Tokenisation potentially revolutionises fund transactions and could provide quick, liquid access to private markets in future. Here, Nicholas Pratt explains what it is.
Tokenisation specifically refers to the creation of digital contracts that are held in blockchain systems and which underpin real-world assets like property and company shares.
The crucial point is that it is the file, not the asset, that has been tokenised and that the file is held in blockchain – the innovative ‘distributed ledger’ system created by a mysterious coder, thought to be Japanese.
Tokens are known more technically as ‘security tokens’. When these are issued, it is a ‘security token offering’ (STO). More generally, we may call a security token a digital security or a digital asset.
Being contracts, the tokens act in the same way as any other security or investment contract and are currently subject to the same rules and regulations.
There are tokenised funds, too. Essentially the same vehicles as traditional funds, the difference lies in how they are traded. With a tokenised fund, the investor acts as a direct counterparty rather than having to place an order via a fund administrator or transfer agent. But this will necessitate the creation of a new intermediary to identify and verify investors.
It is similar to how bitcoin does not require an intermediary – a broker – between the investor and the exchange. But it is important to state that tokenisation is not bitcoin or any other cryptocurrency. This distinction is important and still not widely understood. Security tokens apply the tokenisation concept to real assets or financial instruments within a regulated environment such as an exchange, as opposed to the relatively unregulated world of cryptocurrencies. While this will grant institutional investors more comfort, tokenisation will take longer to establish than the less stringent world of cryptocurrencies, bitcoin mining and initial coin offerings.
Why are so many people excited about tokenisation?
A report from Deloitte in 2019 stated that “tokenisation allows the creation of a new financial system – one that is more democratic, more efficient and more vast than anything we have ever seen”. Tokenisation is already a reality, the report says, with “both new players and traditional infrastructures paving the way for mainstream adoption”.
Three inter-related advantages to tokenisation are cost, accessibility and liquidity. Tokenisation lowers processing and administration costs due to automation and digital record-keeping. And as we’ve seen, it also potentially does away with costly intermediaries. This makes it cheaper to manage.
Because of the lower cost, firms are more likely to issue extra securities at a lower entry cost, making previously exclusive asset classes more accessible to ordinary investors. And because of the greater availability of securities to a larger number of investors, this should increase liquidity, especially in illiquid asset classes such as real estate or fine art.
The so-called sweet spot for tokenisation is in the secondary markets around private assets rather than vanilla, publicly traded shares and bonds. In part this is because electronic trading in equities, for example, is well established and works relatively well. In contrast, most private markets are still using filing cabinets and spreadsheets, meaning they are greenfield sites for tokenisation.
Is the excitement in tokenisation warranted?
The interest in tokenisation is rising but is still relatively low, especially when it comes to secondary markets. The Security Token Group’s annual survey of secondary market activity in 2019 showed that total volume exceeded $2.4 million, which equates to daily volume of just $7,156. There is also a lack of infrastructure. By the end of 2019 there were only three regulated exchanges, all US-based. That said, at the beginning of 2020, 60 digital exchanges across the world had applied for licences and in August, the UK’s FCA authorised the first digital assets exchange.
Nor is everyone convinced by the liquidity argument. In 2019 the Financial Stability Board warned that the broad adoption of tokenisation could “create an appearance of liquidity in assets that are inherently illiquid”.
For example, in real estate, investors may have limited understanding of the asset packaged into a token and may overestimate the ease at which an asset can be sold at market price, especially during a time of market stress. Regulators are especially sensitive to this issue, given the problems around open-ended property funds and liquidity.
Tokenisation will also create new risks that have to be mitigated. For example, if a tokenised fund makes investors direct counterparties to the fund, doing away with the role of transfer agents or fund administrators, what body will verify the investor’s identity or ensure client onboarding? Or, with the use of ‘smart contracts’, who do you hold accountable if things go wrong? Would it be the software developer, the asset owner, the broker or the fund manager? Regulation will have to cater for these changes.
What is happening with regulation?
Regulation is crucial for the development of tokenisation and particularly if it is to attract an institutional audience. On the one hand, there is the uncommon situation that both participants and supervisors are calling for more regulation. On the other hand, what they are really calling for is more regulatory alignment and consistency, which is harder to deliver.
A European Parliament report (Crypto-Assets: Key developments, regulatory concerns and responses) recommended there should be a uniform approach to the legal classification of crypto-assets. A 2019 investigation by Esma, the European securities regulator, reached the same conclusion, while the private sector has been calling for this for some time.
Europe’s regulators also recognise that there is an opportunity to help develop the market. “Lack of legal certainty is often cited as the main barrier to developing a sound crypto-asset market in the EU. This is a good chance for Europe to strengthen its international standing and become a global standard-setter with European companies leading new technologies for digital finance,” European Commission executive vice president Valdis Dombrovskis has said.
The problem, though, is that certain countries are already pressing ahead on their own, spying an opportunity to claim an advantage. Liechtenstein has been one of the most forward-thinking nation states, earning itself the tag ‘Bitcoinstein’ in the process. Crucially, it has passed the so-called Blockchain Act, setting an example to other EU states. The Act recognised the legitimacy of a tokenised fund and also laid out the responsibilities for the different counterparties involved, from the token issuers to the distributors to the custodians, and the identity-verification providers.
Furthermore, it is seeing fruit from this, with the launch of the first tokenised real estate fund in Europe, the AARGOS Global Real Estate Fund.
Neighbouring Switzerland is also looking to be a forerunner. In July 2020, the Swiss Financial Market Supervisory Authority approved the STO of Swiss firm Overfuture, approving what is claimed to be the first ever articles of incorporation that explain the digital nature of the shares as security tokens. And in August, the German Finance Ministry announced that it is working on a draft law to create a legal framework for digital securities, including the issuance of tokenised assets.
Meanwhile, the FCA’s approval of the first UK digital securities exchange, Archax, means digital issuances will be able to trade on an FCA-authorised secondary market.
“The launch of the Archax exchange will help bring the institutional and digital asset communities closer together and open up a new era for the global financial markets space,” said David Lester, former chief strategy officer at the London Stock Exchange and non-executive director at Archax.
Another problem is that regulators have to strike a balance between preventing money-laundering and other financial crimes, while also encouraging innovation and fair competition. It is often cited that regulators’ fear of the unknown overshadows the drive for innovation. Regulators will also have to see that institutional investors get the same regulatory protections as in traditional markets.
So, what needs to happen now?
More mainstream involvement across the board is needed for tokenisation to progress. This involves investors, fund managers, custodians and exchanges. Nothing can be tokenised without the consent of asset owners and issuers, but without pioneers there are trading platforms operating with fewer than ten security tokens rather than the 200 or so that are needed for critical mass.
The market also needs more regulated custodians in the tokens market. In 2019, Fidelity Digital Assets launched a custody service in Europe and HSBC announced plans to transfer 40% of its custody assets to the blockchain in the first half of 2020. And more recently, Standard Chartered announced plans to build a digital custody platform.
At the same time, many of the start-ups that offer cryptocurrency custody are looking to expand into tokenisation in search of institutional clients. This sets up the prospect of competition between digitally native newcomers and the establishment. Or more likely, we will see collaboration between the two.
Lastly, there needs to be consensus across the industry and in multiple areas. This includes picking a specific blockchain protocol to develop the majority of security tokens, making regulation more globally consistent and finding a market structure that allows for the benefits of distributed ledger technology without sacrificing governance and accountability.
These are significant challenges, which will take time to overcome – so the last requirement is for patience.
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