Chainlink's Sergey Nazarov Dissects The World of Tokenization

Great to be here, thank you for having me.

So Chainlink is infrastructure that allows smart contracts to operate and do advanced kind of operations. It's also a set of protocols that allow the blockchain industry to function across chains and in relation to data. So in the internet you have protocols like HTTPS which serves websites like YouTube or whatever, and you have TCP/IP over which information moves across the internet. Chainlink is a similar set of protocols and standards for how the blockchain industry works with data and connectivity across chains. And this is important because without that infrastructure you wouldn't have the internet, and without Chainlink you wouldn't have the growth of something called DeFi, and you wouldn't have a secure way to connect across multiple chains to form what we call the internet of contracts. So Chainlink is sometimes a little bit difficult to understand because it's a low-level infrastructure technology. It's kind of like the pipes of what makes a lot of advanced blockchain and smart applications work. It's kind of below the surface. And similarly in the internet there's many technologies below the surface that power the internet — HTTPS, SSL, TCP/IP — that's the kind of technology that Chainlink is.

So a smart contract is a technical agent that both parties can rely on without any trust assumptions. So when you and me do a transaction, we have trust assumptions that I will honor the transaction or that you will honor the transaction, or if I'm a big institution and you're a big institution, we still have assumptions that we won't renege on our agreement to fulfill kind of a delivery versus payment — you buy something from me, I send it to you. Smart contracts are basically on-chain code where you can encode the conditions of our agreement, and neither you nor me can affect those conditions. So we can have a smart contract that says if it doesn't rain then the crop insurance gets paid to me, and if it does rain it doesn't get paid to me and you get my premium. But you as an insurance company would no longer have the ability to decide not to pay me even if it didn't rain, because the system that is executing that agreement is outside of your control. In a traditional insurance company that system is completely within your control, so even if it doesn't rain you as the insurance company could choose not to pay me, then we have to go through a lengthy legal process. So smart contracts are basically these technical agents that operate in this infrastructure called blockchains and Oracle networks, and that's the infrastructure that we kind of work on — eliminating the trust factor.

Sure. So tokenization is taking the ownership rights to something like a gold bar, a piece of real estate, an equity, a commodity, really anything, and putting that ownership right into a blockchain in the smart contract we just discussed. Bitcoin is an example of an ownership right for the digital instrument called Bitcoin. Real world assets are an ownership right for real world things — real estate, commodities, equities, gold and so on. And the transition that Mr. Fink describes is the one where the use of tokenization will no longer be limited to we make a token about, you know, table coin and table coin is worth whatever you and me are willing to pay for it in the open market. That's how tokenization has been used so far. That is not really a financial product and that's not participating in something called securitization, which is basically taking something real in the real world and turning it into a financial product. The real world asset trend is the next stage. The first stage of tokenization was literally millions of cryptocurrencies, most of which have no value. The next step of tokenization is applying that same technology but to real world assets.

Sure. So there's kind of two fundamental reasons. The first fundamental reason is efficiency — for example, something called atomic settlement or T+0. So the US is going to T+1, which means it takes a certain amount of time for transactions to settle. When transactions take time to settle, like one, two, or three days, if it's a hundred billion dollar transaction, we can't gain interest on that money. So I'm stuck in some transactional system where for a few days I don't get interest on the hundred billion that I paid for something, and even a few days of four and a half, five percent interest on a hundred billion is a lot of money. That's a very basic example. That's an example around payments and partly collateral management. So the first thing is that people like Larry Fink are mired in all kinds of legacy problems that cost them literally hundreds of millions of dollars — about how to rebalance their portfolios, about how to buy and sell assets, about how to receive payment, about how to prove things to people like the NAV, the valuation of the fund. These are esoteric middle office and back office problems which the average person has no interest in because it's not their job, it's not their problem. But these problems are worth hundreds of billions in fees, in complexity, in risk, and that's one of the reasons people like him are so excited. Because if you're a craftsman doing something and you had one tool and someone gave you a much better tool, you're excited about that. So that's one level of kind of why it's very important, and that's one of the big driving reasons why the DTCC, Clearstream, Euroclear — basically the three biggest clearing and settlement systems in the world — are now actively talking about transitioning to this model. The other side of it is market demand. So the ability to tokenize things has two really great properties to it. The first one is if you tokenize traditional assets — money market funds, treasuries — you basically put them on chain and then there's a market that wants to get them on chain because they can use them as collateral, so they can use them to back things on chain. And this is what people in the on-chain world have been doing or trying to do for many years — they've been trying to create baskets of assets that are controlled in a private key-based way. So traditional financial instruments are more attractive on chain because people want to own them on chain in a direct way where they control the asset just like they control a Bitcoin. Then there is net new assets. Net new assets are like tokenizing real estate for fractional ownership of a multi-hundred-million building, tokenizing private equity funds where you would have had to have five million to get in, now it can be at ten thousand, tokenizing carbon credits, tokenizing municipal bonds, tokenizing even gold that you can then go and redeem that gold in person against the cryptographically guaranteed token that you control. So then there's this whole category of net new assets that are not currently in the financial system, but once you tokenize them — tokenization is just a better, more efficient way to put them in the financial system.

Hundreds of trillions. I just take every market — take the gold market, the real estate market, the debt market, the derivatives market, the securities lending market, all of these, all assets. What's fundamentally happening is you have a new format for assets, for ownership, and also for the data associated with that ownership, and the data is now appended to it in a way that proves things to you about the underlying asset. So the last time there was this type of transition was in like the 60s and the 70s, where people transitioned from paper to basically databases. That was the last time that value — all the world's value used to be on paper, and then databases appeared and computer systems appeared, and the efficiencies and the benefits of computer systems and databases, even before the internet, right in the 60s and 70s and 80s, were so vast and so great that all the world's value transitioned from paper into a database record. All the world's value — it wasn't some of the world's value. You don't have any piece of value right now that you own other than whatever you have in your house somewhere that isn't in a database. But in the 60s and 70s all of that value would have been in paper certificates or even other paper ledgers. So it's that type of transition where now we're going from databases, which you and me can't trust. So one of the fundamental differences is that you feel you have money in Silicon Valley Bank. And if you talk to people about their account in Silicon Valley Bank — they're in the valley, they're genius tech entrepreneurs, the US financial system is wonderful — two weeks before Silicon Valley Bank's collapse, it's like, you ask them what degree of ownership and real control do you have over this asset that you have in this database, they will say complete control. In Silicon Valley Bank, two weeks after Silicon Valley Bank, you ask them what's your relationship with this asset — it's a great question, we don't know what our relationship is with this asset. But your relationship with a private key that you control, and that private key mathematically guaranteed control over an asset, is very different.

Yes.

Because the amount of centralization and control other people have over everything they own, and more importantly the underlying value of everything they own, is extremely high — currently. So people are like, I have a brokerage account and I have a bank account, that's great, I control all this stuff. Yeah, let's take a look at countries that have bank default scenarios where they institute capital controls, like Greece, where you couldn't get more than I think sixty-five dollars a day, whether you were an individual or a business. And then take a look at the Bitcoin wallet registration numbers from that time period in Greece, and also take a look at the wallet registration numbers in what people thought were going to be the next economies to fail, like Spain. Those wallet registration numbers go up like hundreds to thousands of percent, because people realize that their relationship with their assets is a fiction. And it's a fiction that benefits people with a brand that have over a hundred years with their brand, and their logic is, I have the legal system protecting you, I could hypothetically deny you access to your assets like Silicon Valley Bank did, but I won't because why would I. And then the situation changes, like in Greece, and capital controls are implemented, or the situation changes and the solvency of the bank is in question because Moody's decides to do their job and clarify something even to a very small degree, and all of a sudden you can't access your life savings. So I think what has happened at this point is that brands and institutions are unbelievably expert at assuring everybody that they are safe and that it is safe to put your value and your assets in the system. What blockchains do really — another way to look at it is it creates what we call the verifiable web, and that has three properties. The first property is you can verify how the system works before you join it. Then you can verify what's going on in the system at any one moment in time. So imagine if you knew every single piece of information that the CEO of your bank knew — you had access to exactly the same information, there was no delay between the solvency information of your bank and what you knew and what the CEO of the bank knew, so nothing could be hidden from you. That's the second property. And then the third property is that you can always choose to leave the system under the conditions you initially verified. And this is where private keys come in. So this is the new world we're kind of shifting towards.

It's inevitable, and if they don't participate they will lose usership. And these are very smart people — like the wages that people in banks and asset management get are on the high end of all wages. This attracts people who are very, very smart. They're not dumb people. I interact with them on a daily basis. They're very clever, smart people. It's not like there's this huge monumental structural shift in how all value is managed and secured and transacted, and they're just going to sit there and the numbers won't go from less than a hundred billion to over two and a half trillion in the crypto industry, and they're just going to ignore it. This is just an inevitable reality because of the benefits of this technology. It's like right now the internet is obvious to everybody. It's obvious that we communicate over the internet, we do Zoom calls, we send emails. 60s and 70s, you ask people about the internet, they're like, why would I need that? But the benefits are obvious now. So if you can't beat them, join them, and this is the trend.

The tokenization trend and the DeFi trend and like the private chains of things, right — like you had publishers. We still have some print stuff, listen, I'm old school, I like my hard copy, but obviously you had a lot of publishing businesses just to put on a very rudimentary level that got taken out of business, that lost out on this. Yeah, so there's two groups. The first group is anything that can be packaged into a smart contract that some service or system charges a lot of money for. So if your financial service is doing some automated function that you do in your database in servers, and then you charge half a percent or a quarter of a percent in fees for that, and that can now be written in this technical agent, and this technical agent is so reliable that the chance of its failure is less than your system, and so using your system is both more costly and more risky than this technical agent that's doing some calculation or some transfer or something — and there are parts of the financial services infrastructure that fall into that. And there are other parts that people think fall into that but actually don't fall into that, and this is where a lot of people are confused about who will be displaced. There will be parts of people's financial services infrastructure offerings that are replaced by smart contracts, and there will be parts of what they do that will actually become more valuable in certain ways, like for example providing legal finality. So one answer is the people who create the financial system of the world and how that all works, which is complicated and varies from use case to use case, but basically the way to think about it — anything that can be turned into a smart contract will be turned into a smart contract. That's the question you should be asking: can this be turned into a smart contract? Yes. If it's turned into a smart contract, assume it costs less and assume it's viewed as more reliable than a centralized thing. And then the next question is why would someone choose this thing over that thing? Once you're in that kind of lens, and the answer is pretty much always they would never choose the current thing, just like we don't communicate over Postal Service. That's the situation.

And then the second group are the people who exploit information asymmetry, which is a lot of people in the financial markets. Information asymmetry is how most hedge funds, most places that speculate, make money — legally or illegally, many times illegally. And the global financial crisis was a great example of this, where you had certain very small groups of people that had unique access to information that they were able to exploit to become massively rich, where the rest of society had to cover the cost. And that's basically information asymmetry. Now, information asymmetry is eliminated by putting the data that those people would have had on chain. So the thing that's happening beyond just the ownership right going on chain is the data is going on chain. So I'll give you an example. Let's say we had a million mortgages and they were bundled into some product, and they were bundled into some other product. In the traditional system, no one could really understand who the mortgage holders are. In the new system, every mortgage holder will have their own smart contract. And the second that their credit score changes, the second they buy five more houses, the second their wages go down in some way or something significant happens, that specific single mortgage holder smart contract gets updated, and then the packaged asset is a collection of millions of those individual smart contracts. But you don't have to be John Paulson, you don't have to be these advanced people to understand what's going on with the underlying assets, because all of the data is flowing into this smart contract, which is becoming what we call a unified golden record. So the second thing that's happening is the markets are getting more efficient. You have atomic settlement, huge efficiencies, which fundamentally make everything cheaper, and that value ends up going back to the consumer through competition, which is the power of capitalism. And then the second thing that's happening is the information asymmetries are eliminated, because imagine if you knew everything about an asset that the asset issuer knew. Like one of the biggest problems of asset managers, frankly, is that the asset issuer, the sell-side bank making the asset, knows all this stuff about how that asset actually works and is actually performing, and then they get really good updates about that. And this is what defines some of the best asset managers, actually, is that they have access and understanding of that information similar to the sell-side banks. And the worst asset managers don't have that. But imagine if all of this same information that the bank had, the issuer had, was on chain to begin with, and then it was consistently updated. So let's say we have a tokenized piece of real estate, and instead of having to have a hundred million dollars to buy into a building, we need to have one dollar. So we buy a portion of this big convention center because we think it's going to be worth more, and then that is an ownership right on chain, and it is also a data container where let's say there's a new debt obligation on this convention center. The second that that debt obligation becomes publicly known in some database, it gets written into that on-chain record, and now you don't need to have access to that database, you don't need to know where to find that debt information, it is delivered to the place where you have your ownership. And this eliminates these information asymmetries, which actually are one of the biggest reasons of the size of the cyclical booms and busts of the global financial system, because the story is always we have this information asymmetry, there's a big boom, then it becomes apparent, there's a big bust. So with more transparent information, you see more stability for financial systems at large.

Well, you could — not to get off topic, but you could say the rating agency did not do their job in the way that they rated the — because the friction for them to understand was very high. So imagine if the friction is very low. Imagine if each of the mortgage holders in a million basket mortgage-backed thing — you can know when that mortgage holder's credit score goes down and if he's taken an extra mortgage on another house and extended his credit.

So you know, it's very interesting with people — they say they want control, but when you give them control it comes with responsibility and risk, and this is like a constant pattern with human beings. So they even have studies where they put them into supermarkets where they can choose twenty ketchups, or they put them into a supermarket with two ketchups — they're happier with two. People are much happier with two ketchup choices than twenty choices. But if you ask them, would you like more choice, the answer is always yes. And one of the key problems of our industry is the user experience. So the user experience of the crypto industry, of the real world asset industry, because of these private keys, is not good. It's gradually improving, and this is an example of a role that institutions will play. So institutions will abstract away this kind of key management problem. You will see some control, but I think we'll actually end up in a middle ground where you gain some control and the institution helps you manage the rest. So the user experience of moving cryptocurrency by clicking little keys — little devices, I don't know if you have a Ledger or Trezor or one of these, but clicking those things is not fun. And whenever we do those transactions or we see those things, we are always joking about, this is so ready for my grandmother, I can't wait to have her transfer some Bitcoin somewhere, and we're laughing about the quality of that experience. So that needs to change significantly for wider adoption. But I think there will be a layer between people and that in the form of various apps, fintechs, institutions. So that'll be simplified partly in that way. The other thing that is a concern, frankly, is the scalability of the system. So the scalability of blockchains has not reached its full potential yet, and this is still a limiting factor. And then the two other big problems that the industry still faces are connectivity — full connectivity — and privacy. So full connectivity is what we work on. We connect the largest amount of data, we connect the largest amount of existing backend systems, we connect chains in the most secure way across both bank chains and public chains. So this connectivity problem is what Chainlink is heavily focused on, in addition to validation and other problems. And then the privacy problem is another key thing, which existing transactions in the web system have. So there's a lot of privacy in how people transact today. That privacy doesn't inherently exist on chain right now. That's another limitation. But once you solve these four monumental limitations, then all of this is beyond obvious. And even with these limitations, you have a two-and-a-half-trillion-dollar public chain industry, you have the biggest asset manager in the world saying that all of this is going to convert, and you have the three largest clearing and settlement systems of the world at this conference announcing a joint digital asset control principles framework, which they I think announced yesterday. So even with these limitations, right, and the way to think about that in my opinion is every technology kind of gets to a point and then it reaches diminishing returns — it can maybe do another two percent increase or five or ten percent increase. Internet technologies have reached that point. Internet technologies can improve another five, ten percent. Blockchain technologies are in the early to mid stages of their development and they can improve on hundreds of percent.