The recent crash of FTX was a startling revelation for the industry, as well as financial markets worldwide. But others, like BlackRock CEO Larry Fink, do not seem to have these fears. A mere month after the FTX collapse, it was Fink who said, "the next generation for markets, the next generation for securities, will be tokenization of securities."
Ultimately, these “black swan” events only reinforce why decentralized financial systems are so critical for future economies. The crash lends itself to a mounting case for asset tokenization that will enable greater transparency and speed in the borderless world in which we live. With the sudden erosion of trust besetting the space, it would be easily surprising that the value provided by tokenization and a trustless system is still a step toward a cleaner financial future.
If they’re not asking it yet, financial institutions will soon be wondering, “Should we consider tokenizing our funds, and where do we go to do it?”
What is tokenization, and what does it afford?
Tokenization is the process of digitizing an asset as a token on a blockchain, which may result in the digitization of certain rights associated with that asset. The implications of this digital transformation are only beginning to be understood.
The process of tokenizing assets can be applied to any class, from financial instruments like debt, equity, or funds, to physical goods like fine art, jewelry, sports cars, or collectibles. Even larger assets, like commercial and residential real estate and land, can be tokenized and subsequently fractionalized into smaller parts to create more liquid markets. When assets exist on-chain, a whole new world of transparent access is opened up for investors.
Why would an institution want to do this?
A major goal of tokenizing assets is to create broader access, and a more liquid market, for previously illiquid assets, while also increasing transparency associated with that asset. With high-value assets, a seller typically needs a single buyer with the capital backing in the form of equity or debt to accept the risk of that investment. This constraint often results in a smaller customer pool.
But when an asset is tokenized and fractionalized, suddenly a broader group of people have access. The potential client base for asset managers, who previously focused on relationship development to sell their funds, expands quite significantly. And the situation is mutually beneficial. The seller has greater access to liquidity, while the pool of buyers becomes more robust through greater access to previously out-of-reach investments.
Circumventing fee extraction
Tokenization removes significant friction from the process that takes place in the middle of an asset sale. Instead, transparency and legitimacy are automated on each side, buyer and seller, by design. And all this can be programmable to adhere to financial regulations.
Fee extractions with traditional transactions include underwriting costs, capital raising costs, compliance fees, listing fees, and so forth. Considering a global tradable financial assets market of an estimated $180 trillion, the prospect of a 10% fee on transactions makes it clear why institutional leaders are having conversations about disintermediation and tokenized markets.
By removing intermediaries and utilizing proofs, transparency, and the speed of blockchain technology, cost savings will be significant.
The case against tokenization
Of course, there are valid concerns about tokenization. How do we regulate liquid, private securities? How is KYC performed on investors in different tokenized markets to ensure that proper regulations are applied? Is a digital token a security itself?
The answers to these questions are not totally crystallized, and some remain active areas of research and development. On-chain credentialing is being developed by a number of companies, including the international standards organization World Wide Web Consortium (W3C), as well as Ethereum scaling platform Polygon, to provide on-chain KYC and instantly verifiable compliance checks.
What about securities? Tokens vary meaningfully in what they represent. A token can represent the security itself. In other cases, token may represent the right to own the equity. And yet in other cases, tokens may represent a right to a revenue stream or debt. Right now, the SEC hasn’t created standards for tokenization, so tokenizing assets today has not certain path, though certain conservatives approaches to tokenizing assets provides confidence in holding and investing in those assets. But there are regulatory models to emulate, namely the regulatory environment in Switzerland, where a framework of regulation permits tokenized securities to trade on a blockchain with the same legal standing as traditional assets.
Further, we can expect that regulation is now more imminent than ever in the wake of the FTX collapse and the need for consumer protection, thereby removing existing hurdles for would-be users.
Absent these obstacles, tokenization naysayers seem interested in preserving the status quo rather than opening up grand new vistas of liquid markets and accessibility.
Financial opportunity for everyone
By facilitating a nearly infinite number of new investments, I think tokenization will democratize access to financial opportunity for every person in the world, regardless of country, income, or background.
In taking a real-world asset like a house and creating an associated digital token, ownership can be fractionalized into smaller, more affordable investment units. Long priced out of the real estate market due to soaring prices and capital-intensive requirements, tokenized real estate enables prospective stakeholders to own a fraction of property.
The bigger picture
Picture a farmer in India who just had an exceptionally strong crop, allowing him to take care of his family for the next two months. The farmer may have some additional money that could be invested. They identify the California real estate market as a promising investment, projected to grow from 15% to 25% in the next five years. The farmer can purchase shares of a home and gain entry into the lucrative California real estate market despite his low relative income.
None of this sounds particularly glamorous, but the accessibility of blockchains makes this sort of investment more realistic for such demographics. Tokenization simply takes the current systems we have and applies the distributed powers of the trustless blockchain, with its secure, instantaneous features, to vastly improve them. This democratizes opportunity, broadens investor bases, and creates a much more capital-efficient marketplace.
So when you see the world's largest banks, like J.P. Morgan and the Monetary Authority of Singapore, performing cross-currency swaps between tokenized Japanese Yen and Singapore dollars on Polygon, don’t write it off as institutional experimentation. They’re building the infrastructure for an integral component of the future economy, enabled by web3. The fabric of our financial future is being woven right now, and it’s closer than you think.
About the Author:
Colin Butler is the Global Head of Institutional Capital at Polygon companies, driving education and awareness within the institutional investment community. Prior to Polygon, he spent 18 years in financial markets. He has worked as Head of Business Development at a global L/S equity hedge fund, the Global Revenue Officer in a company that used AI to quantify human decision-making, and a variety of other leadership roles that spanned institutional equity sales and trading, private wealth management, and alternatives marketing. Colin has the ability to describe both the novel technology and institutional opportunity of Web3, to connect with institutions across industries. He is eager to educate investors about Web3 in general and Polygon in particular, a new technology that promises to disrupt many facets of traditional industry, from brokers and banks to global logistics and supply chains. He lives in New York City.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
