Deutsche Bank works on standardized protocols for asset tokenization

Deutsche Bank is working “backwards” in order to propose standardized protocols that will eventually facilitate the adoption of tokenized assets. In May, it joined Project Guardian, an initiative by the Monetary Authority of Singapore that seeks to enhance the liquidity and efficiency of financial markets through asset tokenization.

“If I can work backwards, the goal is to propose standardized protocols for smart contracts to facilitate adoption [of tokenized assets],” says Boon-Hiong Chan, Asia-Pacific head of securities and technology advocacy and industry applied innovation lead at Deutsche Bank. “The uber goal is—and as part of Project Guardian—to facilitate adoption and commercialization eventually.”

He says that in order for that to happen, though, the bank first needs a better understanding of the risks involved. Then, they’ll need to develop a common understanding of the terminologies involved with the project. And finally, they’ll have to create “a level of standardization of how you implement certain things, so it facilitates the risk, due diligence, and people’s understanding of what actually goes into the platform,” Chan tells WatersTechnology. “These are the three things that we are aiming to achieve to propose some standardization of smart contracts involved in asset servicing.”

Chan, who is also the bank’s project lead for its involvement in Project Guardian, says the foundation of that is to build a permissioned layer on top of a public blockchain and then build applications on top of that permissioned layer.

“It’s a public permissioned layer architecture that we’re putting in. So it will be on public Ethereum with a permissioned layer on top of the public Ethereum,” he says.

Deutsche Bank is working with Memento Blockchain, a decentralized finance and hyper-chain, zero-knowledge specialist to build that permissioned layer. And then, it will work with Interop Labs, the developer of the Web3 interoperability platform Axelar network, to extend that permissioned layer with interoperability.

Interoperability between blockchains is something that companies like R3 and Digital Asset have been working on, too. R3, for example, unveiled the next generation of its flagship Corda platform in June 2023. The update was meant to allow financial market infrastructure providers and central banks to interoperate within applications and across other open enterprise distributed-ledger technology (DLT) networks.

Meanwhile, Digital Asset has its Canton Network initiative—a privacy-enabled, interoperable blockchain network designed for institutional assets. The network is, however, limited to applications built with Daml, Digital Asset’s smart-contract language.

According to Deutsche Bank’s Chan, blockchain has two general principles. The first is that each blockchain has its own signing protocol and cryptography. And the second is that digital assets that are launched on one chain can only live on that chain.

“This is why if everybody uses [a] private chain, you have a fragmentation of liquidity and fragmentation of product ranges, because the asset can only live on that chain precisely because of this unique cryptography that that chain uses,” he says.

Where Interop Labs’ Axelar network comes into the picture is by building bridges between each blockchain, which Chan says can be thought of as “relayers” or “interpreters”. On one chain, you take the asset, and it’s locked there. Then, on the other chain, you re-mint that asset there. It will be the twin of the asset.

For example, suppose an asset manager on an Ethereum blockchain wants to distribute assets to other blockchains. In that case, the bridge that Axelar will help build will help the asset manager do that.

Chan says it’s important to think about how custodian banks like Deutsche Bank, as custodians of the asset on the Ethereum chain, can continue to discharge their proper duties for that asset that’s also on other blockchains.

“That’s the crux that we really need to solve. … It’s almost like moving your assets from Singapore to the US today. A custodian needs to be on both ends of the transaction to ensure the assets are safe and investor protection is still maintained,” he says.

Deutsche Bank will work with both its asset management clients and other asset management firms involved in Project Guardian, which have expressed interest in observing its progress. “Their feedback is the most valuable so that we know what we are doing—what we are designing—is in the right direction of what they are looking for in the near future,” he says.

Servicing tokenized assets

This is in fact Deutsche Bank’s second initiative experimenting with tokenized assets, and what it now calls Digital Asset Management Access 2 (Dama 2). Its involvement in Project Guardian is within the asset and wealth management workstream. The project has two other workstreams: fixed income and foreign exchange.

Chan says the efforts with Dama look at how asset servicers like Deutsche Bank can service tokenized funds, including the cash components. For Dama 1, the use case it worked on assumed that the asset manager and Deutsche Bank would work on the same blockchain. It then built capabilities around that assumption and produced a report outlining its key findings on the proof-of-concept.

However, Chan says that asset managers increasingly have their own preferred chains—Ethereum, Stellar, Provenance, and so on. And therefore, Dama 2 builds on what the bank has learned from Dama 1 and will explore the interoperability of how an asset servicer can assist asset managers who may be on different chains. 

Blockchain is really open, you can see patterns and over time, basically work backwards and find out who the transactions belong to. … If an asset manager doesn’t mind, that’s fine. But let’s say an asset manager minds and wants to try to have a level of anonymity. How can we try to do that?

Boon-Hiong Chan, Deutsche Bank

For Dama 2, the bank is looking at three use cases. The first explores interoperability between different blockchains and how Deutsche Bank might service asset managers who are on different blockchains without needing to onboard new blockchains. “That’s not sustainable for us to go through due diligence and onboarding for each new blockchain,” he says.

To solve this, Deutsche Bank is exploring a “multiplug” concept, where it can connect to different asset managers on different blockchains.

The second use case is where an asset manager on say, “blockchain 1”, wishes to distribute to “blockchain 2” and “blockchain 3” to capture the potential interest and liquidity on those chains.

The third use case looks at the case where an asset manager may not want to launch anything new on chain, but instead wants to package its existing funds into another basket on chain and distribute it. “So it’s an ETF of funds tokens,” Chan says.

But from a functionality and feature perspective, underpinning these three use cases, Deutsche Bank is looking at digital identity and managed anonymity. “Digital identity is really important for many things, not just for know-your-customer and anti-money laundering (KYC and AML), but also for investor suitability, sanctions filtering, and even regulatory compliance—for example, no one investor should hold more than 20% of the assets under management,” he says.

Building on this digital identity, Deutsche Bank is experimenting with managed anonymity, which will essentially protect asset managers from unintentionally showing the transactions of their funds to their competitors.

“Blockchain is really open; you can see patterns, and over time, basically work backward and find out who the transactions belong to. … If an asset manager doesn’t mind, that’s fine. But let’s say an asset manager minds and wants to try to have a level of anonymity. How can we try to do that?” he says.

Deutsche Bank will assess the potential of zero-knowledge proofs to accomplish this on-chain. It’s called managed anonymity because, from a regulatory perspective, the regulator should be able to see everything, and from a service provider’s perspective, Deutsche Bank should be able to manage everything. But asset managers shouldn’t be able to see their competitors’ transactions. In other words, to what extent can anonymity be maintained?

Deutsche Bank plans to have a limited prototype by November.

Benjamin Quinlan, CEO and managing partner at Hong Kong-based strategic consultancy firm Quinlan and Associates, says from various project engagements and discussions with asset managers, asset tokenization has the potential to address numerous pain points, leveraging DLT’s programmability, atomic settlement, and fractionalization characteristics.

However, a challenge that firms running DLT initiatives may face is the lack of standardization. “Many financial institutions have conducted pilots and proofs-of-concept for digital asset exploration, which yielded a variety of network types and data formats. Private-sector players are building interoperability solutions to solve for the lack of standardization, but they still cite discrepancies in data and communication protocols as major implementation obstacles,” Quinlan says.

In addition, firms face high integration costs when incorporating DLT into their existing technology stack. Legacy systems, such as execution management systems, will need “intensive customization” and, therefore, significant capital to integrate with on-chain capabilities.

Another challenge has to do with throughput and scalability. Quinlan says that compared to traditional trading systems, DLT networks support lower throughput. “For permissionless systems, in particular, throughput is throttled without the use of solutions like ZK-proofs (zero-knowledge proofs) and Layer 2 chains. Even in permissioned systems, many industry players comment that DLT rails may not be suitable to support use cases like high-frequency trading,” he says.

That said, Quinlan believes that Singapore’s efforts with Project Guardian encourage the financial industry to explore DLT and invest in digital assets, and it is a “very clear sign” that the regulator sees a role for the still-emerging technology in the financial system.

The lack of regulatory clarity on tokenized assets and systems remains a common concern in the industry. For example, Quinlan says the balance sheet treatment of digital assets remains uncertain and most regulators are still in the midst of developing clear and comprehensive guidance for regulated entities to follow DLT adoption.

While it is an inevitable part of DLT adoption, as the technology is still in its nascent stages and supporting regulations tend to be more “reactive” than “proactive”, Quinlan says the market faces a “chicken-and-egg” dilemma: solutions tend to thrive in well-regulated environments … but well-regulated environments are derived from extensive testing of solutions.

“We see regulators generally adopting a risk-based, ‘same risk, same regulation,’ approach. In other words, change in the underlying technology (in this case, DLT) does not change the inherent risks of financial assets and activities,” he says.

Nadine Chakar, managing director and global head of DTCC Digital Assets, said that “technology on its own will not change the markets—it will require collaboration and coordination among all stakeholders, and it needs to be measured and thoughtful.”

Chakar testified before the US House Financial Services Committee on Digital Assets on June 5 about the potential for tokenization to further automate, increase efficiency, and lower costs for financial markets.  

The DTCC recently worked with Clearstream and Euroclear on a blueprint establishing six principles as a roadmap for the industry to develop standards for the digital asset marketplace. The principles include legal certainty, regulatory compliance, resilience and security, safeguarding customer assets, connectivity and interoperability, and operational scalability.