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Future of Web3 in Debt Capital Markets



Avtar Sehra discusses the future of institutional DeFi, as is being done by Clinaro, where flexible instruments can be deployed.


Avtar Sehra has a PhD in theoretical particle physics and a masters in computational engineering and is a graduate of Imperial College. After his academic career he transitioned to capital markets, focusing across risk management, pricing systems and infrastructure sales.

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Sehra: I'm Avtar Sehra. I'm the founder of Nivaura, a technology company that was developing workflow automation platforms for the capital markets. I exited the company last year, after seven years. Now I'm taking the next step in developing technology solutions using Web3 for the capital markets. I'm going to be explaining the future of Web3 in the debt capital markets. There's three things that we'll be talking about. The first one is, how do the debt capital markets actually work, and how are they changing? Secondly, how will technology such as Web3 drive this change? Finally, what are the factors limiting such a technology change?

History of Tech in the Debt Capital Markets

I want to go through some of the history. When I started in my previous company, there was very little technology in the capital markets, especially the debt capital markets. Majority of the workflows in this industry were pretty much through emails or phone calls. When we started the company in 2015, some of the early advances that we'd made was using our platforms to automate the end-to-end process for the structuring and issuance of bonds and structured products. We took that information from the transaction process, and we used that to tokenize the bond issuances. I'd like to explain how a bond issuance actually works, as we go through the process. The issuer normally wants to issue a bond, and the investors normally purchase the bond. The issuer normally works with a dealer and the dealer normally interacts with the issuer through phone calls, in-person meetings. When they interact, they can structure the deal and negotiate key terms for the deal, but ultimately, you have to price the deal according to what investors are seeking. The pricing is done through some industry infrastructure, like Ipreo's technology, or DirectBooks. This is the book building process for pricing the deal. Then, once all of this is structured, then the bond can be finalized and settled with the investors. Ultimately, the lawyers and the law firm, for example, acting on a deal would work with the issuer and the dealer to structure all the documentations for execution.

Once the deal has been structured and priced, normally the investors would utilize their own custodian and go through a clearing system to be able to pay for the bond. On the issuer side, they use their own custodian in issuing and a paying agent, and the funds will be registered with the clearing system to be able to send the assets to the investors. Normally, this would go through a clearing system to be able to transfer the assets to the investors and for the investors to transfer the money to the issuer. This is the delivery versus payment process. The investors would deposit their money into the custody account, that would go through a clearing agent into the clearing system. The issuer as I highlighted, would issue the note and that would get registered into the clearing system. Then they're ready for settling with investors. Then once the money and the assets are matched, you can then essentially do a reverse payment transfer, where the notes are allocated to the investors and the money is allocated to the issuer.

We developed a technology for dealers to be able to automate all these interactions, to be able to work with the issuer to structure and negotiate the transaction documentation. Then also to work with the investors to be able to price the deal, and then aggregate all of this information to generate the instrument, and to be able to feed that information into the infrastructure, and to enable clearing and settlement of the asset. As we were automating this process, one of the first things that we thought we could do was to take that technology and use the data that was generated, instead of going through a clearing system, to be able to tokenize those assets. We did some of the first tokenized transactions over the last seven years, starting in 2015, 2016.

What we did was the same as before, the dealer platform could interact with the issuer and the investors. Then, ultimately, the deal is structured. Then, you could tokenize the cash on the investor side. There isn't any CBDC or commercial bank money that is already tokenized. Ultimately, the tokenized currency needed to come through our technology. Then we could then use a custodian to be able to allow an investor to hold their tokenized cash and then deposit that cash into a custody account. The tokenized cash can then live on the blockchain. Then ultimately, on the dealer side, the notes when they're structured and issued can be tokenized. The securities custodian could hold the keys, and then the tokenized assets could be registered on the blockchain. The tokenized cash is registered on the blockchain and the tokenized assets are registered on the blockchain. Then using a settlement process, you could then do delivery versus payment. The actual cash that is represented by the tokenized cash on-chain could then undergo a gross or net fiat currency transfer off-chain. Obviously, if we have CBDC, or other form of payment on-chain, you don't need this gross or net fiat currency settlement off-chain. We did do instruments that were denominated in Ether. When instruments are denominated in Ether, you could generate the instrument denominated in Ether, then the investors could just settle the asset using Ether on-chain. No off-chain payment is required. Ultimately, the assets can then be held by the investors, where the investors are just holding the key that has access to the assets on-chain. The money on-chain, or the funds on-chain is held by the issuer.

What we did in my previous company, was we tried to focus on building a platform that could bridge the gap between these two worlds. This was the technology and we tried to use the same technology that could actually help structure and execute the deal. Then feed that data into a clearing system to be able to settle and register the deal. Or you could go down into a blockchain and tokenize the assets for settlement on-chain. Ultimately, what this was, it was a platform that was mostly focused on making the whole transaction process easy as possible for the traditional market participants. It was all about registering and onboarding users. It was about setting up all the transaction documentation to be able to execute the transaction and then leverage the market data for pricing. You can follow the whole transaction process and execute the transaction and settle and transfer the assets and the money. Then, finally, we also had a distribution mechanism where investors could do self-service execution. The investors could directly trigger an issuance with the issuer rather than waiting for something to be issued. Ultimately, this was all about making the whole process as easy as possible for investors, issuers, and the dealer that would provide this technology.

Platform Architecture Overview

The underlying technology that all the platform was developed on, the majority of the solution was a standard Web2 infrastructure. You had an external area where participants like issuers and investors would come in and access the solution. They might even have their own proprietary platform that they might go through and connect it with an API. Or they would access the bank's own interface to be able to access the platform itself. This would be the bank's own proprietary platform. This is the type of solution that we deployed for firms like DBS, or the London Stock Exchange. On the other side, on the internal side, or the administration for the transaction and structuring processes from the dealer side, they would have their own access to the solution. Then, ultimately, all the core services for structuring, execution, and managing the lifecycle are shown over here.

The key thing that you can focus on here is that even though we were trying to bridge the gap between traditional execution and tokenized instruments, the tokenization part was pretty much quite simple. We did majority of the things off-chain. We held the keys for custody of the assets. There was an indexer to be able to store various information on the chain. There was an API service that we used to broadcast the blockchain transactions. Then there was a transaction orchestration service. This essentially allowed a smart contract to be constructed, and signed, and deployed on-chain. Essentially, every time a bond issuance was done, all the relevant smart contracts were structured and deployed on-chain. There wasn't any dependency on any on-chain smart contracts, everything was completely done off-chain. The blockchain was simply utilized to create a tokenized instrument on-chain, and to be able to allow that instrument to be transferred to investors, if they pay for those assets. You can see there wasn't anything specific that had to be on-chain, everything existed in the platform itself. In a way, the platform had a complete dependency on off-chain services, and Web3 was almost an afterthought.

As I noted, for every transaction, the system constructed the smart contracts, and these were deployed on-chain. For the life of a transaction, all interactions took place through the platform. They were required to be sent to the blockchain to trigger any transfers or redemptions. Then, interaction with the blockchain was done always through the platform. In a way, even though we utilized the blockchain for creating a tokenized asset, the platform became a key dependency to access these on-chain instruments. This, in a way, defeats the purpose. This is part of the reason the main limitation of the way that this technology was designed, it was all about creating a very simple user journey for the dealers to be able to execute transactions. We didn't really try to create a truly Web3-focused technology for the debt capital market.

However, what we're seeing nowadays in the DeFi space, on the Web3 infrastructure like Ethereum and Solana and other blockchain infrastructures, it's on the opposite end of the spectrum. In these cases, you might have a very minimum infrastructure, a very simple frontend and maybe a basic backend infrastructure with some data. Majority of the time, the majority of protocols in DeFi, they don't even have a real backend service. The frontend as well is a very simple transaction composition client. Depending on what the user wants to do, it composes a transaction and enables the signing of that transaction. That can be transmitted to an existing protocol on-chain. Normally this is done through the Meta Mask wallet, which is an injected wallet into the browser. Then when you go to the website, the client allows a transaction to be composed, signed, and then transmitted into the blockchain, and interact with the right protocol to be able to invest, borrow, or do whatever you want to do, like exchange one tokenized asset for another.

This is an infrastructure that is on the complete opposite end of what we did previously. Essentially, you have no dependency on using this infrastructure. You go directly into the blockchain and utilize a protocol with any interface. Even the interfaces themselves are sometimes completely decentralized, where they're served through IPFS, the InterPlanetary File System. Ultimately, they are unstoppable. You could access the interface to be able to compose a transaction and transmit through Infura into the blockchain. Ultimately, this is where DeFi is right now. There is no off-chain dependence. This is complete off-chain independence. The DeFi infrastructure completely relies only on on-chain systems of smart contracts of the relevant service. It interfaces through a simple thin client used for composing transactions and triggering the smart contract. Even the interface, as I noted, can be decentralized, so there isn't dependency on any one party. Anyone can access the infrastructure through any computer. As I noted, this is on the opposite end of where Nivaura, my previous company were. We developed a platform where you'd have to go on the platform to do anything. The blockchain was simply utilized for tokenized assets. You have to access those assets through the infrastructure, even though those assets were developed as standard ERC-20 tokens so they could be transferred to other people not on the platform. Ultimately, the limitation was if you wanted to do anything to manage the lifecycle of the asset, all of that logic was built in to the platform itself.

Web3 infrastructure is giving us some signals, how can digital markets really operate? Ultimately, what these Web3 infrastructure solutions show is that you have an input. These inputs are essentially you put some digital assets or you create an asset, but you do something, and then it goes through an infrastructure, it's an autonomous system. For example, a decentralized exchange. It takes your assets, and it transfers your asset into another asset. Then it gives you whatever asset that you've asked to transfer for. Or if you're depositing some collateral, it will deposit some collateral, and you can borrow some money based on that collateral. This is essentially how DeFi infrastructure works. For example, this is not just in DeFi, this type of Web3 infrastructure also is driving a lot of innovation around governance markets, staking assets, and using this for voting and accessing services, but also goods. How can you create the ownership of an asset like an NFT, to be able to auction and have fractional ownership, and even have in-game assets tokenized in order to be transferred? These autonomous systems have a variety of uses.

The key element of autonomous systems is that they do not have any off-chain dependence. You normally interact with them. You deposit some asset in, or you transfer some asset through it, and then you get something out. The way they currently operate, these are completely open public infrastructure. There's a lot of risks with such assets. With this kind of technology where we've seen time and time again, in these autonomous systems, sometimes assets get stuck, assets held in the smart contracts can get drained through an attack. Or sometimes you might send something to an asset and it gets sent to a wrong address, and that you've lost those assets forever. Or there's other problems that can occur, that assets can be liquidated, or you're penalized if the price changes for your collateral, and you don't top it up in time, your assets can be liquidated and transferred out to repay your debt. On the other side, as well, there could be other issues where inadvertently, this open infrastructure enables things like money laundering and intermingling of funds, which isn't something that any institution, or especially a regulated institution wouldn't want to be a part of. However, this infrastructure is a starting point for some of the most innovative technologies that are being developed. We're seeing DeFi infrastructure such as exchanges, lending protocols, money markets, central bank type of protocols all being developed on-chain. This gives us a sign or a signal of where the technology is going for capital markets, in particular, for the debt capital market.

Putting DeFi and Web3 in Context Using Video Distribution

Just before we talk a bit about where this could be leading, I want to put DeFi and Web3 in context using an example around video distribution. We all know that in the late '70s, and over the '80s, early '90s, VHS pretty much ruled, it dominated. VHS was pretty much dominant until the late '90s, and even somewhat in the early 2000. However, over the late '90s, and over to 2000, DVD became the dominant format. By the mid-2000s, pretty much VHS was disappearing, and everybody was pushing DVDs. As we reached the end of the 2000s, and went to the early 2010s, Blu-ray was taking over, but the lifespan of Blu-ray was pretty much diminished, because over the same time, there was a new emerging technology that developed very quickly. This was streaming. Streaming essentially took over how video was distributed. Now any form of disk, or any hardware format is pretty much non-existent.

Streaming didn't just come out of the blue. It didn't just pop up in the late 2000s. There was a lot of work going in, in the '90s, early 2000s, and even some things that were fairly dubious at the time in terms of copyright, and issues around stealing content. In the late '90s, early 2000, there was a growth in file sharing. This really became popular in the early 2000s to the mid-2000s with BitTorrent and Pirate Bay. It still exists to this day, even though there was a lot of drive to cut access to these services, and ISPs were told to block these services. They still exist to this day, and people still share files and especially films through such infrastructure. However, as the technology became more refined for streaming, and people understood exactly how to do distribution for video in a more structured and legal way, this legal way of doing things just became more prominent. The majority of people who would have spent a couple of hours downloading a film illegally would prefer just to pay 5 pounds per month and access through like Netflix. This is essentially how even though something could be free, the convenience of having something that just works and that is quite smooth, and that also isn't illegal, becomes just a no-brainer to utilize. Even though these services exist to this day, streaming services are becoming stronger.

DeFi Can Be a Disruptive Change in Capital Markets

Where does this leave us in terms of DeFi? With these kinds of technologies that are on the fringes, almost like as you would say, where BitTorrent and Pirate Bay was, over the 2000s, these services are currently serving that client base. Where there's problems in terms of people's privacy, there's problems in terms of regulatory and legal issues, especially KYC, AML, and intermingling of funds. These challenges, what does this tell us? Where could the industry be going in terms of capital market? The analogy, as we follow the video distribution market, we can say, in the '90s, especially, and over to the 2000s, everybody was working on on-premises platforms. Installing all the software, hardware in their own data centers. That's still happening to this day. The majority of people still prefer to have their own software in their own data center. However, that's changing a little bit, where some of these technology providers are providing those services now through web-based platforms. These web-based platforms are still essentially single user software, where it's providing them some solution to be able to book their trade. The majority of the client interactions are still done completely off of the technology, and they're done through phone, or they're done through meetings. This is where an off-chain platform for blockchain access came in. What the digital platforms of the last seven, eight years is trying to do is to provide a layer on top of this web-based technology that banks and dealers are trying to utilize. These platforms give a seamless digital experience to issuers, investors, and all of the internal users within the bank. Then, that technology can then plug into a blockchain or into their traditional infrastructure, which they have on-premises or on the web.

This is where Nivaura, my previous company was focused, essentially, developing this digital layer, and then plugging things in, individual tokenized assets onto the blockchain or into the traditional infrastructure. In this way, you can assume that the direction of travel is some form of complete on-chain institutional DeFi markets that are not reliant on any of this legacy infrastructure. You could actually interact with a DeFi infrastructure on-chain that is completely compliant in some form, with regulations and the legal requirements. Then, ultimately, parties can interact through a single API into a service and plug into the DeFi infrastructure, to structure and execute a trade and to be able to manage the lifecycle. Essentially what some of these public DeFi infrastructure technologies are doing right now, but for very simplistic instruments. This, we think, could be the evolution of where the industry is going.

What Does Institutional DeFi Look Like?

If DeFi currently looks like this, where you have a very simple infrastructure on-chain just to be able to do the basic things around exchanging assets, or borrowing and lending, there will be an additional set of requirements for compliance. How do you actually create an instrument on-chain that is completely compliant in terms of how it's distributed, how the lifecycle events are managed? How the lifecycle events align with the legal documentation that is a majority of the time off-chain. Then, also, the kind of investors. Who are the investors, and can they interact with this type of instrument? A majority of the time the people interacting with these on-chain lifecycle solutions or instruments will not come through a single platform, but they will potentially come through multiple platforms. This infrastructure becomes an industry-wide infrastructure. Institutional DeFi enables market participants to operate without relying on a single platform operator. Infrastructure completely relies on the on-chain system of smart contracts for process and instrument rules. There isn't a dependence on a platform needing to be updated every time an instrument needs to be created on-chain. Most importantly, the key compliance processes like whitelisting users and instruments are all managed completely on-chain. Finally, such on-chain institutional DeFi can be operated and governed by regulated market participants within the ecosystem. They can all work through a governance type of model to be able to manage this infrastructure, in the same way a board of directors might operate with the current market infrastructure nowadays.

What Is Limiting Adoption of such Web3 Based Institutional DeFi in Capital Markets?

However, if this is where the industry is going, we have to understand why isn't it getting there faster? What's causing the delay? There are three key issues we think that are limiting the adoption of this institutional DeFi infrastructure. The first one, essentially, is crypto regulation. There is a lack of clarity in terms of what cryptocurrency is. As cryptocurrency underpins blockchain infrastructure, especially public blockchain infrastructure, majority of institutions are hesitant to either hold the infrastructure, or to utilize that infrastructure where they have to pay fees in cryptocurrency, and they don't know where these fees are going in terms of stakers or miners. The lack of regulation and control around the core infrastructure is one of the key limiting factors at the moment in terms of how this infrastructure is utilized. As a result, majority of institutional innovation is happening on private chains at this stage, even though with the work that we've done and the work that I've done over the last 10 years, and 7 years in my previous company, was all on public chains, because we believe that that's where the future is. That's where the regulation will be tending towards.

The second key limiting factor that's driving this adoption of Web3 technologies for institutional DeFi is the lack of tokenized fiat currency. At the moment, the only real country driving a form of CBDC is China. While there's a lot of talk in other countries, there isn't really development of a CBDC, or real commercial bank digital currency to be able to use on this institutional DeFi for tokenized instrument settlement. The limitation without having this kind of payment infrastructure, is then you create a tokenized assets on-chain, but then you have to then still pay people off-chain with traditional payments infrastructure. This is essentially one of the key issues as well, in terms of why institutional DeFi doesn't really take off at this stage. Because you can do a delivery of an asset on-chain, but then you have the settlement risk of waiting to transfer the actual cash off-chain.

Then the third and the key issue around privacy, majority of things that happen on-chain in any form of protocol DeFi, be it public or institutional, it's all completely transparent. There is little or no privacy because ultimately a blockchain operates and works in such a way that every node has to know exactly what transactions are going through, and what smart contract states have been triggered. What's being done by who and when? All of this needs to be completely transparent. All the validators on the network or the miners can check, have the tasks been performed correctly? If they have, the transactions can be compiled into the blocks, and the blockchain can be secured. Without this form of transparency, you can't have security. Ultimately, while there are some innovations taking place, like zero-knowledge proofs, even they have their limitations. They require some off-chain coordination. For zero-knowledge proofs, parties have to coordinate activities off-chain. Then those proofs can be posted on-chain to be able to be validated that something can be done or not done. Ultimately, if you're still doing coordination off-chain, you're starting to rely on off-chain platforms, and off-chain dependence, again.

The only real change that will happen in terms of on-chain privacy and that would drive a weaning off of off-chain platforms is the use of homomorphic encryption. We're still at the very early stages as an industry in terms of where that is. Homomorphic encryption is essentially the technology that will allow transactions to be encrypted, and computations to be performed between encrypted transactions on-chain. That means you can do coordinated activity on-chain using encrypted data. That's potentially one of the key steps that the industry is heading towards, in terms of really adopting Web3 technology in capital markets, like the debt capital market. Parties can completely work on structuring an instrument on-chain, to be able to negotiate the structure and to price the instrument on-chain with complete privacy and not giving away prices in an auction, or in a book building process and giving away the identities of investors. Then to be able to then completely settle those instruments on-chain using tokenized fiat currency. All of this done through a controlled public infrastructure where only the relevant users are allowed to access and see various transactions and data on the infrastructure.


We're probably around 5 years away from even getting close to anywhere like this. However, the one thing that I wanted to highlight was the industry is starting to see that DeFi as it is right now isn't just a blip. It's not something that is going to come and go. It's a signal of where the industry is going. It's very similar to what BitTorrent and Pirate Bay did in the early days of video distribution. There is definitely a huge change coming in capital market, and this change will be driven by this kind of Web3 infrastructure to be able to create and manage the lifecycle of assets on Web3 infrastructure. Just like Web2 infrastructure became the way videos were distributed to users' homes.


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Recorded at:

Dec 08, 2023