The history of tokenization: Why assets are moving to public chains

Author: Alex Weseley Source: Artemis Research Translation: Shan Ouba, Golden Finance

Key Points

• While billions of dollars worth of tokenized real-world financial assets have been deployed on public chains to date, there is still much work to be done at the intersection of law and technology to rewrite the plumbing of the financial system on public chains.

• History tells us that the financial system was not designed from the beginning to support the level of globalization and digitization required today, and instead became a walled garden built on outdated technology. Public blockchains are uniquely positioned to improve these issues in a global, trusted, neutral way.

• Despite the challenges, Artemis believes that stocks, treasuries, and other financial assets will move to public blockchains because they are more efficient. This will unleash network effects as applications and users converge on the same underlying platform that supports programmable and interoperable assets.

Introduction

Currently, tokenized fiat currencies have exceeded $160 billion, and the total tokenization of U.S. Treasuries and commodities has reached $2 billion. The tokenization of real-world financial assets on public blockchains has begun.

For years, the financial industry has been curious about the potential of blockchain technology to disrupt traditional financial market infrastructure. Promised benefits include increased transparency, immutability, faster settlement times, improved capital efficiency and reduced operating costs. This promise has led to the development of new financial instruments on the blockchain, such as innovative trading mechanisms, lending protocols, and stablecoins. Currently, decentralized finance (DeFi) has over $100 billion in locked assets, demonstrating the strong interest and investment in this space. Proponents of blockchain technology believe that its impact will extend beyond the creation of crypto assets such as Bitcoin and Ethereum. They foresee a future in which global, immutable, and distributed ledgers will enhance the existing financial system, which is often limited by centralized and siloed ledgers. Central to this vision is tokenization, the process of representing traditional assets on the blockchain using smart contract programs called tokens.

To understand the potential of this transformation, this article will first examine the development and operation of traditional financial market infrastructure from the perspective of securities clearing and settlement. This review will include a review of historical developments and an analysis of current practices, providing the necessary context for exploring how blockchain-based tokenization can drive the next stage of financial innovation. The Wall Street paperwork crisis of the 1960s will provide a key case study that highlights the vulnerabilities and inefficiencies in the existing system. This historical event will set the stage for a discussion of the key players in clearing and settlement and the inherent challenges of the current delivery versus payment (DvP) process. The article concludes with a discussion of how permissionless blockchains offer unique solutions to these challenges and have the potential to unlock greater value and efficiency in the global financial system.

Wall Street’s Paperwork Crisis and the DTCC

Today’s financial system was shaped by decades of high systemic stress. An often underestimated event that explains why the settlement system works the way it does is the paperwork crisis of the late 1960s, which is described in detail in George S. Geis’ book, Historical Context for Stock Settlement and Blockchain. Reviewing the development of securities clearing and settlement is essential to understanding the current financial system and recognizing the importance of tokenization.

Today, it takes only a few minutes to easily purchase securities through an online broker. Of course, this was not always the case. Historically, stocks were issued to individuals who held a physical certificate representing ownership of the stock. In order to exchange stocks, a physical certificate must be transferred from the seller to the buyer. This involves handing the certificate to a transfer agent, who will cancel the old certificate and issue a new one in the name of the buyer. Once the new certificate is delivered to the buyer and payment is delivered to the seller, the trade is considered settled. In the 19th and 20th centuries, brokers increasingly held stock certificates on behalf of investors, allowing them to more easily clear and settle trades with other brokers. The process was still largely manual, with brokerage firms typically using 33 different documents to execute and record a single securities trade (SEC). While manageable at first, the process became increasingly cumbersome as trading volumes grew. In the 1960s, stock trading activity increased dramatically, making physical delivery of securities between brokers an impossible task. Systems designed to handle daily trading volumes of 3 million shares in the early 1960s were unable to handle the 13 million shares traded in the late 1960s (SEC). To give the back office time to complete settlements, the NYSE shortened the trading day, extending settlement to T+5 and eventually banning trading on Wednesdays.

The NYSE has been struggling to find a solution since it established Central Certificate Services (CCS) in 1964. CCS aims to be the central depository for all stock certificates, meaning it will hold all stocks on behalf of its members (mostly brokers), while end investors are granted beneficial ownership represented by book entries in brokerage ledgers. CCS's progress was hampered by a series of regulations until 1969, when all fifty states amended their laws to authorize CCS to hold certificates centrally and transfer stock ownership. All shares were transferred to CCS so that they could be stored in what was called "fixed fungible bulk." Since CCS held all shares in fixed form, it recorded the balances of its member brokers in its internal ledger, and the member brokers in turn recorded the balances of the end investors they represented in their internal ledgers. Stock settlements could now be accomplished through book entry rather than physical delivery. In 1973, CCS changed its name to the Depository Trust Company ("DTC"), and all stock certificates were transferred in the name of a subsidiary, "Cede & Co." Today, DTC, through Cede, is the nominal owner of nearly all company stock. DTC itself is a subsidiary of the Depository Trust & Clearing Corporation (DTCC), whose other subsidiaries include the National Securities Clearing Corporation (NSCC). DTC and NSCC are two of the most important components of today's securities system.

The emergence of these intermediaries changed the nature of stock ownership. Previously, shareholders held physical certificates; now, this ownership is represented by a book entry in a chain of ledgers. As the financial system developed, the increase in complexity led to the emergence of more custodians and intermediaries, each of which had to maintain its own record of ownership through book entries. The following diagram simplifies the hierarchy of ownership:

A Note on the Digitization of Securities

Beginning in the wake of the paperwork crisis, the DTCC stopped holding physical shares in its vaults, so shares went from being “fixed” to being completely “dematerialized,” with almost all now being represented only in electronic book records. Today, most securities are issued in dematerialized form. As of 2020, the DTCC estimates that 98% of securities are already dematerialized, with the remaining 2% representing nearly $780 billion worth of securities.

A Primer on Traditional Financial Market Infrastructures (FMIs)

By understanding Financial Market Infrastructures (FMIs), you can gain the deeper structural context needed to understand the potential of blockchain, the very entities that are poised to disrupt. Financial Market Infrastructures are critical institutions that form the backbone of our financial system. The Bank for International Settlements (BIS) and the International Organization of Securities Commissions (IOSCO) have detailed the role of FMIs in the Principles for Financial Market Infrastructures (PFMIs). The key FMIs defined by BIS and IOSCO for the smooth functioning of the global financial system include:

• Payment Systems (PS):Systems responsible for the secure transfer of funds between participants.

• Example: In the US, Fedwire is the primary interbank wire transfer system that provides real-time gross settlement (RTGS) services. Globally, the SWIFT system is systemically important because it provides a network for international funds transfers, but it is only a support system - it does not hold accounts or settle payments.

• Central Securities Depository (CSD): An entity whose role is to provide securities accounts, central custody services, asset servicing, and plays an important role in helping to ensure the integrity of securities issuance.

• Example: In the US, it is DTC. In Europe, it is Euroclear or Clearstream.

• Securities Settlement System (SSS):Securities settlement systems allow securities to be transferred and settled through book-entry according to a set of predetermined multilateral rules. Such systems allow for the transfer of securities for free or for a consideration.

• For example: In the US, it is DTC. In Europe, it is Euroclear or Clearstream.

• Central Counterparty (CCP):An entity that becomes the buyer to every seller and the seller to every buyer to ensure that open contracts are fulfilled. A CCP does this through debt novation, which splits one contract between the buyer and seller into two contracts: one between the buyer and the CCP, and the other between the seller and the CCP, thereby absorbing the counterparty risk.

• Example: In the United States, the National Securities Clearing Corporation (NSCC).

• Trade Repository (TR): An entity that maintains a centralized electronic record of trade data.

• Example: DTCC operates global trade repositories in North America, Europe, and Asia. Mainly used for derivatives trading.

Throughout the lifecycle of a transaction, these systems interact as follows:

Transfers typically use the FMI as a central hub in a hub-and-spoke model, where the spokes are other financial institutions, such as banks and broker-dealers. These financial institutions may interact with multiple FMIs in different markets and jurisdictions, as shown in the figure below.

This isolation of the ledger means that entities must trust each other to maintain the integrity of the ledger as well as to communicate and reconcile. Some entities, processes and regulations exist purely to facilitate this trust. The more complex and global the financial system becomes, the more exogenous forces are needed to strengthen trust and cooperation between financial institutions and financial market intermediaries.

The inefficiencies of current financial markets are highlighted by the following data on corporate securities settlement failures, which have recently grown to account for more than 5% of total trading volume. Additional data provided by DTCC on the value of daily settlement failures in U.S. Treasuries shows that between $20 billion and $50 billion of trades fail each day. This represents about 1% of trades cleared by DTCC, which clears about $4 trillion in Treasuries each day (DTCC).

Settlement failures can have serious consequences because the buyer of the securities may have used them as collateral in another transaction. This subsequent transaction will also face non-delivery, which could trigger a domino effect.

Securities Settlement: Delivery Against Payment

“By far the greatest financial risk in securities clearing and settlement occurs during the settlement process”, according to the Committee on Payment and Settlement Systems. Securities can be transferred for free or for a fee. Some markets use a mechanism whereby a transfer of securities only occurs if the corresponding funds are successfully transferred - a mechanism known as delivery versus payment (DvP). Today, the delivery of securities and the payment of funds occur on two fundamentally different tracks through different systems. One is through the payment system, while the other is through the securities settlement system, the system mentioned in the previous section. In the United States, payments might be made through FedWire or ACH, while international payments might use SWIFT for communication and settle through a correspondent banking network. On the other hand, the delivery of securities occurs through securities settlement systems and central securities depositories such as DTC. These are different tracks and different ledgers, requiring increased communication and trust between different intermediaries.

Blockchain and Atomic Settlement in DvP

Blockchain can mitigate certain risks in cash-on-delivery systems, such as principal settlement risk, due to the unique property of blockchain transactions being atomic. A blockchain transaction itself can consist of several different steps. For example, delivering a security and completing a payment. What is special about blockchain transactions is that all steps of a transaction either succeed or fail. This property, called atomicity, enables mechanisms such as flash loans, where users can borrow uncollateralized funds in a single transaction as long as they return them in the same transaction. This is possible because if the user fails to repay the loan, the transaction, as well as the loan, cannot be recorded. In blockchain, cash on delivery can be completed in a trustless manner through smart contracts and atomic execution of transactions. This has the potential to reduce principal settlement risk, as one step of the transaction is unsuccessful, exposing all parties to potential losses. Blockchains have key characteristics that enable them to eliminate the role played by traditional securities settlement systems and payment systems in cash on delivery settlements.

Why permissionless blockchains?

For a blockchain to be public and permissionless, anyone must be able to participate in validating transactions, producing blocks, and reaching consensus on the canonical state of the ledger. In addition, anyone should be able to download the state of the blockchain and verify the validity of all transactions. Examples of public blockchains include Bitcoin, Ethereum, and Solana, where anyone with an internet connection can access and interact with the ledger. Blockchains that meet this criteria and are sufficiently large and decentralized are essentially trusted neutral global settlement layers. That is, they are unbiased environments for the execution, verification, and settlement of transactions. Transactions can be conducted between parties who do not know each other through the use of smart contracts, which enables trustless, intermediary-free execution, making immutable changes to the globally shared ledger. While no single entity can restrict an individual's access to the blockchain, individual applications built on the blockchain can implement permissions, such as whitelisting for KYC and compliance-related purposes.

Public blockchains can improve back-office operational efficiencies and increase capital efficiency by leveraging the programmability of smart contracts and the atomicity of blockchain transactions. These capabilities can also be achieved with permissioned blockchains. So far, much of the corporate and government exploration of blockchain has been through private and permissioned blockchains. This means that network validators must pass KYC checks before being allowed to join the network and run the ledger’s consensus mechanism, transaction validation, and block production software. Implementing a permissioned blockchain for institutional use is no more beneficial than using a private shared ledger between institutions. The financial system will no longer be unbiased and credibly neutral if the underlying technology is completely controlled by entities like JPMorgan Chase, a consortium of banks, or even governments. Corporate and government agencies have been researching distributed ledger technology since 2016, and we haven’t seen any major implementations of these systems beyond pilot projects and testing environments. In the view of Chris Dixon of a16z, this is partly because blockchain allows developers to write code that makes strong commitments, without the companies having to make as many commitments themselves. In addition, blockchain is designed to be like a massively multiplayer game, not just a multiplayer game like enterprise blockchains.

Case Study of Select Tokenization

Maker, the protocol that manages the DAI stablecoin, has increased the use of real-world assets (RWAs) to collateralize the issuance of DAI. In the past, DAI was primarily backed by crypto assets and stablecoins. Today, a large portion of Maker's balance sheet (about 40%) is held in RWA vaults that invest in U.S. Treasuries, generating significant revenue for the protocol. These RWA vaults are managed by various entities, including BlockTower and Huntington Valley Bank.

BlackRock’s USD Institutional Liquidity Fund (BUIDL) was launched on the Ethereum public blockchain in March 2024. BlackRock’s fund invests in U.S. Treasuries, and investors’ ownership of shares in the fund is represented by ERC-20 tokens. In order to invest in the fund and issue additional shares, investors must first pass KYC through Securitize. Shares can currently be paid for via wire transfer or via USDC. While there is an option to issue and redeem shares via stablecoins, the actual settlement of the transaction will not occur until the fund successfully sells (in the case of redemption) the underlying securities in the traditional financial market. Additionally, the transfer agent, Securitize, maintains an off-chain register of transactions and ownership that replaces the blockchain as a legal register. This suggests that there is still a lot of work to be done from a legal perspective before US Treasuries themselves can be issued on-chain so that they can be atomically settled with USDC payments.

Ondo Finance is a fintech startup pioneering the tokenization space. They offer a variety of products, including OUSG and USDY, which are issued as tokens on multiple public blockchains. Both products implicitly invest in US Treasuries and provide yield to holders. OUSG is available in the US, but only to qualified purchasers, while USDY is available to anyone outside the US (and other restricted regions). An interesting point about USDY minting is that when a user wishes to mint USDY, they can either wire USD or send USDC. For USDC deposits, the transfer is considered "completed" when Ondo converts the USDC to USD and wires the funds to its own bank account. This is for legal and accounting purposes, clearly demonstrating that the lack of a clear regulatory framework for digital assets is hindering innovation.

Stablecoins are tokenization’s greatest success story to date. Over $165 billion of tokenized fiat currency exists in the form of stablecoins, with trillions of transactions occurring each month. Stablecoins are becoming an increasingly important part of financial markets. Stablecoin issuers are collectively the 18th largest holder of U.S. debt worldwide.

Conclusion

The financial system has experienced many growing pains, including the paperwork crisis, the global financial crisis, and even the Gamestop incident. These periods have stress-tested the financial system and shaped it into what it is today: a heavily intermediary and siloed system that relies on slow processes and regulations to establish trust and conduct transactions. Public blockchains offer a better alternative by establishing censorship-resistant, trusted neutral, programmable ledgers. However, blockchains are not perfect yet. Due to their distributed nature, they have technical characteristics such as block reorganizations, forks, and latency-related issues. For a deeper dive into settlement risks associated with public blockchains, see Natasha Vasan’s Solving the Unsolved Problems. In addition, despite improvements in their security, smart contracts are often hacked or exploited through social engineering. Blockchains can also become expensive during times of congestion and have not yet demonstrated the ability to handle transactions at the scale required by the global financial system. Finally, compliance and regulatory barriers need to be overcome in order to achieve widespread tokenization of real-world assets. With the appropriate legal framework in place, and sufficient advancement in the underlying technology, asset tokenization on public blockchains is expected to unlock network effects as assets, applications, and users are brought together. As more assets, applications, and users are brought on-chain, the platform itself (the blockchain) will become more valuable and more attractive to builders, issuers, and users, creating a virtuous cycle. Using a globally shared, trusted, neutral underlying layer will enable new applications in the consumer and financial sectors. Today, thousands of entrepreneurs, developers, and policymakers are building this public infrastructure, overcoming barriers, and working toward a more connected, efficient, and equitable financial system.

Questions for Future Research

• How do smart contract languages ​​affect tokenization? Is Move’s object data model better suited to securely representing financial assets on-chain than EVM-based smart contracts?

• To what extent should finance be open and transparent? How can zero-knowledge proofs enable multi-chain/cross-Rollup financial infrastructure while preserving privacy where necessary? Is this better than using permissioned chains?

• In a world where real financial assets exist on-chain, how should we think about blockchain interoperability protocols? What is their role and how should they be built?