Opportunities and Challenges of Financial Tokenization
Digitization is far from new in the financial sector, but tokenization based on Distributed Ledger Technologies (DLT) could be a new turning point. In my introduction, I would like to explain why we at Banque de France and ACPR are interested in the development of tokenized finance in terms of our financial stability mandate and how this affects the tools we use. to fulfill our mandate.
I/ Tokenization of finance is of great interest for two main reasons:
1/ It is one of the main driving forces behind the transformation of our financial landscape
In fact, digital technologies are profoundly changing finance, at the intersection of IT and finance, creating a new wave of players for investment and settlement of digital assets in a new, tokenized form, commonly called crypto-assets. exchange and settlement infrastructure. Their combination results in activities and services that first touched the field of payments and are now expanding more broadly.
Among them, decentralized finance, DeFi, is emerging as a crypto-asset-based alternative to traditional finance where service delivery is seamless and management is decentralized; this is especially made possible by permissionless blockchains, automatic clause enforcers (smart contracts) and decentralized applications (Dapps).
For now, the crypto-asset ecosystem is not large enough to threaten the dominant role of traditional finance. However, looking beyond the sector’s current challenges, this may change in the future. For this reason, we believe it is important to be vigilant.
2/ The second reason for our interest is that the tokenization of finance cannot have an unambiguous effect on the functioning of our financial system, both in terms of efficiency and stability.
From an efficiency perspective, a good example is the use of DLT, which underpins the development of tokenized finance. In addition to the potential for improved transparency through better tracking of transactions and property rights, DLT is also cost-effective and available 24 hours a day. However, it also carries the risk of process fragmentation if the blockchains supporting it are not interoperable and existing centralized clearing, settlement, and payment systems fail. cannot interact smoothly with This interoperability must be guaranteed for now.
From a stability perspective, it is clear that the current crypto-asset ecosystem, as it stands, is not large enough to threaten the stability of the entire financial system and is interconnected. crypto-asset market following the collapse of Terra-Luna last May and June, and more recently the collapse of crypto-asset conglomerate FTX.
However, let me first note that these collapses have significant negative contagion effects on the crypto-asset ecosystem, and secondly, that the crypto-asset ecosystem inherits weaknesses when trying to replicate some of the functions provided by the traditional financial system. the latter and can strengthen them. For example, tokenization increases operational risks, especially cyber risks. Cyber risk is the number one operational risk for financial players today and has the potential to destabilize the financial system as a whole. In this context, the tokenization of finance creates new points of vulnerability: As an example, I will show bridges between blockchains or oracles (database management systems) that provide data to blockchains. In addition, public DLT infrastructure management issues, which strongly contribute to the risk of hacking, are still unresolved.
II) Impact on our role and activities
In response to these transformations, we believe that our role is two-fold: as the body responsible for financial stability, it involves helping to integrate tokenized finance into a regulatory framework that allows us to take advantage of its benefits, as well as controlling its risks. an appropriate way to maintain financial stability and therefore confidence. But we also see ourselves as part of an innovative ecosystem, aiming to act as a facilitator and catalyst through our operational role as a central banking service provider.
1/ Contribute to a trust-friendly regulatory framework
Basically, it is the need for trust that has not changed in the financial sector. Consumers of financial services should be sure of: security of transactions, protection of their assets and freedom of choice. The players in the sector must also trust each other, as they remain interdependent and rely on the rules of the game, the regulatory framework within which they operate.
As authorities responsible for financial stability, central banks and supervisory authorities must play a role in maintaining this confidence in all the forms I mentioned above.
In this regard, I would like to share with you three conclusions:
– first, the traditional pillars of trust, including trusted third parties, central banks and supervisors, cannot be replaced by “algorithmic” trust, i.e. rules of the game that will be codified once and entrusted to them to comply with. algorithms, even if they are integrated into “smart contracts”… Will the forces moving towards tokenized and decentralized finance eliminate unbalanced relationships? Or failed governance mechanisms, concentration of operational risks and cyber-attacks? I think the answer is no. Therefore, trusted third parties, central banks and supervisory authorities remain necessary and, in my view, are not about to disappear…
– secondly, and this is a corollary to my first point, the belief assumes that central bank money remains the anchor of the financial system;
– finally, trust requires a regulatory framework that is clear, fair (“same activity, same risk, same rule”) and balanced, i.e. able to both encourage innovation and adequately protect consumers and preserve the stability of our financial system.
The crisis of confidence caused by the upheavals in the crypto-asset ecosystem and their collapse clearly shows the urgent need, from our perspective as the body responsible for financial stability, to implement such a regulatory framework that creates conditions for trust. imperative. Europe has led the way in this area by defining a new regulatory framework called MiCA – Markets in the Regulation of Crypto Assets. It is important that its implementation takes place as soon as possible within a broader international effort based on the high-level recommendations developed by the CSF-Financial Stability Board.
2/ In addition to supporting the development and adoption of a trust-building regulatory framework, we as a central bank can play a positive operational role by revising the central bank money services we provide to fit the digital system. age and the possible development of tokenized finance.
Therefore, in 2020, Banque de France launched a large-scale pilot program in wholesale MNBC with several market players. This program has given us the opportunity to better understand how DLTs work and their potential benefits and risks for financial markets.
Our main motivation is to extend the existing trust in our infrastructure and settlement assets to transactions performed in DLT. Settlement of these transactions in central bank money appears essential to protect participants in these markets from the counterparty risks inherent in other private tokenized settlement assets. The new European pilot scheme for DLT, which will come into effect in March this year, will allow us to continue our experiments in a simplified regulatory framework.
At the same time, the Banque de France is contributing to the reflection of the possibility of a retail MNBC: the central banks of the Eurosystem are currently engaged in this project under the auspices of the ECB, and the research phase for the digital system is ongoing. euro. The changing payment landscape has us thinking about the tools citizens can use to access central bank money, including in the digital world.
At the end, I would say that tokenization can be a blessing or a curse for the functioning of the financial system. I am confident that we can collectively make the most of it if we ensure that its development takes place within a framework of trust in which good regulation plays an important role.