In today’s global financial ecosystem, lack of trust between counterparties, unequal access to investment opportunities, limits on liquidity, multi-day settlement cycles, and underdeveloped market standards contribute to fragmented and inefficient trading and settlement across both public and private capital markets.
Imagine a more advanced ecosystem in the future where an ordinary retail investor is able to trade 20k shares of a private equity position directly for a fractional share in a commercial real estate building, where a limited partner can sell partnership interests in an alternative investment fund to gain liquidity without penalty, where a portfolio manager can increase liquidity of a new fund by issuing fractional shares that attract new investors, and where a speculator can quickly buy and sell shares in illiquid private unicorns with cryptocurrency.
Such a future could become a reality, as major banks and other key financial institutions are exploring a new approach known as “tokenization” where a wide range of different assets can be repackaged into smaller bits that make them much more transparent, affordable, liquid and efficient to service and where global standards can exist across different jurisdictions, subject to further regulatory developments in this space. This not only helps make investing more accessible, but it also expands the potential client base for global asset managers who were otherwise focused mostly on institutional relationships.
Brown Brothers Harriman and PolySign, Inc. collaborated on this article to explore tokenization’s potential to transform financial services and how the ability of the technology to deliver on its promise of automation, liquidity and transparency will require interoperability between traditional service providers and digital players to bring all its benefits to investors.
How does asset tokenization work?
Tokenization is the process of converting ownership rights into purely digital representations of an asset that can be subdivided, traded, and stored on decentralized ledger technology (DLT). A token can theoretically represent any asset type, but they are usually considered either native to the blockchain and have no physical presence, such as Bitcoin, or are not native to the blockchain and represent some form of a real-world asset, such as shares of a company.
Tokenized assets are widely considered the next generation of book entry processing in which a digital token is used to represent an actual security for example. While book-entry and tokenized assets are both digital representations of value, there are key differences in terms of the verification process and degree of centralization. For book-entry securities, transfer authorization ultimately depends on the ability of the central security depository (CSD) to verify the identity of the account holder who is its direct participant. By contrast, a digital token’s authorization depends on the validation of matching public and private keys on a DLT or blockchain to unlock ownership rights.
With traditional securities, only the CSD can update a central ledger and is the single entity responsible for recording all transaction histories. Tokenized asset accounting and transfer are completely decentralized, meaning that ownership is validated by multiple participants in the network. However, most tokenization platforms today are not completely open and have had to incorporate various restrictions to ensure accountability for compliance with regulatory requirements relating to know-your-customer (KYC), anti-money laundering (AML), and cybercrime.
Introducing tokens also changes the way payments are made for the delivery of assets. If both the securities and the cash required for payment reside on the same DLT and are already linked to an account on that ledger, then a single-ledger transfer can take place through a process called atomic settlement. In the future, though, we should expect that tokens will also be required to represent cash in the payment legs between different DLT platforms. Because the order and timing of those transfers is critically important, smart contracts, or transaction protocols that automatically execute based on a sequence of processing steps, will likely be needed to conditionally process both transaction legs across platforms where true atomic settlement is not possible. In order to fulfill the cash transfers on a blockchain without introducing additional volatility associated with cryptocurrencies, many existing tokenization platforms currently take advantage of a special type of token called a “stablecoin” whose value is tied to a stable real world asset like the US Dollar or gold. Likewise, the industry may soon be able to leverage digital currencies issued by central banks (CBDCs), which would be backed the issuing government’s monetary authority.