Much has been said and written about distributed ledger technology (DLT) as the solution to counterparty risk, but that only applies to traditional post-trade contexts. In a recently published research paper, James Si Zeng, associate professor at the University of Hong Kong argues that DLT might not suffice to address an overlooked problem that is specific to tokenisation – redemption counterparty risk.
“Even if a DLT system guarantees that ‘what’s on-chain is correct’, it cannot guarantee that on-chain tokens are in fact redeemable for the off-chain assets they claim to represent,” Zeng writes in a summary of his paper on the Oxford Business Law Blog. “Whether token holders can actually redeem the token at par, access the underlying asset, or enforce their rights is not determined by code but by law, institutions, and off-chain behaviour.”
The prediction among industry insiders that DLT could make CCPs obsolete is thus “overstated”.
The big three
According to Zeng, redemption counterparty risk arises through three main reasons: uncertainty about whether reserves exist or are sufficient; delays or legal constraints in accessing those reserves; and the legal enforceability of claims to real-world assets.
The paper proposes three legal and institutional solutions “aimed at making DLT-based settlement robust without simply recreating today’s CCPs in new guise”.
The first addresses the cash leg and identifies central bank digital currencies (CBDCs) as “the most direct way to eliminate redemption counterparty risk”. Because a CBDC is “a native digital liability of the central bank, not a claim on a private issuer backed by reserves”, it removes the need for “a trust-based oracle to verify reserves and no run risk on a private stablecoin operator”.
The second focuses on the securities leg and proposes a change in corporate and securities law to allow natively digital equity. Zeng explains, “If company law recognises DLT-recorded tokens as the official shareholder register, then no external verification is needed to link on-chain state to real-world ownership.”
The third advocates for stronger regulation of stablecoin issuers, custodians, and tokenisation agents. This should include “stringent segregation and ring-fencing of reserves in bankruptcy-remote structures” and “resolution regimes that allow regulators to quickly take control of troubled issuers”.
Last but not least
In addition to the three solutions above, the paper presents what Zeng describes as its “most innovative institutional suggestion” – a mutualised insurance fund for DLT-based settlement. “Licensed stablecoin and real-world asset (RWA) issuers would make risk-based, prefunded contributions to a central backstop that could provide rapid, capped liquidity when an issuer fails or redemptions are temporarily blocked. The fund would step in to pay token holders quickly, then recover from segregated reserves as courts release them. In this design, the fund is aimed at liquidity, not long-term credit support, and is structured to minimise moral hazard and ‘too-big-to-fail’ concerns.”
