Asset tokenization is the process to dematerialize financial instruments on blockchain, and many institutions have already taken actions: The European Investment Bank and Société Générale have tokenized 100 million euro bonds respectively in 2021; SWIFT announced plans to explore tokenized assets this year. HSBC predicted that the market could reach 24 trillion USD by 2027. Not long ago, Luxembourg Stock Exchange admitted security tokens listing.

It is obvious that the institutional adoption of tokenized securities has begun. Decision-makers must act quickly to avoid losing market share. Suitable and secure tokenization platforms will be the catalyst for further growth of the adoption, as both compliance and security come down to coding on the blockchain.

Huge potential to save costs and improve liquidity

Traditional capital markets are underpinned by many fragmented and siloed networks with barely any interoperability between them. This leads to an industry that is slow, inaccurate, and costly.

Over the past few years, most financial institutions have studied how tokenization can change this by using shared and distributed ledgers to create a fully digitized experience for investors, reduce compliance and administrative costs for themselves, and improve the liquidity of assets.

Roland Berger’s study projects that tokenized equity could reduce €4.6 billion on the trading costs by 2030. It accounted for only one asset class, when all other asset classes are taken into account, the cost savings will be much higher.

The technology gap needs to be bridged

While financial professionals have a greater understanding of blockchain technology and its benefits, one question remains: how can they technically tokenize new or already existing securities and still comply with regulations?

As compliance rules are encoded into security tokens, eventually, it becomes a technical matter. Institutions can choose to build their own tokenization platforms, which will take years to develop; or decide instead to find a technology partner, who provides a complete infrastructure with user-friendly interfaces designed for non-blockchain users. The latter option may be preferable since institutions can benefit from the protection of the technical shields provided by experts, freeing financial actors to focus on what they do best: provide high-quality assets and services to investors.

Regardless of their choices, it is essential to ensure compliance rules are well written into security tokens and enforced throughout the lifecycle of asset-backed tokens, as securities regulatory rules must be followed. This can only be achieved by issuing assets as permissioned tokens to set rules and linking them to the digital identities of asset owners.

Code compliance rules through permissioned tokens 

Permissioned tokens act as automated compliance validators, transactions can only be triggered when pre-written eligibility conditions are met. For example, ERC-3643, an official smart contract standard for permissioned tokens, allows issuers to encode investor rules and offering rules into tokens. This assures that token transfers only occur when all conditions have been satisfied in both the primary market and the secondary market.

Guarantee ownership of tokenized assets with digital identities  

While all the rules are well encoded into the permissioned tokens, the key to ensuring compliance is the digital representation of identity on the blockchain. There are many solutions in the market that whitelist wallets for compliance checks. However, a wallet is like a browser for blockchain, whoever knows the private key can access it, so who owns the assets in a wallet?

Furthermore, identifying wallet owners is a regulatory obligation for issuers, therefore, linking security tokens to holders’ identities is the solution to this legal requirement. An onchain identity is like a blockchain account for investors, and they can connect as many wallets as they want to it.

Complexity beyond using standard smart contracts

When an issuer creates a simple ERC-20 token, the smart contract is the key element because there is no lifecycle management per se. We can see some features, such as “burn in your own wallet” features used by Binance, or “address blacklisting” features in Tether, but that is mostly it.

However, when an issuer represents a financial instrument on the blockchain, all securities rules need to be followed to ensure compliance, requiring the issuer to be able to manage asset-based tokens at any time. Managing complex smart contracts functions, one-by-one or in batch, with blockchain addresses can quickly become a nightmare for users. Errors will keep popping up and the learning curve will be very difficult for the operational teams. Software, which scans the blockchain in real time, reconciles blockchain and investors’ data, and helps to prepare complex blockchain-based operations via user-friendly interfaces, is mandatory to truly benefit from this shared infrastructure.

Here are some highlighted functions a complete tokenization platform should provide:

• Smart contract management: There are hundreds of functions in permissioned token smart contracts, the platform needs to ensure every action triggered by issuers in the system by simply clicking buttons or filling in human-readable information translates well into code and executes on the blockchain.
• Useful data aggregation: The system needs to aggregate relevant data from blockchain to present them in an insightful format (e.g. real-time cap tables) for both issuers and investors.
• Security: Security of the system is critical, but most importantly, extra security measures such as multi-sign or custody solutions should be integrated as the owner of smart contracts has full control over permissioned tokens.
• Recoverability: Issuers have obligations to return tokenized assets to their owner in the event of wallet loss, a recovery process must be provided.
• Permission delegation: Issuers need to delegate specific permissions to their trusted agents to improve efficiency or comply with regulations, therefore, a permissioned system is needed. (e.g., grant token recovery function to a custodian).
• Confidentiality: As required by law (e.g., GDPR), investors’ privacy needs to be protected while compliance is enforced.
• Cost and speed of transactions: The system must provide solutions to solve the gas fee issue to ensure low-cost and high-speed transfers of tokenized securities.  
  
• Cross-chain capability: As asset tokenization is becoming popular, the interoperability of tokenized assets needs to be provided to make sure assets are not locked in one single blockchain forever, paving the way for further improvements of asset liquidity.
• …
  

Leave technical complexity to the expert and thrive in prosperity

The function list goes on, resulting in many technical obstacles. The speed of adoption, therefore, relies on the development of resilient and secure solutions that can provide all functions required while ensuring compliance. Fortunately, after years of development, mature technology platforms have emerged and are used by many asset issuers, such as T-REX Platform.

To stay competitive, institutions that want to modernize their assets using blockchain technology should work with existing reputational technology providers to quickly and securely provide cheaper, faster, and better financial services through tokenization to their existing and new clients, gaining a larger market share.