The transformative potential of tokenization – it will take a village!

Tokenization has significant transformative potential in financial services. It will revolutionize how assets are issued, managed, traded and accessed, opening new profit pools and market segments. Financial institutions and investors have begun to see this alluring future, but more pieces need to be put in place before this value can be realized.

Financial services firms and investors see value in asset tokenization

The potential to radically transform financial services is compelling:

1)???? New product opportunities: Tokenization opens the door to new business models, financial products and composability of new products that aren’t possible today in traditional markets.

2)???? Fractional ownership: Assets can be fractionalized, driving accessibility to new investors.

3)???? Automated asset servicing and processes: Tokenization can automate asset servicing tasks and lifecycle events through smart contracts, which can reduce costs and administrative overhead and ultimately drive lower fees to the end investor.

4)???? Increased liquidity: Tokenization has the potential (once many parts come together – including data, asset servicing, distribution, valuation of assets, etc.) to create liquidity in illiquid markets by enabling fractionalization, ease of trading and access, and automated servicing of the assets.

5)???? Increased capital efficiency: Capital can be more efficiently utilized and managed due to nearly instant settlement instead of taking multiple days to settle assets.

6)???? Greater transparency: Using blockchain technology makes it easier to maintain ownership records clearly, reducing the need for reconciliation across systems and platforms.

7)???? Enhanced compliance: Smart contracts can embed compliance and regulatory requirements.

According to EY-Parthenon’s recently published institutional investor survey conducted in March 2024,1 asset managers specifically noted the following five drivers of tokenization for their firms:

1)???? Access to new investors and capital (52%)

2)???? Cost savings / lower administrative fees (46%)

3)???? Operational efficiencies (40%)

4)???? Ability to offer fractional ownership of assets (38%)

5)???? Increased liquidity (36%)

In addition, 50% of institutional investors surveyed (asset owners, family offices, hedge funds and asset managers) noted they were interested in investing in tokenized assets.

Top asset classes or security types of interest included the following:

1)???? Alternative funds (53%)

2)???? Public funds (46%)

3)???? Real estate (38%)

4)???? Treasuries (31%)

5)???? Bonds (31%)

Current state of tokenization

In the past year, the market has seen a growth in tokenized treasuries and money market funds, with the AUM of these assets having grown approximately 261% from September 2023 to September 2024.2 These assets are especially popular with institutional investors in the crypto space and companies involved in digital assets that are looking to keep cash in a digital asset form and earn a yield during the current interest rate environment. Banks like JPMorgan and Citi have started offering tokenized cash products to their corporate clients,3 and PayPal introduced a stablecoin (PYUSD) that recently surpassed $1 billion in market value.4

Efforts to tokenize alternative assets, including private equity funds, real estate, private placements, etc. have helped prove out the technology and the ability to draw in new investor segments, but have not taken off at scale.

Multiple banks have launched tokenization platforms using different forms of blockchain technology (e.g., public vs. private) to support their own efforts in tokenization, as well as to serve as revenue-generating products. In addition, multiple tokenization firms have emerged, each covering different legs of the value chain – asset tokenization (e.g., minting/burning), asset servicing (e.g., Transfer Agent, smart contract management), and distribution (e.g., trading).

A minimum viable ecosystem is needed to scale

For tokenization to become a significant part of capital markets and overall financial services, a minimal viable ecosystem (MVE) across the value chain is needed to drive transformative change. Participants across the ecosystem currently are at varying degrees of readiness and scale. In addition, there is a need for interoperability and standards to tie the ecosystem together to achieve scale as an industry. MVE participants include:

1. Security Issuers: Banks, corporations and asset managers to tokenize their assets such as bonds and investment funds, to meet investor demand.
2. Tokenization engines: Entities to facilitate the creation and management of tokens, including minting, burning and overseeing the entire token lifecycle.
3. Transfer agents and asset servicers: These parties will handle the servicing of tokenized assets, including managing token access through approved lists, processing dividend payouts, and handling corporate actions. They will also be responsible for recordkeeping and maintaining transfer of ownership.
4. Distribution platforms and secondary markets: User-friendly platforms are required to enable investor access to tokenized assets. These platforms should handle onboarding, anti-money laundering and know-your-customer (AML/KYC) processes, and facilitate secondary trading and liquidity. Investors may look to traditional distribution channels and brokers as they seek familiarity.
5. Custodians: Custodians are needed to protect the underlying assets that are being tokenized, safeguarding their security.
6. Central securities depositories: These institutions are needed to support the clearing and settlement of digital securities (e.g., bonds), and in some parts of the world, issuance, registration and exchange of the tokens.
7. Infrastructure and data service providers: Providers will be required to assist in establishing and managing the blockchain nodes, as well as offering essential on-chain data, analytics, monitoring and supporting the required security measures.

Developing an MVE ecosystem is essential for tokenization to fully integrate into financial markets and realize its innovative potential. Financial institutions and market participants should look to begin with pilot programs to help assess 1) priority use cases for their businesses, 2) key gaps in the MVE for their use cases, and 3) begin to identify potential partners to close these gaps as the industry accelerates adoption of this technology.

Sources

1. “Institutional sentiment points to increased adoption of digital assets,” EY website, https://www.ey.com/en_us/insights/financial-services/evolving-digital-assets-sentiment-among-investors

2. RWA.xyz website, https://rwa.xyz

3. “Citi unveils tokenized deposits for institutional trade, cash,” Ledger Insights website, https://www.ledgerinsights.com/citi-tokenized-deposits-institutional-digital-assets/

4. “PayPal’s PYUSD stablecoin hits $1b market cap,” Coin Telegraph website, https://cointelegraph.com/news/paypal-pyusd-stablecoin-1-billion-market-cap

The views reflected in this article are the views of the author(s) and do not necessarily reflect the views of Ernst & Young LLP or other members of the global EY organization.