Digital Finance’s Quest for Interoperability: A Slow but Steady March, Says Moody’s

As blockchain network technology evolves, it holds promising benefits. Among these are higher efficiency and potential cost savings, extending beyond the realms of finance. However, the realization of these advantages is contingent on achieving interoperability among different blockchains. Interoperability facilitates communication between currently isolated platforms, enabling industries to merge the control of private networks with the scalability and adaptability of public blockchains.

While private blockchains are available to authorized users only, public blockchains like Ethereum remain open to any user, with Ethereum dominating the landscape. Ethereum’s recent Merge and Shapella upgrades, position it as a leading blockchain. It is the foundational layer upon which more specialized Layer 2 blockchains are built.

Over half of Ethereum transactions now stem from Layer 2 networks, drawing institutional investors with their robust performance and cost-effectiveness.

Ethereum’s Challenges

However, Ethereum faces challenges in speed, scalability, and security, hindering its adoption. Planned upgrades aim to enhance its attractiveness for businesses, but uncertainties in the upgrade process pose risks of instability, accessibility issues, and potential regulatory scrutiny.

Increasing concerns about cybersecurity risks and regulatory compliance have led financial institutions to favor private (permissioned) blockchains. Key players like JPMorgan Chase & Co., Goldman Sachs Group, and HSBC Holdings have developed their enterprise blockchain solutions, particularly suited for asset tokenization, payments, and settlement.

For blockchain technology to fulfill its potential, scalability is crucial to achieving the critical “network effect” in digital finance. Scalability requires linkages among separate blockchain systems. However, recent incidents in decentralized finance (DeFi) highlight vulnerabilities in cross-platform connections, leading to significant losses. Interoperability solutions such as Chainlink CCIP and the DAML Canton Network consortium may usher in a new wave of technological innovation to address these challenges.

In the past year, one compelling application of blockchain networks that have gained increasing popularity is asset tokenization. The total value of tokenized Real World Assets (RWA) on public blockchains surged from $1 billion to $2 billion last year. Asset tokenization involves converting traditional assets like real estate or art into digital tokens using distributed ledger technology.

This enables storage and transfer. This process has the potential to enhance liquidity, allowing secondary market trading and fractional ownership. It democratizes access to previously inaccessible asset classes, reduces costs, and dependence on intermediaries, and accelerates settlement times, Moody’s said.

Various entities in asset management, including firms like Franklin Templeton, abrdn, and Wisdomtree, are actively exploring or considering tokenization.

However, the credit implications for asset managers depend on the strength of safety measures against potential technological failures and regulatory treatment of tokenized assets in different jurisdictions.

Obstacles To Tokenization Adoption

Regulatory progress and technical challenges in on-chain management of off-chain data are significant obstacles to wider tokenization adoption. Transparency in tokenization transactions requires access to off-chain data, like company financials, not currently stored on distributed ledgers.

Another challenge is the lack of a reliable form of digital cash in the digital finance sector. Presently, transactions are settled off-chain using fiat money or stablecoins. However, the adoption of stablecoins faces limitations due to their stability concerns and reliance on traditional banks.

Two promising forms of digital cash that could address these vulnerabilities are tokenized bank deposits and Central Bank Digital Currencies (CBDCs). Tokenized bank deposits offer a digital alternative to traditional banking deposits, being transferable 24/7 and compatible with smart contract solutions. Unlike stablecoins, tokenized bank deposits adhere to established regulatory requirements, potentially surpassing the current stablecoin market given their substantial volume.

The sustainability of the current cryptocurrency price rebound hinges on future changes in global monetary policies and institutional investors’ confidence in navigating potential financial, legal, and reputational risks associated with this asset class.

Bitcoin (BTC) and Ethereumm (ETH) continue to dominate the cryptocurrency market, collectively constituting over 60% of its capitalization. Their returns this year have outpaced those of traditional assets like the S&P 500, Nasdaq, and gold, with a decreasing correlation to these assets over time.

However, 2023 witnessed a notable decline in trading volume on cryptocurrency exchanges, exacerbated by reduced liquidity and ongoing regulatory challenges, Moody’s analysts recall. Compliance concerns, triggered by enforcement actions against major platforms like Binance, Coinbase Global, and Kraken, have led to some exchange closures. Stricter regulations are pressuring exchanges lacking robust compliance and risk management frameworks, with regulators aiming to reduce service concentration.

According to Moody’s, two main factors will influence the future of BTC and ETH. The approval of a spot exchange-traded fund (ETF) in the US could attract substantial institutional inflows into the cryptocurrency market. Leading asset management firms such as BlackRock, Inc. and Fidelity Investments have applied for BTC and ETH ETFs, with approval seeming increasingly likely in 2024.

Additionally, the Bitcoin halving scheduled for April 2024 may have a dual impact. While it could boost BTC‘s price due to reduced inflation and increased scarcity, it may also concentrate mining power among fewer large players, potentially compromising network security.