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Blockchain can become the main feature not only of financial markets but also of many other sectors of the economy. In theory, any asset can be tokenized, and the rights to it are represented in a distributed ledger. But it is most likely that in the coming years, this process will affect the following industries — Infrastructure, real estate, intellectual property, music and culture, stocks and trade, gold and rare precious metals, foundations and their assets, art and collectibles, foreign exchange transactions and insurance. But at the same time, it should be understood that the tokenization of these industries will seriously change them, and will actually hit finance.
A blow to financial markets
The potential proliferation of asset tokenization in financial markets could hit liquidity, but could also affect trading, price, clearing and settlement of securities, and even monetary policy. When considering the potential consequences of such a phenomenon, a distinction must be made between the following two types of tokenization:
• tokenization of securities that also exist outside the blockchain network;
• the issue of securities in tokenized form directly within the blockchain.
DLT allows securities transactions to be carried out in a mode in which trust is distributed among the nodes participating in the blockchain network, where the participation of a central institution or intermediary is not required to settle the relationship between the parties to the transaction. Investors can act as broker-dealers for themselves, and transactions are confirmed by participants in the decentralized network in exchange for some commission.
A blow to market makers
Market makers provide two-way quotes to investors who want to buy or sell a security. The role of market makers is more prominent in markets with a small investor base and the need to provide liquidity, especially during times of market stress when market makers take the other side of a trade order in the absence of balance between supply and demand. In theory, the search for buyers and sellers in the decentralized securities market is automatic and no mediation is required. At least in the context of securities, the increase in efficiency from tokenization can be associated with the exclusion of the broker from the logic of the process, which is already done today by decentralized finance and the Uniswap tool. In practice, however, asset tokenisation system operators offer market maker services to clients even in blockchain-based markets. This does not necessarily mean that broker intermediation cannot be replaced by the technology behind the distributed ledger, but rather means that DLT network-based tokenization may not have sufficient liquidity or that the owner of the trading platform may have economic incentives that help maintain the broker model in a tokenized environment.
For now, most of the secondary token trading takes place on centralized crypto trading platforms. This is due to the fact that abandoning the traditional model of a market maker of the market can affect the normal functioning of some markets and the redistribution of risks between them. The stability of markets can be influenced by the consequences of sales that can occur in the absence of market makers, who usually take traded assets to their balance sheets and act as “shock absorbers” of the market. At the same time, the presence of an intermediary is not always guaranteed, and it is believed that market makers may not work in markets that are under stress. In the case of tokenized assets, the complete absence of an intermediary capable and willing to take tokens on the balance sheet and provide liquidity in the event of a fall in markets can have an indirect effect on market liquidity.
REPO under threat
The development of asset tokenization may also have an impact on repo transactions to fund positions, as well as on securities lending used as a component of trading strategies. Moving the aforementioned activities to blockchain could potentially lead to faster and less costly securities lending as fewer steps are involved in the process and collateral is sold instantly. This could mean that the overnight repo market is becoming almost instantaneous. The market can benefit from increased liquidity as collateral will be released and mobilized between pools of securities that are held in different accounts around the globe and participate in the same blockchain network. When assets and transactions with such assets are conducted in a distributed ledger, the network knows where the assets are at a particular point in time, and collateral can be tracked and moved seamlessly across the various accounts in the system. The downside to the aforementioned advantages is that netting will not be possible and each trade will likely need to be fully funded and settled. This could result in more collateral being moved instead of the traditional net collateral.
Blow on Liquidity
In a tokenization spread scenario, the number and variety of assets that will be traded on public markets and receive liquidity may grow, especially given that, in theory, any asset can be tokenized. DLT infrastructure providers already offer white different types of tangible and intangible assets using the same market infrastructure and protocols. Asset tokenization can be a double-edged sword, with both positive and negative consequences for liquidity. On the one hand, tokenization of illiquid assets such as securities of small and medium-sized enterprises (SMEs) or private equity/venture capital funds can provide sufficient liquidity for illiquid asset classes. Likewise, the tokenization of assets with limited liquidity, such as private placements of unlisted securities, equity participation in private limited companies, and small bond issues can also improve liquidity in these asset classes. Trading such assets in secondary markets is vital to liquidity, as well as helping in price disclosure and furthering capital accumulation.
An indirect benefit from improved liquidity in the asset classes mentioned above could be an increase in the investment flow needed to finance the real economy. As such, wider adoption of asset tokenization on a large scale could be more easily implemented for private placements of securities not listed on the exchange, small bond issues, or private equity/venture capital funds. Conversely, public stock markets in developed countries benefit from highly automated and efficient processes, where the potential for efficiency gains from DLT is very limited. It is important to note that such markets enjoy a high level of trust from their participants. Thus, the net efficiency gains achieved by a possible transition to a tokenized form of the market may be more limited.
The tokenization of a fraction of the free float that also continues to trade off-chain could lead to a shift in liquidity from traditional markets to blockchain, leading to depletion of liquidity in off-chain markets. The above scenario is not a risk if securities (and assets in general) are issued directly on the blockchain and do not have an underlying asset in the real world. Parallel trading of tokenized assets, both within the blockchain network and in regular traditional markets, risks creating bifurcation of markets for the same asset, with negative consequences for liquidity and a potentially high risk of arbitrage. The rise in the use of tokenized assets and the trading of such assets on the blockchain network risks robbing the traditional market of liquidity, with potentially costly consequences for market participants and impairing the smooth operation of markets. The level of interoperability and connectivity between internal (blockchain) and external (traditional) tokenized asset markets can determine the magnitude of this liquidity impact. Arbitrage risks will naturally arise only in the markets within the blockchain network, since incompatible DLT networks and exchanges give rise to such an arbitrage risk.
Blow on pricing
Trading in a tokenized environment will benefit from the increased transparency provided on DLT-based networks. An important benefit of increased transparency is the reduction of information asymmetries, which in turn can improve the pricing mechanism by providing investors with incentives to increase their participation and provide additional liquidity in the market, as well as improve the conditions for competition in the market. However, it should be noted that the increased level of transparency inherent in blockchain trading might not appeal to market participants where anonymity matters. For example, large purchases or sales of market participants (large institutional investors who do not want to influence the markets with a large trade order) will not be possible on a DLT-based network. The relationship between domestic (tokens) and foreign markets (traditional instruments) may have other implications for instrument pricing.
Trading in tokenized assets in a decentralized world takes place around the clock on multiple networks. In the absence of communication between domestic and foreign markets, trading in tokenized assets can become fragmented. This fragmentation, in turn, will almost certainly create arbitrage opportunities. Conversely, the potential interoperability of markets could allow for a kind of “double listing” of assets inside and outside the blockchain, similar to the case when companies list common securities on several exchanges at the same time. Arbitrage can occur even on tokenized assets issued only on the blockchain if they are traded on different exchanges with limited or no connectivity. This can lead to a mismatch in how assets are priced against the market if there are discrepancies in pricing across different platforms, creating exchange arbitrage opportunities. In a scenario dominated by tokenization, even if price discrepancies occur for a short time, they can affect market stability.
Blow on clearing
In some traditional financial markets, central settlement institutions act as central counterparties to both parties to a transaction, ensuring that the transaction is matched and settled even if one of the parties defaults, thereby reducing counterparty risk. Clearing centers confirm these trades and use CSDs to maintain transaction records. Custodians (client depositories) holding an investor’s assets work to ensure the safe delivery/receipt of assets and funds to each of the parties involved in transactions and to settle transactions. The use of blockchain in post-trading allows maintaining a single common immutable register of information about transactions, which is updated at every stage of the process and can be instantly accessible to all parties to the transaction. Systems with DLT support and the use of smart contracts for clearing and settlement of tokenized assets have the ability to check the availability of assets, confirm the compliance of transactions, and register transactions in an automatic, immutable, transparent form almost instantly.
A distributed ledger can act as a decentralized ledger of transaction data and as a counterparty to all parties that transact. Using DLT can reduce back office costs by minimizing discrepancies in transaction data, which will facilitate faster reconciliation of transaction data. Efficiency gains can also be driven by the fact that legal and beneficial ownership in DLT clearing and settlement systems is not shared between investors and system participants. Using DLT for clearing and settlement reduces the number of intermediaries and streamlines the process of payment or delivery of securities to the ultimate beneficial owners.
If the tokenization of assets begins, the potential “destruction” of the market structure could lead to a substitution for a distributed ledger as a decentralized version of the central depository. Likewise, clearinghouses could theoretically be ultimately downsized by using the blockchain platform as a clearing entity, acting as a common counterparty to complete settlements. Proof-of-concept projects and DLT computational use cases have produced mixed results when it comes to evaluating effectiveness. For example, the Bundesbank / Deutsche Borse joint blockchain project for securities settlement proved to be most suitable for mainstream use but did not perform better than the currently used clearing and settlement systems: settlement sometimes took longer and caused relatively high computational costs. This suggests that obstacles to the development of the technology must be overcome in order for its application to reach the stage where it can provide higher performance than traditional systems currently in use.
Blow on custody
Despite the potential to exclude intermediaries at many levels, asset tokenization will ultimately depend on having a reliable and trustworthy central institution to ensure that real assets are backed by tokens and to store such assets. This could imply a central role for a third party trusted institution, such as custodians, who can be invited to act as a trusted party, and which will ensure that the world outside the blockchain network is connected to the distributed ledger. When distributed ledgers interact with the real world, a trusted third party is usually required to establish such communication. The data on the characteristics and ownership of the asset to be tokenized must be verified by a trusted institution that can confirm the accuracy of the asset’s characteristics information (including ownership) before it is placed on the blockchain.
Given the above, a potential application might be reasonable in a token system where clearing houses and central depositories have been liquidated, while custodians play a key role in the structure of the markets by acting as a centralized trusted institution that seamlessly connects the blockchain platform and the external environment. The role and responsibilities of custodians may be revised to include responsibility for providing tokens with real assets in addition to protecting such assets. Appropriate regulation and supervision of blockchain-related custodians will protect investors from risk. The role of the central institution may also include ensuring the transfer of the real asset to the blockchain and ensuring the accuracy of the information regarding the asset to be tokenized.
Blow on central bank currencies
For securities to be settled in near real-time and delivery versus payment (DvP) to be guaranteed, the securities and cash must change ownership at the same time. In order for the exchange to take place quickly or without the cost of intermediaries, it is necessary to ensure that a tokenized form of money is available on the blockchain. Since tokenized securities are already on the blockchain, the presence of a tokenized form of money allows for certainty about the delivery of securities and allows settlements in near real-time. In the absence of tokens of currencies supported by Central Banks, stablecoins (stablecoins) are used for settlements in DLT to provide the monetary component of settlements. Stablecoins are also used by cash settlement platforms when it comes to servicing securities and corporate actions throughout the life of a security (such as paying dividends). This raises the question of whether central banks will facilitate the tokenization of central bank money for use in tokenized markets, or whether stablecoins (or central bank digital currencies, if available) will play this role.
Asset tokenization can improve asset liquidity and tradability as they can benefit from increased efficiency. Tokenization can lower barriers to investment by giving investors access to previously illiquid, unavailable, or disputed assets. This can facilitate and simplify the inflow of capital to start-ups by issuing debt and equity in private companies where there is no trading infrastructure. Asset tokenization can be meaningful in markets where there are clear advantages in efficiency, in terms of cost, speed, complexity of processes and intermediation, or in markets with a lack of trust. Therefore, wider adoption of asset tokenization on a large scale would be easier to envision in markets with limited liquidity and multiple levels of intermediation, such as private placement of unlisted securities, small bond issues, or tokenization of private equity and venture funds.
The efficiency gains that can be achieved through the introduction of tokenization of public shares in developed countries will require a careful assessment of costs and benefits, since such markets already enjoy a high level of trust from their participants and are supported by fast, safe and efficient processes. In such markets, it will be difficult to tokenize processes. In such markets, only small efficiency gains are possible as a result of the move to tokenization. It can be argued that some of the potential benefits of asset tokenization can only be achieved if the blockchain network reaches a sufficient scale. The scale will help ensure that benefits such as increased liquidity are fully realized.
Sergey Golubev (Сергей Голубев)
Crynet Marketing Solutions, EU structural funds, ICO/STO/IEO projects, NGO & investment projects, project management, comprehensive support for business
How tokenization will destroy the conservative world of finance was originally published in The Capital on Medium, where people are continuing the conversation by highlighting and responding to this story.