Tokenized Assets and Securities — What are the Advantages of Tokenization?
Security token offerings are issued as distributed ledger tokens aimed to comply with the securities regulatory framework at the jurisdiction of issuance and at the jurisdictions where the offering is marketed to investors. They have a programmable enforcement of ownership and trading restrictions. The tokens are tokenized versions of securities that are already issued by conventional methods, and brought to the secondary on-chain market in digital form, acting as a store of value. They are thus traded both on-chain and off-chain (traditional financial market infrastructures). The communications between the off-chain and on-chain environments will be crucial for assets that continue to exist off-chain.
Advantages of tokenized assets and securities
The tokenization of assets has several potential positive implications in terms of efficiency, transparency, speed, and flow of capital.
Efficiency gains driven by automation and disintermediation
On-chain settlement via security tokens enables disintermediation. The need for middlemen is reduced with value transfers being conducted without a trusted centralized intermediary, through efficient automation of the process using smart contracts. This automation can lead to reduced costs in the issuance and servicing of securities, which might reduce the costs throughout the security’s lifetime. This is beneficiary for both issuers and investors, and could lead to reduced fees.
The distributed ledger will lead to greater recording and sharing of information. The ledger strengthens the data integrity through its immutability. It also improves the safety of the securities, as the single point of failure is removed once a decentralized ledger verified by nodes all over the world is enabled. This has further implications as it enables automatic auditability. This might lead to registrars/transfer agents being redundant, as corporate/shareholder registries gets replaced by the decentralized ledger. In addition, regulatory enforcement can be automatically enforced as it could be programmed into the smart contracts, notifying regulators when restrictions are violated.
Faster and more efficient settlement
With automation of value transfers through a decentralized ledger, transactions can occur more rapidly. Today, the front-end trade execution at Wall Street is fast, but the back-end settlement still takes days. As trust is decentralized, counterparty risk is reduced, and the reduced friction in terms of time could lower operationally risk. Atomic swaps, the process of a wallet-to-wallet exchange (i.e a swap of shares in this context) could further improve the efficiency and speed of settlement. As an asset can be converted into another asset, this makes it possible to skip the entire leg of going through cash between settlements.
Broad market exposure
Today, most investments lack exposure to a global investor base as there are boundaries that complicates trading equities in other markets. Further, there are significant boundaries as to which types of investments retail investors are eligible to trade. Today, partaking in PE/VC funds are reserved for institutional investors, but the tokenization of funds could enable retail to get access to asset classes and risks that otherwise would be beyond their capacity. In other words, the flow of private financing from capital owners to small and medium sized enterprises (SMEs) could be expanded. This could improve the ability for a retail trader to diversify, both by investing into new funds, and also through fractal ownership of real estate.
Decentralized access through fractal ownership
Fractal ownership of assets can lead to higher inclusiveness for smaller investors. This will benefit the investors, but also SMEs seeking access to financing. This might also improve the liquidity for illiquid assets such as SMEs, real estate and art, and thus lead to more efficient price discovery in these markets. This could in turn lower the illiquidity premia attributed to these assets, enabling these assets to trade closer to its fair value.
Hurdles to overcome for tokenized assets and securities
Most of the hurdles is based around regulatory and governance issues, in addition to current technological limitations.
By removing intermediaries, more responsibility is placed on the buyer and seller of an asset, and it is unlikely that financial authorities are interested in removing such intermediaries any time soon. A new framework needs to be built in order to make sure that the security token market is compliant with the existing regulatory and supervisory framework. The decentralized networks enabled by distributed ledgers are complex from a regulatory point of view, as both national and cross-jurisdictional regulations need to be accounted for. The decentralized nature of the network might also complicate the implementation of regulatory action once necessary.
In addition, governance problems further complicate the picture. Fractal ownership is an exciting feature, but requires innovative game theoretic approaches and regulatory standards to enforce effective governance. A company owning a high-value commercial property today is incentivized to maintain the property with renovations and general maintenance. However, if the property is distributed through fractal ownership, problems could arise. The largest stakeholder may not hold a large enough stake for him to find the same value in the maintenance of the building, and smaller investors might not be able to contribute either. This is challenging from a governance point of view.
We are still in the early and experimental phase of blockchain technology and blockchain interoperability. The liquidity on decentralized exchanges is relatively poor, yet it is improving as seen in the rise of Decentralized Finance (DeFi) this summer. However, the rise in DeFi has been followed by large fees, highlighting the current issues of blockchain scaling as activity increases.
Tokenized assets and securities could reduce friction and improve the efficiency in traditional financial markets, as it enables faster execution in addition to increased involvement from more entities. However, from a regulatory point of view, it still requires a clearer framework. From a technological point of view, we need to see improved scalability in order for the transition from the current systems to blockchains to be economically rational.
Nevertheless, tokenized assets are an exciting development in the blockchain space, and we expect the market to prosper with time.
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