Tokenization is a big deal, but rollout and adoption will be slow

The appeal of asset tokenization is tantalizing and the advantages over existing market operations can appear obvious. The most compelling benefits are improvements to the operation of markets that should make them faster, cheaper, more transparent and increasingly accessible. These include faster settlement, in some cases “atomic,” i.e., the transfer of security and payment happens simultaneously. This post-trade automation would do away with multi-day settlement times and enable 24/7 trading, which, in some markets, could improve liquidity by bringing in additional supply and demand. Similarly, the shift to smart contract-enabled distributed ledger technologies implies fewer intermediaries and less fees spent on their services. The key feature of blockchain technology to permanently record transactions could also greatly improve market integrity and accountability. And finally, for certain financial instruments, smart contracts allow for automation and reduction in operational complexity by embedding certain corporate actions, such as scheduled coupon or dividend payments, into the token itself. All of the above is attainable but requires time to materialize. This is because most of the efficiencies only come to fruition once the entire ecosystem is built. This includes a market solution that enables the settlement of the cash leg for digital asset transactions.

It is ultimately a network innovation, which requires all parts of the network to modernize, including issuance, trading, custody, etc. For this to occur, investors and providers need regulatory clarity and standardized norms. There are also technological challenges, such as cybersecurity, network protection, scalability and interoperability among different blockchains. These may all seem daunting but are eminently solvable; again, it just will take time. And of course, investors will need to gain comfort with the purchase, trading and usage of tokenized assets, which requires operational and governance changes in their organizations, too. Disrupted intermediaries are likely to exaggerate all these challenges, which will delay broad-based adoption, but will not ultimately prevent it given the compelling benefits.
 

Systemic implications

Of course, there are caveats to the benefits of tokenization, especially that they do not apply equally to all asset classes and markets. In fact, they are greatest where current market inefficiencies are large. In some asset classes, such as equities, the current digital representations of shareholder ownership work relatively well and, while tokenization offers an efficiency gain, it is much smaller than for bond or private markets.

• Lower barriers to entry
  Asset tokenization is therefore likely to lower barriers to entry both for issuers and investors, and it will do so most meaningfully in markets where operational inefficiencies have the greatest impact on market participation. The macro consequences could be greater efficiency in capital allocation across an economy, with access to capital drawing in or amplifying smaller economic actors. In those instances, notably in bond and private markets, the technological and market structure shifts associated with tokenization could also open up new economic models. Wide swathes of assets could be bundled into new forms of securitization, leading to the expansion of capital market products. For example, tokenized bonds will transform the repo market, allowing deal maturities in hours or even minutes, whereas overnight is the shortest time period today. Similarly, the programmability and composability of securities assets would allow for new links and less reliance on intermediaries, thus creating new opportunities. 
• Fungibility of assets
  Tokenization overall will also enable a greater fungibility across asset classes and markets, facilitating new economic linkages and businesses. In many ways, tokenization is just another technological leap toward more integrated capital markets, further simplifying cross-asset allocation and trading. This has important implications for how capital markets function and the scope of systemic financial linkages. In this context, the tokenization of private markets – initially just as tokenized private equity, real estate or private credit funds – will further correlate them with public markets, accelerating a trend that has been occurring in recent decades. Tokenization should make access to each asset class easier, lower the barriers to entry and simplify trading. These features should make global asset allocation nimbler, with reduced friction and costs when shifting assets between markets, asset classes and geographies.
• Integration with AI
  Finally, the arrival of tokenization – converting financial assets into programmable code – aligns with the rise of artificial intelligence (AI) and its integration into finance. As the industry builds AI into its various processes, a rising share of portfolios will be constituted by digital assets with built-in automative programming. In plain English, AI-guided portfolio management will have machine readable digital assets as a counterpart, allowing computers and software to drive the less strategic parts of portfolio management and trading. While this clearly poses new forms of systemic risks, the potential productivity gains appear enormous, especially as they could reduce the costliest, least productive work within the financial industry.

There are a number of questions to consider:

• How will financial markets transition to tokenized assets, and how will this shift affect supply and demand dynamics?
• What impact will increased asset fungibility have on global capital allocation and trading?
• What will be the cash-leg for digital asset transaction?
• What are the potential risks and productivity gains from AI-guided portfolio management with tokenized assets?
• Traditional financial institutions will need to adapt their operations and governance to embrace tokenization, but how will they support investors and make them comfortable with tokenized assets to ensure adoption?

When considering the long-term vision, one might ponder what the financial ecosystem will look like once all parts of the network are modernized to support tokenization and how it will reshape global capital markets in terms of efficiency, transparency and accessibility. These questions aim to provoke thought and discussion on the multifaceted aspects of asset tokenization, its potential benefits, challenges and long-term implications for the financial industry. However, it is difficult to see how tokenization will be stopped; it seems a matter of when not if financial markets will embrace asset tokenization.