What tokenisation will enable the financial markets to deliver tomorrow which they cannot provide today

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Can tokenisation lower the cost of capital?

In theory, tokenisation can lower the cost of capital in four ways. First, it eliminates the cost of intermediation. A maxim of blockchain technology is that it can dispense with the trusted intermediaries of the traditional markets, and fewer intermediaries translates into a lower cost of capital.  Secondly, it permits efficient matching of assets and liabilities, relieving companies of the need to borrow large lump sums up-front and allowing them to tailor capital-raisings to the timetable of an investment. Thirdly, tokenisation broadens the range of investors and lenders a company can reach, especially retail savers, because it makes previously inaccessible asset classes available to them, within portfolios tailored to their personal needs. The fact that a digitally native generation is about to inherit significant wealth from the Boomer generation will accelerate the transition to tokenised lending and investing. Fourthly, tokenisation increases the velocity of assets, especially of the illiquid kind. This is obvious in the use of tokenised assets as collateral, which not only reduces the cost of money but also reduces the capital banks must dedicate to cover their liabilities.

Can tokenisation make it easier for SMEs to access equity and debt capital markets? 

So far, the chief beneficiaries of tokenisation are indeed the limited number of small and medium-sized businesses (SMEs) that have issued tokenised securities. Instead of being subject to bank credit assessments, SMEs can borrow at prices set by investors in secondary markets. A leasing company with US$5 billion in assets reckons it is paying 20-50 basis points too much to refinance its assets because it cannot access the capital markets, as opposed to tapping bank finance. In a tokenised market, the firm could issue tranches as machine-readable and machine-executable tokens to investors seeking to invest for period measured in days or even minutes as well as months or years. True, SME-focused digital asset exchanges and service providers have so far struggled to build scale. But the fact that regulators in the European Union (EU) are looking to wean SMEs off bank finance as part of the Capital Markets Union (CMU) programme means tokenisation could gain momentum from regulatory backing as well.

Can tokenisation lower the costs of cash, collateral and capital for banks?

The ability to access cash and securities currently trapped behind infrastructural or operational barriers, especially across borders, can in principle reduce the cash and collateral buffers global banks need to maintain in multiple markets. This ought to reduce the cost of intra-day credit and liquidity. Even if the assets cannot be moved, tokenisation makes it possible for them to be mobilised as collateral by changing title on a blockchain rather than moving the assets between accounts. This is now seen as a major opportunity and is the focus of several blockchain projects aimed at the securities financing and collateral management markets. The benefits extend beyond banks to the brokers, asset managers and end-investors that finance and lend securities in the repo markets.

Can tokenisation create new opportunities for custodian banks and fund administrators?

At the moment, custodian banks and fund administrators face the challenge of supporting clients in token markets that are sub-scale, which is why most of them are content for now to cede the market to specialist digital asset custodians that emerged from the cryptocurrency markets. However, institutional asset managers are already looking to custodian banks and fund administrators to make it possible for them to invest in tokens and to tokenise their funds. Asset managers see tokenised funds as a way of increasing distribution to new classes of investor, and they want custodians and administrators to help them. Chief among the reasons they seek the assistance is the assurance of placing assets with a party that they work with already and which will make them whole if they incur losses for operational reasons. Investors, both institutional and retail, are also looking to custodians and administrators to safekeep, transfer, register and value their digital assets safely. Buy-side understanding of the unique risks associated with digital assets - including the risks posed by the operational infrastructure and the lack of fiat currency cash on-chain - is improving, and asset managers and end-investors want the risks to be covered. Custodian banks are the natural takers of those risks. Custodian banks also have an opportunity to help asset managers adapt to tokenised markets by providing interfaces and support services on an outsourced basis, to lower the cost to asset managers of entering the market. At least four major global custodian banks are already providing digital asset custody services, and at least three alternative fund administrators are also providing services.

What can tokenisation do for asset managers?

Tokenisation presents asset managers with an opportunity to transform their industry by shifting from the sale of risk-adjusted market returns to selling guaranteed outcomes, but this would also entail shifting risks on to the balance sheet. That in turn would require them to hold a much larger proportion of equity capital against those risks. In the short term, asset managers face the costs of operating traditional and tokenised asset systems and infrastructures simultaneously. Even to benefit from the cost savings created by tokenisation, asset managers would have to invest in the technology (or the outsourced service provision) needed to support blockchain-based digital assets. Those costs would include the costs of connecting a novel Investment Book of Record (IBOR) to a traditional Accounting Book of Record (ABOR). Since it would be difficult to pass on the costs of the investment to investors, the additional expense would reduce the value of the cost savings created by tokenisation.

What new opportunities does tokenisation create for large corporates?

The balance sheets of large corporations are not liquid. They hold circa 5 per cent of their assets in cash and cash equivalents. They would like, for example, to borrow against the other 95 per cent of their assets. Tokenisation provides a flexible way to mobilise those assets as collateral. The banks that service large corporations are likely to tokenise their deposit liabilities and create closed systems for corporate clients to exchange value with each other. Companies that tokenise the asset side of their balance sheet will be well-placed to participate in these internal bank networks – which may eventually become inter-operable – because they will have the collateral to do more business. In effect, the tokenisation of balance sheet assets extends asset financing beyond tradeable assets such as securities to physical assets, intangible assets and unsecuritised cash flows (such as trade receivables) that currently rest unused on corporate balance sheets. Such collateralised cash flows could become a major source of scale. Indeed, it would be surprising if large corporations do not demand such services from their banks.

What can tokenisation do for institutional end-investors? 

Asset liability matching by pension funds is crude. They purchase blocks of securities and cover any remaining mismatches by purchasing (expensive) derivatives. Tokenisation would allow assets and liabilities to be matched precisely. This would lower costs for end-investors and relieve corporate pension plan sponsors of the cost of underwriting pension fund deficits - which is one of the drivers of the shift from defined benefit to defined contribution pension schemes. Indeed, the outcome-based investing that  tokenisation facilitates would in one sense mark a return to the guaranteed outcomes of defined benefit pension plans. It could also revive the with-profits life assurance policy, which combined a minimum sum assured with scope to share in investment profits as well. Tokenisation certainly creates room to share risk with plan sponsors and asset managers, whereas defined contribution pension schemes and mutual funds leave all the risk with the investor.

What will tokenised capital markets look like?

Tokenisation is not purely about increasing the issuance, trading and operational efficiency of the status quo in the capital markets. Though tokenisation can deliver cost savings in  the primary and secondary markets and in post-trade operations, ultimately it is about expanding the universe of collateralisable assets. This is already evident in the issuance of tokenised money markets funds, which can be used on blockchain networks as cash and cash collateral. But it is easy to start with cash and cash equivalents because they do not present the same challenges as debt securities (equity securities are another matter altogether). The difficulty with debt securities is that, although they are interchangeable in terms of the cash flows they represent, they are documented, calculated and serviced slightly differently, instrument by instrument and jurisdiction by jurisdiction. As a result, asset managers and brokers must invest large sums in buying data streams from vendors and hiring analysts to understand and model different debt securities and combinations of debt securities. Until the cash flows of all debt securities conform to a standard model, tokenisation will fail to scale. It will remain merely a wrapper around the status quo. It cannot transform securities by transitioning them from "digital twins" to digitally "native" tokens, because it requires investing in and operating separate systems for digital and traditional assets.  Heads of operations will never agree to that, so ultimately only a single model can effect change. The businesses and jurisdictions that grasp this reality and act upon it will own the capital markets of the future because they will attract the largest pools of capital. They will achieve that not just via lower costs but by building a market for capital that is not only trustworthy (because it is collateralised) and transparent (because transactions are recorded on a blockchain ledger) but fully automated (because debt instruments and infrastructures follow standard, blockchain-based designs that, inter alia, make them inter-operable).

Can tokenisation raise the rate of economic growth?

A more efficient financial services sector - as opposed to a merely bigger one, which studies suggest can retard economic growth – ought to raise the rate of economic growth. It can lower the cost to companies of raising debt and equity capital, not least by widening the range of assets that can be used as collateral, and so make more investments viable. It can reduce for everyone the transactions costs of all economic activity, by reducing the friction between making a sale and collecting the payment. The effects are likely to be pronounced in less developed economies. One reason tokenisation can lower the cost of capital is that it broadens the range of investors, so it creates a secondary positive effect by increasing the wealth of consumers. Wealth effects can be expected to encourage consumer spending, which will further augment economic growth.