A History Primer on Tokenization: Why Assets Will Move to Public Blockchains

Wall Street’s paperwork crisis and the DTCC

The financial system of today has been molded over decades by times of high systemic stress. One often underappreciated incident which illuminates why settlement systems work the way they do is the paperwork crisis of the late 1960s, which is recounted in great detail in The Historical Context of Stock Settlement and Blockchain by George S. Geis. A review of the development of securities clearing and settlement is crucial to building an understanding of the current financial system and to recognizing the significance of tokenization.

Today, a person can easily purchase a security through their online broker in a matter of minutes. Of course, this was not always the case. Historically, stocks were issued to individuals who held physical certificates representing stock ownership. In order to exchange a share of stock, the physical certificate had to be transferred from seller to purchaser. This included delivering the certificate to the transfer agent who would cancel the old certificate and issue a new one in the name of the purchaser. Once the new certificate was delivered to the purchaser, and the payment monies were delivered to the seller, the transaction could be considered settled. In the 19th and 20th centuries, brokers increasingly held stock certificates on behalf of their investors, allowing them to more easily clear and settle trades with other brokers. This process was still primarily manual, and a brokerage firm typically used 33 different documents to execute and record a single securities transaction (SEC). Although initially manageable, this process became increasingly cumbersome as trading volumes grew. The 1960s witnessed a dramatic increase in stock trading activity, making the physical delivery of securities among brokers an impossible task. Systems designed to handle daily trading volumes of 3 million shares in the early 1960s were incapable of dealing with the 13 million share days seen at the end of the decade (SEC). To give the back offices time to catch up on settlement, the NYSE established shorter trading days, increased settlement time to T+5, and eventually prohibited trading altogether on Wednesdays.

The NYSE had been working on a solution since 1964 with the creation of the Central Certificate Service (CCS). The objective was for the CCS to become the central depository for all stock certificates, meaning it would hold all stocks on behalf of its members (mostly brokers), while end investors were granted beneficial ownership rights represented by a book-entry in their broker’s ledger. Progress with the CCS was hindered by a combination of regulations until 1969 by which time all fifty states had changed their laws to sanction centralized certificate holding and transfer of stock ownership by the CCS. All stocks were moved to the CCS such that they were stored in what was known as “immobilized fungible bulk”. Since the CCS held all stock in immobilized form, it recorded in an internal ledger the balances of its member-brokers, who in turn recorded balances of the end investors they represented in their internal ledgers. Now stock settlement could be done by book-entry rather than physical delivery. In 1973, the CCS was renamed the Depository Trust Corporation (“DTC”), and all stock certificates were transferred in name to its subsidiary, “Cede & Co”. Today, the DTC, through Cede, is the named owner of nearly all corporate stock. DTC itself is a subsidiary of the Depository Trust and Clearing Corporation (DTCC), whose other subsidiaries include the National Securities Clearing Corporation (NSCC). These companies, the DTC and the NSCC, are two of the most mission-critical components of today’s securities system.

The creation of these intermediaries changed the nature of stock ownership. Previously, stockholders held physical certificates; now, this ownership is represented as book-entries in a chain of ledgers. As the financial system has evolved, increasing complexities have led to the creation of additional custodians and intermediaries each of which must maintain its own records of ownership via book-entry. The tiering of ownership is simplified in the diagram below:

A note on the digitization of securities

Starting in the aftermath of the paperwork crisis, the DTCC stopped the practice of holding physical shares of stock in its vault, so shares went from being ‘immobilized’ to being completely ‘dematerialized’ and now almost all shares of stock are represented only as electronic book-entries. Most securities today are issued in dematerialized form. As of 2020, the DTCC estimates that 98% of securities have been dematerialized, with the remaining 2% representing nearly $780 billion dollars worth of securities.

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A Primer on Traditional Financial Market Infrastructures (FMIs)

The deeper structural background knowledge needed to understand the potential of blockchains can be obtained by learning about financial market infrastructures (FMIs), the very entities blockchains are poised to disrupt. FMIs are critical institutions that make up the backbone of our financial system. The roles of FMIs are extensively elaborated by the Bank for International Settlements (BIS) and the International Organization of Securities Commissions (IOSCO) in “Principles for Financial Market Infrastructures” (PFMIs). The key financial market infrastructures defined by BIS and IOSCO for the smooth functioning of the global financial system are:

• Payment systems (PSs): Systems tasked with safely and securely effecting the transfer of funds between or among participants.
  • Examples: In the US, Fedwire is the primary inter-bank wire transfer system providing Real-Time Gross Settlement (RTGS) services. Globally, the SWIFT system is systemically vital as it provides a network for international transfers of funds but it is only a supporting system - it does not hold accounts or settle payments.
• Central securities depositories (CSDs): Entities whose role is to provide securities accounts, central safekeeping services, asset services, and that play an important role in helping to ensure the integrity of securities issues.
  • Examples: In the US, the DTC. Euroclear or Clearstream in Europe.
• Securities settlement systems (SSSs): Securities settlement systems enable securities to be transferred and settled by book entry according to a set of predetermined multilateral rules. Such systems allow transfers of securities either free of payment or against payment.
  • Examples: In the US, the DTC. Euroclear or Clearstream in Europe.
• Central counterparties (CCPs): Entities that become the buyer to every seller, and the seller to every buyer to ensure the performance of open contracts. CCPs achieve this through novation, the process of splitting one contract between buyer and seller into two contracts: one between buyer and CCP, and another between seller and CCP, thus absorbing counterparty risk.
  • Example: In the US, the National Securities Clearing Corp. (NSCC).
• Trade repositories (TRs): An entity that maintains a centralized electronic record of transaction data.
  • Example: The DTCC operates Global Trade Repositories across North America, Europe, and Asia. Mostly used in derivatives transactions.

During the lifetime of a transaction, the interplay of these systems looks something like this:

A transfer is usually organized with an FMI as the central hub in a hub-and-spoke model, where the spokes are other financial institutions like banks and broker-dealers. These financial institutions may interact with multiple FMIs in different markets and jurisdictions as shown in the image below.

This siloing of ledgers means that entities have to trust one another to maintain the integrity of their ledgers as well as their communication and reconciliation. There are entities, processes and regulations that exist purely to facilitate this trust. The more complex and global the financial system becomes, the more exogenous forces are needed to enforce trust and cooperation among financial institutions and financial market intermediaries.

Current inefficiencies in financial markets are highlighted by the following data on corporate securities settlement fails which have recently grown to represent more than 5% of total trading volume.

Additional data from the DTCC on the value of daily failed settlements of US Treasuries reveals that between $20bn and $50bn USD fail every day. This makes up about 1% of trades cleared by the DTCC which clears about $4 trillion in Treasuries every day (DTCC).

There are consequences to settlement failures as the buyer of the securities may have already used them as collateral in another transaction. This subsequent trade will also face a failure-to-deliver, potentially causing a domino effect of failures.

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Securities Settlement: Delivery versus Payment

“By far the largest financial risks in securities clearance and settlement occur during the settlement process”, says the Committee on Payment and Settlement Systems. Securities can be transferred either free of payment or against payment. Some markets employ a mechanism whereby the transfer of securities happens if and only if the corresponding transfer of funds is successful - a mechanism known as delivery versus payment (DvP). Today, delivery of securities and payment of funds happen on two fundamentally different rails, via different systems. One takes place via payment systems, while the other takes place via securities settlement systems, the same ones mentioned in the previous section. In the United States, payment might take place via FedWire or ACH, while international payments might use SWIFT for communication and settle via correspondent banking networks. On the other hand, securities delivery takes place via securities settlement systems and central securities depositories like the DTC. These are different rails and different ledgers, requiring increased communication and trust among diverse intermediaries.

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Blockchains and atomic settlement in DvP

Blockchains can mitigate certain risks in delivery-versus-payment systems, such as principal settlement risk, due to a unique property of blockchain transactions known as atomicity. A blockchain transaction can itself be made up of several distinct steps. For example, delivering a security and finalizing its payment. What makes blockchain transactions special is that either all legs of the transaction succeed, or none of them does. This quality is known as atomicity, and it enables mechanisms like flash loans, where, in a single transaction, a user may borrow money with no collateral so long as it is returned within the same transaction. This is possible because, if the user fails to pay back the loan, the transaction, and thus the loan, will fail to be recorded. In blockchains, delivery versus payment can be done trustlessly through smart contracts and the atomic execution of transactions. This has the potential to reduce principal settlement risk where one leg of the transaction is unsuccessful, exposing parties to potential losses. Blockchain have key qualities that position them to disintermediate the roles played by traditional securities settlement systems and payments systems in delivery-versus-payment settlement.

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Why permissionless blockchains?

For a blockchain to be public and permissionless it must be possible for anyone to participate in validating transactions, producing blocks and achieving consensus on the canonical state of the ledger. Additionally, 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 ledgers. Blockchains that fit this criterion, and are sufficiently large and decentralized, are, by nature, credibly neutral global settlement layers. That is to say, they are unopinionated environments for transaction execution, validation and settlement. Transactions can take place between parties that do not know each other through the use of smart contracts, enabling trustless, unintermediated execution, resulting in immutable changes to a globally shared ledger. Although no single entity is able to restrict a person’s access to the blockchain, individual applications built on blockchains may implement permissions like whitelists for KYC and compliance related purposes.

Public blockchains can lead to improved efficiency of back-office operations, and to greater capital efficiency by leveraging the programmability of smart contracts and the atomicity of blockchain transactions. These functions can also be achieved through permissioned blockchains. To date, much corporate and government exploration of blockchains has been through private and permissioned blockchains. This means that validators of the network must pass KYC checks to be permitted to join the network and run the ledger’s consensus mechanism, transaction validation, and block production software. Implementation of a permissioned blockchain for institutional use would not be much more beneficial than using a private shared ledger among institutions. The financial system would cease to be unopinionated and credibly neutral if the underlying technology was entirely controlled by entities like JP Morgan, a coalition of banks, or even a government. Research on distributed ledger technology has been done by corporates and government institutions since at least 2016, and we have still not seen any significant implementation of these systems beyond pilot programs and testing environments. In a16z’s Chris Dixon’s opinion, this is partly because blockchains allow developers to write code that makes strong commitments and corporations don’t have much need to make commitments to themselves. Additionally, blockchains are meant to be like massively multiplayer games, not merely multiplayer as is the case with enterprise blockchains.

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Select Tokenization Case Studies

Maker, the protocol that manages the DAI stablecoin, has increased its use of real world assets (RWAs) to collateralize issuance of DAI. In the past, DAI was mostly backed by crypto assets and stablecoins. Today, a significant portion, about 40%, of Maker’s balance sheet is held in RWA vaults that invest in US Treasuries, generating substantial revenue for the protocol. These RWA vaults are managed by a variety of entities including BlockTower and Huntingdon Valley Bank.

BlackRock’s USD Institutional Liquidity Fund (BUIDL) was released on the public Ethereum blockchain in March 2024. BlackRock’s fund invests in US Treasuries, and investor’s ownership of shares in the fund are represented through an ERC-20 token. In order to invest in the fund and for additional shares to be issued, investors must first pass KYC through Securitize. Payment for shares can currently be done by wire transfer, or via USDC. Although the option to issue and redeem shares via stablecoins exists, the actual settlement of the transaction does not occur until the Fund successfully sells (in the case of a redemption) the underlying securities in a traditional financial market. Moreover, the transfer agent, Securitize, maintains an offchain register of transactions and ownership that supersedes the blockchain as the legal register. This is indicative that there is still a lot of work to be done from a legal standpoint before the US Treasuries themselves can be issued onchain so they may settle atomically with USDC payments.

Ondo Finance is a financial technology startup trailblazing the tokenization space. They offer several products including OUSG and USDY that are issued as tokens on several public blockchains. Both products invest in US Treasuries under the hood and offer holders yield. OUSG is available in the US but only to qualified purchasers, while USDY is available to anyone outside the US (and other restricted territories). An interesting point on 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 ‘made’ when Ondo converts the USDC to USD and wires the funds to its own bank account. This is for legal and accounting purposes and is a clear demonstration that a lack of clear regulatory frameworks for digital assets has hindered innovation.

Stablecoins have been tokenization’s greatest success story so far. Over $165 billion of tokenized fiat currencies exist in the form of stablecoins, with trillions in monthly transaction volumes. Stablecoins are becoming an increasingly important part of financial markets. Stablecoin issuers are, combined, the 18th largest holders of US debt in the world.

Conclusion

The financial system has gone through many growing pains including the paperwork crisis, the global financial crisis and even the Gamestop saga. These periods have stress tested and molded the financial system into what it is today: a massively intermediated and siloed system relying on sluggish processes and regulations to establish trust and effect transactions. Public blockchains offer a superior alternative by establishing censorship-resistant, credibly neutral, programmable ledgers. However, blockchains are not perfect yet either. They suffer from technological idiosyncrasies like block reorganizations, forks, and latency related issues due to their distributed nature. To read more in depth about the settlement risks associated with public blockchains, see Settling the Unsettled by Natasha Vasan. Additionally, although smart contract security has improved, smart contracts are frequently hacked or exploited through social engineering. Blockchains also become expensive in times of high congestion, and have not yet demonstrated the capacity to process transactions at the scale required by a global financial system. Lastly, there are compliance and regulatory hurdles that need to be overcome in order to make widespread tokenization of real world assets a reality.

With the appropriate legal frameworks in place, and sufficient advances in the underlying technology, the tokenization of assets on public blockchains is poised to unlock network effects as assets, applications, and users are brought together. As more assets, applications, and users are brought onchain, the platforms themselves - blockchains - will become more valuable and attractive for builders, issuers, and users, creating a virtuous cycle. The use of a globally shared, credibly neutral substrate will enable novel applications across the consumer and financial sectors. Today, thousands of entrepreneurs, developers and policymakers are building this public infrastructure, overcoming hurdles, and striving for a more connected, efficient, and equitable financial system.

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Questions for Future Research

• How do smart contract languages affect tokenization? Is Move’s object data model better suited for representing financial assets safely on chain than EVM based smart contracts?
• To what extent should finance be open and transparent? How can zero-knowledge proofs enable a multichain/cross rollup financial infrastructure while preserving privacy where needed? Is this a better solution than using permissioned chains?
• How should we think about blockchain interoperability protocols in a world where real financial assets exist on chain? What is their role, and how should they be constructed?

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