Reasons other than lack of digital money that explain why tokenised securities and funds have failed to scale

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Does tokenisation have a scaling problem today and, if so, why? 

Some token platforms are growing. But tokenisation as a whole is struggling to scale. This is largely because the business case for adoption is not yet clear. However, the Initial Coin Offering (ICO) bubble of 2017, the cryptocurrency crisis of 2022 and the Proofs of Concept and Pilot Tests of the early explorations of blockchain by regulated institutions were important staging posts and are in the past. The industry is now in a more mature phase in which both start-ups and established financial institutions are exploring the profitable use-cases for blockchain technology. In other words, tokenisation has transitioned from a Proof of Technology stage to a Proof of Business Value stage. Institutional quality digital assets were never going to be adopted at the same pace as cryptocurrencies because security and fund tokens – unlike cryptocurrencies – must contend with established instruments, conventions and infrastructures. Adoption of tokens entails shifting established industries on to new infrastructures. The benefits flow from network effects and, by definition, early adopters do not experience network effects. So there is no incentive to move away early from established markets. As a result, the scaling process is bound to be slow, and possibly even slower than centralised networks such as CLS (which took more than 20 years) and TARGET2-Securities (or T2S, which took almost 20 years) managed. That does not mean tokenisation is not going to happen. But the cost of migration is making it harder to prove Business Value, especially in the securities markets. Another difficulty is the fear of making the wrong choice. The sheer multiplicity of token platforms, each of which aims to create a closed network in which they capture all the value, obviously inhibits the development of network effects. But fragmentation creates inertia too, by increasing the risk of joining a closed network that fails. It follows that inter-operability, to facilitate open flows of tokens between platforms, is an essential prerequisite for scaling.

Is regulation a barrier to scalability?

Regulated institutions want to work with regulated counterparties and infrastructures, and pay and get paid in regulated money, so the state of regulation is a key driver of institutional engagement. Regulatory attitudes to tokenisation vary as does the speed at which they are responding to the opportunity. Some regulators encourage experimentation, as the Bank of England is doing with the Sandbox it launched in October 2024 and the British government is with its proposed digital government bond issue. But sandboxes are designed precisely not to scale. True scalability needs harmonisation of regulatory approaches across national borders. As a class, regulators are cautious about overturning the status quo in securities markets. In particular, they fear that decentralised networks will be ungovernable and therefore beyond the reach of orthodox regulatory measures designed to regulate centralised markets. Most regulators see the opportunity to use blockchain technology to improve post-trade processes, for example, but are anxious about disturbing the existing rulebook and the infrastructural status quo of central counterparty clearing houses (CCPs) and central securities depositories (CSDs). This is especially true of markets such as government bonds, which are crucial not only to fiscal policy but as a source of collateral in the repo markets and of High Quality Liquid Assets (HQLAs) for banks subject to liquidity ratios. This continuing regulatory uncertainty, however understandable, further inhibits institutional involvement with token markets.

Should regulators be more proactive?

Innovation will always proceed faster than regulation, so businesses should work with regulators to educate them about blockchain technology and convey what sort of regulatory barriers they are encountering. Established businesses also have an incentive to engage with regulators on blockchain because the technology was originally designed to disintermediate them and replace their services with peer-to-peer interactions that take place in a completely unregulated environment. But regulators should also be more willing to assume a leadership role in adapting existing regulations to the demands of the digital asset markets, rather than restricting themselves to attempting to discover through Sandboxes and other experiments what the market “wants.” Some regulators are willing to take a lead. The Abu Dhabi Global Market (ADGM), for example, has attracted thousands of registrations by providing an amenable regulatory environment. The central bank of the United Arab Emirates (UAE) has helped by approving issuance of Dirham-backed Stablecoins. But it is not obvious that established jurisdictions should follow such examples and create new regulations and encourage new instruments. In the United Kingdom, for example, any firm wanting to interact with assets on a blockchain must register as a Virtual Asset Service Provider (VASP), which creates additional expense even for firms that are regulated already. It would be quicker and cheaper to adapt existing regulations to digital assets than to write new regulations. Either way, regulators in established markets need to move at a faster pace.

Is technology an obstacle?

Technology is not an obstacle in the sense that it is proven to work. There is also plenty of choice of Layer 1 blockchains, and users can select the blockchain best suited to their purpose. The only thing that makes technology an obstacle is not the technology itself but the still limited understanding of it at regulated institutions. They are also anxious about inadvertent breaches of their regulatory obligations, and about the security of digital assets they hold in custody from cyber-attacks. These three factors mean regulated institutions lack the confidence to adopt tokenisation.

Is inter-operability an obstacle?

The need to agree on standards to facilitate inter-operability between the various blockchains is an issue. It affects digital asset custody in particular, since ownership has to be tracked as assets move across chains. But inter-operability is being solved through cross-chain bridges, token bridges, sidechains, token swaps, routers, protocols, token standards and various standards working groups. R3 Corda and Hyperledger Fabric and Besu, the main institutional grade blockchains, all work with each other already, and with legacy technologies as well. What blockchain markets can learn from traditional markets about inter-operability is the value of what the payments industry calls “schemes.” These specify data fields to technical standards such ISO 20022, impose standard business processes for different tasks such as settlement and the collection of entitlements, establish the procedures to follow when part of the process fails and assign liability for failures. They also encompass large geographical areas, which enlarge scale.

Do the returns on the identified use-cases provide a sufficient incentive to invest in tokenisation?

The value of the opportunity varies between asset classes. The public equity markets, for example, are already extremely efficient. But even capital markets that are working well in the sense that the costs of trading, settlement and custody are low can still be improved by blockchain technology, because blockchain creates new possibilities. Instances include greater speed and efficiency in the issuance process of the primary corporate bond markets, greater transparency into the underlying investors in the mutual fund markets, easier distribution of mutual funds across national borders, and convenient access to privately managed asset classes such as private equity, private credit and real estate. There is no case for investing in the replication of existing functionality and processes, so all use-cases require new ways of working. If they are to add to revenues or reduce costs, new ways of working require others to work the same way and create network effects, or must reverberate throughout the workflows from token issuance to cash settlement, or facilitate the distribution and sale of an entirely new product or service. 

Why is the buy-side not more engaged?

Asset managers ought to be excited about tokenised assets priced independently by automated market-makers and tradeable around-the-clock. Tokenised bonds would generate additional yield to asset managers of 1-2 per cent over the life of the bond. Yet the buy-side believes that the ultimate incentive for them to issue tokenised funds and buy and sell tokenised assets is the prospect of more efficient post-trade processing. Certainly, operational cost reduction is a priority for the buy-side, but the benefits of tokenisation seem too marginal and remote for asset managers and asset owners to invest in now. After all, tokenisation is a more difficult and expensive proposition than changing a technology stack.