Tokenisation, is it Technology Neutral?
The regulatory treatment of tokenised financial instruments should consider the unique technological risks associated with different blockchain architectures, challenging the traditional principle of technology neutrality in financial regulation.
From a regulatory standpoint, the ongoing debate about the treatment of tokenised traditional financial instruments might seem peculiar. Historically, regulatory frameworks remained unchanged when financial records transitioned from paper to electronic formats. The financial instruments themselves did not change; hence, their regulatory treatment stayed the same. Today, however, financial instruments are transitioning from static, siloed databases to dynamic, distributed ledgers (i.e., blockchains) through tokenisation, warranting a closer examination of regulatory approaches.
Tokenisation involves creating natively digital financial instruments using blockchain technology. This process is not merely a digital upgrade; it fundamentally alters the asset by encoding its workflows to automate previously manual processes and synchronise data among transaction parties, eliminating costly and inefficient reconciliation. Through tokenisation, assets become dynamic entities where workflows are integrated into the asset itself.
Given this technological shift, questions arise: Why should it necessitate a new regulatory approach? Why is this innovation so significant that it demands regulatory changes? These questions rest on the assumption of technology neutrality, a principle where regulators do not favor any technology choices of the institutions they oversee. Financial regulators traditionally focus on financial risk, not technology.
However, the Basel Committee on Banking Supervision’s December 2022 Prudential Standards for Cryptoasset Exposures challenges this understanding. These standards indicate that the choice of technology impacts the capital treatment of tokenised financial instruments. In December 2023, the Basel Committee further clarified that financial instruments tokenised using “permissionless” blockchain networks would receive unfavourable regulatory treatment. This stance appears to conflict with the principle of technology neutrality, prompting a reevaluation of whether the Basel Committee’s approach is justified.
To understand this, one must delve into the nuances of tokenisation and blockchain technology. Blockchains vary widely, from permissionless systems where all participants can view all data to permissioned systems where data access is restricted to authorised parties. For regulated financial institutions, permissioning is crucial. Even when using permissionless blockchains, institutions often add permissioning layers, such as sidechains or Layer 2 solutions, to meet regulatory requirements.
Despite appearing similar, a permissionless blockchain with added permissioning layers differs significantly from a fundamentally permissioned blockchain. Adding a permissioning layer creates an isolated “island” of permissions, requiring bridges to connect back to the primary layer. These bridges prevent atomic settlement of individual transactions, reintroducing reconciliation risks that tokenisation aims to eliminate. Data remains siloed across islands, undermining the efficiency and risk-reduction benefits of blockchain technology. Additionally, institutions still rely on the consensus mechanisms of the underlying permissionless layer, raising concerns about meeting settlement finality and AML/CFT compliance.
In contrast, a fundamentally permissioned blockchain integrates permissioning within its architecture, allowing seamless connection and movement of tokenised financial instruments between applications. No additional layers or bridges are needed, enabling atomic settlement of transactions. Institutions can choose validators, ensuring compliance with regulatory requirements for settlement finality and AML/CFT.
The key distinction is that the risk profile of a tokenised financial instrument is inherently linked to its underlying blockchain technology. Not all blockchain technologies are the same, even when labeled similarly. Thus, the principle of technology neutrality in financial regulation may need reevaluation in the context of tokenisation. The Basel Committee’s approach, considering technological architectures in regulatory frameworks, aligns with the evolving relationship between technology choice and financial risk.
As discussions on regulatory treatment of tokenised financial instruments continue, it is essential not to use technology neutrality as a defense against addressing technological concerns. Technology neutrality should not equate to technology blindness. Instead, regulators must recognise the intrinsic link between blockchain technology and financial risk, ensuring that regulatory frameworks appropriately address the unique characteristics and risks of tokenised financial instruments.
