Deposit Tokens: The Future of Interbank Transfers via Tokenisation

Authored by Mustafa Syed

Imagine the potential that may arise if stable, dependable, and controlled digital money could be used to settle trillions of dollars' worth of payments that are processed daily by international financial institutions promptly and around the clock. These days, the processing and settlement of payments and asset transfers through numerous financial intermediaries might take several days. What if blockchain technology enabled the worldwide, fast, direct, and simultaneous exchange of institutional payments, including those for transaction settlement with other assets at the same time?

The demand for blockchain native "cash equivalents," which function as liquid means of exchange and value storage in blockchain-native environments, is being driven by the ongoing advancement of blockchain technologies for commercial applications. Thus far, stablecoins have mostly satisfied this need.

"97% institutional investors agree that tokenisation will revolutionise the asset management industry according to Celent's 2022 survey" (Summerville, M., 2022).

But as blockchain technology is expected to be used for more intricate business transactions, particularly those involving institutions, the issue of what kind of digital currency would be required to sustain blockchain payments on a large scale has come to light. When it comes to analyzing the ideal future state of digital money, deposit tokens and central bank digital currencies (CBDCs) in particular have gained prominence. In this latest article I attempt to explain the recent interest in deposit tokens (DT).

Introduction

To address the need for stable and liquid value on-chain, a variety of digital money solutions have been developed. These solutions range in terms of issuers, claim rights, reserve characteristics, and regulatory requirements. The primary types of digital money, or alternate forms of payment that is often referred to as digital money [1]. This includes the following:

1. Blockchain-based deposits, i.e., distributed ledger-based deposits issued by a licensed depository institution, including deposit tokens, which are forms of commercial bank money;
2. Stablecoins, digital assets designed to maintain a stable value relative to an external reference asset, and serve as an alternative store of value for blockchain native payments and liquidity needs; and
3. Central Bank Digital Currencies (CBDCs), digital forms of national currencies issued by central banks, which are forms of central bank money.

Deposit claims for specified amounts recorded on blockchain against a licensed depository institution are referred to as blockchain-based deposits. They are unique forms of existing deposits that are economically equal and used to settle trades between digital assets, pay for transactions, and serve as a store of value and a medium of exchange on blockchain ledgers. This is where the value proposition of deposit tokens (DT) becomes even more evident and clear for institutions.

DT's are transferable tokens that are issued on a blockchain by a licensed depository institution and serve as proof of a deposit claim against the issuer. Since deposit tokens are essentially commercial bank money in a new technological form, they easily fit into the banking ecosystem and are governed by the same laws and regulations that currently apply to commercial banks. This covers current minimum capital and liquidity requirements for banks as well as additional regulatory standards and regulations for technological risk management that govern the prudential and operational risks related to deposit-taking and other relevant bank activities [1].

Deposit tokens are transferable tokens that evidence deposit claims against a commercial bank—the same claims evidenced by deposit account balances today [2] (Financial Times, 2023).

DT's provide a digital money solution that expands traditional banking services to more complicated digital asset markets since they are issued by regulated banks that are involved in deposit taking. They also highlight the benefits of blockchain technology, such as digital programmability and composability, instantaneous and "atomic" settlement (simultaneous settlement of digital assets and deposit tokens), and the ability to be used to expedite transaction settlement times, lower payment costs, and improve liquidity management.

Atomic settlement is the instant exchange of two assets that are linked, such that the transfer of one occurs only upon transfer of the other one [3] (R3, 2022).

The Potential

Similar to how commercial bank money is used today, deposit tokens can be used for a wide range of purposes, such as providing cash collateral, trading and settlement, and cross-border and domestic payments. New features, like programmability and fast, atomic settlement*, are made possible by the token form, which speeds up transactions and automates complex payment processes. DT's could play a significant role in a larger ecosystem of tokenized assets by supporting these use cases. These assets are expected to have a significant impact on financial services and will probably necessitate payment solutions from reliable institutions; according to a survey of institutional investors, 97% of respondents believe that tokenization will transform asset management and be advantageous to the sector. Institutions are becoming more at ease with digital currency as well, as long as it originates from a reliable source.

The emergence of stablecoins, a significant financial innovation in recent years, has aided in the expansion of the ecosystem for digital assets. However, as on-chain transactional activity grows in volume and complexity, stablecoins may pose large-scale problems in relation to their effects on monetary policy, credit intermediation, and financial stability [1]. DT's can be positioned to handle some of the risks associated with stablecoins getting close to systemically important scale by utilizing the procedures and laws currently in place for conventional commercial bank deposits. This will lessen the burden on stablecoin issuers and prevent volatility in the market.

Furthermore, DT's might offer more smooth access to bank services and conventional payment rails, which would be advantageous for financial institutions and counterparties in commercial transactions.

Deposit Token Process

The ways that blockchain-based deposits use ledger technologies, collaborate with others, and obtain permissions vary. Two primary criteria can be used to categorize blockchain deposits: (i) whether they are token- or account-based, and (ii) if they are considered "native" to the blockchain. In this study, "native" refers to reflecting value that is directly stored on the blockchain as the master record. "Non-native" refers to mirroring values for which there is an off-chain conclusive record.

Based on the aforementioned definitions, we can observe that blockchain deposits can take four different forms. Deposit accounts that are not native, native deposit accounts, and non-native token-based. DT's are referred to as "native," token-based blockchain deposits. The most promising type of tokenized deposits appears to be native deposit tokens since they can benefit from future blockchain features and create new use cases in addition to not being constrained by off-chain reconciliation procedures [1].

Classification of Deposit Tokens

There are three broad types of ledger designs that financial institutions can choose to introduce blockchain-based deposits: (i) single bank ledgers, (ii) shared ledgers, and (iii) universal ledgers. The JPM Coin System is a live example of a single bank ledger for blockchain deposit accounts — it is operated by JPMorgan and acts as its own ledger and payments rail for US$ balance transfers among JPMorgan participating customers.

Based on a recent publication by JP Morgan, there are three broad types of ledger designs that financial institutions can choose to introduce blockchain-based deposits: (i) single bank ledgers, (ii) shared ledgers, and (iii) universal ledgers. The JPM Coin System is a live example of a single bank ledger for blockchain deposit accounts — it is operated by JPMorgan and acts as its own ledger and payments rail for US$ balance transfers among JPMorgan participating customers [1].

1. Single bank ledgers, such as the JPM Coin System, offer greater operational efficiencies relative to traditional systems by facilitating faster transfers with extended operating hours. This can offer significant improvements when moving money across geographies or systems even among accounts held with one institution globally.
2. Shared ledgers bring multiple institutions onto the same network, allowing institutions to seamlessly interact with a common set of digital assets and operational protocols, and share in increased transparency around the status of transactions. However, they also demand coordination and agreement on common standards and governance from participants in the network.
3. Universal ledgers are public blockchains that maximize interoperability by facilitating broad access by many participants, but their permissionless nature also requires regulated financial institutions to establish appropriate alternative controls to create a trusted environment for funds transfers.

DT's represent a claim against the issuing depository institution, just like traditional deposits are. Therefore, they ought to be bound by the risk management guidelines and liquidity criteria that are now in place for deposit-taking banks in order to guarantee the security and integrity of deposits recorded by non-blockchain means. Token holders may also profit from deposit insurance to the extent that the product satisfies scheme requirements and the depository institution is otherwise covered by an insurance plan.

Use Cases for Deposit Tokens

By enabling advanced programmability features, the ability to exchange money with other digital assets atomically, and the transfer of commercial bank money on shared or universal ledgers where enhanced transaction transparency and round-the-clock transfer availability are possible, DT's can improve a number of traditional payments and liquidity management related uses of commercial bank money. Additionally, DT's function as a viable alternative to stablecoins, on both public and permissioned blockchain environments, and can be offered organically within the regulatory and commercial framework applicable to modern banking institutions.

They are designed to meet demand at scale for blockchain-based payment technologies by enabling faster, cheaper, and more advanced solutions within established bank regulatory frameworks that offer clarity to banks, as well as their customers [1].

Notable use cases for DT's include the following:

1. Payments: The procedures used in today's funds transfer operating model involve the separation and mediation of value and information transfers by financial institutions.Messages are frequently sent between various bank systems to initiate the transfer of money in a sequential fashion, with information coming before the money at each middleman. This is accomplished through a network of middlemen that link the organization holding the beneficiary's information and the institution holding the payment originator's account details. Rather, deposit tokens represent the value transfer as well as the data in the payment instructions. Deploying DT's on a shared blockchain infrastructure that links the payer and the recipient can therefore lessen the need for third-party mediators, who are typically needed to reconcile disparate value and information flows across various banking systems.
2. Programmable Money: DT's programmable nature allows for creative solutions to support related banking services like conditional intra-day lending decisions or interest payment disbursements, as well as current deposit-taking activities like the conditional transfer of funds based on conditions at a smart-contract* level. When a deposit token connected into the financial system is programmable, it offers further advantages by lowering the possibility of human mistake or delay, automating manual solutions, and enabling complicated logic for transactions without manual intervention. Automation like this promotes efficiency in protocol interaction, liquidity and collateral management, payment execution, and other areas.In addition to being more programmable than account-based deposits, deposit tokens may also be used with specific smart-contract protocols more effectively. Recently, JPMorgan and SBI completed a test transaction as part of MAS' Project Guardian to demonstrate the viability of utilizing deposit tokens with smart contract protocols for institutional applications.
3. Protocol Interaction: In addition to being more programmable than account-based deposits, deposit tokens may also be used with specific smart-contract protocols more effectively.Recently, JPMorgan and SBI completed a test transaction as part of MAS' Project Guardian to demonstrate the viability of utilizing deposit tokens with smart contract protocols for institutional applications. It executed a foreign exchange transaction utilizing SGD deposit dokens issued by JPMorgan and a JPY tokenized asset issued by SBI using a modified version of the decentralized finance* (or "DeFi") protocol. Another way to reap the benefits of automation and interoperability may be through the usage of protocols, especially when it comes to multiparty transactions that call for the application of common standards.
4. Trading & Settlement: As market efficiency improves significantly due to the fractionalization of assets, simplicity of transfer, potential interoperability across institutions, and institutional DeFi protocols, the trading and settlement of tokenized assets on blockchains will become more and more significant. Beyond cryptocurrency, tokenized asset markets which include everything from conventional stocks and commodities to real estate and artwork have witnessed an increase in usage and research. In order to eliminate the risk that some portions of a transaction will not be settled because a counterparty fails or is unable to deliver an asset, deposit tokens provide a blockchain-native way to use commercial bank money to settle transactions across these expanding tokenized asset marketplaces "atomically or simultaneously and nearly instantly." As previously mentioned with regard to payments, deposit tokens can independently enable extremely quick or instantaneous settlement through the use of more effective rails, even in situations where a transaction is not subject to the requirements for atomic settlement.

Current Case Studies: Project Guardian (MAS)

DT development is already underway at a few banks and consortiums.?Examples include the USDF currency, which intends to debut on a permissioned basis on a public blockchain for transactions within a consortium of licensed banks, and the pilot issuance of Singaporean Dollar (SGD) deposit tokens by JPMorgan in association with MAS Project Guardian [2].

In the first phase of this groundbreaking effort, Onyx by J.P. Morgan made deposit tokens a reality in partnership with the Monetary Authority of Singapore and other financial institutions. The Monetary Authority of Singapore's multiphase program examines how asset tokenization, public blockchain, and decentralized finance (DeFi) protocols might enhance conventional financial services.

The Singapore dollar deposit tokens were issued by J.P. Morgan in a currency trade for tokenised Japanese yen. The transaction occurred on a public blockchain and was facilitated through a modified DeFi protocol, typically used to create liquidity pools with digital assets. The protocol was programmed to allow only the project parties to interact in the trade and to let the trade occur based on certain pre-agreed pricing conditions [3].?

The token form of the deposit allowed it to communicate with the protocol directly. Benefits like automated market making, or matching bids and offers for assets, are made possible by this. The protocol instantly connects buyers and sellers based on the availability of assets and agreed-upon pricing terms, and it also enables the execution of transactions between parties when certain additional agreed-upon conditions are met. This might be especially helpful in intricate multiparty transactions involving commercial money that call for the use of common transaction rules.

Summary

The introduction of DT's using Distributed Ledger Technology (DLT) has the potential to revolutionize the way we think about traditional banking and deposits. By leveraging the transparency and security inherent in DLT, deposit tokens can offer users a new level of trust and control over their financial assets. These tokens can be interest-bearing instruments that enable users to earn a return on their holdings while maintaining direct ownership and control. The elimination of intermediaries and the use of smart contracts can streamline the process, reducing costs and increasing efficiency.

For this exciting concept to progress in the market, several key steps must be taken. First, regulatory clarity is essential. Regulatory bodies must establish clear frameworks for the issuance and trading of deposit tokens to ensure consumer protection, prevent fraud, and maintain financial stability. These regulations should strike a balance between fostering innovation and maintaining the necessary safeguards [5].

Second, widespread adoption and user education are crucial. People need to understand the benefits, risks, and technical aspects of deposit tokens. This requires educational initiatives, user-friendly interfaces, and industry-wide efforts to build trust in these new financial instruments.

Additionally, interoperability between different blockchain networks and standards must be addressed to enable the seamless transfer of deposit tokens across various platforms. Finally, building robust security measures to protect against hacks and vulnerabilities is paramount to ensure the safety of users' funds.

As DLT and blockchain technology continue to evolve, deposit tokens represent a promising avenue for the financial industry. By combining the advantages of blockchain with interest-bearing deposit instruments, we can reimagine the future of banking, making it more inclusive, efficient, and user-centric. However, collaboration between innovators, regulators, and the wider financial ecosystem will be key to unlocking the full potential of deposit tokens and bringing this innovative concept to the forefront of the financial market.

Citations:

1. https://www.jpmorgan.com/onyx/documents/deposit-tokens.pdf
2. https://r3.com/everyday-blockchain/atomic-settlement-if-you-have-amazon-prime-you-already-understand-the-process/
3. https://www.ft.com/partnercontent/onyx/deposit-tokens-a-new-financial-services-paradigm.html
4. https://www.ft.com/partnercontent/onyx/deposit-tokens-a-new-financial-services-paradigm.html
5. https://www.bloomberg.com/news/articles/2023-09-07/jpmorgan-jpm-explores-blockchain-deposit-token-for-payment-settlement