RWA Design Imperative to Coexist with TradiFi: To be Digital Asset aware an Enterprise needs – ‘Ledger Link’

In my recent article, I discussed the impediments and challenges associated with the mainstream adoption of tokenized assets within an enterprise. Understanding these challenges is crucial in order to navigate the technological and structural changes required for effectively bridging traditional finance with emerging tokenized finance, which I believe is the first step towards transforming the industry and transitioning to a tokenized digital asset-based financial system. The conversation around tokenizing Real-World Assets (RWA) is gaining momentum, with investments from both traditional and non-traditional financial institutions, as well as innovative protocols.

These new protocols, unburdened by the legacies of traditional financial institutions, are leading the way by developing cutting-edge technology with the core principles of decentralized finance (DeFi). They are also challenging the status quo by reshaping financial primitives like borrowing, lending, collateralization, and risk models. Tokenization of real-world assets has the potential to revolutionize financial markets and asset management, but it must be approached thoughtfully and responsibly. It requires a keen awareness of various imperatives, including the existing market infrastructure, regulatory and compliance frameworks, model risk management, governance, and more. These imperatives are not only essential for the operational regularities of running a financial institution but also reflect the practices that have evolved over decades to ensure proper risk management, benefiting all stakeholders, including customers.

While risk models represent a simplified representation of real-world relationships among observed characteristics, value, and events and may not factor in the real-time nature of transaction processing, the industry's focus should be on updating these models to accommodate the digital proliferation and the need for near real-time settlement finality and liquidity aggregation, which stems from the innovation that cutting-edge protocols aim to address through RWA tokenization.

In a previous article, I identified two critical areas essential for lowering barriers and reducing costs:

-?????? A harmonized operational framework

-?????? Interoperability on-chain and off-chain

In this article, I'd like to expand on these concepts and focus on the fundamental infrastructure requirements for the industry to progress. In one of my earlier articles, I discussed the role of token market utilities in modernizing financial infrastructure. As the industry debates the tokenization of financial assets, there is also a debate among current market participants about the readiness of their existing infrastructure.

It's important to understand the current market infrastructure, its participants, the governing regulations, and the incentives before we aim to disrupt and seek efficiencies in terms of time and trust. The "chicken-and-egg" problem arises regarding whether we should tokenize assets first or build the appropriate digital asset rails that facilitate the movement of tokenized assets. The disconnect between the incentive economics of decentralized financial infrastructure and the focus on RWA tokenization lies in the imperatives of model risk management (MRM), security, and infrastructure resiliency, as dictated by supervisory guidance on MRM.

This brings me to a concept I've been exploring and discussing with thought leaders and industry peers—the need to solve the "last mile problem." To make an enterprise truly digital asset-aware, we require the concept of 'Ledger Link.'

The Concept of 'Ledger Link':

Since the emergence of smart-contract blockchains, the industry has sought to bring real-world assets (RWAs) onto the blockchain. Currently, RWAs such as real estate, bonds, equities, and other assets are scattered across various jurisdictions, exchanges, and databases. Aggregating this information within a single open ledger should reduce informational asymmetry and transaction costs— this is one of the key selling points for transitioning to blockchain-based systems.

To converge and leverage the touted technology and business advantages, the blockchain-based ledger must coexist with existing ledgers. This is where the 'Ledger Link' concept comes into play, aiming to address technological, processing, and Transactionally challenges. Let's explore these challenges in more detail:

Technology Challenge:

Blockchain ledgers are designed for decentralized, secure, and transparent data recording, while traditional financial ledgers focus on financial accounting within organizations. The debate often revolves around data storage, distribution, and whether to adopt a traditional double-entry system or a blockchain-induced triple-entry system, where the third entry represents a digital receipt, cryptographically secure and stored on a DLT or blockchain system.

The challenge lies in ensuring that the blockchain-based ledger system is inextricably linked with the traditional financial system, which serves as the system of record. This linkage is essential for reconciliation and maintaining the book of record.

Processing Challenge:

Financial institutions manage numerous payments, settlements, and financial messages daily from multiple back-office systems. Processing these messages involves a complex web of global, regional, and domestic market infrastructures and utilities. These messages undergo various checks and verifications, with an emphasis on message ordering and durability for auditability. In the realm of tokenized RWAs, the aim is to streamline transaction processing and reduce transaction costs.

To coexist effectively, it is essential to ensure that the processing of tokenized assets seamlessly integrates with the existing processing stream. This simplifies operational and risk models, making it less disruptive to the business.

Transactionality Challenge :

In traditional finance, transaction finality refers to the assurance that a financial transaction is legally binding, settled, irrevocable, and that all parties have fulfilled their obligations. Transaction finality in traditional finance is established through legal and regulatory frameworks and governing procedures. Achieving transaction finality in traditional finance can vary by jurisdiction, asset class, and specific transaction type.

Blockchain transactional finality, on the other hand, ensures that once a transaction is confirmed and added to the blockchain, it cannot be reversed or modified. This guarantees the transaction's irrevocability and settled status.

However, blockchain's efficiency in achieving transaction finality contrasts with the traditional financial system's reliance on technology, data, and ledger challenges. This presents a velocity mismatch and increases the veracity of transactions due to the digital efficiencies of blockchain-based systems.

The design imperative here is to ensure that asset-class-specific transaction systems remain isolated and efficiently managed, reducing systemic risks. Given that there cannot be two transaction systems for the same assets, there may be a need to converge at the ledger layer, serving as the system of record to achieve transactional finality.

In conclusion, to achieve a harmonized operational model where people, processes, and technology don't have to distinguish between tokenized assets and those processed through the traditional financial system, the concept of 'Ledger Link' is vital. While interoperability protocols have made significant strides in addressing disparities among various blockchain and traditional finance protocols, the last mile problem still needs a solution. 'Ledger Link' bridges the technological gaps and provides a transitory path for the ubiquitous use of tokenized RWAs, addressing both the instrument and infrastructure.

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Opinion:

Aggregating information within a single open ledger should reduce informational asymmetry and transaction costs, a significant advantage of the transition to blockchain-based systems. For this to succeed, blockchain-based ledgers must coexist with existing ledgers. The concept of 'Ledger Link' aims to address the Technological, Processing, and Transactionally Challenges.

Financial institutions rely on various models and functions to enhance efficiency in lending, marketing, underwriting, pricing, collateral valuation, risk assessment, and transaction monitoring. Each of these functions utilizes a complex network of systems, such as market data for valuation and accounting book of record (ABOR) for asset recording. Financial institutions cannot create a parallel system to handle tokenized RWAs. 'Ledger Link' is designed to bridge the gap and solve the last mile problem, offering a transitory path to the ubiquitous use of tokenized RWAs while addressing both the instrument and infrastructure.

For further reading, you may find the following links informative:

1. Unlocking Deeper Insights: A Dive into the 2023 RWA Market

2. Understanding Impediments and Hidden Challenges in Asset Projects

3. A Primer on Real-World Assets

4. Asset Tokenization: A Systemic Shift from Digitization to Tokenization

5. Modernizing Financial Markets: The Role of Token Market Utilities