The author of this article, who has already explained broad outlines of the world of digital assets, and dealt with a few misconceptions, takes a look at what are called native digital assets.

In this article, Dr Ian Hunt (more detail on the author below), goes further into the subject of digital assets. (See a previous article from Dr Hunt here.) As this news service knows, digital assets – a term covering various entities – are important for wealth managers to understand. The editors at this news service are pleased to share these insights; the usual editorial disclaimers apply. Jump into the conversation! Email tom.burroughes@wealthbriefing.com

In the previous article in this occasional series on digital assets, we suggested that there were advantages in trading and settlement if we moved from our conventional representation of assets and cash into a digital representation.

Our conventional representation of an asset is a depositary record, exhibiting essentially evidencing its existence, and a custody record, essentially exhibiting its ownership. Our conventional representation of cash is as a balance in a bank account. In the digital world, both are represented by a token on a digital ledger. A digital ledger is a network of nodes, or addresses, where tokens are held, the location of a token at an address evidences title to an asset or cash for the owner of that address.

When we trade in the conventional world, we generally exchange assets for cash. The assets are delivered by transferring entries from one custody account to another, while the cash is transmitted between bank accounts along separate payment rails. Both the delivery and the payment are managed in accordance with settlement instructions provided by the parties to the trade, but they are separate movements. 

In the digital world, trades exchange one kind of token (an asset token) for another (a cash token) in the same environment – on the digital ledger. The movements of cash tokens and asset tokens can be locked together in a process known as “atomic settlement.” It is perfect “delivery versus payment” (DVP), which gives certainty to both parties, and removes risk from the trading and settlement process.

There are other benefits in the digital world.

If the asset, cash, and transaction data is represented in a blockchain, then its history will be both complete and unchangeable (“immutable” in blockchain-speak).  Attempting to change data in a blockchain corrupts the entire chain and makes the data that it contains inaccessible, so fraudulent manipulation of data is not productive, and it’s obvious when that it happens.

If the digital ledger is built on distributed ledger technology, then the nodes share data, in real time, replicating any transaction that they have an interest in. The DLT ensures that the relevant data is both visible and aligned between addresses. This enables the elimination of messaging between the nodes because they share all of the relevant data. It also reduces or eliminates the need for reconciliations between different data stores, because the DLT ensures that their data is maintained in alignment.

The distributed ledger approach makes fraud much harder because the data is replicated between nodes. So, any attempt to change the data at an individual node will be immediately obvious. A fraudster will need to corrupt all nodes simultaneously, which is a big ask!  To corrupt a centralised, conventional system, like a commercial bank’s account ledger, the fraudster must only get access to one platform. Combined with the immutability and complete history of blockchain data, DLT shows very significant benefits in security. This enhances the trust of participants in a digital ledger.

Types of token on a digital ledger
We saw in the previous article that there are four kinds of token that inhabit a digital ledger. These are:

1. Collateralised cash tokens – tokens giving title to off-ledger conventional cash or cash-like assets;     

2. Collateralised asset tokens – tokens giving title to off-ledger conventional assets;

3. Native digital cash – currency tokens that exist only on-ledger and have no off-ledger backing; and

4. Native digital assets – asset tokens that exist only on-ledger and have no off-ledger backing.

The first two of these (i.e. the collateralised tokens) are what are commonly described as ‘tokenized’. The word gives it away – they are conventional assets and cash whose title to ownership has been represented in token form. The advantages over a conventional financial ecosystem set out above apply to tokenized assets and cash, as well as to native tokens, so they are useful in their own right. However, tokenized assets and cash, and the collateralised tokens that represent their title, are not the belles of the ball. Native assets and cash have far more potential benefit and far greater power to transform the industry.

What are native digital assets and native digital cash?
Native digital cash is widely familiar in at least one form: cryptocurrencies. These are widely discussed, and widely distrusted because their volatility limits their usefulness as stores of value and means of exchange. Central Bank Digital Currency (CBDC) will resolve this issue and give us a native form of digital cash that can be used with confidence in digital vs digital transactions and held with confidence as a store of value.

Native digital assets are much less familiar. They do not rely on any off-ledger cash or assets as collateral, and their value is therefore inherent to themselves; where they reference other entities, these must therefore be tokens on the ledger itself. Their nature becomes immediately clear if we consider what happens on a digital ledger. There are really only two things going on:

-- Value held at nodes/addresses on the ledger in token form; and
-- Value moving as token flows between the nodes/addresses on the ledger.

Nothing else is happening, so native digital assets can only possibly relate to these two. They can either be:

-- A token with inherent value at a node on the ledger; or
-- An entitlement to a flow of tokens on the ledger.

It is as simple as that.  

An example of the former is relatively familiar: Non-Fungible Tokens (NFTs). These are generally collateralised, and represent title to an off-ledger asset, like a work of art. However, some NFTs are natively digital and do not reference off-ledger assets: they are purely digital artefacts and are therefore genuinely native digital assets. They have had some moments in the sun, and are an interesting phenomenon, but they are not going to transform our industry.

Commitments to future flows of tokens – or “pledges” for short – are a powerful and interesting form of native digital asset, and a close relative of the humble IOU.

Far from being an obscure and dangerous phenomenon, pledges are the building blocks of most of the familiar assets and derivatives that populate our conventional financial ecosystem. Think of a bond, a loan, or a swap. We treat them as a single investable asset (or contract) with terms, conditions, and cash flows. What they really are is a fistful of pledges, a cluster of IOUs.

A 10-year, annual coupon bond, for example, has two immediate and 11 future flows. The immediate flows are the payment of cash from the investor to the issuer of the bond, as principal, and the delivery of the bond itself to the investor. There follow 10 flows of cash from the issuer, at yearly intervals, as coupon. At the end of the term, there is a redemption payment of the principal amount from the issuer to the investor. The flows are committed by the execution of an order for the bond.

The truth is that there is no coherent thing that is the ‘bond’, and that is transferred to the investor, distinct from the obligations of payment undertaken by the issuer.

The title to the bond means nothing more or less than the entitlement to the flows. There is no risk or value attached to the bond either, separately from the aggregate risks and values of the flows. Each flow has a different risk, because it occurs at a different point in future: the further out it is, the less likely it is to happen. Each flow should therefore be valued separately. When we talk about the risk and value of a bond, it is shorthand for the risk and value of a fistful of flows.  

There are, of course, exceptions to the rule that assets are built of future flow commitments. Purely financial instruments are, but there are solid physical assets, like buildings, paintings, and fairground rides, which are not made of flows. Owning one means that you have title to a physical thing, out there in the non-digital world. The best we can do with these assets in the digital world is to tokenize their title, representing their ownership in the form of a token on-ledger. 

There are composite assets too, where part of the asset is tokenized/collateralised, and part is represented by future flow commitments. Equities are a good example, where the owner owns part of a company, which is an off-ledger, if not physical, entity. However, ownership of an equity also brings with it an entitlement to a future flow of dividends. So, an equity, in a digital ecosystem, is represented by a cluster of tokens: one collateralised token representing company ownership and one native digital token representing the dividend commitment.

What happens when flows are primary
Each of our current, familiar asset classes has an associated issuance model and an associated operating model. Each has a set of legal terms defining its nature and title, and a set of regulations saying who can own it and how it is held and transacted. Each has a set of entities and roles, defining who must be involved, and how, in safekeeping and transactions in the asset. 

If we treat the flows as the starting point, rather than the conventional asset, then the world gets very interesting very quickly.   

If purely financial assets are built out of flows, and we define an issuance and operating model at the flow level, then we could have a single issuance and operating model across all financial assets, rather than one of each per asset type. There is also no limitation on what asset types we can construct: assets and derivatives are clusters of flow commitments, so we just need to define a new set of flows, cluster them together, and put a label on the set, and we have a new asset class. Instead of two to three years to implement a new asset class, we can do it on the same day. The financial world can be both much simpler and much more flexible.

The single issuance and operating models can address much more than just assets too. Income is just a future flow, and corporate actions are future flows that may be contingent or elective. An order is just a back-to-back pair of flow commitments, and an execution is just the delivery of those flows. An invitation to trade, or indication of interest to the market, is just a flow commitment that someone would like to make but hasn’t made yet. All these fit within the single model too.

A single issuance and operating model across asset types opens the possibility of a massive reduction in the weight and complexity of regulation, rolling back what has been seen as an inevitable and unavoidable tide.

The first big step forward is to see that flows commitments are primary, and that financial assets are clusters of flows. Alongside financial assets, we will tokenize any resolutely non-digital asset, to bring its trading and settlement on-ledger. 

What happens when you make tokens smart
We have an established idea of how systems operate that is so deeply engrained that we rarely, if ever question it. We see business systems as the venues where the operations of a business are codified, and which have the power to make them happen. Business systems rule the roost and push dumb messages and data around. Even new developments in DLT essentially follow this pattern but add tokens to the data and messages that are pushed around. 

If we turn this idea on its head, and make tokens smart and potent, then the world gets very interesting, very quickly. 

A smart token is a future flow commitment that has knowledge of the flow that it commits, and has the power to implement it, without intervention from any human or from any business system.  It is an entitlement with finesse, an IOU with attitude. 

It may sound as if smart tokens are going to be very complex objects: after all, they are taking the power away from huge and complex business systems and doing it for themselves. However, and fortunately, the opposite is true: smart tokens are actually very simple entities, because of the nature of the digital ledger. The only thing actively happening on the ledger is the movement of tokens between addresses/nodes. Therefore, the only thing that a smart token can possibly do is to move other tokens (or itself) between addresses. This makes the smart token, the data that it holds, and the things that it does, very limited.

A smart token is a token, so it is held at the node of its owner (who is the recipient of the future flow), like any other token. It is issued as a pledge by its issuer, who sends it to the recipient. Again, because the smart token is a token, it can be fractionalised and traded without limitation, so the recipient can on-trade it, in fractions or in a cluster with other tokens.

Smart tokens just need to know when to activate and move the committed tokens; what the committed tokens are; how many of them are pledged; where they are to move from (always the issuer’s node) and any restrictions on where they can be held, and therefore where they can be sent to. The smart token doesn’t need to know where to send the committed tokens, as that will always be the address at which the smart token itself is held – the recipient’s own ledger address.

If the smart token knows all this, then it has everything it needs to move the committed tokens.  It just needs the power to do so, which means that it must be able to take tokens from the issuer’s node and deliver them to the recipient’s node.

Smart tokens will self-actuate when the timing or conditions for their activation are met; they will then work out what they need to do and do it by self-execution. This delivers a level of automation which is way beyond anything which conventional business systems can achieve. It replaces all payments, deliveries, trade processing, settlement management, income and corporate actions processing, entitlement calculation, registry maintenance, execution, and order management. The win for participants in the market is remarkable.

The massive automation achievable with smart tokens significantly simplifies the single issuance and operating models which are delivered by native digital assets, will deliver material cost savings while reducing operational risk, and will foster a further reduction in the scope and weight of regulation. 

The second big step forward is to make native digital assets smart and potent. 

In the next article in this series, we will look at the application of smart tokens and native digital assets in funds and wealth management.

About the author
Dr Ian Hunt is an authority on buy-side business process and technology. He is a frequent conference speaker and contributor to industry publications. Dr Hunt has advised many leading asset managers and asset owners on investment processes, operations and technology. He is particularly recognised for his work in promoting innovation in technology for investment. His clients include M&G, BNP Paribas, Legal & General, Insight Investment, Fidelity, Hiscox, Threadneedle, Royal London and Hermes.