Tokenization, i.e. the act of digitally representing a tradable asset on a blockchain, is a notion that is attracting a lot of attention from financial services. The French multinational bank, Société Générale, has declared tokenization ‘reduces cost and the number of intermediaries‘, whilst the advisory giant Deloitte stated the process is effective ‘by greatly reducing the friction involved in the creation, buying and selling of securities.‘ The World Economic Forum also made its position clear and announced ‘Blockchain will become the ‘beating heart‘ of the global financial system.‘ It‘s clear the institutional stance is positive, but we are yet to see this new technology transform capital markets.
Why hasn’t tokenization come to fruition? Globally, there have been many projects announced but many of the public STOs have failed to reach their fundraising targets and it’s clear that there is still some way to go before this new infrastructure is fully built. In this article I give some thoughts on the three missing bricks that are needed to build this ecosystem:
Distributors of digital assets
A company, an investment bank or a fund can dematerialize any kind of financial asset on the blockchain. Although the tokenization process can happen at anytime in the lifecycle of a security, for the moment it is mostly considered with new issuances, and when the issuer is in the most frequent contact with their investors. Here, the argument is strong to convince issuers on tokenization as they can propose a fully digital experience, increase transferability and improve the operational efficiency for their investors.
As a result, issuers are currently looking for the global reach brought by the combined powers of blockchain and internet technologies. In principle, if they apply compliance properly to the onboarding processes for their investors, a STO allows the issuer to target a much wider audience than a standard issuance. By seeking legal advice and using a tokenization platform to enforce these rules and regulations into the tokens, issuers can target investors from across the globe with greater ease and efficiency.
So what‘s missing? As a new form of capital raising, the distribution networks are not ready yet. As it stands, issuers have to invest in communication (time and/or marketing) and education to attract and convert investors. Investors need to be able to discover tokenized investment opportunities, and this is very difficult without professional marketplaces. Such marketplaces need to be digital to fully benefit from the capabilities of blockchain. Investors need to be able to onboard themselves and self-custody their tokenized assets. In an ideal world, they should be able to list and filter the offerings depending on their attributes, and participate in a compliant way. Robot advisors, neo-banks, DEX and specialized marketplaces will start listing tokenized investment opportunities one by one.
Finally, asset managers and broker-dealers should be aware of the tokenized opportunities and include them in their investment strategies. These players could become the main drivers and users of these marketplaces. They should also comprehend the legal and compliance needs to avoid investment errors. Additionally, just as non-digital assets are legally monitored, the SEC can investigate brokers and other financial professionals who are responsible for the securities laws associated with tokenized assets.
Auditable quality of tokenized assets
As a nascent space, there is a low supply of quality STOs, and the market is driven by early adopters. As a result, tokenization is the main argument to find and convince investors, whereas the underlying asset should be the most important piece of information to assess the credibility of a project. Security tokens represent the value of the underlying asset on the blockchain, but details such as the number of tokens and the amount issuers want to raise can often lead to confusion.
We are in a new industry, one where traditional auditors and rating agencies are not very active yet. At the moment, it isn‘t easy to find the necessary information about the offering once the tokens have become accessible on the network. Technically speaking, most people don‘t know how to read information on the blockchain and computer systems built on DLT are alien to many.
To make decisions, investors and asset managers need to be able to verify who issued the tokens, if the underlying asset is true and valuable, and if the price per token is fair. Thanks to the issuance platform, this information can be shared with interested investors on the issuer website. However, on marketplaces and exchanges (especially decentralized ones), how do investors verify this information and assess the risk/opportunities? Perhaps tokens could embed this information and carry them wherever they go. To enable this, wallets, marketplaces, tools, would need to evolve but it would bring transparency and efficiency as everybody would share the same data set in an interoperable network.
Technical tools for security tokens
Ethereum is ready to welcome security tokens to tokenize assets on private markets. The capabilities of smart contracts are impressive, and thanks to permissioned tokens, transfers can be completed in a few minutes by automatically enforcing compliance obligations. This is a great advancement, as the regulation is now embedded within the financial instrument. It gives a lot of control to the issuer, even on a public blockchain. Security token and onchain identity standards are live and are beginning to be used by issuers. For the moment we continue to use Ethereum, but as technology advances, it is important to keep the debate open about the best blockchain for security tokens. However, there is no doubt that it should be a permissionless one in order to bring true interoperability and a sufficient level of resilience.
Wallets and digital assets custodian services are not ready yet. It is still complicated for investors to setup a recognized multi-sig and secure wallet. Moreover, investors don‘t tend to know that a STO is a centralized offering controlled by the issuer: If they lose access to their wallet, the issuer can burn the lost tokens and re-allocate the tokens in another wallet.
Most security tokens are issued on Ethereum and based on ERC20 functions, but they are permissioned. This means the tokens will only be transferred if a validator system confirms the compliance of the trade, and especially if the buyer is eligible to receive the token. With most ERC20 compatible wallets, investors will be able to receive their tokens. However, when they try to send them to someone else the transaction will not happen because of a reason not known to the investor. Wallet providers should make an effort to return the error message to the sender, and invite the receiver to become eligible.
Finally, the main tool the industry needs is a recognized stablecoin. It would allow a high level of automation and enable stakeholders to manage the cash leg of transactions. It is great to have tokenized assets but if we don‘t have tokenized money, we still need connections with the existing financial computer systems and this is slowing down the adoption of the blockchain as a legitimate infrastructure. As everyone is aware, investors will not invest in promising investment opportunities with 5-10% of annual yield by using crypto-currencies with +/- 50% of variation every year.