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Digital Tokens: The Building Blocks of Tomorrow’s Financial Markets

By Todd McDonald, Co-Founder and Chief Product Officer at R3

The financial services industry has experienced its fair share of hype when it comes to blockchain. But as the technology has matured, one particular byproduct has proven itself worthy of the hyperbole for its ability to reshape the way financial markets are organised and operated: the digital token.

Todd McDonald

Unfortunately the initial coin offering (ICO) frenzy of 2017 got tokens off to a shaky start, giving birth to practices and players that created justified caution among regulators and institutions. But, testament to their potential, there remained a widespread recognition that digital tokens could be impactful in an enterprise context. 

In the same way the telecoms bubble of the 1990s laid the fiber beneath the ground for a new generation of interconnected technologies, one positive legacy of the ICO boom is that it built the initial foundations for the creation of a new global capital market, powered by digital tokens.

As a result, 2018 was marked by an increased focus on security tokens, that is, financial securities recorded digitally as tokens. These securities, when recorded on purpose-built enterprise blockchain platforms, offer the promise of a new, lower friction method of asset and capital formation, as well as the more efficient management of these assets during their lifetime.

These ‘enterprise-ready tokens,’ if developed appropriately, can automate or simplify much of the asset origination, issuance, execution, secondary trading and lifecycle processes that currently make up so much of investment banking fees.

Today, as more enterprise tokens emerge, their common attributes are becoming clear – the token needs to be unique while still representing a claim to real-world cash flows or obligations, rather than just being a vehicle for speculative trading or get-rich-quick schemes. In addition, the legal and regulatory construct has to be from a solid foundation, with a clear integration with existing laws and structures, such as the role of a custodian, settlement finality and adherence to securities law.

An early example of this interplay between new technology and established institutions was R3’s collaboration with Bank of Canada, Payments Canada and others in 2016. In this example Bank of Canada issued a digital token called CAD-COIN that represented Canadian dollars held in a collateral account. 

the token needs to be unique while still representing a claim to real-world cash flows or obligations, rather than just being a vehicle for speculative trading or get-rich-quick schemes.

Fast forward to today and the digital asset landscape has matured significantly. The appeal and benefits of raising capital by issuing debt and equity in a blockchain-enabled marketplace has struck a chord throughout the financial services world. Momentum is now building among some of the biggest names in finance. New token-based projects by major institutional players are unveiled almost weekly, such as Wells Fargo’s recent announcement of a US dollar-linked stablecoin that will run on its first blockchain platform.

These properly regulated tokens are fit for real businesses and sovereign entities, and they are on the cusp of becoming a reality in financial markets. This momentum is being fueled by innovation in areas such as custody, settlement and post-trade processing – which remain critical functions in regulated financial markets.  Providers are developing an ecosystem of services that replicate these functions efficiently for digital assets traded in a blockchain environment. 

Ultimately these developments promise to drive major improvements in user experience of both issuers and investors, as well as increased efficiency and cost-reduction. End-to-end trading solutions are being built which combine trading, settlement and custody services into one seamless experience.

The applicability of digital exchanges is broad and extends beyond traditional securities such as bonds and equities to a whole new universe of assets.

Another specific area of innovation is in financial exchanges. Leading Swiss stock exchange SIX recently stated they expected digital exchanges on blockchain platforms would completely replace traditional ones within ten years. SIX is building its own digital exchange, SDX (SIX Digital Exchange), that will be completely overseen and regulated by the Swiss government and FINMA, the securities regulator. SDX will facilitate trading in traditional stocks, bonds and exchange-traded funds while also introducing new types of digital assets, starting with tokens that represent equity in the exchange itself.

The applicability of digital exchanges is broad and extends beyond traditional securities such as bonds and equities to a whole new universe of assets. By providing a digital marketplace that directly connects issuers with investors and enables secondary market trading, the scope for boosting liquidity in a range of markets – many of which may not have even been conceptualised yet – is huge. 

Digital tokens can also act as a catalyst to integrate existing payments network into the new blockchain ecosystem. Payments giant Mastercard is a leader in this field, recently announcing a pilot of a new blockchain-based solution for cross-border payments on R3’s Corda platform. The potential for further token-fueled innovations in this space is huge.

Projects like these are driving an unprecedented period of evolution across capital markets. In five years’ time the financial services landscape is likely to look unrecognisable to its current form, with current assets fully digitised and new types of tokens being traded in markets that don’t even exist today.

Enterprise tokens, with legal underpinnings and support from real-world custodians and asset issuers, will enable 24/7 transactions, settlement with finality and full regulatory compliance, unlocking valuable liquidity and delivering efficiencies for issuers and investors across the globe.

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