Tokenization over blockchain, AI, seen as two areas of financial innovation that can be beneficial, Fed governor suggests

Tokenization and artificial intelligence (AI) are two areas of financial innovation that may have the potential to deliver substantial benefits, a member of the Federal Reserve Board said Thursday.

Speaking to a conference focusing on cryptocurrency and the future of global finance in Sarasota, Fla., sponsored by the Global Interdependence Center, Fed Governor Christopher Waller said the world is rapidly changing, “and we need to be open to the potential benefits of innovation.”

On tokenization, Waller said blockchain could be a suitable use for traditional assets, such as securities and derivatives, as a ledger of record provided the assets are tokenized. “Before a blockchain can be used to facilitate transactions in traditional assets, the assets must first be ‘tokenized’–that is, represented on the blockchain such that the blockchain becomes the ledger of record for the asset,” he said. “At that point, parties can engage in transactions with the tokenized asset by updating records on the blockchain.”

He said tokenized assets offered over blockchain allows parties precise control over settlement times and may enhance efficiencies and reduce liquidity risks. “Another advantage is that they are ‘programmable’ and have ‘smart contract’ functionality,” he said, defining a smart contract as a computer program stored on a blockchain, which can be programmed to execute predefined actions once certain conditions are met.

“When assets are tokenized, smart contracts can be used to construct and execute transactions involving the asset,” he said. “When the smart contract is activated, the transaction proceeds automatically as long as the specified conditions are met. This is the sense in which smart contracts are smart: they do not depend on the parties to the transaction to implement them; instead, they implement themselves, based on the terms specified by the parties.”

As for AI, Waller said banks are also looking to it for a range of customer service applications such as chatbots that can help reset passwords, locate a branch or ATM, and check account balances without the need for human intervention. He said AI has also proven useful for fraud monitoring because it can, he said, help banks spot potentially fraudulent credit card transactions, including by identifying new spending patterns that are indicative of fraud.

He also noted that AI is being used to refine bank credit underwriting process and analysis. He said that has the potential to “speed up underwriting decisions and lower loan pricing.”

However, the Fed governor was also cautious about AI’s future. “Like many innovations, AI involves novel risks, or at least new variations on old risks,” he said. “AI models are only as good as the data they are trained on. This can raise challenges when AI depends on high volumes and different varieties of data, which can complicate efforts to detect problems or biases in datasets.”

Another key consideration, he suggested, is the “black box” problem. “With some AI models it can be difficult to explain how they arrive at outputs given a set of inputs (this is often called a lack of explainability),” he said. “In some cases, even the AI developers themselves may not know precisely how the AI approach works.”

Gov. Christopher J. Waller: Innovation and the Future of Finance