How does Chainlink unlock the full functionality of tokenizing capital markets?

Author: Ryan Lovell

Translation: Shenchao TechFlow

Chainlink is the core infrastructure needed to drive tokenization from the concept validation stage to the production stage in the capital market. Chainlink’s role in supporting the capital market is necessary for three key tokenization use cases:

1. Enabling tokenized assets to settle on any blockchain (public or private) to achieve secondary markets for tokenized assets.

2. Facilitating the execution of atomic transactions on a single chain or across chains, ensuring the irreversible exchange of assets between blockchains, and eliminating transaction failures to facilitate delivery versus payment (DvP) workflows.

3. Synchronizing on-chain and off-chain systems by supporting communication between traditional infrastructure and blockchains.

In the following sections, we will explore the current state of tokenization in the capital market, introduce Chainlink, and then examine real-world cases of how financial institutions leverage Chainlink to unlock the full potential of tokenization.

The Current State of Tokenization

Since 2017, tokenization efforts in the capital market have primarily remained in the concept validation stage. While some institutions have announced the tokenization of traditional assets such as bonds, these experiments have mainly focused on the initial issuance of assets. For example, an investment bank acting as the issuer may tokenize bond notes, acquire them, and quickly mature the notes. Other successful application cases, particularly those related to banking and financial transactions (e.g., Broadridge’s DLR and HQLAx), are tailored to specific use cases and managed by a single central entity overseeing the entire technological process.

Both of these examples highlight a common problem: friction resulting from a lack of seamless connectivity between ecosystems and applications. Of particular note is the relatively absent participation of asset managers and asset owners, despite their critical role in creating sufficient liquidity. Their involvement requires robust enterprise-grade infrastructure to establish the necessary connections and facilitate the formation of secondary markets. This interoperability infrastructure should seamlessly integrate into existing internal systems without significant disruptions. Ultimately, each additional link in the chain enhances the overall utility of blockchain-based financial products.

Chainlink: Connecting Existing Infrastructure with Blockchain Networks

Chainlink is an enterprise-grade infrastructure that enables financial institutions to establish the necessary connections between blockchains (on-chain) and existing infrastructure (off-chain). If your existing tech stack requires “blockchain operations,” simply integrate it with Chainlink to connect with public and private blockchains.

Chainlink provides a suite of services that facilitate the transfer of data and tokens between blockchains, enable bidirectional communication between blockchains and external systems, and support various computational services such as privacy and automation. Three Chainlink services particularly relevant to tokenization in the capital market include:

Cross-Chain Interoperability Protocol (CCIP) – This is a blockchain interoperability protocol that serves as an abstraction layer and cross-chain messaging protocol, enabling existing infrastructure to communicate with any public or private blockchain, instruct smart contracts to send arbitrary data, and transfer tokens between blockchains.

Proof of Reserve – A decentralized network that verifies or proves the cross-chain or off-chain reserves supporting tokenized assets, providing transparent on-chain audit tracking for consumers, asset issuers, and smart contract-based applications.

Functions – Institutions can provide services for any asset on any blockchain by synchronizing off-chain events or data with on-chain operations. Any off-chain event or data can be synchronized, such as position settlement instructions, corporate actions, proxy voting, ESG data, dividends and interest, and net asset value.

Chainlink has successfully enabled over $80 trillion in transaction value for blockchain applications. The exceptional security standards of the Chainlink network were pioneered by a world-class research team and enforced by independent, Sybil-resistant nodes operated by leading enterprises like Deutsche Telekom MMS, LexisNexis, and Swisscom in their decentralized oracle networks (DONs). Chainlink takes a defense-in-depth approach to development, maintaining high availability and tamper-resistant security over years, even in the most turbulent and unpredictable market conditions.

Tokenized Real-World Use Cases Enabled by Chainlink

The following section is divided into three use cases: Secondary Markets, DvP, and On-Chain/Off-Chain Synchronization.

Secondary Markets

Secondary markets are crucial for the efficient operation of capital markets. They facilitate liquidity and price discovery by providing a platform for investors to buy and sell previously issued financial instruments. Currently, the financial markets rely on Central Securities Depositories (CSDs) and custodian banks to maintain records of securities holdings. These securities can freely transfer from one custodian bank to another through a messaging standard of instructions from various front, middle, and back-office systems. This interconnected infrastructure not only supports the operation of secondary markets but also contributes to the overall stability and resilience of the global financial system.

Chainlink enables secondary markets for tokenized assets in three different ways:

1. Connecting buyers and sellers on different blockchain platforms

Business Background

Most bonds and illiquid assets are traded in over-the-counter markets due to their heterogeneous nature. To bring the tokenization of bonds and illiquid assets to the production stage, the same liquidity platforms (such as MarketAxess and TradeWeb) need to be able to list these tokens from market makers’ inventories or allow them to set prices. One component of market makers setting prices is based on liquidity risk – how quickly can they sell their inventory to clean up their books at the end of the trading day? To maximize liquidity and achieve attractive pricing spreads that match or improve upon traditional issued assets, tokenized assets must be able to settle on any blockchain that asset managers and owners wish to use.

Roles of Chainlink:

Chainlink CCIP provides a single integration gateway for financial institutions to communicate with any public or private blockchain.

Chainlink CCIP enables tokenized assets to be available on any blockchain, transforming them from single-chain assets to multi-chain assets.

Chainlink CCIP facilitates secure cross-chain DvP settlement through atomic transactions.

Example workflow using Chainlink CCIP:

Asset management company A needs to sell BondToken, which is currently issued on public blockchain 1 and held by a fund custodian.

Trader from asset management company A logs into MarketAxess to view the bid-ask spread of dealers in the OTC market. Dealers can provide tighter spreads because they know this asset is enabled with Chainlink CCIP, meaning it is a multi-chain asset that can settle on any public or private blockchain.

The trader pays a small spread to transfer BondToken from public blockchain 1 to private blockchain 1 for the dealer to hold.

Asset management company B using private blockchain 2 wants to purchase BondToken.

The dealer proposes a price and an agreement is reached. CCIP transfers BondToken from private blockchain 1 to private blockchain 2.

2. Easy integration of traditional infrastructure with blockchain networks

Business Background

Financial market participants have been slow to adopt new technologies such as blockchain because many of them still use traditional systems. These systems have significant value guarantees, and the cost and risk of replacing or developing new connections are exceptionally high.

In the past few years, hundreds of blockchain proof-of-concepts have been conducted by financial institutions. However, few projects have entered the production stage, mainly due to issues with integrating blockchain into core business infrastructure. This connectivity problem is exacerbated by the increasing number of blockchain ecosystems they may need to interact with.

Roles of Chainlink:

Chainlink CCIP connects existing infrastructure with any blockchain, allowing financial institutions to interact with tokenized assets without modifying traditional systems. This enables financial institutions to interact with tokenized assets through existing infrastructure, such as Swift messages, APIs, hosts, and other traditional formats.

Example scenarios realized by CCIP:

An order management system can only convey instructions through Swift messages, so I want to be able to communicate with any blockchain through Swift.

As a bank custodian, I want to be able to communicate with any blockchain through my wallet infrastructure or client application.

My middle office needs confirmation and status updates on token transfers, such as pending, completed, or failed.

I want to be able to publish data to smart contracts on the blockchain from an FTP server or Excel spreadsheet.

I want to be able to publish data to smart contracts on the blockchain from a host MQ connection.

3. Providing Blockchain Interoperability Standards for the Capital Markets Industry

Business Background

In the continuous development of information technology, large financial institutions instinctively rely on three basic pillars: standards, reliability, and security. Standards provide a common language for collaboration, reliability enhances confidence in service continuity, and security protects against malicious threats.

Blockchain interoperability standards are crucial for supporting a global tokenized asset market. However, attempts to achieve interoperability so far have often been controlled by central institutions, involve fragmented technology stacks, or require financial institutions to integrate with each new private or public chain on a peer-to-peer basis. With hundreds of blockchains in existence and the potential for more to emerge, financial institutions need a widely adopted blockchain interoperability standard across the industry.

Role of Chainlink:

Chainlink CCIP is an enterprise-grade infrastructure that enables financial institutions to standardize the issuance, acquisition, and settlement of tokenized assets with each other.

Adopting CCIP as the blockchain interoperability standard for the capital markets will provide financial institutions with various benefits:

Standardized communication: Consistent communication reduces errors, misunderstandings, and the need for manual intervention.

Automation and Straight-Through Processing (STP): Transactions can flow seamlessly from initiation to settlement without manual intervention at each step.

Global coverage: Seamless communication and transactions between entities in different countries facilitate cross-border trading, payments, and investments.

Reduced operational costs: Standardized communication and automation reduce operational costs by minimizing the need for manual data entry and verification.

Integration with other systems: Messages can be integrated with other financial systems and platforms such as trade matching, risk management, and order management systems.

Delivery versus Payment (DvP)

Delivery versus Payment (DvP) is a key concept in financial transactions, especially in the securities market. It reduces counterparty and settlement risks by ensuring simultaneous transfer of assets and corresponding payment. DvP plays a critical role in maintaining the integrity of transactions, preventing one party from delivering assets without receiving the agreed-upon payment, or vice versa. Resolving DvP on the blockchain is essential to unlock the full potential of tokenized assets, as it enables more asset classes to be issued on-chain.

Real-World Examples

To achieve a fully functioning digital asset ecosystem, cash transactions must be incorporated into various DvP workflows. Banks and central banks preparing to issue cash tokens, such as tokenized cash deposits and central bank digital currencies (CBDCs), may initially use their proprietary private chains. Their clients, primarily asset management companies and owners, must be able to freely use these cash tokens to purchase assets on other blockchain ecosystems. However, to increase the utility of cash tokens, settlement risks must be minimized first.

The Role of Chainlink

CCIP manages single-chain and cross-chain atomic settlement scenarios involving tokenized securities and tokenized cash. CCIP supports multiple interoperability primitives that can be used to build various cross-chain workflows (see the example below) and eliminate transaction failures in cross-chain asset exchanges.

Key Steps:

Bank A issues an institutional deposit token called BankCoin on a private chain (i.e., the cash chain), which is backed by cash and short-term fixed income instruments.

Asset Manager A, a client of Bank A, maintains a $5 million cash position in their funds held in the form of BankCoin on the private chain.

Bank B issues BondToken on public chain 1 (i.e., the token chain).

Asset Management Company B, a client of Bank B, purchases BondToken in the initial offering and holds it in one of their funds.

Asset Management Company B wants to sell BondToken because they have net redemptions in their fund that day and investors want to receive cash as soon as possible.

Asset Management Company A and Asset Management Company B match their trade on an over-the-counter trading platform. The token instructions are then sent to CCIP to facilitate the atomic DvP transaction between BondToken and BankCoin.

Off-Chain and On-Chain Synchronization

Establishing synchronization between off-chain traditional systems and on-chain blockchain ecosystems has profound benefits and serves as a key support for improving operational efficiency, transparency, compliance, and enhancing customer experience. Here are some examples:

Operational Efficiency: Real-time updates of internal systems based on asset reconciliation between blockchain events or off-chain and on-chain records.

Transparency and Audibility: Providing real-time on-chain proof of off-chain asset reserves through encrypted verification of assets in wallets or proof from top-tier accounting firms.

Compliance: Compliance oracles make it possible to authenticate transactions between wallet addresses on any blockchain.

Enhanced Customer Experience: Real-time provision of financial market data (e.g., pricing) for reserved assets to both on-chain and off-chain, increasing user confidence in using blockchain-based financial products.

Business Background

Banks need infrastructure to verify the ownership of off-chain reserve assets for on-chain tokenized assets. They also need to verify the proper storage and management of these off-chain reserve assets. This requires a robust and independent monitoring framework that is not influenced by each bank’s infrastructure and where the validators of the asset issuer’s statements about the collateral assets have no conflicts of interest. The composition, valuation, and valuation frequency of reserve assets are crucial to ensuring sufficient reliability for tokenization in production.

The role of Chainlink

Chainlink’s reserve proof provides data for tokenized assets on the blockchain, and Chainlink’s functions allow off-chain data required to complete financial processes to enter the chain.

Real case

Bank A wants its customers to use cash/deposit tokens on various blockchains.

Bank A chooses a custodial bank account to manage a traditional asset portfolio that supports deposit tokens. They select an asset portfolio consisting of cash and short-term treasury bills.

Bank A uses Chainlink’s reserve proof to provide real-time market value of assets supporting deposit tokens to its customers. The bank can provide the value itself or allow third-party auditors access to its custodial account. This provides transparency and confidence for customers to use deposit tokens in capital market activities and ensures that the token supply does not exceed the market value of the supporting assets (e.g., preventing infinite issuance attacks).

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