The next opportunity for tokenization?

This content was originally published by Kenan Maciel of Lab49, as a guest article in the November issue of the IBSi FinTech Journal.

High global interest rates in the past 18 months have created volatility across most asset classes, one of the most notable has been bonds. As a key funding source for governments and enterprises, bonds have always played a vital role in financial markets. Recent turbulence in US Treasuries, during which yields grew to a 16-year high, reignited conversations about the importance of this segment of the market.

Despite their importance, efficiency has lagged compared to other asset classes, limiting growth and accessibility to investors. However, automation and digitization efforts have been made to navigate recent conditions; in 2022 40% of US investment-grade and 62% of European corporate bond trading volumes were executed electronically.

The industry is now exploring how to unlock further efficiency. Despite an unpredictable year for digital assets, tokenization – a technology vital to the crypto market – is receiving considerable attention. Providing benefits to both pre-trade and post-trade operations, this could transform the bond market.

The benefits for bonds

Since the first tokenization in 2017, financial institutions have explored its application in traditional finance. For bonds, one of the most notable recent developments was the successful offering of a tokenized green bond in Hong Kong. Led by the Hong Kong Monetary Authority (HKMA), the project highlighted how a key technological driver of tokenization – distributed ledger technology (DLT) – could enhance efficiency for institutional bond issues.

Benefits of tokenization are consistent across asset classes, this includes 24/7 operations, data access, and atomic settlement. For bonds, a great advantage is democratization. Traditional bonds are illiquid, traded over the counter in large quantities, limiting access for individual investors and reducing transaction speeds. Purchased and sold on blockchain-based platforms, tokenized bonds allow individuals to make smaller transactions, enhancing accessibility and liquidity.

Eliminating intermediaries, bond tokenization provides traders with a more transparent view of transactions at a lower cost, with additional savings made by embedding operations such as interest calculation and coupon payments into smart contracts. Automating these tasks alongside manually-led processes such as compliance creates opportunities for a more streamlined, trusted, and efficient bond market.

An inflection point?

With approximately $120 billion of tokenized cash circulating in the form of fully reserved stablecoins, there are arguments that tokenization has reached an inflection point. This statement could be premature, as several factors hinder wider adoption.

Differing regulatory approaches present challenges – especially for compliance. The lack of a legally binding status of smart contracts and unclear custody requirements make the US particularly difficult. Adoption is limited by current infrastructure, when facilitating both dual and single-existence approaches to tokenization, with fragmentation creating specific interoperability challenges. The split between on-chain and off-chain ownership has heightened this, introducing new risks to financial institutions. Given the size of bond transactions, a lack of throughput, scalability, and high transaction fees is another obstacle.

Enabling widespread adoption

While efforts by individual banks including J.P Morgan, Goldman Sachs, and Crédit Agricole CIB have normalized tokenization, further standardization of protocols and market coordination is required for more adoption. Central securities depositories (CSD) and international CSDs can shift the dial, for example by being an actor which holds a node or supervising the nodes being kept by actors. Having led coordination on other initiatives, CSDs can also be the driving force behind the development of an international, standardized approach to tokenization.

Responsibility does not solely lie with CSDs. Technology is critical to overcome the fragmentation that currently hinders adoption. Infrastructures able to interoperate with existing platforms – and also interact with other blockchains – remove the need for costly individual build and connectivity projects. As new platforms emerge, interoperability will be even more important for the wider adoption of bond tokenization. Despite challenges, the excitement behind bond tokenization continues to grow. Sharpened focus on interoperability from institutions such as SWIFT offers optimism for further adoption. Ultimately, coordination between financial institutions, CSDs, regulators, and technology to overcome current hurdles will determine whether current momentum materializes.