreed, noting that even assets like receivables could be tokenized, which would expand the way they are used for financing now.

“You can convert these receivables into digital tokens, because everybody understands the underlying value of these receivables,” Agarwal said. “And those could be split into smaller values. You can’t split an invoice – you can’t just tear the invoice and say, ‘Hey, you finance this part’. Tokenization helps to split that receivable. This opens up a new class of markets.”

Naturally, trading tokenized assets requires exchanges that are capable of trading them and understanding their value. Traditional financial exchanges aren’t set up to do this, which is why SIX undertook a project to create the Swiss Digital Exchange (SDX), which aims to create a fully regulated digital exchange using tokenized assets that bridges the fundraising gap between traditional IPOs (which are expensive enough to prevent smaller companies from qualifying) and crowdfunding (which is accessible to everybody but largely unregulated and not always trustworthy, as patrons of PledgeMusic recently found out the hard way).

The key word there is “regulated” – one of the core principles of SDX is ensuring that clear regulation is part of the design. That means getting the regulators onboard with the project, which Thomas says has been the biggest challenge.

“We believe truly that you have to do this in a regulated environment, so we’re working hand in hand with the Swiss regulator FINMA (Swiss Financial Market Supervisory Authority),” he said.

Regulatory complexities

Compounding that challenge, he added is the fact that exchanges are also distributed and international in nature, which means getting  regulators in other markets to participate. And that means getting regulators in different markets to agree on the finer details of how tokens should be classified and regulated.

John Ho, head of Financial Markets and Legal at Standard Chartered, explained just how complicated global tokenization regulations can get. For a start, he said, you have to decide how to classify tokens (i.e. payment tokens, utility tokens and security tokens), how each category should be regulated, and how cross-border payments should be handled. Each jurisdiction may have different answers for each of these questions.

“In terms of the barriers of mass adoption, especially in the context of banking and finance, we need clear rules, especially in particular from national regulators and international regulators on the classification [of tokens], the regulation, and also cross border,” he said.

A related issue for tokenized securities in particular is settlement finality, Ho continued.

“When you put things on blockchain, are you assured that the transactions are settled in accordance with legally enforceable, binding rules?

“It’s important for the participant ecosystem to build proper governance, resilience and systems and ensure that they can foster trust within the ecosystem.”

SIX’s Thomas placed particular emphasis on the necessity of a participant ecosystem, which would encompass banks, financial institutions, fintech start-ups and regulators.

“If you’re going to put this sort of investment into a DLT project, you’ve got to make sure that there’s a market for this,” he said. “We’ve got to make sure that when we ramp up, we have the people onboard to co-create these things so that you don’t go it alone and hope for the best.”

Technology challenges

Tokenization also presents a number of technical challenges, such as DLT interoperability, Ho added. “We have looked at all the different public and private blockchain networks out there [and] some of them do not interoperate very easily when we look at it in the context of use cases for tokenization.”

Then there’s scalability, an issue various implementations of blockchain have struggled with simply because they’re not designed to scale at levels that can compete with the financial industry’s status quo.

“In the context of Bitcoin, the building block of blockchain is probabilistic, where you have ten blocks to confirm a transaction. That hobbles the speed, but obviously, that’s by design,” Ho explained. “If you compare that to Visa’s payment system, Visa can handle thousands of transactions within milliseconds.”

While all of that might sound discouraging, Ho said it’s worth remembering that blockchain is still in the “early innings”, which simply means there’s still a lot of work to be done before it can deliver on its promises.

“The rules and the infrastructure have to come up to speed, and the ecosystem is premature in terms of cyber resilience, systems governance, and a whole host of things that need to come in to play,” he said.