During the SIBOS banking event yesterday, David Durouchoux from Société Générale (SocGen) FORGE explained that combining tokenization and derivatives is crucial to encourage the sector to grow. However, derivatives are not part of the EU DLT Pilot Regime, which relaxes certain laws for DLT and tokenization.
Derivatives traders have to provide collateral as margin when prices move against them. However, traditionally the transfer of collateral is slow because it takes time to settle. This results in added risks. It also means when traders want to withdraw collateral, it takes time. Hence, the desire to explore alternatives such as tokenization.
Meanwhile, Stateside there are moves afoot to get the Commodity Futures Trading Commission (CFTC) to support DLT-based collateral used for margin. We spoke to the CEO of Hashnote, a traditional finance (TradFi) affiliated firm that has launched a tokenized money market fund, USYC. He sees the crypto world as a stepping stone to getting tokenized money market funds (MMFs) accepted as collateral in TradFi.
SocGen FORGE: digital bonds as collateral for derivatives
As context, SocGen FORGE provided the infrastructure for the issuance of the very first European Investment Bank (EIB) digital bond of €100m that was issued on the Ethereum blockchain in early 2021.
Mr Durouchoux said that a key requirement is to develop liquidity for digital bonds first. While DLT is already used for repo, it is usually based on the tokenization of existing government bonds. The next step is to use digitally native bonds for repo. This is already happening in some jurisdictions, such as Switzerland.
“If we have that, then we can build up on that a derivative market, which is efficient. We have trading rooms, we are sell side and we know how to do it,” he said, adding that there have been discussions with the European Commission about reforming the DLT Pilot Regime law to support derivatives.
There are two types of derivative opportunities. One is tokenized derivatives, and the other is the use of tokenized collateral for derivative margin calls. The latter is the one more widely discussed and experimented with because tokenization enables collateral mobility. Rather than collateral being stuck with a single custodian and taking two days to settle, tokenization enables collateral to transfer almost instantly.
Tokenized collateral takes shape
Several solutions are already available. Europe’s HQLAᵡ is the traditional finance platform for mobilizing collateral. JP Morgan has its Tokenized Collateral Network and Broadridge’s repo solution DLR can also be used for collateral mobility. State Street says it’s working on a tokenized money market fund for use as collateral.
Some of this has been triggered by the interest in tokenized money market funds in the crypto world. Franklin Templeton was the first traditional finance (TradFi) firm to launch a tokenized money market fund on a public blockchain, with BlackRock launching BUIDL this year.
Hashnote’s tokenized MMF used as collateral for derivatives
In fourth place in crypto money market funds (MMF) is another TradFi affiliated firm, Hashnote, which is associated with high frequency trading firm DRW and its crypto offshoot, Cumberland. Hashnote’s USYC fund, with $375 million in assets under management, isn’t a typical MMF in that its cash is in a bank during the day and earns yield on overnight repo.
It is the first tokenized money market fund to be accepted as collateral by crypto derivatives firm Deribit. Cumberland and Brevan Howard Digital are amongst the TradFi-linked firms that are using it as collateral. Hashnote’s CEO Leo Mizuhara told Ledger Insights that it sees crypto as a stepping stone to getting USYC accepted in the TradFi sector.
“My long game for the collateral product at least (is) that we want to be in the CME, in Eurex and LCH,” he said, calculating the collateral between them at around $90 billion, a figure substantially larger than crypto sector collateral. Short term he hopes to roll out the offering with crypto exchanges Binance, ByBit and OKX.
There are sufficient traditional finance firms active in the crypto world that they can lobby to include tokenized collateral.
“You get adoption in the crypto world, and you get the TradFi firms to tell the CFTC, ‘hey we trust this product, it’s working’,” said Mizuhara. “That’s how you get into the TradFi world and become dependable”.
In fact, the CFTC’s advisory group is already recommending that DLT-based collateral be allowed.
Meanwhile, Bloomberg reported that BlackRock has similar plans with its BUIDL MMF. BUIDL is already accepted as collateral at prime brokers FalconX and Hidden Road and it is eyeing Deribit, Binance and OKX as well.
Tokenized design matters
Hashnote’s Mizuhara pointed out that its USYC fund has a key advantage, because interest accumulates within the token. By contrast, BlackRock airdrops interest as new tokens to BUIDL holders once a month. That’s fine for individual holders, but it’s a challenge if an intermediary has to ensure these airdropped tokens are distributed to clients. It’s an extra process that has to be programmed.
And the whole point of tokenized collateral is to reduce friction and enhance efficiencies.
This is just one example where tokenization and design really matter. We’ve recently published a report exploring the design of tokenized deposits in depth, highlighting potential pitfalls with some of the current projects.
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