McKinsey Report on Tokenization - A Reply

What McKinsey gets right on Tokenization - and what is missing from its report

The McKinsey report offers a refreshing view on the state of tokenization.? It provides succinct explanations of the process, explains challenges and and points out the difficulties in overcoming cost considerations and hurdles to adoption.??

…AND HURRAY, the report, in its entirety, is avoiding the misleading and frankly, unnecessary term “Real World Asset”!? It is a useless term only increasing the alienation between advocates of blockchain solutions and CIOs, CTOs and mainstream Venture Capital investors.? Let’s hope McKinsey with its position of authority can kill the term RWA…

When assets are tokenized, it really helps to think along well established terminology and finance practices.? Assets are represented on balance sheets, and as McKinsey points out, in three fundamental categories:? financial assets, tangible assets and intangible assets.? And describing tokenization in this context makes a lot of sense (see more extensive discussion on this topic here).

The McKinsey report does a great job in summarizing the process of tokenization.? However, it misses the opportunity to elaborate on the differences in process and implementation driven by the nature of the underlying assets being tokenized.? Specifically, the tokenization of natively digital assets as opposed to assets which first have to be represented in digital form and are then only tokenized.??

For example, servicing of native digital assets differs significantly from tangible assets which are tokenized.? Consider how one would service a tokenized patent, trade secret, digitally stored music tracks, as opposed to the fractional ownership right to a physical painting stored in a bonded warehouse.??

Thus the problem then shifts to challenges of digitization of the underlying asset or the way a natively digital asset is represented on-chain.? In order to benefit from the efficiency, transparency, smart contract automation, and auditability of blockchains, machines, rather than humans,? must be completing more tasks.? Most importantly in finance, computers, not humans must be in a position to resolve reconciliation differences…:))??

Tokenization of Financial Assets is a special case

In the McKinsey report, the special case of the nature of the Financial Assets is not sufficiently considered.? Why is tokenization of financial assets a special case??

Because the core building blocks of finance are financial contracts, i.e. the agreement of two parties on the exchange of cash flow over time.? Financial contracts are by their nature digital (consisting of only numbers) and algorithmic (defined by calculations, of interest, principal, etc.)? and can be standardized.??

Now, when we combine well and deterministically defined financial contracts with blockchain/DLT technology, the potential for improvement in traditional finance and innovation is dramatic.? This is why I call blockchain the most important technology in finance since the introduction of computers in banks in the 1960s.?

As the McKinsey authors pointed out, the use case of cash and cash equivalents is already here and proven to be of value.? However, when we think beyond cash and cash equivalents, in categories of the financial contract as the granular building block of finance, the opportunity resulting from tokenization is much larger than described in the report.??

Tokenization benefits mentioned

Additional benefits not considered by McKinsey for Financial Asset Tokenization which is based on algorithmic standards.?

Capital efficiency

In addition to shorter settlement time, a more granular understanding of cash flows will allow nearly automated securitization of balance sheets depending on the risk appetite of capital providers.? This will result in the ability of firms to refinance larger parts of their balance sheets with greater ease.

Capital efficiency - Democratization of access

Large asset managers have decided, and publicly stated, that their ability to offer investment products to retail clients must be enhanced by accessing private markets.? Motivation for tokenization here is about unit costs, efficiencies, but more importantly the lack of public market liquidity which can be tapped to create investment products.??

Operational cost savings

System automation, standards for custody, exchange, etc. are mentioned, what is missing is the recognition that mid- and back-office cost savings will only be realized if the underlying cash flow based financial asset is digitized with a machine readable and machine executable term sheet, before it is tokenized.??

Without a clear representation of the state of the financial instrument, i.e. a real time balance sheet, price discovery, trading, securitization will not see gains in efficiency, regardless if the system is running on blockchains or not.??

Enhanced compliance, audit-ability, transparency

Blockchain applications will provide the key assurance layer in finance for compliance and transparency.? However, audit-ability of financial assets depends on a deterministic understanding of the underlying agreement, i.e. the payment obligations of the parties.? Without such information available in the tokens, there will be no change in the value chain in the financial services industry.??

If we do not build this understanding on an open source algorithmic financial standard, we will soon find ourselves in more chaos than 2008…?

Cheaper more nimble infrastructure?

Just because blockchains are open source, does not make them better software.? Unfortunately, the universe of blockchain developers is rather small due to the fact that many public chains are using proprietary languages and inadequate tooling for enterprise environments.? Therefore, only blockchains and DLT solutions built on modern widely adopted programming languages will survive.??

Certain efforts by large players to introduce domain specific languages for digital assets are an outright risk to the entire financial infrastructure, and are highly likely to fail in the long run given the lack of success of domain specific languages overall.??

Comments on Challenges to Tokenization discussed by McKinsey

The McKinsey report points to the success of tokenization of cash and cash equivalents.? In my opinion, the next implemented use case is tokenization of fund shares.? Both show the power and applicability of the key technical aspects of blockchain/DLT systems in Finance:? 1) Blockchain is the most efficient transfer of value, 2) the trade is the settlement, 3) the private key is the perfect collateral, 4) tokenization is origination.??

However, I disagree or would modify several of the challenges identified in the report

Technology and infrastructure preparedness

Managing private keys is not new for banks and institutional grade technology has been available for the custody of digital assets for a while.? From my discussions with industry participants and COOs of large banks, it is the lack of enterprise grade blockchains (scalability), related tooling, and the existing security requirements and protocols which create barriers to implementation.? It does not help that very large banks and solution integrators have made equity investments in certain technology providers and hence are pushing technology solutions which are considered subpar by most of their peers.? The spectacular failures of large scale exchange projects and similar undertakings provide additional hesitation among boards to engage with blockchain/DLT based technology.??

Limited short-term business case and high cost to implement

In my view, the key to mid- and back-office efficiency is the standardized and algorithmic definition of the financial contract.? The benefit of using the ACTUS standard accrues to each individual firm first, independently if other firms use it or not.? Only with such a representation, can a digital twin setup be effective and lead out of the current chaos in the legacy world.??

Regardless, whether the new rails and systems are blockchain/DLT based or not.??

Market immaturity

Clearly,? the inflection point for cash and cash equivalents has been reached and the McKinsey authors seem to suggest so.? No private equity firm will be able to avoid fund share tokenization, no relevant bank will abstain from tokenization of deposit, cash and cash equivalents.? The value drivers and opportunity for efficiency are simply too obvious.??

Debt and structured instruments will follow soon, with some of the largest banks for banks and investment banks in Europe building highly performant systems enabled by the ACTUS standard.??

Regulatory uncertainty?

Players outside of the USA have clearly understood what blockchain/DLT technology offers:? The first chance in over 220 years to build a capital market infrastructure without Anglo Saxons.??

The largest sovereign funds, the (no longer) emerging economies with maturing and massive capital formations, recognize that essentially all payment rails, most securitization rails, and relevant cash reserves are dominated by one country and one currency.??

The implementation race to take advantage of tokenized (natively digital) financial assets and the control over the future capital markets infrastructure is on.? The longer the U.S. is caught in agency in-fighting over definitions and jurisdiction, the more time the competition will have to create facts on the ground.??

Standard setting

The McKinsey report encourages participants to contribute to standard setting bodies and efforts.? The industry has done a pretty good job in defining technical standards for tokens, how they enter into traditional data providers and definitions, e.g. ITSA, WM Datenservice, etc.??

The key to innovation however, lies in the recognition that the underlying cash flows of financial assets are algorithmic in nature and can be standardized with the Open Source Algorithmic Financial Standard ACTUS.??

Conclusion?

It is now time to move on from the proven tokenization use case of cash and cash equivalents to tokenization of cash flow based instruments.? However, a true and native digitization of the underlying financial asset based on the ACTUS standard is a precondition for successful tokenization.??

Relevant links:??

McKinsey Report referenced herein:??

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

Coindesk article:

https://www.coindesk.com/consensus-magazine/2023/08/10/how-crypto-tokenization-can-go-wrong-and-how-to-make-it-right/

15 Theses on the future of finance with or without blockchain:?

https://www.dhirubhai.net/pulse/15-theses-future-finance-without-blockchain-ralf-kubli

Allan Mendelowitz: The future of regulation with blockchain:? https://youtu.be/PcpLK-DIXEo