Financial experts interpret J.P. Morgan's experimental results: Three major visions of Tokenized Finance

This article, originally from "Three big ideas for tokenized finance", was written by Daniel H. Neilson and edited with annotations by the author. As an expert in monetary finance, Daniel H. Neilson interprets the tokenized finance sector Onyx of JPMorgan Chase and tokenized finance experiments by the central banks of France and Singapore through the "currency framework."

From the peak at the end of 2021 to the present, the sharp drop in cryptocurrency asset prices has exposed several issues, including poor asset management (Celsius), well-intentioned but severely flawed protocols (Terra/Luna algorithmic stablecoins), and a strange recapitulation of the financial history of the ultimate borrowers (SBF transforming into the persona of JP Morgan from a century ago, providing institutional loans).

Despite the turmoil in the crypto market, some core crypto ideas have not yet faced a true political-economic test, such as public blockchains. I believe public blockchains will eventually be shut down, but it does not seem likely to happen at present.

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However, what is truly significant is that three important concepts that emerged alongside cryptocurrencies have withstood challenges, as it seems that everyone agrees that cryptocurrencies and blockchain technology can bring about "potential financial innovation."

The first is tokenization, where during transactions, both parties only need to prove what assets they have, without needing to prove their identities. This anonymous technology is suitable for distributed ledgers, where the transaction parties and nodes independently verify transactions and then mutually prove and coordinate block creation. This technology enables smart contracts and their benefits to be implemented in finance: allowing for the writing of complex transactions and their execution without monitoring or prior agreement.

In today's article, I will use this technology (blockchain technology) to record the tokenization of the finance sector and cross-currency tokenization experiments by the central banks of France and Singapore.

Please note that this experiment was conducted in July 2021, with the documentation only being made public in November 2021, so readers should not consider the experiment below as the latest standard for wholesale tokenized finance (referring to CBDC). Because since November 2021, there have been significant changes in tokenized finance (referring to TerraUSD).

However, this experiment mentioned records the most fundamental tokenized finance of the monetary system, making it worth a look.

Tokenization of Assets

Asset tokenization is just the foundation of the Onyx experiment, so the white paper does not discuss the process, but we can still reconstruct the process.

In the T-account diagram below (T accoounts, the representation of a balance sheet), I have illustrated how commercial banks can convert reserves into an equivalent amount of central bank digital currency (CBDC).

[Editor's note]: Reserves are issued by the central bank, so they are the central bank's liabilities, while commercial banks hold reserves as assets.

Reserves and CBDC have the same structure on the balance sheet, but they serve different purposes. Reserves are account-based and can only be held and traded by counterparties that meet regulatory requirements; CBDC, on the other hand, is asset tokens based on blockchain, which are anonymous transaction tools protected by encryption.

Asset tokenization is just a tool, so it can be issued by different institutions for other assets, such as private banks issuing tokenized assets, not necessarily central banks. However, the most important thing is that there needs to be someone willing to accept off-chain funds and then create on-chain funds. Central banks have a unique position in issuing tokenized assets (meaning issuing currency with the highest status), but other institutions can also do so.

Distributed Ledger

The Onyx mCBDC experiment uses a distributed ledger, where different tokens represent different national currencies, similar to the mCBDC Bridge used by the Bank for International Settlements (BIS). The distributed ledger used by Onyx is a fork of Ethereum, a permissioned version that requires permission to use, with technology from the blockchain software company ConsenSys. Appendix B of the Onyx mCBDC white paper is where I spent most of my time, detailing the transaction process. Interestingly, at each step of the transaction, it shows which nodes can see the account balances of other nodes.

In a distributed ledger, multiple participants may see the same transaction message, so the system must consider who sees what. The diagram in the white paper shows that a single participant's wallet balance reveals who can see other people's transaction messages. Although it does not clearly show the financial implications of different tokens, it does remind us to pay attention to the visibility of transactions in a distributed ledger. In a transaction, both parties, as well as the token issuer, regulatory authorities, and nodes, can see the transaction.

If it is a public distributed ledger like Ethereum, then everyone can see every transaction. It is conceivable that the transparency of transactions will trigger discussions in political economy about how such mechanisms will be useful in fully developed tokenized finance.

Why Tokenize Assets and Use Distributed Ledgers?

As we all know, the main claim of Onyx mCBDC is that cross-border payments are complex, slow, and expensive. In theory, a tokenization system can provide a simpler (at least for end-users), faster, and cheaper solution. Some of the benefits come from the distributed ledger itself, as it helps simplify cross-border transactions that would otherwise require multiple intermediary banks.

Programmable Contracts

While distributed ledgers are valuable, the white paper emphasizes an even greater treasure: programmable contracts.

Once all funds are on the same distributed ledger, the distributed ledger can be used for automated trading. The Onyx mCBDC experiment applied the concept of a foreign exchange market maker, allowing automatic market makers to conduct currency transactions: programmable contracts can be executed without the need for human monitoring. Programmable contracts are like options with complex delivery conditions that will execute if the conditions are met.
The transaction structure is shown in the T-account diagram below. At 1, liquidity providers provide funds to the unattended FX pool, where the bank provides euros and new coins to the pool, and the FX pool provides the bank with liquidity provider tokens (LP tokens) as proof.

In the Onyx experiment, liquidity providers are obligated to provide the tokens needed for bilateral transactions (euros and new coins) to create a bilateral market.

[Editor's note]:
1 Liquidity providers provide EUR and SGD to the Unattended FX pool. The FX pool receives the assets, uses EUR and SGD as collateral to issue LP tokens, and transfers the LP tokens to the liquidity provider as proof of liquidity provision.
2 Liquidity takers exchange EUR for SGD, increasing EUR and decreasing SGD in the FX pool.
3 Liquidity providers redeem assets with LP tokens (-LP token) to receive EUR and SGD (+ EUR & SGD).

In the Onyx mCBDC foreign exchange application experiment, the automatic market maker is designed to be "asset constant": if the quantity of assets in the pool changes, the prices of both assets will automatically adjust to maintain the total value as before.

A few months after the Onyx experiment, the Terra/LUNA incident occurred, which may prove that adjusting prices with automatic market makers is not feasible. Since the logic is similar between the two, if the price of one token goes to zero, it will end up like Terra/LUNA.

Nevertheless, numerous variants of automatic market makers can be imagined, some of which may not face the zeroing problem encountered by asset constants.

[Editor's note]: The asset constant mechanism of automatic market makers is similar to DEX's x+y=z, where if the quantity of x in the pool decreases, the price of x will increase, and the price of y will decrease, ensuring that the total value of x+y remains equal to z.

Mutual Misunderstanding?

These tokenization financial experiments seem to continue, and I believe that internal departments of regulatory agencies will build the next generation of technology.

However, the sideline conversations between the crypto community and government agencies are still worth noting: one side is responsible for the operation of the global monetary system, including central banks, monetary bankers, and regulatory agencies, who communicate in the language of the currency market. On the other side are tech newcomers, such as developers, cloud service providers, and fintech entrepreneurs, who speak the dialect of Silicon Valley. There is still a long way to go in the communication between these two parties.