tokenization regulation

Proper tokenisation under Basel requires a blockchain network that offers both connectivity and control

author by Yuval Rooz January 30, 2024

In this article

The release of the Basel Committee’s final standard on the prudential treatment of banks' crypto assets in late December last year has flagged that permissionless blockchains could give rise to a number of ‘unique risks’. Here, Yuval Rooz, CEO of Digital Asset, highlights how connectivity and control are both required for banks to realise the benefits of tokenisation through a blockchain network that is public yet permissioned.

Bank regulators are turning their attention to tokenisation. The benefits are too big to ignore. As Acting Comptroller of the Currency, Michael Hsu, stated in a speech in June 2023: “The greatest promise for blockchain technology today may lie in its potential to improve settlement efficiency through tokenisation of real-world assets” which could “save 35 to 65 percent across the settlement value chain, including, for instance, cost savings of up to $5 billion for equity-post trading.” These tremendous cost savings come about because tokenisation eliminates the multiple, manual, inefficient steps and costly reconciliation necessary to settle transactions today.

Tokenisation, however, does not happen in a vacuum (or a silo)—connectivity matters. As General Manager of the Bank of International Settlements, Agustin Carstens, noted in a speech in November 2023: “To harness the full benefits of tokenisation” requires that “all the digital assets networks are interconnected and interoperable.” What is needed is “a network of networks that would allow various components of the financial system to work seamlessly together.”

 

Thus, the benefits of tokenisation can only be realised if assets are tokenised on interconnected, interoperable networks (or networks of networks). Assets that are tokenised on networks that have limited numbers of participants, or that are not interoperable, are dropped into silos where the benefits of tokenisation cannot be realised. Settlement efficiency cannot be improved if there is no one to settle a transaction with.

Connectivity is not the only thing that matters, however. Control is equally important. The Basel Committee’s December 2022 standards on the prudential treatment of “cryptoasset” exposures make clear that if a blockchain network does not provide participants with control over key functionality of tokenised assets—including control over who validates transactions, to whom a party is connected (impacting AML), and who sees what data—then the tokenised assets on that network cannot be classified in “Group 1”—where they would retain the same capital treatment as the non-tokenised form of the asset—and instead will be placed in “Group 2” and be subject to a punitive 1,250% risk weighting.

Under this control rubric, the Basel Committee makes it clear that permissionless networks do not make the cut. The Basel Committee’s December 2023 consultative document concludes “that the use of permissionless blockchains gives rise to a number of unique risks, some of which cannot be sufficiently mitigated at present,” with “the most significant risks stem[ming] from the networks’ reliance on third parties to carry out basic operations” including those related to “AML/CFT risks, and risks around settlement finality, privacy, and liquidity.” Accordingly, the committee will not “allow for the inclusion of cryptoassets [including tokenised assets] that use permissionless blockchains in Group 1,” and these assets will instead be in Group 2.

 

Connectivity and control are both required for banks to realise the benefits of tokenisation without incurring punitive capital charges. How do these requirements fit into the public-versus-private dichotomy that drives blockchain discussions today? They unfortunately do not.

Public blockchains today provide connectivity at the expense of control. The permissionless architectures they use to achieve connectivity force participants to cede control over key functionality—including control over who validates transactions, to whom a party is connected (impacting AML), and who sees what data. This makes them a non-starter for banks looking to tokenise assets without incurring punitive capital charges. Meanwhile, efforts to mitigate this loss of control through “layer 2” chains come at the expense of connectivity by creating new silos that need to be reconciled with the main ledger.

Private blockchains provide control at the expense of connectivity. A small island is created where participants enjoy siloed connectivity with shared control over key functionality and data. Though this may be more palatable to regulators from a control perspective, an island is still an island; and connectivity is inherently limited.

Either option requires a tradeoff between connectivity and control. Neither option is suitable if the benefits of tokenisation are to be fully realised without impacting capital treatment. In light of this, the pursuit of tokenisation—to improve settlement efficiency and gain billions of dollars in cost savings—seems quixotic.

But these promises can be fulfilled. What is needed for tokenisation to deliver its promised benefits within regulatory requirements is a blockchain network that is public yet permissioned. Unlike public networks today that are permissionless—and so suffer from fatal flaws from a bank regulatory perspective—what we need is a public permissioned network where anyone can participate but where each participant has full control over key functionality of the tokenised assets, including over who validates transactions, to whom a party is connected (impacting AML), and who sees what data.

Only with a public, permissioned blockchain network can banks fully realise the benefits of tokenisation without incurring punitive capital charges on tokenised assets.