A new report demonstrating that central banks can port their monetary policy tools into a tokenized financial system is an important step in transforming how we trade securities including stocks and bonds.
There’s never been a shortage of cryptophiles saying, “Of course central banks can run monetary policy with tokens,” nor of conservative bankers saying, “I’ll believe it when I see it.” The report from the Bank for International Settlements and the Federal Reserve Bank of New York is not just one more opinion added to the mix, the authors actually built the necessary tools and tested them in 10 financial stress environments.
Although only a tiny fraction of financial transactions are tokenized in the sense used in the report, the technique is growing rapidly. For example, JPMorgan Chase & Co. recently announced it had settled a tokenized US Treasury transaction. It’s hard to put figures on the dollar value of tokenized transactions both because definitions are fuzzy and not all transactions are disclosed publicly. But it is plausible that much of the financial settlement system will move to tokens in the next few years, and central banks must be ready.
Tokenization as a concept is simple and ancient. Replace an asset with a token that is easier to transport and trade. Consider the difference between an airline ticket and a ticket to a baseball game. The baseball ticket is a token. If you have it — whether on paper or in electronic form — you can enter the stadium and take a specific seat for a specific game. You can give or sell it to anyone. The ticket is the asset — the right to sit in the seat for the game.
Airline tickets are different. You have to buy it from the airline or an authorized intermediary. You can’t give it away or sell it. It doesn’t give you the right to occupy a specific seat on a specific flight, it’s only a reservation to get a boarding pass 24 hours before the flight, subject to modification or cancellation by the airline.
Tokens are quick and easy to transfer. Tokenized financial securities could be traded and settled in milliseconds, like handing someone cash and getting a baseball ticket. That’s one major reason many people want to replace stocks and bonds with tokens. Settling security transactions today takes a day or longer, and there are many errors and reconciliation issues. If you buy a stock or bond in your brokerage account, lots of databases of intermediaries have to be updated in a complex cascade of information.
By the same token (sorry), tokens are harder to control, which is a concern for central banks and other regulators. A baseball team only knows who was the first purchaser of a ticket, not who is going to present it at the gate. Airlines can charge every flyer a different price and give different service terms — such as upgrades, boarding priority and baggage fees — and know that the person for whom the ticket was purchased is the person who can use it.
Today central banks exercise their monetary tools — borrowing and lending reserves, doing repos and reverse repos, lending at the discount window, etc.— through intermediaries such as banks and dealers. If financial transactions bypass these intermediaries because one end investor transfers a token to another end investor without telling anyone else, central banks need new tools.
An important difference between baseball tickets and tokenized financial instruments is baseball tickets do not pay dividends or interest, nor take other actions. Tokenized financial instruments are dynamic. They are governed by smart contracts that can automatically transfer money and take other actions. Central bank tools to influence things such as interest rates, liquidity and money supply will need to be smart contracts as well.
Another important difference is all baseball tickets exist in a single database. When your ticket is scanned at the gate, the system only needs to check in one place to verify it is a valid ticket and has not been used previously. But financial tokens exist on different ledgers so settlement has to be cross-chain. The money to pay for a token will generally be in a different ledger from the token, so the smart contract will need bridges to bring both ledgers into alignment.
The complex technical issues for tokenized financial systems have been quietly worked out by crypto developers while most of the world was obsessing over the ups and downs of Bitcoin, meme coins and various industry scandals. It’s part of the massive software infrastructure built with money invested in crypto. So central bank interventions using smart contracts, such as the one built by the BIS and New York Fed, did not require technical innovation.
What no one really knew for sure before the report is how lots of different smart contracts among private individuals would interact with central bank smart contracts designed to keep financial markets liquid and efficient, protect financial institutions from excessive shocks and run the economy at capacity without overheating or slack resources. Would many computers all over the world running many smart contracts making transactions in milliseconds operate as designed? Or would some kind of self-reinforcing “flash crash” blow everything up?
We now have a thorough answer from extensive stress simulations. Of course, that’s not as good as practical demonstration in a real financial crisis. However, since we know that the existing financial system has its flash crashes and other disruptions, and central bank tools are less effective than we would like in crises, successful simulations seem like a good reason to move ahead with financial tokenization and for central banks to build the infrastructure to deal with it.
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