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(Kitco News) - Institutional investment into digital assets is once again on the rise – thanks in part to the filing of an application for a spot Bitcoin (BTC) exchange-traded fund (ETF) by BlackRock, the world’s largest asset manager – and it's not just specific cryptocurrencies that are garnering attention as blockchain technology is also being used to launch regulated investment products around the world.
A recent example of this is the Tel Aviv Stock Exchange’s (TASE) Project Eden, which successfully issued a “dummy digital governmental bond” on a blockchain-based platform as an ERC-1155 security token using a dedicated decentralized app (dApp).
While this event marks a significant development in the digital bond space, Ralf Kubli, a board member of the Casper Association, said this is “simply a veneer of innovation – and potential the catalyst to spark the next financial meltdown.”
Kubli sat down for an interview with Kitco Crypto to elaborate on this perspective and provide insight into where the future of blockchain-based investment products is headed.
According to Kubli, “Current tokenization methods simply digitize the asset, not the liabilities or cash flows. In other words, an asset-backed token gets created and appended to a blockchain with a PDF of the Terms and Conditions attached. This means that tokenized assets, designed to be more efficient and automated, still require human intervention, which can introduce errors and discrepancies.”
Kubli noted that “A similar lack of transparency and verifiability around cash flows was one of the primary triggers of the 2008 banking crisis.”
Diving into the concept of tokenization, Kubli said the terminology being used is not really correct due to the nature of financial assets vs. real-world tokenization. “You can tokenize a financial asset because a financial asset is digital in its form, they are digital innate. When people talk about real-world tokenization, dealing with physical assets such as a house or car, they can only be ‘represented’ on-chain, which poses a problem as it requires a verified link between what you are representing on-chain and what exists off-chain.”
Kubli said one of the reasons he is so passionate about financial assets is because they are truly digital. “These days we are hardly ever paid coupon payments in cash anymore; it’s all digital. That’s why I’m so passionate about it. And the problem with these tokenization efforts in financial markets is that they are not digitizing the financial instrument; they are merely digitizing the form of the financial instrument and defining the obligations of the parties in the instrument. Not necessarily digitally, and certainly not with an algorithm.”
Referring back to the digital bond released by TASE, Kubli said, “a bond pays interest over time, so you need to define how this is calculated. If you don’t actually have this logic in the token you basically only have a dumb token. So you just have a token that says, ‘Hey, I’m a bond, but if you want to know how much money that you’re owed, please go and read the PDF, which is hashed inside my contract.’”
“That’s not very efficient and it will basically not lead to anymore transparency,” he said. “It will not lead to more efficient markets, it will not lead to more liquidity.”
This is where the concept of smart financial contracts comes into play.
“You take the financial contract, which defines clearly the obligations of the parties to the contract, and then we combine it with blockchain to make a smart financial contract.”
Approaching it in this manner aligns with computer scientist Nick Szabo’s definition of a smart contract, which is that it is observable, verifiable, enforceable, and has privacy, he said.
Integrating smart financial contracts
To help build out the smart financial contract ecosystem, Kubli has been working with the Casper Association and the Algorithmic Contract Types Universal Standards (ACTUS) Research Foundation to build out a Tokenization as a Service (TaaS) solution that “translates financial instrument data into standardized Smart Financial Contracts on the Casper blockchain.”
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 TaaS solution is an open-source standard that any business can use. It enables the creation of native financial digital assets that are machine-readable and executable, allowing for faster trading and settlement. Algorithmic logic is also tied to the underlying digital asset, which makes it possible to analyze, organize and automate information about any aspect of the financial instrument.
Kubli noted that while they have implemented some of these smart financial contracts on Casper, the solution is chain agnostic, which means that institutions can use it to launch contracts on any blockchain network.
He added that this system can be used in both cash flow-based environments as well as commodity-based environments, and both will benefit from the tokenization of these contracts. This aligns with the discussion that Kitco Crypto had with Ingo Rube at Kilt about the concept of applying digital identities to commodities to enable them to be recorded, tracked, and traded on the blockchain.
Once these assets are given digital identities on the blockchain, “you can build financial instruments on top of it,” Kubli said. “It’s a lot easier; it’s standardized. It lets you reap the benefits of blockchain – which is efficiency – in mid-office and back-office operations.”
One company that has already implemented a similar solution in the precious metals market is aXedras, a Swiss-based distributed ledger technology (DLT) infrastructure and application provider digitizing the precious metal value chain, from miner to investor. “They are really far ahead in the bullion market,” Kubli said.
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| Tokenization of securities will be the next evolution in markets - BlackRock CEO |
The importance of transparency
The main idea behind what Kubli is helping to develop is a way to provide a clear definition of an asset's cash flows on-chain. While you can’t make calculations or computations on-chain due to costs, “you can represent a computation of the instrument on-chain, and then when you look at the instrument on-chain, at any given time, you can see whether you have paid any monies due and can see what the future obligations are,” he said.
This can be combined with concepts like zero-knowledge proofs that will allow you to hide the positions you hold, he added.
Kubli called this type of solution “a precondition to efficiency. If you just have multiple random programmers programming bonds in their own ways, at some point you will have all these representations of bonds living on these new rails, but then the complexity of what it is that I am looking at has just increased even more.”
One of the best applications of this solution is decentralized finance (DeFi), he said, because DeFi is mainly just over-collateralized lending currently, but with the introduction of smart financial contracts that can deal with cash flows over time, “you can have real financial instruments live in DeFi environments.”
“DeFi and TradFi are both finance, the only difference is the counterparty,” he said. “You have a centralized counterparty, you have no protocol, and you have people that assert that what they are doing is correct, even though many times they’re not. In order for DeFi to scale beyond overcollateralized lending, as you have on AAVE, you need smart financial contracts that live in the DeFi environment.”
When it comes to applying the solution in TradFi, Kubli said they are currently in talks with five investment banks in Europe on the integration of the new smart financial contract system and have also had some preliminary discussions with Citibank in the U.S.
Regulatory developments
On the topic of the recent passage of the Markets in Crypto Assets (MiCA) bill in the EU, Kubli said that it is a good starting point for a regulatory framework that people can build from. That being said, he also suggested that developers shouldn’t sit around waiting for global regulations, “they have to innovate.”
As for the effects the solution could have on global financial markets, Kubli said that the situation at FTX could have been avoided if we had smart financial contracts because “we would have seen the positions that they were building and would have known that it wasn’t sustainable.” The same is true for the collapse of Terra/Luna. “It was clear in the code that once it reversed, it was infinite dilution, and it was right there in the code.”
“The standard we are building was the result of the 2008 financial crisis,” Kubli said. “This standard is about having transparency, which helps provide a better understanding of the waterfalls of cash flows and all the obligations that are inside a token in a machine-readable and machine-executable fashion. That’s the key. There's going to be zero adoption unless you have that logic inside the tokens.”
