Many advantages can be brought to the future of finance by introducing digital currency and the many benefits of blockchain technology: 7/24 availability, instant global liquidity, fair access without permission, asset composability, and transparent asset management. The future financial world in this imagination is gradually being constructed through tokenization.
Blackrock CEO Larry Fink emphasized the importance of tokenization for the future of finance earlier in 2024: “We believe that the next step in financial services will be the tokenization of financial assets, which means that every stock, every bond, and every financial asset will operate on the same ledger.”
Although the digitalization of assets has the potential to unfold with mature technology and measurable economic benefits, the widespread adoption of asset tokenization will not happen overnight. The most challenging aspect is the transformation of the infrastructure of traditional finance in this heavily regulated industry, which requires the participation of all players in the entire value chain.
Nevertheless, we can already see the first wave of tokenization arriving, mainly benefiting from investment returns in the current high-interest rate environment and the existing use cases, such as stablecoins and tokenized US Treasury bonds. The second wave of tokenization may be driven by use cases of asset categories with smaller market share, less obvious returns, or more severe technical challenges.
This article attempts to examine the potential benefits and long-term challenges of tokenization from the perspective of traditional finance, as well as real and objective cases, with the analysis framework of McKinsey Co. Despite the existing challenges, the first wave of tokenization has arrived.
Tokenization is the process of creating digital representations of assets on the blockchain; tokenization can bring many advantages, including 24/7 availability, instant global liquidity, fair access without permission, asset composability, and transparent asset management, to the financial services sector. The focus of tokenization is shifting to “blockchain, rather than cryptocurrency.”
Nevertheless, with the widespread adoption of stablecoins, the release of tokenized US Treasury bonds, and the clarity of regulatory frameworks, the first wave of tokenization has arrived. McKinsey estimates that by 2030, the total market value of the tokenization market may reach approximately $20 trillion to $40 trillion (excluding the market value of cryptocurrencies and stablecoins); comparing the current status of tokenization with other major paradigm shifts in technology, it is evident that we are still in the early stages of the market.
The next wave of tokenization may be led by financial institutions and market infrastructure participants.
Tokenization refers to the process of recording ownership of financial or real assets existing in traditional ledgers onto programmable blockchain platforms, creating digital representations of assets. These assets can be traditional tangible assets (such as real estate, agricultural or mineral commodities, and simulated artwork), financial assets (stocks, bonds), or intangible assets (such as digital art and other intellectual property).
The resulting “tokens” are tradable ownership certificates recorded on programmable blockchain platforms. Tokens not only serve as single digital certificates, but also generally combine the rules and logic for managing the underlying assets in traditional ledgers. Therefore, tokens are programmable and customizable to meet personalized scenarios and regulatory requirements.
The “tokenization” of assets involves four steps:
1. Determining underlying assets: When asset owners or issuers determine that assets will benefit from tokenization, the process begins. This step requires a clear structure for tokenization, as specific details will determine the design of the entire tokenization scheme, such as the tokenization of money market funds being different from the tokenization of carbon credit limits. The design of tokenization schemes is crucial to clarify whether tokenized assets will be treated as securities or commodities, which regulatory frameworks will apply, and which partners will be involved.
2. Token issuance and custody: Creating digital representations of assets based on the blockchain requires locking digital representations corresponding to the underlying assets into a controllable range (whether physical or virtual), usually handled by qualified custodians or licensed trust companies. Then, specific forms of tokens are adopted on the blockchain to create digital representations of underlying assets, with embedded functions for executing code according to preset rules. Asset owners select specific token standards (such as ERC-20 and ERC-3643), networks (private or public blockchains), and functions to be embedded (such as user transfer restrictions, freezing functions, and recovery), which can be implemented by tokenization service providers.
3. Token distribution and trading: Tokenized assets can be distributed to end investors through traditional channels or new channels such as digital asset exchanges. Investors need to establish an account or wallet to hold digital assets, while any physical assets or equivalent are still locked in the issuer’s account with the traditional custodian. This step typically involves distributors (such as private wealth departments of large banks) and transfer agents or trading brokers. Depending on the issuer and asset category, tokenized assets can also be listed on secondary market trading venues to create liquid markets for these tokenized assets after issuance.
4. Asset servicing and data reconciliation: Digitally distributed assets to end investors still require continuous servicing, including regulatory, tax, and accounting reporting, as well as regular net asset value (NAV) calculations. The nature of servicing depends on the asset category. For example, servicing of carbon credit tokens requires different audits than fund tokens. Servicing needs to coordinate on-chain and off-chain activities and handle extensive data sources.
The current tokenization process is quite complex; for example, in a money market fund tokenization scheme, it can involve up to nine parties (asset owners, issuers, traditional custodians, tokenization service providers, transfer agents, digital asset custodians or trading brokers, secondary markets, distributors, and end investors), two more parties than the traditional asset process.
Tokenization can enable assets to realize the enormous potential brought by digital currencies and blockchain technology. Broadly speaking, these advantages include 24/7 operation, data availability, and so-called instant atomic settlement. In addition, tokenization provides programmability – the ability to embed code in tokens – and the ability for tokens to interact with smart contracts (composability), enabling a higher degree of automation.
More specifically, as the tokenization of assets advances on a large scale, in addition to concept validation, the following advantages will become more prominent:
1. Improving capital efficiency: Tokenization can significantly improve the capital efficiency of assets in the market. For example, repurchase transactions or redemptions of tokenized money market funds can be completed instantly at T+0, whereas the current traditional settlement time is at T+2. In the current high-interest rate market environment, a shorter settlement time can save a substantial amount of funds. For investors, these cost savings on funds may be a significant factor in the recent impact of the tokenized US Treasury bonds project.
On March 21, 2024, Blackrock and Securitize launched the first tokenized fund, BUIDL, on the public blockchain Ethereum. The tokenization of the fund allows for real-time settlement on-chain, significantly reducing transaction costs and improving capital efficiency. It can achieve (1) fiat USD 24/7/365 fund subscriptions/redemptions with real-time settlement, a feature that many traditional financial institutions are very eager to achieve. Simultaneously, in collaboration with Circle, it realizes (2) real-time exchange of stablecoin USDC and fund token BUIDL in a 1:1 ratio.
This tokenized fund, which can link traditional finance with digital finance, is a milestone innovation for the financial industry.
2. Fair access without permission: One of the most touted benefits of tokenization or blockchain is democratized access, which, combined with the fragmentation of ownership (dividing ownership into smaller shares, reducing investment thresholds), may increase asset liquidity, provided that the tokenization market becomes widespread. In some asset categories, simplifying intensive manual processes through smart contracts can significantly improve unit economic efficiency, thus providing services to smaller investors. However, access to such investments may be subject to regulatory restrictions, meaning that many tokenized assets may only be available to qualified investors.
We can see that prominent private equity giants Hamilton Lane and KKR have partnered with Securitize to offer a “fair” way for a multitude of investors to participate in top-tier private equity funds by tokenizing their managed feeder funds. The minimum investment threshold has been greatly reduced from an average of $5 million to only $20,000, but individual investors still need to go through the qualified investor verification process on the Securitize platform, which still presents a certain threshold.
3. Saving operational costs: Asset programmability can be another source of cost savings, especially for asset categories with services or issuances that are often highly manual, error-prone, and involve numerous intermediaries, such as corporate bonds and other fixed-income products. These products typically involve custom structures, imprecise interest calculations, and coupon payments. Embedding functions such as interest calculations and coupon payments into tokens’ smart contracts will automate these functions, significantly reducing costs. System automation achieved through smart contracts can also lower the costs of securities lending and repo transactions.
In 2022, the Bank for International Settlements (BIS) and the Hong Kong Monetary Authority launched the Evergreen project to issue green bonds using tokenization and a unified ledger. The project fully utilized the distributed unified ledger to integrate the participants involved in bond issuance on the same data platform, support multi-party workflows, and provide specific participant authorization, real-time verification, and signing functions, improving transaction processing efficiency. Bond settlement achieved a Delivery versus Payment (DvP) settlement, reducing settlement delays and risks, while the real-time data updates on the platform enhanced transaction transparency for participants.
As time goes on, the programmability of tokenized assets can also create benefits at the portfolio level, allowing asset managers to automatically rebalance portfolios in real-time.
4. Strengthening compliance, auditability, and transparency: Current compliance systems usually depend on manual checks and retrospective analysis. Asset issuers can automate these compliance checks by embedding specific compliance-related operations (such as transfer restrictions) into tokenized assets. Additionally, 24/7 data availability based on blockchain systems creates opportunities to simplify consolidated reporting, immutable record-keeping, and real-time auditability.
An intuitive case is carbon credits. Blockchain technology can provide secure, transparent records for credit purchases, transfers, and withdrawals, and embed transfer restrictions and measurement, reporting, and verification (MRV) functionality into the smart contracts of tokens. This way, when carbon token trading is initiated, tokens can automatically check the latest satellite images to ensure that the underlying energy-saving emission reduction projects are still operational, enhancing trust in the project and its ecosystem.
5. Cheaper, more flexible infrastructure: Blockchain is inherently open source and has been continuously developed by thousands of Web3 developers and billions of dollars in venture capital. Assuming that financial institutions choose to operate on public, permissionless blockchains or public/private hybrid blockchains, the innovations in blockchain technology (such as smart contracts and token standards) can be easily and quickly adopted, further reducing operating costs.
Given these advantages, it is not difficult to understand why many large banks and asset management companies are so interested in the prospects of this technology.
However, due to the current limited use cases and adoption scale of tokenized assets, some of these advantages remain theoretical. Despite the numerous advantages that tokenization may bring, there are still many challenges to be faced.
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