Making sense of it all -Tokenisation and Digital assets

Financial technologies Series 1 - Catapulting structured finance to the modern digital age

If you are intrigued by what it means to do a structured finance transaction on block chain- know about all parties to the chain- about disintermediation and emergence of new roles,?merits (costs/ efficiencies) and challenges of market making, disintermediation and interoperability, this series is for you. In the next series, we will talk about revolutionizing debt market issuances and funds platforms

Tokenised assets to make up 10% of global GDP by 2030?

?Banks, asset managers and other institutions are intrigued by the technological potential of ‘tokenization’—the process of issuing a digital representation of a traditional asset on a (typically private) blockchain, sometimes referred to as distributed ledger.?

Asset Tokenization to grow into $16 trillion opportunity by 2030 - with a 50-fold increase predicted between 2022 and 2030, from US$310 billion to US$16.1 trillion, tokenized assets are expected to make up 10% of global GDP by the end of the decade.(Source: BCG and ADDX Reports)

Companies in financial services, retail, music, gaming, and media, among other sectors, continue to pursue opportunities in Web3, such as tokenized assets and loyalty programs.

Tokenisation of assets and securities will revolutionise finance

Since the early days of blockchain, there has been much talk of the opportunities of tokenising real-world assets (RWA) and ‘bringing them on chain’. And for good reason.

RWA on-chain could represent a multi-trillion dollar opportunity. Advent of ETFs was a revolution for the mutual fund industry back in the day. Tokenisation of assets and securities could be next. Should tokenisation go mainstream, there will be significant impact on business and financial systems.

Decentralised debt markets

RWAs (Real world assets) are digital tokens of tangible assets like real estate, commodities and even instruments on securities markets. Development of RWA protocols is leading to the rise of decentralised debt markets, which is a highly significant development. Issuance of debt tokens have become the hottest use case for RWA tokenisation, even eclipsing real estate. These markets are of course still quite small compared to traditional debt markets. But they may be harbingers of things to come.

Tokenised real estate and private equity

We are also seeing increasing uptake in the tokenisation of traditional assets like real estate or private equity. There are excellent examples of how tokenisation marries real-world assets with the advantages of DeFi (Decentralised Finance). At RealT marketplace, tokenisation allows for easy fractional ownership of real estate properties. In case of Private Equity offering like the Hamilton Lane new fund, tokenisation allows for much smaller ticket sizes – USD 20 thousand minimum as opposed to the usual USD five million – opening the door to private equity to a far wider range of investors.

Tokenisation of Securitisation

Blockchain securitisation comes into play in the world of structured finance via a process known as ‘tokenisation’. In tokenisation, typical illiquid assets held by the SPV are converted into a number of ‘tokens’ that represent the individual securities sold to investors on the blockchain. These tokens will then be distributed to each individual investor and act as proof of ownership of each individual security issued by the SPV.

Blockchains provide an easy, inexpensive, highly accessible platform for securitisation of any asset. Unlike other securitisation platforms, they also bring with them the benefits of DeFi, including immediate settlement, programmability (which can help automate things like trading and compliance), global markets, and composability (which can make it easier to bridge protocols and create innovative new products and services).

Blockchain securitisation would, therefore, catapult structured finance processes to the modern digital age. Let us take a look at how securitisation and intermediaries work today and how it will work in a tokenised environment.

Securitisation in Blockchain environment

Blockchain securitisation: the benefits

Blockchain securitisation has a number of advantages that would benefit the multiple parties involved in the securitisation process including originators, issuers, servicers and investors.

Higher quantity and quality of loan originations - First, it improves the loan origination and asset collateral pool via the creation of a set of smart contract templates for securitisation, allowing it to form the asset pool and issue the underlying securities at a faster pace. As a result, larger homogeneous asset pools can be created to adapt better statistical analysis and asset diversification. This reduces the possible economic stresses on investors, resulting in an additional form of credit enhancement to protect them.

Efficient reporting of transaction data allows better analysis - In blockchain securitisation, all cashflow between the parties involved in the securitisation process is recorded on the blockchain. This results in faster and more accurate cashflow reporting and greater transparency in executions, since every transaction is recorded and stored on the blockchain. A wider range of analytics in this technology provides for greater statistical inference, making outcomes more predictable.

The technology’s potential to streamline processes, lower costs, increase transaction speed, enhance transparency, and fortify security could impact all securitization lifecycle participants—from originators, sponsors, and servicers to ratings agencies, trustees, investors, and regulators.

The combined impact of blockchain benefits could lower risks in the securitization market as a whole and lead to greater investor interest. This, in turn, would improve prices, volume, and spreads. With better and more transparent information, regulatory compliance could also be simplified and market failures would become less likely.

Implementation challenges

With new technology comes new risks. Securitization is an important source of capital not just for the financial sector, but also for the wider economy. Any change in the industry’s market structure, including the supporting technology infrastructure and safeguards, should only be taken with extreme care. Issues that need to be resolved before the industry can successfully transfer operations to a blockchain include:

• Data security and privacy.?With so much information on the same technology platform, a successful cyberattack could be systemically devastating. And privacy issues may arise since blockchain’s distributed structure shares and stores sensitive data on multiple nodes.
• Technology that isn’t yet fully vetted.?Blockchain is still a relatively new technology. And although several blockchains have multi-year track records, many smart contracts and other blockchain applications have not yet reached a demonstrably bullet-proof level of reliability.
• Legal and regulatory uncertainty.?Regulators, starting with the SEC, ESMA will have to accept blockchain’s use for securitization, including—but not limited to—blockchain’s methods for entering, verifying, and protecting data. One possibility is that a new monitoring environment will be needed with regulatory presence on the blockchain. Regulators will also have to rethink how financial institutions should integrate blockchain into regulatory reporting.

The case for Disintermediation

The role of intermediaries often gets questioned in the process. With as many as 14 intermediaries in a traditional securitisation, there is certainly a case of partial if not complete disintermediation. ?Many experts believe that rather than eliminate the role of intermediaries, smart contracts and other blockchain-enabled tools will simplify some of the functions performed by intermediaries. After all, some level of human scrutiny will always be desirable to manage risk, particularly in the complex area of securitisations whether due diligence prior or after, fiduciary checks, compliance with regulation, handling of triggers and coordination between parties.

Blockchain technology is changing the securitisation transaction process through smart contracts and other tools. These tools promote transparency and efficiency, but also introduce new and evolving risks. To manage the benefits and risks effectively, issuers, investors and other stakeholders would continue to need key intermediaries in this largely automated landscape.

West to East - Regulation/ law and markets

The regulatory frameworks for digital assets and tokenization are still evolving and vary significantly across different jurisdictions. In the past six months, the European Union has approved Markets in Crypto-Assets (MiCA) legislation?and five other regions such as Hong Kong, Japan, Singapore, the United Arab Emirates, and the United Kingdom have published new guidelines that enhance the regulatory clarity for digital assets. However, there are some common themes and approaches that regulators are taking to address the challenges posed by these assets.

• Securities regulation:?In some countries, digital assets and tokens may be considered securities under existing regulatory frameworks. This means that they are subject to the same regulations as traditional securities, including registration requirements and investor protection rules.
• Anti-money laundering (AML) and Know Your Customer (KYC) compliance: Regulators are increasingly focused on ensuring that businesses dealing in digital assets implement robust AML and KYC procedures. This includes conducting thorough due diligence on customers and monitoring transactions for suspicious activity.
• Custody and storage:?Digital assets are typically stored in digital wallets, which can be vulnerable to hacking and theft. Regulators are focused on ensuring that businesses that hold digital assets on behalf of customers implement robust security measures to protect these assets.
• Taxation:?The taxation of digital assets is a complex and evolving area, with different jurisdictions taking different approaches. Some countries have introduced specific tax laws for digital assets, while others treat them as property for tax purposes.
• Innovation-friendly regulation:?Regulators are also exploring ways to promote innovation in the digital asset and tokenization space, while still protecting investors and ensuring financial stability. This may involve introducing regulatory sandboxes or other frameworks that allow businesses to test innovative products and services in a controlled environment.

Emerging regulatory framework in the United States - Market participants are exploring various tokenization and distribution approaches, leveraging existing rules and guidance to mitigate the impact of the current regulatory uncertainty—for example, by limiting distribution of tokenized assets to accredited investors only and by running digital-twin instead of digital-native operations.

In Singapore, Monetary Authority of Singapore (MAS) released proposals in 2022 to further regulate and introduce customer protection in Digital Payment Token Services (DPTs) – a term that encompasses, among other things, cryptocurrencies. These proposals have since been enacted into law.

Dubai’s?Virtual Assets Regulatory Authority (VARA), has issued its Virtual Assets and Related Activities Regulations 2023. The Regulations set out a comprehensive Virtual Asset (VA) Framework built on principles of economic sustainability and cross-border financial security.?

Ministry of Finance (India) recently brought transactions relating to Virtual Digital Assets under the Prevention of Money Laundering Act (“PMLA”)

The most comprehensive by far is the European Union’s ‘Markets in Crypto Assets’ Regulation (MiCA), which is a new piece of large-scale EU legislation designed to regulate crypto assets in the EU. This includes e-money tokens, all crypto asset service providers and NFTs in some cases. MiCA covers several key areas, including?transparency,?disclosure,?authorization and?supervision of transactions.

For Regulators and agencies, this is giant work in progress and in order to be effective, would need global coordination. ?Recent G-20 leaders’ declaration has endorsed the Financial Stability Board (FSB) recommendations to regulate and supervise crypto-assets’ activities. The International Monetary Fund (IMF) and the FSB have been tasked with a roadmap for a coordinated regulatory framework that factors in risks to global economy and financial system and those pertaining to money laundering and terror financing.

No crystal ball, sheer insight

A tokenized future does not mean the emergence of a separate, virtual and totally decentralized ecosystem. For tokenization and its attendant benefits to scale up while containing risks, compromises and hybrid solutions are necessary. Disintermediation will be a new reality however, intermediaries will still exist, even if they take new forms, and stakeholders must remain mindful of the emergence of new forms of concentration in some of these agents.

Despite the many risks of blockchain securitisation, its positive implications have driven much attention to this new form of structured finance, which is likely to continue to grow in terms of global adoption. Many stakeholders in the finance sector have shown great interest in the use of blockchain in finance, with blockchain securitisation at its heart.

Since 2020, large investment managers and banks have been working to develop blockchain platforms designed to digitise the issuance of asset-backed securities. There have been some announcements of private asset-backed securitisations where all processes including origination, servicing, financing and sales were performed on the blockchain, further shaping a strong future for the global adoption of blockchain securitisation.

Financial markets are still quite new to the concept of blockchain securitisation and it remains work in progress for the pilot to become mainstream. However, blockchain securitisation continues to grow in popularity among the many global financial market participants due to its ability to open up new market opportunities not seen in traditional securitisations.

Taking a global approach to blockchain securitisation, including standardising global regulations and establishing strong technological interoperability, is key to mainstreaming. Having the necessary support, data sharing and interoperability between all stakeholders will be the main drivers of transformation to blockchain securitisation.?

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References:

https://www.acuitykp.com/blog/blockchain-securitisation-a-revolution-in-global-structured-finance/

https://www.sygnum.com/future-finance/crypto/the-tokenisation-of-real-world-assets-is-going-mainstream/

https://www.careyolsen.com/briefings/securities-tokenisation-guernsey

https://www.hubbis.com/article/rising-to-the-opportunity-in-digital-assets-tokenisation-in-asia-s-wealth-management-markets

https://www.mckinsey.com/industries/financial-services/our-insights/tokenization-a-digital-asset-deja-vu

https://addx.co/insights/bcg-addx-report-asset-tokenization-to-grow-50x-into-us-16-trillion-opportunity-by-2030/

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