The Bank of England, German Lessons and Token Disruption

The waves of change are starting to break over the financial markets levee.

Jul 24, 2024

Dateline: New York, 23rd July 2024.

Speaking at the Swiss National Bank’s “Towards the future of the monetary system” event earlier this year, Bank of England Deputy Governor Sarah Breeden predicted two distinct waves of benefits arriving because of tokenisation. First, she said that in the near future she expects to see efficiencies that “broadly preserve the current structure of payment and settlement” but in the longer term, she sees it as more disruptive with post-trade processes collapsing and layers of intermediaries being flattened. Not that it matters what I think, but I think she is spot on.

North and South

Ms. Breeden’s perspective is important because while the Bank of England, in common with many other central banks, is experimenting with wholesale central bank digital currency (CBDC) of one form and another, the Old Lady of Threadneedle Street adopted a particularly innovative approach by creating a new category of central bank account (the “omnibus” account) for institutions. As I wrote in Forbes recently, the introduction of the omnibus account led directly to the creation of Fnality, a private institutional form of tokenised money supported by a great many institutions. Insititutions transfer Sterling from their accounts to the omnibus account and in return obtain Sterling Tokens that can be used in on-chain transactions.

The importance of this innovation should not be understated. Andrew Griffith (then the Economic Secretary of the UK Treasury) said last year that a wholesale private sector stablecoin (such as Fnality, for example) would precede a wholesale CBDC (which he sees as happening before a retail CBDC), while the Governor of the Bank England Andrew Bailey has said that he doesn’t see the need for a wholesale CBDC at all because the real time gross settlement system (RTGS) used for interbank payments already settles in central bank money (and, frankly, is always going to be faster than any form of shared ledger).

He has a point, as you might expect, because the benefit of a wholesale CBDC is that it gives the ability to settle trades in tokenised assets on the ledger itself, enhancing liquidity in capital markets: if an institutional CBDC is backed by central bank money, then there is no need for a central bank to issue the wholesale CBDC itself. Having the entirely separate infrastructure also means that trading can continue on various ledgers even if the RTGS goes down, as does happen now and then (last August, RTGS went down for six hours and last week CHAPS went down for a while too.)

If some kind of tokenised central bank money comes to circulate between institutions, private or public, the Deputy Governor’s point about the flattening of the infrastructure is key to understanding why. The desire for decentralised finance — that is, exchanging fungible and non-fungible tokens via persistent scripts (they are not “smart” and they are “not” contracts) — is not because of ideology but because of money. These transactions will be cheaper, because the money tokens will be exchanged directly for the asset tokens with no need to do “traditional” clearing and settlement. The money, as Marshall McLuhan might have said, is the message.

Experiments

There is some interesting experimentation going on here and it’s not only the Bank of England exploring the potential benefits. The central bank “club”, the Bank for International Settlements (BIS), has just announced its Project Agora which will bring central banks today and private sector players to explore how tokenisation can enhance the functioning of the monetary system. The Bank of France (representing the Eurosystem), Bank of Japan, Bank of Korea, Bank of Mexico, Swiss National Bank, Bank of England and the Federal Reserve Bank of New York will seek to work in partnership with financial sector companies convened by the Institute of International Finance (IIF) to investigate how tokenised commercial bank deposits can be seamlessly integrated with tokenised wholesale central bank money in a public-private infrastructure using smart contracts and programmability, while maintaining its two-tier structure.

Tokenised central bank money will be used between institutions for payment vs. payment (PvP) and delivery vs. payment (DvP) to exchange money and tokenised assets. What kind of assets will tokenised? Well, all of them in the long run, but right now funds are a particular focus. Taking an investor’s share or unit in a collective investment scheme (i.e., a ‘fund’) and turning it into a token that can be traded in a programmable, composable, automatic and cryptographically secure database shared between parties looks to be a practical way to improve markets. Apart from anything else, a range of information can in theory be coded into the token, such as details of its ownership and the value of the token’s reference assets.

Case Study

Noelle Acheson provides an interesting case study from Germany looking at LBBW. This is the country’s largest “landesbank”, a type of savings institution renowned for being among the most conservative financial institutions in existence. Jürgen Harengel, COO of the Corporate Bank at LBBW, recently said that they see increasing demand for digital assets from their corporate customers. Now, in contrast to the US, Germany’s financial industry is dominated by banks rather than by markets and, as Noelle points out, German banks are more deeply embedded in corporate activity than are their US counterparts.

LBBW is not so much interested in “crypto” for speculative trading as it is in utility, and what that can do for its corporate clients. In 2022, LBBW was one of the first to issue digital securities on Deutsche Börse’s D7 post-trade platform this year it will be one of the first participants in the ECB’s wholesale DLT trial. As LBBW is actively exploring enterprise distributed ledgers applications it is seeing the need for some kind of token management services to allow for “on chain” settlement and is therefore preparing for a business ecosystem where value is "more about function than form, and liquidity matters more than price appreciation.” Noelle concludes, and I could not agree more, that future digital-first markets about more efficient distribution, accountability and flexibility and it is interesting see such institutions emerging.

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The New

Frankly, the move towards the tokenisation of real-world assets (or “stuff”, as I call it) and the trading of stuff for money in 24/7 decentralised markets is more of a vision of future global financial market infrastructure (FMI) than the co-ordinated manipulation of the meme stocks or the mempool front-running of cryptocurrency trades is. This is why it is so important to the get a solid legal framework in place, and soon, because that vision is pretty desirable.

I rather agree with Aisha Williams in her piece for NASDAQ in which she writes that the fully digital infrastructure of real-world asset tokenisation and decentralised finance protocols will reshape financial markets by creating accessible and tradable assets. The new infrastructure will consolidate distribution, trading, clearing and settlement in a single layer, meaning more streamlined (i.e., less expensive) financial intermediation. This infrastructure is already under construction.

Here in the UK, the Financial Conduct Authority (FCA) is working with the industry to explore potential uses of fund tokenisation which could make collective investment schemes more efficient, transparent, and accessible to a wider range of consumers. Meanwhile, in the US, BlackRock has already announced the launch of its first tokenised fund issued on an Ethereum blockchain, the BlackRock USD Institutional Digital Liquidity Fund. The financial system is heading for disruptive change.