Why the benefits of tokenisation depend on the issuance of “native” rather than “asset-backed” (or "digital twin”) digital assets

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Why are most tokens issued so far in “asset-backed” or “digital twin” rather than “native” form?

Although “native” tokens have existed in the cryptocurrency and Decentralised Finance (DeFi) markets for years, they have proved of minority interest so far in the tokenised securities and funds markets. The preference for “digital twins” is partly a question of the immaturity of the tokenised markets. It takes time to eliminate the intermediaries that stand between issuers and investors, and to squeeze the middle office functions that stand between the front office and the back. Change is inevitably incremental, and “digital twins” are part of that process. But “digital twins” are also more convenient than “native” tokens. Creating an asset that exists in digital form only is more complicated that taking an existing private equity fund or real estate asset, wrapping a legal structure around it and then distributing it using existing sales channels. Indeed, in some jurisdictions, prevailing company, securities and funds laws cannot yet accommodate “native” assets.  Investor interest in “native” assets is also limited, not least because the service provider and operational infrastructure to facilitate investment in “native” assets is not yet in place. There is at present a large mismatch between the potential issuers of “native” assets and actual demand from investors. But the main obstacle to “native” issuance is the limited incentives issuers, intermediaries and investors face to encourage transformational change. Issuers baulk at the legal costs of researching and documenting innovative token issues. Front office intermediaries profit from underwriting, repackaging and distribution rather than issuance or investing. Back-office intermediaries profit from the very inefficiencies that “native” tokens would eliminate. And investors, which rely completely on intermediaries for access, transfer agency, fund accounting, custody, and asset servicing but at cross-subsidised prices that are invisible to them, adopt a largely passive stance towards innovation.

What are the differences between “native” tokens and “asset-backed” or "digital twin" tokens?

Tokenising a conventional financial asset while leaving the entire paraphernalia of the traditional capital markets - multiple intermediaries, extended processes and proprietary technologies – in place changes little. It means only that the asset is owned in a different way, via a token that certifies title to the asset. The paraphernalia that remain in place obscures the essential simplicity of the work that is being done. Every financial product transfers value through time. Investors in an equity or bond, for example, give up current value in return for future cash flows. Issuers of bonds or equities, on the other hand, give up future cash flows in return for current value. Both current value and future cash flows can take the form of tokens. The tokens can be held in digital wallets and transferred between digital wallets, in the form of flows of tokens. Ultimately, any current financial instrument or entitlement, including equities, bonds, swaps, futures and options and corporate actions, reduce to promises (in reality, contractual obligations) to pay cash flows in the future. Which in turn means that any financial instrument or entitlement can be structured to the same design and fulfilled by the same operating model. As the Algorithmic Contract Types Unified Standards (ACTUS) vision of standardised, machine-readable and machine-executable cash flows sets out, a single operating model can dissolve the hard boundaries between asset classes. It is the essential starting point for transformational change, because it breaks the link with the status quo.

What are the benefits of “native” tokens?

The single operating model for all financial instruments that “native” tokens makes possible means that there is no need for the bespoke issuance, distribution, trading, settlement, custody and asset servicing models currently used to support each individual asset class. In addition, conceiving financial instruments as tokens entitling the holder to future cash flows creates room to drastically simplify law and regulation, which are at present largely asset class-specific. The efficiency gains of such a simplified model are significant. Chief among them is the opportunity to dispense with cash – which is currently available on-chain mainly in the form of Stablecoins - as the universal settlement currency. Tokenised money market funds are already being used as cash equivalents in token markets, but in theory any token can be used to purchase any other token (“token versus token” settlement as opposed to “delivery versus payment” (DvP) or “payment versus payment” (PvP) settlement). A single operating model also enlarges the range of financial assets that can be manufactured and creates the opportunity to build personalised portfolios of assets that match precisely the investment needs of individual investors because capital and income can be fractionalised and combined in innovative ways. “Digital twins,” because they start from the assumption that existing asset classes, intermediary roles, infrastructures, laws and regulations must remain in place, cannot deliver these benefits.

What can token markets learn from the apparent success of the reforms to law and market infrastructure in Germany? 

The passage into German law in 2021 of fresh legislation to permit digital securities (the Gesetz zur Einführung von elektronischen Wertpapiere, or eWpG) eliminated the need for issuers to issue securities – including digital securities - in physical form. This encouraged the issuance in Germany of a small number of both securities and funds as genuinely “native” tokens. However, a much larger volume of issuance is of “digital twins” of structured products into D7, the digital CSD owned by Clearstream Banking Frankfurt, which continue after issuance to be processed in the same way as conventional securities. The benefit to the issuer stems from a cheaper and faster primary market process. The longer-term ambition of D7 is to digitise the entire process, from issuance to custody, with a view to supporting innovative banks and exchanges in Germany that are trying to replace centralised, physical securities and funds markets with a decentralised, tokenised alternative.  If the German model succeeds, and is shown to be efficient, there will be pressure in other markets to replicate its success.

Bonds are seen as an early use case for tokenisation. How enthusiastic are bond market issuers about “native” tokens?

Issuers are easily convinced of the merits of tokenisation because the existing primary market process, which determines their cost of capital, is so inefficient. This is true even for the largest companies. Mid-sized companies are admitted to the market but at even higher cost and smaller issuers are precluded from entering the traditional bond markets altogether. These second and third tier companies are precisely the type of issuers the European Union (EU) authorities would like to attract to the bond markets as part of their Capital Markets Union (CMU) programme, so there is support from policymakers and regulators. Even “digital twins” represent progress for issuers because the costs are lower, the pace of issuance is faster and there is greater certainty that they can raise the funds in the bond market, eliminating the need to hold an alternative funding mechanism in place in case the bond issue fails. Issuers are also important in catalysing change throughout the bond market value chain because the replacement of PDFs and Excel files and faxes with digitised, machine-readable information at the primary market level prompts the digitalisation of secondary market and post-trade processes as well.

How enthusiastic about “native” tokens are sell-side firms in the bond markets? 

Bond dealers appreciate the value of greater efficiency in primary market processes such as documentation. The continuing use of analogue technology in the primary market documentation of bond issues, despite the efforts of several start-ups to digitise the process, is widely agreed to be inefficient. At present, bond documentation is still prepared in Microsoft Word and distributed in PDF format, which makes it difficult to digitise the subsequent issuance, underwriting, distribution, trading, settlement and custody processes. So dealers are open to improvements in the primary market. Trading floors, on the other hand, have yet to embrace the transformation of a market that works well from their point of view – though their attitude is bound to change as volume increases. Likewise, post-trade service providers, such as custodian banks and central securities depositories (CSDs), are not yet heavily engaged with tokenisation, despite the efforts of pioneers such as D7.

What is the current state of play in the tokenised bond markets?

Despite the limited enthusiasm of established firms at the trade and post-trade levels, tokenisation in the bond markets is no longer mired in high level, theoretical discussions. Issues are taking place, particularly since the volatility in the cryptocurrency markets in 2022 has receded in to the past. The HK$1 billion issuance by HSBC in September 2024 of one year 3.6 per cent digital bonds on the HSBC Orion platform was especially noteworthy. Even though the bonds were both listed on a conventional stock exchange (the Hong Kong Stock Exchange (HKEX)) and issued into a central securities depository (CSD, in this case the Central Moneymarkets Unit of the Hong Kong Monetary Authority), they were dubbed “native” tokens. The logic of retaining the services of the CSD, which in reality turned the issue into a hybrid of a “native” and a “digital twin” bond, was to attract a wider range of investors and so enhance liquidity. Certainly, tokenised bond issues to date have struggled to generate liquidity. SDX, the digital asset exchange owned and operated by the Swiss stock exchange group SIX, has also retained issuance of bonds into both a traditional CSD (for the conventional version of the bond) and a digital CSD (for the tokenised version of the same bond) in the expectation the ability to switch between the two would assist in generating liquidity. Repo transactions are the major source of liquidity in the bond markets, and SDX also hoped that working with the Swiss National Bank to settle tokenised bond repo transactions in a central bank digital currency (CBDC) version of the Swiss franc would improve liquidity as well. The disappointment of these expectations indicates that tokenisation is better suited to the creation of entirely new products than to improvements in existing ones such as bonds. In addition, the ability to issue genuinely “native” tokens is hampered in some jurisdictions by legal and regulatory obstacles and long-held market practices. Progress in Hong Kong and Germany, for example, is offset by continuing barriers to tokenised bond issuance in the United States, where dual accounting and physical custody, collateral and centralised clearing requirements make it harder to issue “native” bonds.  There is nevertheless considerable interest in other innovations that “native” issuance makes possible, such as programmable coupons and intra-day interest.

What is the opportunity for sell-side firms concerned that tokenisation will disintermediate them?

Tokenisation is a major opportunity for custodian banks. Investors in cryptocurrencies understand that self-custody is risky when the loss of private keys means the loss of the asset. Although the risk is lower for tokenised securities and funds, since missing tokens can be cancelled and replaced, institutional investors would still prefer to outsource the management of the risk to an independent custodian. Transfer agents will find their role as registrar is affected by the fact transactions and ownership are recorded on a blockchain ledger, but so far the registration function has proved important in tokenised securities and funds markets. However, their roles in the investor on-boarding process (which can be automated by digital identities) and in subscriptions and redemptions (which can be automated by smart contracts) are at risk of disintermediation. Fund accountants and fund auditors will benefit from the high quality - indeed, the immutability - of the financial data recorded on blockchains. In the privately managed asset markets, which are currently plagued by unstructured data, there is scope for fund accountants to use tokenisation to overcome the operational inefficiencies they encounter already in the private equity fund markets. Another opportunity is for service providers to work out how to generate liquidity in tokenised assets. Tokenisation alone is not sufficient to make an asset liquid.

What is the opportunity for asset managers?

In theory, tokenisation offers asset managers the opportunity to completely reinvent their business. They could sell products that offer guaranteed outcomes instead of risk-adjusted returns against a benchmark, albeit at the cost of restructuring their balance sheets to look more like banks. Instead of charging ad valorem fees, asset managers could charge fees contingent on their ability to deliver a promised outcome. The guaranteed outcomes will be tradeable. Fractionalisation - by permitting assets to be "de-composed" and "re-composed" at a granular level - means portfolios of tokens can be composed that are personalised to the lifetime needs of individual investors, at much lower cost and greater accuracy than current personalisation techniques such as Separately Managed Accounts (SMAs). Tokenisation also means that asset managers will generate permanently higher returns for investors because they will pay lower transaction and operational costs. However, capturing these benefits requires a change of attitude by asset managers. At present they have no appetite to be heavily capitalised or assume the risk of becoming bank or insurance company-like asset/liability managers. In short, they prefer to offer investors a single product (the net delta between subscription and redemption values, less all the costs and profits charged by the asset manager and their service providers) that loads all the risks on the investor. Although fund distributors build detailed profiles of their investors, including the life-events they need to fund over long periods of time and their risk appetite, the information is not translated into a portfolio of assets designed to meet those needs. Despite a regulatory requirement imposing on asset managers a duty to look after the interests of investors and monitor the outcomes achieved for them, undifferentiated savings products (funds) are pushed (sold) and not purchased, and certainly not based on and designed to meet the needs of individual investors. The relationship between the needs of the investor and their portfolio of assets is tenuous from the outset and becomes more tenuous still over time as the needs of the investor change but the fund vehicles and the portfolio of assets do not. Regulators are urging asset managers to prioritise the interests of investors but asset managers are not using the tool – namely, “native” tokenised assets - that would enable them to do that. Returns to the investor are further reduced by the fact that the current retail investment process is heavily regulated and intermediated. In the United Kingdom, for example, an Individual Saving Account (ISA) invested in domestic equities requires the employment of 16 regulated intermediaries.

Is tokenisation ever going to happen at scale?

There is a risk that the commercial incentives are steering capital market participants towards replicating the existing system on blockchain. The privately managed markets, where there is an opportunity to redefine the underlying assets in “native” form, are at risk of falling into the same pattern. On the other hand, entrepreneurs are clearing individual obstacles to progress already and bringing viable products and services to market such as tokenised bank-to-bank payments, collateral and money market funds. This is prompting established firms to question legacy systems, technologies, processes and infrastructures. For many entrepreneurs, their businesses will not survive to enjoy long-term success. But a high rate of failure among start-up firms is a natural part of the innovation process. Change will happen incrementally rather than suddenly, but it will happen, on a timescale that lies somewhere between five and 15 years in the future.