Asset tokenization: the next revolution in securities?

April 24, 2024

BlackRock, the world’s biggest asset manager, in March took a significant step in its digital journey with the launch of its first tokenized fund issued on an Ethereum blockchain.

Asset tokenization, whereby ownership rights of physical or financial assets are represented and stored as digital tokens on a decentralized digital ledger, has the potential to unlock vast amounts of untapped resources and help democratize financial markets. BlackRock’s move is a testament to this.

According to McKinsey research, up to USD 5 trillion of tokenized digital securities could be issued by 2030. Roland Berger estimates that the total market value of tokenized assets – both tangible or intangible – will exceed USD 10 trillion by 2030. BCG says it could be USD 16 trillion.

The opportunities are abundant, but so are the challenges. Let’s take a look.

Using tokenization to release trillions in collateral

Asset tokenization allows for more fractional ownership, making high-value assets more accessible to a wider pool of investors. This is particularly impactful in markets like real estate and derivatives.

In 2023, the global listed derivatives market saw an impressive trading volume of futures and options contracts, exceeding 137 billion. There are indications that the existing infrastructure may struggle to accommodate escalating trading volumes, industry body FIA said recently.

Tokenization might help enhance the efficiency and reliability of trading, and has emerged as a recurring topic of conversation, particularly in the context of derivatives markets and clearinghouses, it said.

Blockchain’s smart contracts make trading more efficient by replacing human intermediaries with mathematical algorithms. Tokenization can unlock previously illiquid asset classes and streamline short-term borrowing through the exchange of cash for tokenized collateral.

Despite the vast amount of collateral globally, less than 10% of marketable securities, estimated at USD 201 trillion, was used as collateral as of 2019, according to a 2021 paper by BNY Mellon & Euroclear.

New technologies like Distributed Ledger Technology (DLT) can also help address collateral fragmentation, presenting a significant growth opportunity.

JPMorgan’s in-house blockchain-based Tokenized Collateral Network (TCN) is an example of these advancements, allowing investors to utilize assets as collateral.

Tokenization also has potential in alternative investments, such as hedge funds, private capital, natural resources, real estate, and infrastructure. It can streamline and automate most stages of alternative investments, potentially bringing USD 400 billion in additional annual revenue for the industry, according to Bain & Company.

However, managing alternatives is challenging due to the lack of uniform rules and infrastructure.

Bolstering compliance, lowering barriers

Blockchain and tokenization offer a solution, enabling improvements in data management, liquidity, collateralization, and introducing innovations like automating capital calls and scalable customization.

Tokenization can also add compliance criteria to smart contracts, ensuring transactions abide by legal obligations. This lowers the risk of fraud and facilitates investor compliance.

Additionally, it can boost efficiency in the investment process. By digitizing assets and using blockchain technology for transactions, it streamlines processes like issuance, trading, and settlement, whilst cutting expenses and reducing the need for paperwork.

Being inherently global, blockchain technology allows investors from around the world to access and trade in tokenized assets, without geographical barriers or intermediaries.

Regulatory hurdles and market fragmentation

However, the path to the widespread adoption of asset tokenization is fraught with challenges.

The absence of a clear, unified regulatory framework leads to a complex compliance environment, increasing costs and risks. This fragmentation can result in isolated networks, undermining the trust and long-term investment necessary for tokenization to thrive.

Regulations for tokenized securities vary significantly, complicating the storage and transfer of digital assets for banks. For instance, the UK’s FSMA 2023 introduces a Digital Securities Sandbox, while the EU’s MiCA and DLT Pilot Regime standardize crypto-asset rules. The US, Hong Kong, Singapore, and Australia are also developing their frameworks.

To overcome this, a collaborative market approach is essential, focusing on regulatory alignment, inclusivity of stakeholders, and interoperability across markets and networks.

Law firm Herbert Smith Freehills expects increased cross-border collaboration. It cites joint efforts of financial regulators in Switzerland, Japan, and the UK with Singapore, whose Project Guardian is testing the feasibility of applications in asset tokenization and Decentralized Finance (DeFi) while managing risks to financial stability and integrity.

Technology and infrastructure limitations

Market immaturity is another challenge highlighted by McKinsey. Achieving faster settlement times and higher capital efficiency requires large-scale, cross-bank solutions.

The speed of adoption in the securities industry hinges on how quickly the financial community adopts new practices. Significant companies embracing tokenization and integrating it into their business models could expedite this transition.

Technological readiness and maturity are essential for the broad use of tokenized securities. To that end, it is crucial to create a stable and expandable blockchain infrastructure, along with improved smart contract technology and security protocols.

Colin Butler, global head of institutional capital at Polygon Labs, argues that the main reason why the tokenization market hasn’t yet taken off is not the lack of trust, but rather the technical bottlenecks, and the limitations around current infrastructure and interoperability.

A McKinsey report notes the shortage of institutional-grade digital-assets custody and wallet solutions, as well as blockchain technology’s low system uptime at high transaction throughputs, which makes it unsuitable for tokenization, especially in mature capital markets.

Furthermore, a (private) blockchain infrastructure that is fragmented across different smart contract guidelines and token standards makes interoperability difficult for financial institutions.

Evolution more than revolution?

Nevertheless, the real use cases of the technology are growing in number.

In derivatives, a booming market with billions of transactions per year, where volatility and continued growth are anticipated to continue, a complex web of interconnected systems to move collateral to meet margin calls from clearinghouses is a hurdle.

Tokenization could pave the way for greater efficiency, particularly in certain post-trade processes, by allowing cash and securities to be transferred instantaneously on a 24/7 basis, eliminating the risks that can arise over weekends and holidays.

Given some of the challenges we have outlined, tokenization is likely to evolve rather than revolutionize capital markets.

ION Markets

Don't miss out

Subscribe to our blog to stay up to date on industry trends and technology innovations.