The existence of the internet and, increasingly, the rise of the metaverse have resulted in both physical and intangible assets, such as the creation of a data ‘digital twin’ which means the asset can be represented in the physical and virtual environment. Whilst historically we paid for things over the counter, the internet revolution has enabled global payments between parties - electronically and now digitally. The internet and the virtual world are now more than simply themselves - they are an extension of the real world in enabling a wide range of assets to be traded, such as treasury bills, gold, real estate and art in the form of non-fungible tokens (NFTs). Blockchain-powered platforms are altering the way we buy and sell goods by allowing us to do so 24/7 from the comfort of our mobile devices, whereby making the ability to invest as simple as going on-line to buy our weekly groceries. And, according to a report from digital asset management firm, 21.co, the tokenized asset market is projected to hit $10trillion by the end of the decade. Key drivers include increased need for data breach protection, improvement of compliance systems and standards and enhancement of the customer experience. Meanwhile, large enterprises have been early adopters, valuing tokenization's ability to secure sensitive data, making illiquid assets such as real estate and private equity funds more accessible, and also helping to address challenges regarding fraud. Pushing this trend has included the growing popularity of contactless payments and the impact of the COVID-19 pandemic. Notably, a number of financial firms believe 2024 is the year of tokenization for private investors and institutional markets.
Potential assets that could be tokenized
Source: TeamBlockchain
Tokenization itself breaks down large assets into smaller, tradable units (tokens), so making them more accessible to a wider range of investors with varying budgets. This, in turn, increases liquidity and facilitates fractional ownership where multiple individuals can invest in a previously illiquid asset such as a piece of art or commercial property. This tokenization trend marks a significant step towards a more inclusive, efficient and decentralized future and, by bridging the gap between the physical and digital worlds, it unlocks the potential for a more immersive and engaging interaction between investors and the asset management industry. Furthermore, tokenization revolutionizes the management of real-world assets (RWAs) by leveraging blockchain technology. The deployment of smart contracts allows repetitive manual tasks such as record-keeping, dividend distribution and voting rights to be automated, so reducing administrative costs and simplifying transactions. This innovation also extends to fundraising and investment - tokenization transforms real-world assets (RWAs) into digital tokens whereby providing global investors access to previously restricted markets. The lowered barrier to entry for traditional financial markets also allows individuals with smaller investments to engage in high-value assets, fostering a more inclusive and democratized financial system. Additionally, the transparency and security features of blockchains mitigate counterparty risks in RWA transactions, hence minimizing the potential for fraud or errors. This paradigm shift in asset representation enables the creation of new investment vehicles (such as tokenized funds and derivatives linked to real-world assets) so offering investors new opportunities as well as expanding the range of available risk-management tools. The challenges and opportunities for traditional financial markets in terms of ownership and liquidity presented by tokenization include:
Fractional ownership
Challenges:
· Lack of clear legal frameworks around fractional ownership of assets can create confusion and discourage participation. How will movement from entitlements affect your organization? E.g. the financial institution owes me a share of an equity, to titles of property (certificates of enumerated ownership).
· Determining the fair value of fractions of an asset can be complex, especially for illiquid assets such as art or real estate.
· Central banks and government loss of control, e.g. the investigation into $20billion of Tether potentially being used to break Russian sanctions.
· Ensuring smooth operation and fair representation for all fractional owners can be challenging, requiring robust systems and clear agreements. The Deposit Trust Clearing Corporation (DTCC) in the US provides clearing and settlement services for the world’s financial markets. In 2021, the DTCC processed 800 million securities transactions valued at more than $2.37 quadrillion. As RWA tokenization can create possibly millions of enumerated tokens from one share of equity or debt, this is likely to challenge the current capabilities of a centralized clearing house such as the DTCC. How will each financial institution trade these RWAs?
Opportunities:
· Fractional ownership allows individuals to invest in high-value assets previously out of reach, diversifying their portfolios and potentially increasing returns, e.g. infrastructure projects and private equity.
· Makes distributions on equities, bonds, funds, real estate more frequent, i.e. from six monthly to weekly.
· Breaking down large assets into smaller units facilitates easier trading and potentially increases marketability, so benefiting both investors and asset owners.
· Fractionalized assets can be combined into innovative investment products such as tokenized funds or derivatives, providing greater choice and flexibility for investors.
Liquidity
Challenges:
· Tokenized assets may face limited trading volume and price volatility due to fragmented markets and lack of widespread adoption.
· Tokenization of assets enables peer-to-peer trading, but how will legacy financial institutions cope with new competitors to this space?
· Scalability, interoperability and security concerns of blockchain technology can hinder market efficiency and user trust.
· Understanding the risks and complexities of tokenized assets requires continuous education and awareness efforts.
Opportunities:
· Tokenization facilitates cross-border trade and unlocks international investment opportunities for previously illiquid assets.
· Smart contracts can automate processes such as trading, record-keeping and distribution, so reducing friction and transaction costs.
· Improved liquidity can attract a wider range of investors, boosting market activity and potentially increasing asset values.
Tokenization’s impact on traditional financial markets includes the introduction of disruptive business models challenging traditional investment structures. Tokenization may compete with conventional financial instruments such as mutual funds or derivatives, so providing higher returns and increased flexibility and the use of blockchain ensures automating and enhancing transparency, simplifying processes, reducing administrative costs and potentially improving overall market efficiency. Key players (IBM, Oracle, Microsoft, Mastercard) are actively engaged in capitalizing on this dynamic market landscape and this trend is set to continue into the year as TradFi titans including Hamilton Lane, BlackRock, Abdrn, Amundi and JP Morgan develop tokenized funds, with many more being projected to join in 2024. Although North America currently holds the largest revenue share, the Asia Pacific region is exhibiting tremendous growth potential, bolstered by increasing awareness and supportive government initiatives. Tokenization is certainly posed to create better financial ecosystems but, as regulators realize that tokenization offer consumers more choice and ushers in greater transparency, how quickly will more banks and asset managers tokenize the funds, bonds and assets they hold and manage?
This article first appeared in Digital Bytes (9th of April, 2024), a weekly newsletter by Jonny Fry of Team Blockchain.