Tokenisation is coming

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Despite such enthusiastic endorsement from the CEO of the largest asset manager in the world, the value of tokenised assets remains trivial.

There is frustration in the digital asset industry with the length of time it is taking to get a breakthrough, despite numerous experiments and ventures, many involving major financial institutions.

Banks, including global custodian banks, have built tokenisation engines to accommodate clients interested in issuing tokens, which rival those offered by the new breed of token exchanges that have emerged, notably in Singapore (where there are no less than seven), Switzerland and the United States.

In addition, policymakers and regulators in multiple jurisdictions around the world are rewriting securities laws and rules to accommodate token issuance, trading and settlement on regulated markets. Singapore, Switzerland, Germany and Luxembourg have all made legal and regulatory changes to accommodate tokens.

In the United States, the Securities and Exchange Commission (SEC) has given provisional approval for a National Market Exchange for security tokens. The American central securities depository (CSD), the Depository Trust and Clearing Corporation (DTCC), is exploring how to make issues on public blockchains eligible for settlement at the DTCC. The DTCC is also building an infrastructure to accommodate the tokenisation of privately managed assets. (1)

Importantly, privately managed assets are a field in which the infrastructure is not well-developed. Although in principle any asset can be tokenised, the first asset classes to be transformed are expected to be those with inefficient and expensive issuance, trading and record-keeping processes and poor liquidity, chiefly because they are not yet even securitised.

Real estate, an intrinsically illiquid asset class, is of course available in securitised form already via real estate investment trusts (REITs) and indirectly via public property companies, but tokenisation promises to improve the liquidity of the asset class.

This is significant because real estate is (see Table 3) the most valuable asset class of all.

Other physical assets, such as infrastructure, are candidates for tokenisation too. Niche markets in uncorrelated asset classes such as fine art and fine wine are also being developed already.

Both alternative and mutual funds are judged too have potential for cost savings, and several funds have been tokenised on the Singapore token exchange ADDX.

If shares in a fund or units in a trust are tokenised, it opens up the twin possibilities of wider distribution, increasing liquidity, and of pricing based on secondary market trading rather than principal-based trading. If the underlying assets are tokenised as well, it creates an opportunity to transform all the underlying data flows, delivering massive cost savings.

However, blue chip equities of the kind held by mutual funds are seen as a less urgent case for tokenisation, because issuance, trading and settlement are already relatively efficient.

Bonds, on the other hand, are seen as an early use-case primarily because the primary market processes are inefficient and secondary market liquidity is exceptionally poor in any instrument other than government debt.

The principal source of liquidity in the bond market – namely repo transactions – is also seen as an early use-case for tokenisation, with both Broadridge in the United States and HQLAx, a venture backed by Bank of New York Mellon, BNP Securities Services, Citibank, Clearstream, Euroclear, and J.P. Morgan, providing services already.

Despite its attractions, the bond market is proving hard to change. Embedded legal structures, which date back to the 1960s, and the internal operating systems of market participants are entrenched in market structures and regulations.

That said, a survey of the 20 biggest global bond issuers found half expect to issue tokenised bonds within five years. They also expect tokenisation to become the primary issuance vehicle.

Although the exact size of the tokenised asset markets is unknown, the limited size of the security token markets is a barrier to growth anywhere. They are not large enough to attract issuers, investors, broking and market-making intermediaries or investment banks to structure and distribute new issues.

However, history also shows that new markets can scale quickly. Mortgage-backed securities, money market funds and passive investing were not invented until the 1970s but today they are worth US$12 trillion, US$5 trillion and US$22 trillion respectively. The digital technology used in tokenisation suggests these timetables could be accelerated.

This expectation is reinforced by a growing sense of certainty that the future of money will be tokenised. The June 2019 announcement attempt by the then Facebook (now Meta) to launch a global, muti-currency Stablecoin called Libra, accelerated official work on regulating Stablecoins and the work of central banks on issuing Central Bank Digital Currencies (CBDCs).

There are now at least [90] central banks working on a CBDC around the world. (2) Four central banks – in the Bahamas, the Eastern Caribbean, Nigeria and Jamaica – have now issued a CBDC. More will likely follow in the next five years, solving a major obstacle to rapid tokenisation: the lack of fiat currency in digital form on blockchain networks.

It is now reasonable to suppose that in the major financial markets the current combination of central and commercial bank money will be replaced by a layered structure of digital monies consisting of CBDCs, mostly bank-issued Stablecoins and tokenised deposits, all of which will be regulated.

Since money is a core activity of any bank, and money is expected to run on blockchain-based or blockchain-influenced infrastructures, banks need to build digital asset infrastructures of their own. Digital asset custody is a crucial part of those infrastructures.

True, at least in the short-term, tokenised assets are likely to remain a relatively inconsequential asset class.

However, in all major markets these new instruments are supported by existing or new securities laws and regulations and could grow quickly. Non-traditional custodians must be able to service tokens within existing regulatory frameworks, so they are investing in digital asset custody capabilities.

One solution to this need that is being developed as a short to medium term transition mechanism is for tokenised securities to be made available to investors without independent digital asset custody services by making digital and conventional securities fungible.

It is now understood that securities in particular do not have to be issued either in conventional form or as tokens but can be issued traded and custodied as both.

For example, SIX, the Swiss stock exchange, has enabled issuers to list bonds on both its traditional exchange and its SDX digital exchange and settle transactions in the bonds in both its conventional CSD and the CSD operated by SDX.

Obviously, the custody of cryptographically based tokens is different from conventional securities. But the dual listing the bonds (with same ISIN) on SIX and SDX means they can be traded by customers without as well as with a digital custody account.

The link that makes it work is that the SIX conventional CSD (SIX-SIS) has become a participant of the SDX digital CSD. So, a conventional security holder settles and holds the digital bond at SIX-SIS while the final settlement process happens at the SDX CSD.

This option is not necessarily unique to SIX. While SIX has built and integrated a digital exchange and CSD within its conventional exchange and CSD, in principle any two exchanges and CSDs could imitate their example.

While the dual listing seems unduly complicated for two ordinary bond issues it is in fact revolutionary and provides a roadmap for what will be a very extended process where conventional and token securities can co-exist.

One of the big constraints on a decisive move to tokenisation is the need to give issuers that want raise capital at the lowest price on a global scale access to investors that are not equipped to invest in digital assets.

The option of issuing a bond in both conventional and digital form solves it by making the instrument available on both a regular exchange (in this case SIX) and a digital native version (on SDX). This enables issuers to reach both types of investors.

The investors can hold tokens through a traditional custody arrangement as well as a digital one. If the transition from the current status quo to a tokenised future is prolonged – and it looks as if it will be – the ability to hold tokens as well as securities through the same custodian will be crucial in attracting institutional money.

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(1) See “What CSDs can do about Tokenisation” at https://futureoffinance.biz/future-of-finance-institute/

(2) Future of Finance Research