The Next Decade in Fintech
The tokenization of finance:
Incremental improvement or game changer?
The Next Decade in Fintech
The tokenization of finance:
incremental improvement or game changer?
If they haven’t already, financial industry executives will need to familiarize themselves with the essentials of tokenization, and quickly. After a decade of fits and starts, momentum is building behind the development of markets in tokenized assets. These are not cryptocurrencies, which are largely unregulated, but rather digital tokens that are linked to existing financial or physical assets and that now enjoy a measure of legal certainty.
The surest sign that tokenization’s time is near is the concerted attention it is receiving from financial industry regulators and central banks. Institutions such as the European Securities and Markets Authority, the Bank for International Settlements, the Monetary Authority of Singapore, the European Central Bank and many others have been busy publishing research and exploring guidelines for transactions involving tokenized assets. The technology foundations for tokenization largely exist today, and nascent markets are taking shape, examples being tokenized money market funds and tokenized bonds.
Bullish forecasts are another sign that the financial industry is taking notice. Recent projections for market value of tokenized assets in 2030 range from USD 1.9 trillion to upwards of USD 10 trillion1. A bright future for tokenization is not guaranteed, however. In particular, continued fragmentation of technology platforms will impede growth. The costs for first movers are also currently high, and much remains unclear about the regulatory frameworks.
We spoke with two experts to understand the current status of tokenization,
the potential it holds for transforming the provision of financial services and
what needs to happen for the potential to become reality.
1
McKinsey & Company is the source of the lower projection and another consulting firm, Roland Berger, is that of the higher one. Estimates of current market value vary widely, but most are in the tens of billions of dollars or close to USD 100 billion.
The essentials of tokenization
Digital asset-backed tokens are created to represent fungible assets — for example, bonds, equities or investment funds. Also known as security tokens,2 these are usually based on a blockchain. A blockchain is a form of distributed ledger technology (DLT), the core technical foundation of tokenization. A blockchain is a digital ledger, distributed across computers in a network, that records transactions. “On-chain” tokens are tamper-proof and immutable due to the distributed nature of the blockchain. Smart contracts embedded in tokens with software code add to on-chain tokens’ immutability by documenting each holder’s ownership of the linked asset. To complete transactions, they can be exchanged with tokens representing currency such as tokenized deposits, stablecoins or, potentially, central bank digital currencies (CBDCs).3
According to Conrad Ruppel, a partner in Baker McKenzie’s Frankfurt office, finance tokenization has three principal layers to be considered in practice.
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Finally, there is the legal layer,
which is the regulatory framework that provides legal certainty to transactions. Regulators’ issuance
of guidelines in recent months and years has done much to improve tokenization’s growth prospects, according to Ruppel. “Legal certainty is a factor that will allow asset tokenization to scale,” he says.
The first is the commercial layer — the profitable use cases that will deliver benefit to institutions.
The second is the operational layer, which consists mainly of the DLT network. “This makes everything technologically possible in tokenization,” says Ruppel.
2
These are distinct from utility tokens, which grant holders access to specific services, and non-fungible tokens (NFTs), which are linked to illiquid assets such as art.
3
For more on CBDCs, see Central bank digital currencies: What they mean for inclusion and for private sector banks.
Main tokenization
use cases today
Tokenized investment funds
Also known as blockchain-traded funds, these have attracted upwards of USD 1 billion of investment. Operated today by large asset-management firms and digital start-ups, they are typically mutual funds in which the shares or units are held as digital tokens and are registered on a blockchain.
Tokenized deposits (payments)
These are digital representations of traditional bank deposits held, for example, in savings or checking accounts. The tokens are registered on a blockchain and can be used as payment for tokenized assets, including shares in tokenized funds and other real-world assets.
The promise
Should it scale to anywhere near the higher-end market value projections, tokenized finance will deliver clear benefits to financial systems, markets, and institutions. The most significant are as follows:
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Reduced risk
Greater efficiency
Increased liquidity
Faster transactions
Greater innovation
The code-based nature of smart contracts makes tokens programmable, enabling the complete automation of transactions, with all the efficiency gains that it brings. “And with transactions proceeding on the same or interconnected blockchains, fewer players need to be involved,” says Ruppel. “That’s the future.”
That automation and efficiency create the basis for the instantaneous settlement of transactions. Instead of the two or more days typical at present, delivery of an asset and the buyer's payment for it can take place within seconds.
Markets for tokenized assets can operate 24/7, enabling continuous trading within and across time zones. Tokens also enable the fractionalization of asset ownership, which can expand the universe of investors active in a market.
Residing on a distributed digital ledger and embedded with smart contracts, tokens are unalterable, decreasing the risks of transaction fraud. Settlement risk is also reduced, or even eliminated, with the instantaneous completion of transactions (delivery and payment).
A feature intrinsic to DLT and blockchains is the composability
of different technology platforms, protocols and applications. Composability makes possible the seamless integration of different blockchains and enables developers to combine different applications and technologies to create new financial products.
What stands in the way?
According to Victor Budau, digital expert lead at the International Monetary Fund, the technology infrastructure necessary for tokenization already exists. “More technical advances are needed,” he says, “but these are engineering problems that will eventually be solved.” However, what’s painfully lacking at present is interoperability of tokenized asset platforms. Scale will only be achieved when numerous market players are transacting with each other on common or interconnected blockchains.
“In the present stage of rapid ecosystem development, there exist numerous monolithic platforms operated by one actor and tied to one type of asset,” says Budau.
Interoperability across DLT and legacy financial market infrastructure will take longer to address. Tokenized and traditional financial markets are likely to coexist for at least another decade, if not longer, which will perpetuate combined on-chain/off-chain transactions (for example,
on-chain asset delivery with off-chain payment).
This increases the prospects of continued fragmentation.
Another tokenization barrier, at least today, is cost, particularly for early movers. Ultimately, the efficiencies
of tokenization at scale should lead to reduced transaction costs for all market players. Today, however, all but the largest institutions are likely to find the costs of implementing tokenization projects prohibitive. “This is pioneering work,” says Ruppel. “Organizations need to
have considerable technical and legal expertise on board
to implement projects.”
Greater regulatory clarity is also needed in several areas to build confidence among investors and other market players. The EU’s recently introduced Markets in Crypto-Assets rules and its Digital Finance Package provide a solid starting point for a regulatory framework in Europe. However, markets in Europe, the US and elsewhere need more guidance on, for example, the classification of tokenized securities and other assets, custodial requirements, anti-money laundering and know-your-customer requirements, and cross-border transactions.
All of the above contribute to a current lack of liquidity
in existing markets. It is a chicken-and-egg situation: “Network effects are not yet present,” says Budau,
“but as the barriers are reduced, investors and issuers will gain confidence, liquidity will build, and markets will scale.”
“Industry-wide agreement on common platform standards is needed to ensure interoperability, including across borders, and to reduce fragmentation," he says.
The stars need more aligning
These challenges are largely the same that hinder the adoption of any technology-based innovation
in its early stages. There is no intrinsic reason why those challenges cannot be surmounted, but there should be
no underestimating their magnitude. “It will take a great deal of human coordination between actors in different parts of the financial industry to clear the way,” says
Budau. These include many organizations that will be reluctant to move away from familiar infrastructure
and processes.
Eventually, however, particularly as common standards
are adopted and the regulatory framework solidifies, tokenization adoption will accelerate. The change it will eventually bring to the financial industry is more likely to be transformative than incremental.
In subsequent articles, we will explore in greater
detail the two use cases that tokenization’s near- and medium-term success will likely rest on: tokenized funds and tokenized deposits.
Experts interviewed
The Next Decade
in Fintech
Conrad Ruppel
Financial Services Regulatory Partner
Baker McKenzie, Frankfurt
Victor Budau
Digital Expert Lead
International
Monetary Fund
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