Asset Tokenization Projects - Understanding its Barriers and Challenges

Asset tokenization is a process that turns ownership of real-world assets (like real estate or stocks) into digital tokens on a blockchain. These tokens are meant to streamline transactions by making them faster and cheaper. Blockchain technology acts as the system that runs the transactions, while tokenization unlocks new opportunities for asset ownership and trading.

This article explores the potential roadblocks that could slow down the growth of asset tokenization, even though it's expected to be a multi-billion dollar industry. While successful pilot projects showcase the potential benefits, actual implementation involves more than just technology. It requires cooperation from different players in the financial market, like brokers, custodians, and regulators. Security, efficiency, and adapting to new regulations are all important considerations.

Understanding Tokenization vs. Cryptocurrencies

Many projects in finance and blockchain involve digitization as a first step. Tokenization takes this a step further by creating a digital representation (a token) of an asset and its ownership rights on a blockchain network. It's important to distinguish between cryptocurrencies and tokenized assets. Cryptocurrencies function as a medium of exchange, similar to traditional currencies, but exist purely in the digital world. They rely on trust and a shared belief system to hold value. Tokens, on the other hand, can represent many things. They can be digital twins of physical goods or units of value within a specific network.

This difference is crucial for understanding how these tokens are exchanged and valued, and how they work across different networks. The challenges aren't just technical but also involve creating fair trading systems for these new asset classes. Tokenization can lead to fractional ownership, allowing people to own a small piece of a larger asset. This creates entirely new business models and opportunities for collaboration between different players in a network.

Blockchain and Tokenization: Building a New System

While blockchain offers the technology to handle ownership, exchange, and trust within a network, the real value lies in digitizing the value elements of assets. In finance, digitizing existing services and using tokens for decentralized finance (DeFi) creates two separate business models that will eventually merge as the industry works towards a unified user experience.

Tokenization means managing accounts and asset claims using cryptographic keys instead of relying on traditional banks. This allows for easier asset division, and trading, and removes the need for intermediaries in some cases. It's a key building block for a future "Internet of Value."

Challenges of Harmonizing Existing Systems

The financial services industry has unique characteristics when it comes to operations. Each asset class has its own risks and requires specific processes, people, and technology to comply with regulations and manage assets responsibly. Tokenizing assets creates a new system for each asset type, leading to a mismatch in speed. Traditional systems rely on batches of messages and reconciliations as assets move through the market. Tokenized assets aim to solve this problem, but ensuring the finality of transactions requires a different approach on a blockchain network.

Financial institutions that innovate with tokenization need to find a way for these two systems to coexist. This means keeping traditional systems as the official record of ownership while integrating them with the new tokenized infrastructure (including blockchain, custody services, etc.). This creates a significant integration effort to connect the new system with existing core banking systems that maintain accounting records.

Overcoming this burden is a challenge that cryptocurrencies don't face. Asset tokenization requires integrating with existing clearing and settlement systems, market data systems for valuing assets, and regulatory reporting systems. While the core technologies for tokenization (blockchain, key management, etc.) are similar to those used in crypto, maintaining these permissioned blockchain networks comes with significant costs.

Asset tokenization is a temporary phase that relies on existing systems while building a new one, all with minimal disruption for end users. The goal is to create a system for handling digital asset transactions that can account for, reconcile, and manage both tokenized and traditional assets. This requires a focus on system integration and can be achieved by creating a layer that connects different systems for authentication, authorization, and accounting.

Interoperability: The Key to Success

As the industry prepares for a future with tokenized assets, each experiment and pilot project helps us move towards modernizing our financial infrastructure. These efforts often happen independently or through industry groups, with the focus being on infrastructure improvements rather than changes in market structure or participant roles.

Previously, the need for a capital markets structure designed for cryptocurrencies was discussed. Here, the argument is that the opposite might be true for tokenized assets, potentially leading to the creation of new market utilities. Regardless of how the market evolves, interoperability is the most critical decision companies need to make to ensure successful pilot projects.

In the context of blockchain technology, interoperability refers to the seamless flow of data, value, and token logic across different blockchain networks, while maintaining security and trust. It's a major hurdle for wider adoption of blockchain technology. Different designs, asset class requirements, company preferences, and even regulations can lead to a mix of technologies and network designs.

For various market participants, supporting multiple emerging technology stacks might be necessary. As assets or information about them move around, they need to follow existing rules as well as blockchain principles for secure transactions. An interoperability architecture for these networks is crucial for secure movement of digital assets across them, while meeting requirements for complete and accurate transfers. This architecture needs to acknowledge that different blockchain networks exist, and they may not be compatible with each other.

Here are some recommended design considerations for asset tokenization projects to ensure smooth operation:

• Secure messaging to share information about assets and their state across different blockchains.
• Enabling asset transfers between two blockchains with the same underlying technology.
• Facilitating asset transfers between blockchains with different technologies.

These can be achieved using existing technologies from the crypto world, such as oracles, trusted bridges (centralized or decentralized), bi-lateral hashed time-locked contracts, decentralized oracle networks, and asset bridges. These technologies play a vital role in ensuring trusted transactions for tokenized assets within the current fragmented market infrastructure. As tokenized assets gain traction and reshape the roles of market participants, these technologies are likely to evolve into essential market utilities.

Conclusion

Asset tokenization offers a promising way to improve efficiency and access to various assets. However, challenges like harmonizing existing systems and ensuring interoperability need to be addressed for widespread adoption. By understanding these challenges and designing tokenization projects with careful consideration for interoperability, companies can help navigate the path towards a future with tokenized assets.