Finternet: Unified Ledgers & Tokenization
A Roadmap to Break Barriers in the current Financial System: Leveraging Unified Ledgers and Tokenization to Boost Economic Activities and Asset Flow Across Economies.
Digital technology has not only transformed social interactions and our daily tasks but also revolutionized the financial system. We have reduced our dependence on physical infrastructure, such as physical bank branches and manual paperwork, by adopting digital platforms and technology for financial activities. However, the current financial system has certain limitations that restricts user participation to some extent, and I wouldn’t hesitate to refer to the current financial system as TradFi.
The digital boom introduced us to smartphones and the internet, making nearly all of our interactions with other entities digital. This transformation broke down barriers in traditional finance by adopting ACID database technology, leading to increased participation in activities such as active account ownership, saving, and borrowing.
While this is certainly an uptrend, there are certain shortcomings that present significant opportunities if resolved, particularly for Emerging Markets and Developing Economies (EMDEs). The convergence of underlying technologies and trends for an open and inclusive financial system is a bullish indication that users—both retailers and businesses—along with public institutions and private entities, are willing to adopt and work toward this change. Initiatives such as open finance and banking, CBDC, ONDC, OCEN, and many others are clear examples of this trend.
When we talk about the financial system, it encompasses more than digital money transfer; it also includes other assets such as company shares, government bonds, intellectual property, real estate etc. Additionally, it's not only about owning and managing assets but also about the new possibilities that could be unlocked by building an appropriate financial infrastructure that addresses the shortcomings of the current system.
So, What are these shortcomings ?
Despite considerable progress in recent decades, 1.4 billion adults are still excluded from the financial system.
The shortcomings fall within three broad categories:
Speed
Cost
Reduced Availability
Speed: Delays in current financial system
Retail payments have seen improvements with faster systems, but transactions involving financial assets like shares, bonds, and real estate still take manual processes and chain of messages and thus takes days to settle and are often hard for many people to access.
Even with digital interfaces, behind the scenes, transfers rely on separate proprietary databases with different standards and third-party messaging systems, which can be inefficient.
Other payments like, Cross-border transactions face additional delays due to various factors such as time zone differences and the need for physical contracts. Regulatory & Governance requirements, like anti-money laundering rules and passing certain checks manually, also contribute to delays but are essential for financial system security.
Cost: Delayed Transactions & Manual Processes
Slow Trade Settlements and Their Costs, Slow trade settlements tie up capital, causing businesses to hold extra cash or borrow at high costs. This also forces individuals to seek expensive short-term loans if their wages or transfers are delayed. For MSMEs in India, these delays are a significant problem, often leading to operational liquidity issues and high-interest loans. Errors or inconsistencies in communication between financial institutions can go unnoticed and take time to fix, adding extra costs for users
Reduced Availability
Limited and costly financial services, combined with a lack of options, restrict accessibility.
Solution: Technological Advances & Finternet
Emerging Technology
To tackle the limitations of today's financial systems, innovative solutions have emerged that address key issues:
1. Fast Payment System (FPS): FPS has revolutionized financial transactions by:
Robust Settlement Infrastructure: Ensuring efficient transaction processing.
Mandatory Participation: Including large banks to ensure broad coverage.
Governance Framework: Central banks play a crucial role in overseeing operations.
Low Costs Transactions: FPS include open application programming interfaces (APIs) and aliases (e.g. mobile phone numbers) to initiate transactions with low costs.
Examples of Success:
Aadhaar: Addressed digital identity.
UPI: Solved interoperability between entities
OTNs and ONDC: Demonstrate the potential for digital infrastructure to drive financial inclusion and economic growth.
Despite their success, FPS adoption is still limited. Expanding their use and integrating other innovative technologies can further enhance financial systems.
2. Tokenization: Tokenization involves creating digital versions of financial assets on a programmable ledger. It simplifies asset trading by:
Integrating Information: Combining ownership, transfer rules, and transaction data into one place for multiple assets.
Change in role of Intermediaries: Intermediaries in a tokenized environment primarily serve a governance role, as the curator of the rules governing the transfer of tokens and minimizes the need for clearing and messaging systems, enabling atomic settlement—where multiple transaction parts are settled simultaneously, reducing risk and collateral requirements.
3. Generative Artificial Intelligence (AI): Generative AI offers significant improvements in financial operations by:
Streamlining Tasks: Automating back-office functions like document processing, data entry, and customer interactions.
Identifying Patterns: Analyzing data to better predict customer needs and borrowing capabilities.
Automating Compliance: Enhancing the efficiency of procedures like KYC checks, reducing costs and processing time.
Finternet: Vision
Technology is not an end in itself. The benefits of tokenized assets, and other forms of financial innovation, are limited so long as the assets exist in isolation.
For example, trading a tokenized asset in exchange for a non-tokenized counterpart would still require a sequence of messages to link the tokenized and non-tokenized systems.
To unlock the full benefits of tokenization, it is necessary to bring multiple tokenized assets together on common platforms.
The ideal financial system, or “Finternet,” would be an interconnected network of financial ecosystems with three foundational pillars:
Economically Sound Architecture: The design of the economic architecture should put its users at the center and ensuring users have control over their financial transactions with minimal costs and high security.
Advanced Technologies: Integrating innovations like tokenization and AI into the financial system.
Robust Governance: Maintaining trust through strict adherence to regulatory and legal standards, ensuring financial integrity and security.
Key Components of Finternet:
Central Bank Money: Remains the trusted basis for final settlement in transactions.
Commercial Banks: Continue to mediate between savers and investors, offering tokenized forms of money.
Technology as Enabler: Enhancing security, speed, and efficiency.
By adopting these solutions and integrating them thoughtfully, we can address the shortcomings of current financial systems and move towards a more inclusive, user-centric and efficient financial system.
Implementation
Now, that being discussed how actually, we can implement the vision of Finternet in-order to build the user-centric, open and inclusive financial system.
A token-based financial system, underpinned by unified ledgers, promises a transformative approach to financial transactions. This system integrates various financial assets and transactions into a shared, programmable platform, which enhances efficiency and opens up new economic possibilities.
Key Components: Components to consider for implementing Finternet
Technology: Unified Ledgers
Economics & Finance
Regulations, Legalities & Governance
Unified Ledgers: Unified ledgers act as a shared platform where digital money and financial assets coexist and interact. They don’t mean having a single ledger for everything but rather a system where multiple ledgers can work together, connected via APIs.
These ledgers may evolve, merge, or expand their roles based on jurisdictional needs.
Advanced Economies: Here, individuals already have access to a broad range of reasonably efficient and variety of retail financial services, the main role of unified ledgers might initially be to enhance the efficiency of wholesale financial services
Emerging Markets & Developing Economies (EMDEs): They might focus more on retail services to improve financial inclusion.
Characteristics of Unified Ledgers:
They combine financial assets, ownership records, and transaction rules in one place.
Assets on these ledgers are "executable objects," meaning they can be transferred electronically through smart contracts, reducing reliance on external verification processes.
Structure of the Finternet:
Core Layer: Ledger Unified ledgers include digital representations of central and commercial bank money, tokenized financial assets, and necessary operational information. Token managers oversee different asset partitions within the ledger, ensuring secure and legal transactions.
source: BIS Application Layer Users interact with unified ledgers through various applications, enabling transactions within and between ledgers or with assets outside the Finternet. These apps offer greater flexibility and customization compared to traditional financial systems. For example, an e-banking app might manage both tokenized and non-tokenized deposits
source: BIS
Economics:
Monetary System: The system features two tiers of money: central bank money (the settlement layer) and commercial bank money (tokenized deposits). Central bank money ensures finality of transactions, while tokenized versions of both central and commercial bank money enhance functionality.
Asset Variety: Unified ledgers can hold a wide range of tokenized assets, evolving over time based on jurisdictional needs and legal frameworks.
This token-based system aims to provide a more integrated, efficient, and inclusive financial landscape, addressing many current shortcomings and paving the way for innovative economic solutions.
Asset Transfer on an Unified Ledger
In a unified ledger system, all assets involved in a transaction can be recorded in one place, including:
The securities being traded
Bank accounts of the buyer and seller
Banks’ reserves at the central bank
Assets are tokenized and programmable, meaning conditions or business logic can be applied to them.
Transaction Cycle:
Asset Transfer: The tokenized assets are instantly transferred to Buyer’s digital wallet.
Tokenized Deposits (In a Bank): Buyer’s account balance updates to reflect the transaction.
Central Bank Token Transfer: Funds are moved from Buyer’s bank to the Seller’s bank.
The central bank’s ledger ensures the final settlement of transactions, guaranteeing the completion of financial deals.
Benefits:
Speed: Transactions are faster with less delay between execution and settlement.
Security & Transparency: Reduced reliance on external verification and messaging lowers the risk of errors.
Conditional Transactions: Transactions can be completed only if specified conditions are met, ensuring precise execution.
Governance & Regulations
Unified ledgers offer a streamlined approach to regulatory compliance in the financial sector by integrating rules and regulations directly into the system. This integration makes it possible to encode policy directly into the tokens and transaction instructions, meaning that compliance with legal standards is embedded in the system itself—essentially, policy becomes code.
Compliance and Privacy: Unified ledgers also simplify adherence to Know Your Customer (KYC) regulations. Verifiable digital identities and smooth data transfers across the ledger help financial institutions meet these requirements more efficiently.
Governance Through Tokens: In the Finternet framework, governance is managed through tokens. Each token incorporates rules to ensure compliance with legal and regulatory standards. Token managers oversee compliance, making it easier to adapt to changes and maintain high standards of security, legality, and transparency while balancing openness with strict regulation.
Advanced Technology for Effective Governance (Smart Contract): Advanced technology enhances governance by improving accountability, compliance, and transparency within unified ledger financial system. It simplifies the tracking of actions, verifies legal adherence, and facilitates quick issue resolution. By automating legal rules into the system, it boosts security and trust, supporting innovation and growth.
Challenges and Limitations in Tokenizing Assets
Implementing new financial infrastructures is challenging. Tokenizing assets—converting physical or traditional assets into digital tokens—comes with both costs and benefits i.e. on-ramping financial assets.
Complex Assets: Assets like residential real estate, which involve complex legal and regulatory frameworks, pose significant challenges for tokenization. The process requires addressing frequent manual workflows and intricate regulations. Despite the difficulties, successful tokenization could bring substantial benefits, such as increased liquidity and easier transferability.
Simple Assets: On the other hand, financial assets that are already digital and have streamlined processes, such as government bonds, are easier and less costly to tokenize. These assets benefit from clear legal and regulatory frameworks. While the tokenization of such assets might be less complex and cheaper, the potential benefits might be smaller compared to more complex assets. This is because their transactions are already relatively fast and efficient.
UseCases of Unified Ledgers and Tokenization
Tokenization has significant usecases across various domains. Here’s how it can transform different areas:
1. Real Estate Transactions: Priya, an aspiring real estate investor in Mumbai. With tokenized real estate, can buy and sell fractions of high-value properties. This makes property investment more accessible and liquid, allowing her to diversify her portfolio and participate in the real estate market with smaller investments.
2. Intellectual Property Rights: Imagine David, a musician who creates a new song. By tokenizing his music rights, David can ensure that every time his song is played or licensed, he receives fair compensation through automated smart contracts. This streamlined process reduces disputes and ensures that David's intellectual property is properly protected and monetized.
3. Charitable Donations: Imagine Chloe, who wants to donate to a charity and track how her contribution is used. With tokenized donations, Chloe can see exactly how her money is spent through a unified ledger. This increases trust in the charity and ensures that her donation supports the intended causes effectively.
4. Energy Trading: imagine Lucas, who generates excess solar energy at his home. With tokenized energy trading, Lucas can sell his surplus energy directly to others.
5. Cross-Border Payments: Imagine Ahmed in Dubai sending funds to Maria in Brazil. Using tokenized money and a unified ledger, Ahmed can transfer digital tokens quickly and securely. The transaction is recorded transparently on the blockchain, allowing Maria to receive the funds instantly and with minimal fees, bypassing traditional banking delays and high cost.
Conclusion & Call-to-Action
Unified ledgers, powered by blockchain technology, have the potential to greatly enhance financial inclusion. By significantly reducing transaction costs, facilitating instant settlements and inclusion of various assets these ledgers can dismantle one of the major barriers that currently prevent many people from accessing financial services.
Unified ledgers bring together multiple types of financial assets in one digital space, making it easier for individuals and businesses to access a wide range of financial services. This means that people with tokenized bank deposits on a unified ledger would have better access to various savings options. The need for physical bank branches would diminish, as the digital ledger can be accessed through multiple devices, overcoming geographical and infrastructural constraints. Additionally, unified ledgers would empower individuals by improving their ability to control and share their financial data, reducing the impact of missing identity documents or credit histories on financial access.
Call-to-Action:
Start with simple, high-impact projects that align with existing practices and have broad appeal.
The goal of the Finternet is to offer the widest range of financial services in the most flexible and cost-effective way. To do this, user needs should shape the technology and rules, not the other way around
Both public and private sectors must collaborate to build the Finternet. The public sector should establish the essential infrastructure and regulations, fostering fair competition among private companies to boost innovation and lower user costs.