By: S&P Global Ratings
In our view, tokenization offers several benefits including the fractioning of assets, which enhances their liquidity and opens the door for investors or borrowers that may have been excluded from existing options. In addition, we believe the technology could allow new players to enter the market, further challenging incumbent banks’ and asset managers’ revenue. As a result, and due to the new digital normal of high-speed transformation, we now expect banks to pursue new products or collaborations much faster than before the pandemic.
With that said, the industry faces several hurdles including the different speed and willingness of regulators to implement a regulatory framework for tokenization. Whether tokenization will replace some financial products remains to be seen, but it may have positive effects on specific business lines, such as capital raising exercises, SME financing, and liquefaction of illiquid assets. Furthermore, tokenization of assets might offer convenient and more cost efficient access to new clientele than current asset-management products, which are mostly offered to only high-net-worth individuals.
What Is Tokenization?
Tokenization is the process of creating one or several digital representations of a physical or nonphysical asset (including financial assets) and managing it on distributed ledgers. There are several types of tokens including payment tokens, utility tokens, and asset tokens. In this article, we will focus on the latter.
So long as the legal environment allows it, any nondigital asset–real estate, private companies, art, and luxury items to name a few–could potentially be transformed into one or several tokens (potentially an infinite number). These would represent the right to the asset (right to use the asset, proof of ownership of a fraction or the totality of the asset, etc.), and would need to be placed with a trustworthy custodian to protect holders, meaning tokens on distributed ledgers are in a sense similar to asset-backed securities on financial markets. However, the underlying quality of a token will always be related to its original asset, while in securitization this link could be blurred by combining different types of assets or through over collateralization.
According to a study conducted by Greenwich Associates and based on the responses of 109 executives active in the blockchain and financial technology space across the globe, equity raising for start-ups and private placements are perceived as the best applications for tokenization. Securitization of cash flows and real estate products, along with private debt placement, were also in the top five application domains. Given the large volumes of transactions in some of these segments, tokenization could quickly attract attention if it were to take off.
Why Tokenization Is Attracting Attention
We see several benefits of tokenization: Fractionalization, liquidity, and financial inclusion.
The creation of a large numbers of tokens out of an expensive asset would make it more accessible to a higher number of users (owners) than previously. This would open the door for broader involvement of retail investors, for example, owing to lower minimum investment size, and enhance the liquidity of illiquid assets. However, this assumption is based on distributed ledger and real world trading not coming into conflict, which could see liquidity transferred from one market to another. Higher liquidity also means lower illiquidity premiums and lower cost of funding for some instruments. This could prove beneficial for SMEs if a tokenized financing product (disintermediated and listed) is cheaper than bank financing (intermediated and over the counter). We think tokenization could also increase available noncash collateral in financial transactions and improve collateral management. There are several examples of tokenization of illiquid assets including the recent partnership between a commercial real estate firm in the U.S. and a platform to tokenize $2.2 billion of properties.
Tokenization allows for the exchange of assets in an efficient manner due to the absence or limited number of intermediaries involved and streamlining of back-office operations. This shortens clearing and settlement times, which ultimately reduces counterparty risk and frees up collateral. The combination of tokenization and smart contract protocols could also help reduce the cost of administering the asset and reinforce compliance with regulation. Having a real-time standardized view of transaction data without needing to conduct multiple reconciliations would remove many of the inefficiencies that hinder the financial system, and could reduce costs. Compliance could also be reinforced through the automatic transmission of information to regulators. However, this may affect market making activity, and price volatility, since orders would need to match to be executed.
Higher transaction security
The use of distributed ledger technology could enhance data integrity and security and provide a more secure exchange of assets or information for utility tokens. On June 17, 2020, MasterCard announced that it tokenized the card credentials for Amazon shoppers in 12 countries including the U.S., Canada, the U.K., Brazil, France, Germany, Italy, Mexico, the Netherlands, Spain, Turkey, and the United Arab Emirates. The replacement of card numbers with tokens allows higher security, since the token can only be used by the specific merchant and is updated regularly. The transition to similar systems may accelerate in the future as the COVID-19 pandemic highlights the importance of electronic commerce and transaction security.
Transparency of ownership
Tokenization would allow the registration of the token holder’s ownership, increasing transparency for transaction partners assuming anonymous dealing is not permitted–not least from an anti-financial crime perspective–and clarifying the rights of different stakeholders.
The existence of a regulatory and legal framework that recognizes the rights of token holders is one prerequisite to success. This includes claims to the income produced by the asset, proof of ownership, a dispute resolution mechanism, and recognition of smart contract protocols. The lack of a proper regulatory environment was recognized as the top challenge faced by security tokens.