Digital wave

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Heads of digital assets at buy- and sell-side firms are busying themselves with digital bond issuances on their proprietary tokenisation platforms. But what is behind their newfound love for tokenising traditional financial assets? Anita Hawser reports. 

It is no secret that banks were initially sceptical of digitally native assets such as cryptocurrencies. They saw them as being too risky and volatile.

“We had some serious concerns,” says Marion Spielmann, chief operating officer of banking divisions and custodian at DekaBank, a more than 100-year-old securities house in Frankfurt serving German savings banks. “But we quickly understood the technology itself would be very helpful for the traditional business.”

Six years ago, a colleague working in Deka’s IT department shared with Ms Spielmann some ideas as to how tokenisation — the ability to turn real-world and traditional financial assets such as bonds, loans or mortgages into a digital token traded on the blockchain or distributed ledger — could transform the bank’s traditional securities business. “I was a little sceptical at first,” she says. “I wasn’t sure if the technology would make it or be accepted by the industry or our clients.”

Having done her homework, it did not take Deka long before it decided to set up a separate IT subsidiary, Secure Worldwide Interbank Asset Transfer (Swiat). Swiat develops and provides decentralised applications for the financial markets and a permissioned blockchain based on Hyperledger Besu — an open source Ethereum client. In December 2021, Deka issued two bearer bonds via Swiat. The issuance of blockchain-based bonds in Germany is made possible by the 2021 Electronic Securities Act, which permits bearer bonds, mortgage bonds and certain fund units to be issued in a pure electronic format.

“Tokenisation is a wake-up call for the industry,” says Ms Spielmann. “It will change the business rapidly. If you look at capital markets or the securities business as it exists today … you have a settlement process with an intermediary in Germany, Clearstream. If we settle on a distributed ledger technology (DLT) basis, you don’t need a settlement partner because you can trust the information on the ledger, and the money and securities leg are matched using DLT. It will make our business much faster.”

The Bank for International Settlements notes in a 2020 paper on the future of securities settlement that instead of securities, such as equities and bonds, being maintained as “electronic book-entry accounts” at centralised securities depositories, they could “live” on distributed ledgers held across a network of traders, where each has a synchronised copy.

Tokenisation is a wake-up call for the industry

Marion Spielmann

In its March 2023 ‘Money, Tokens and Games’ report, Citibank ventures that tokenisation of financial and real-world assets could be the killer use case driving blockchain’s breakthrough.

Several banks now have heads of digital assets who oversee proprietary tokenisation platforms for issuing digital assets. Goldman Sachs’s tokenisation platform, GS DAP, had its inaugural issuance last November. Other tokenisation platforms include JPMorgan’s Onyx, Société Générale’s Forge and HSBC’s Orion.

The cusp of global adoption

A September 2022 report from Boston Consulting Group and ADDX, the digital exchange for private markets, forecasts that asset tokenisation will become a $16.1tn business by 2030. Increased trading volumes in tokenised assets; strengthening stakeholder sentiment across many countries; recognition among monetary authorities and regulators; more asset classes being tokenised; and a growing pool of active developer talent in the blockchain, are all indicators, the report suggests, that “tokenisation may be on the cusp of global adoption”.

Luke Brereton, head of client engagement and strategy at investment company State Street Digital, says tokenisation is attracting significant interest and activity with a majority of its asset manager clients. “In short, this technology can help funds, and the industry, achieve two goals: improved efficiency and enhanced asset utility — with the former providing increased margins and the latter driving capital inflow for funds.”

The added value of tokenising an asset, explains Kevin de Patoul, CEO and co-founder at digital assets market-maker Keyrock, is that you are able to automate a lot of steps in the value chain of exchanging that asset. “The main savings are going to be around the post-trade value chain in terms of clearing, settlement and potential new custody asset servicing. You can automate lots of those steps, and some of them you can eliminate entirely. Also, you potentially get enriched information about the asset and its movement and ownership.”

But what of the much-touted move to T+1 settlement in securities markets in Europe and the US, which is likely to cost billions of dollars and hundreds of thousands of person hours to achieve? Nadine Chakar, CEO of Securrency, which powers global digital assets marketplaces with “compliance-aware tokenisation”, says blockchain infrastructure can settle instantaneously. “There’s less operational risk and much better balance sheet and capital management,” she says.

Crypto and blockchain enthusiasts have been touting tokenisation’s benefits for as long as cryptocurrencies have been used to digitally represent value. But one thing that was lacking until now, at least for those in the traditional finance space, was regulatory clarity.

“Increasingly, we are starting to see clarity,” says Mathew McDermott, global head of digital assets at Goldman Sachs. Since taking over the role of head of digital assets in 2020, the EU’s Markets in Crypto Assets Regulation has been passed by the European Parliament.

Rights and legal obligations pertaining to tokenised assets have also been recognised in jurisdictions such as France, Germany, Luxembourg and Switzerland. The first digital bond executed under Luxembourg law, a €100m two-year bond from the European Investment Bank, was the inaugural issuance on GS DAP in November 2022. While digital money in the form of central bank digital currencies still does not exist, at least not in Europe, the Banque de France and the Banque centrale du Luxembourg provided a digital representation of euro central bank money in the form of tokens to settle the cash leg of the digital bond.

“Huge swathes of the traditional financial system, including banks, asset managers and even financial market infrastructures who are existentially threatened by tokenisation, are accelerating their focus on digital assets,” says Mr McDermott. “But a secondary market is needed to drive buy-side adoption.”

Tokenising more vanilla assets is easier for a variety of reasons, he explains. “You can get volume there more quickly, and see the value feed through, even though the benefits are not of the same magnitude as less liquid markets, which will follow.” In terms of future issuances on GS DAP, he says the commercial reality has to be front and centre of any decision. “We have a healthy pipeline of opportunities, but we’re being judicious in how we deploy our resources.”

Tokenisation also allows traditional assets to be more easily fractionalised, or broken up into millions of pieces. Mr McDermott believes fractionalisation will be hugely beneficial for the wealth management business. “It will give them a much broader cross-section of investment opportunities.”

Ms Chakar of Securrency also points to fractionalisation’s benefits for the unbanked. “It takes millions to be able to get into private equity deals or real estate, but tokenisation lowers the barriers to entry,” she explains, “which for manufacturers means you’re opening up a whole new market where now they’ve got a retail market at their disposal.”

Huge swathes of the traditional financial system, including banks, are accelerating their focus on digital assets

Mathew McDermott

Morgan McKenney, CEO of the Provenance Blockchain Foundation, says private assets like real estate, venture capital and private equity are ‘killer’ applications for blockchain. “Currently, this very large asset class (larger than public assets) is highly illiquid and operationally intensive to issue and manage,” she explains. “But issuing these assets on blockchain in certain fund structures can democratise access.” More than $5bn of lending assets, including mortgages and home equity lines of credit, have been natively issued on the Provenance blockchain.

US investment management firm WisdomTree has tokenised nine funds investing in highly liquid assets which are operational today on the blockchain. A primary record of share ownership for the tokenised funds is kept on WisdomTree’s books and records to make it operationally strong in case someone loses their tokens, but — unlike traditional mutual funds — a secondary record of the shares is also maintained on the Stellar blockchain.

Will Peck, head of digital assets at WisdomTree, says tokenisation has the potential to improve liquidity, transparency and standardisation. “We see the potential for 24/7 trading, instant atomic settlement of assets and solving reconciliation challenges,” he says. “It also unlocks capital efficiencies and user experience benefits.”

Even markets that are more opaque today could attract more liquidity as tokens can be used to airdrop information, such as evaluation reports and key updates from companies, making iat easier for investors.

Dumb or smart token?

But not all tokens are made equal. Ralf Kubli, board member of the Casper Association — a Switzerland-based organisation that oversees the operations of the Casper network, an open, permissionless proof-of-stake blockchain — says a lot of what is being created today are “dumb” tokens, as most tokenisation platforms store a hashed PDF describing the terms.

Even worse, he says, some only digitise the asset, not the liabilities or cash flows that represent actual rights to certain cash-flow streams from a bond.

“A financial asset-backed token gets created and appended to a blockchain with a PDF of the terms and conditions attached,” he explains. “Now, imagine a portfolio of such bonds or even mortgage instruments. Then we’re back to the same problem that we had in 2008 where no one knew what was inside these instruments, and you need scores of analysts to read the prospectuses and recreate the right cash flow streams in their own models, without much better information than what is available today.”

He says the logic of the cash flows need to be incorporated in the token in a machine-readable, machine-executable and standardised format, which can be achieved using open banking standards like the Algorithmic Contract Types Universal Standards, which was created after the 2008 global financial crisis to deliver clarity around the cash-flow patterns of financial instruments based on collateralisation, and “smart financial contracts” that can read and execute tokenised assets automatically and without error.

“If it is not standardised, you have no asset interoperability,” Mr Kubli explains. “Then an instrument that is issued by one bank will look different to an item issued by another bank.”

In addition to turning the physical asset into a digital token, you also need to implement the infrastructure to enable the movement and velocity of the token, says Ms Chakar. “You’ve got to think how you harmonise and create an integration layer. How do you onboard and still do know-your-customer (KYC) and anti-money-laundering (AML) compliance? It’s all these things that eventually allow for interoperability of these tokens so they can be useful.”

The other thing is to ensure the smart contracts are operating the way you want them to, and continue to do so. “If you tokenise assets, you should think about how smart contracts are built up and what they should contain,” explains Ms Spielmann of Deka. “It should also reflect the cash flows of a product; interest payments or principal payments. This has the advantage that the smart contract then also initiates the corresponding payments and you no longer have to intervene manually.”

Getting infrastructure right

As the momentum behind tokenisation of traditional financial assets gathers pace, Mr Brereton says there is fragmentation across multiple private blockchain networks — which is counterintuitive to the benefits of DLT. “It’s also hampering broader institutional adoption,” he says.

Some actors are issuing financial instruments on chain, but in a vacuum, says Mr de Patoul. “You have players like JPMorgan with its Onyx platform and digital bond issuances by Société Générale, for example. These are either private or permissioned blockchains, or the assets issued are not tradable anywhere. You also have fully public blockchains, and within each of those, you have hundreds of alternatives. [But] how do these systems all talk to one another?”

This technology actually allows them to truly become custodians of the data

Nadine Chakar

The private (permissioned) versus public blockchain debate rages on. However, Mr McDermott of Goldman Sachs says there are still concerns around the scalability and costs associated with using public blockchains, especially when considering the volumes across the financial markets. “With private permissioned blockchains you can still get the benefits of decentralisation, but with a focus on security, compliance, KYC and AML, a preference of our clients,” he says.

Ms Spielmann says the industry needs to build digital infrastructure that is open for all market players so assets can be easily transferred from A to B. “This will only come by fostering interoperability between blockchains, but this is unlikely to happen in the next two to five years. You also need to set up infrastructure that will enable smaller institutions to gain access, so they can use what is already available in the market. If we get the infrastructure part right, I’m convinced that the amount of tokenised products will increase rapidly.”

The EU’s DLT Pilot Regime, which was launched on March 23, allows market infrastructures to test DLT for trading and settling tokenised financial instruments. A variety of firms are expected to take advantage of the regime and the regulatory exemptions it provides. However, Ms Spielmann says the amount of assets that banks can trade under the regime is restricted. “Market players also have some doubts about whether firms will invest to set up the necessary infrastructure,” she says.

Getting the infrastructure right for tokenisation of traditional assets to scale is also likely to mean changes to market infrastructure operators and intermediaries business models. “Over time, there is the potential for [tokenisation] to support the consolidation of services and service providers across the value chain,” says Mr Brereton, “bringing capital raising and fund distribution closer to the end investor, and increasing the speed and ease with which capital can transition across markets and from one form to another.”

Mr de Patoul says tokenisation means you could self-custody a digital asset rather than giving it to a third party. “It doesn’t mean you will do either 100% of one or 100% of the other, but you now have an option. The question for traditional players is, do I keep fighting this and eventually become completely irrelevant? Or do I accept that I will not have this full monopoly and that there will be options for people to get directly into it?”

As most issuance gradually becomes tokenised, Ms Chakar of Securrency says middle offices will melt away and get reappropriated elsewhere. And custodians? They will emerge as custodians of data. “This technology actually allows them to truly become custodians of the data, the keys, and add more intelligence into the investment process because of the power of the information they have at their disposal,” she says. 


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