At this point, most people are familiar with the collapse of cryptocurrency exchange FTX, but it is just the latest in a long line of “black swan” events that could have — and should have — been avoided. Mt. Gox, Quadriga CX, Three Arrows Capital, Celsius Network, Voyager, BlockFi, the list of hacks, fraud and resulting contagion goes on. Clearly, new practices are necessary to combat events like these from happening again.
Regulators may need to step in to provide clearer guidance on cryptocurrency assets. But while regulatory clarity is essential, more is needed.
This is especially true with the growing shift towards tokenization. Businesses that staffed up during last year’s crypto boom have faltered amid an uncertain regulatory landscape. Now, with regulators circling, many firms are opting for a relatively well-trodden and regulated route of tokenization.
However, most current tokenization platforms have grave shortcomings. Some simply digitize the paper prospectus and hash it into the token. Others only tokenize the asset side and forget about the liability. Typically, a token gets created and has a PDF embedded that defines the terms and conditions without a liability side and without a clear definition of the underlying cash flows. This means that tokenized assets — designed to be more efficient and automated — still require human intervention to calculate cash flows, which requires reconciliation efforts and introduces discrepancies. This means we are still dealing with the same lack of transparency and verifiability around cash flows, one of the primary triggers of the 2008 great financial crisis.
The key to avoiding another crisis is ensuring that liabilities and cash flows related to financial assets are defined with machine-readable, machine-executable, and — perhaps most importantly — standardized data models and algorithms. This can be achieved by implementing open banking standards and introducing “smart financial contracts” that define the logic of the financial instrument in a token, that can be read and executed automatically and without error.
Building better contracts
The smart contracts that define tokenized financial assets need to describe the underlying obligations of the counterparties. In doing so, they become smart financial contracts. All parties who have a right to see the token, can then ascertain the current state and discover future expected cash flows with certainty. In the distributed ledger technology and blockchain-based financial infrastructure of the future, fulfillment or transference of these instruments can be largely automated on-chain. This can remove the need for human oversight and can eliminate the possibility of fraud or error.
Fortunately, standards already exist that can address these concerns, specifically, the standards outlined by the Algorithmic Contract Types Universal Standards (ACTUS) Research Foundation, a U.S.-based non-profit organization. ACTUS was established in the wake of the 2008 financial crisis to create clarity around the cash-flow patterns of financial instruments that were based on collateralization. The solution was an open-source standard that any business could use.
Traditionally, financial contracts acted as agreements between counterparties to exchange cash flows. However, these contracts were always written by humans (usually lawyers) and for humans (also usually lawyers), thereby introducing room for interpretation and clouding the fact that a financial contract indeed is algorithmic in nature. As one lawyer recently put it: “If you can not show me the calculation, then we do not have a financial contract.” ACTUS addressed this by deploying a global standard for the consistent algorithmic representation of all financial instruments. These algorithms focus on the cash-flow obligations of a given contract, not specific legal jurisdictions or terminology. This is possible because, in practice, all financial instruments can be built on a standardized data model and a translatable set of underlying cash-flow patterns.
Combining ACTUS with blockchain results in smart financial contracts. Such smart financial contracts as part of tokenized financial instruments and digital transaction rails would enable a much more efficient system for all parties — one that provides transparency and auditability. Better yet, this system can be implemented across all financial assets regardless of the infrastructure on which they live. This means that critical problems within the financial system such as reconciliation, systemic risk and regulation can be efficiently addressed. Reports on risk exposure can be generated with greater frequency and automatically in moments rather than slowly compiled over weeks by a team of analysts and accountants.
The on-chain transparency of such a system would make it impossible for financial firms to hide massive shortcomings in liquidity. It would be relatively trivial for them to provide a verifiable audit of their complete balance of all assets and liabilities, and everyone could be independently confirmed by their counterparties. Given how simple it would be, any refusal to implement such a system could be seen as a major red flag for regulators and investors alike and could even be made illegal through legislation.
Beyond the next black swan
Digitally native financial contracts built on the ACTUS standard could be implemented into the architecture of any financial institution. For example, JPMorgan recently launched a pilot program to explore asset tokenization in Singapore. While it is currently exploratory, JPMorgan will need to adopt standardization and smart financial contracts if it is to provide real-time risk modeling and stay in line with regulations.
While the benefits to trade finance and financial enterprises are clear, it doesn’t stop there.
One of the biggest challenges in many economies is the availability of working capital for small and medium-sized companies. Factoring of payables of governments, government-owned entities and large companies that are outstanding to private companies, can be one of the key elements to inject liquidity on scale into local economies.
Tokenized financial assets will enable liquidity and new forms of financing for critical parts of the economy, especially where established financial players have been unable to meet the financing needs due to their high-cost structures.
Other industries, such as energy, telecommunications, healthcare and many others could see similar improvements in efficiency and transparency. The bottom line is, combining tokenization with clearly defined standards, like ACTUS, can bring a new level of efficiency, transparency and legitimacy to finance and businesses. This is essential if we want a future that deters otherwise preventable black swan events, but the upsides don’t stop there. Virtually all walks of life stand to be improved by embracing a clearly defined future for digital, blockchain-powered transactions.
