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Blockdaemon Blog
Asset Tokenization: Unlocking the Future of Finance
Industry News
Oct 20, 2023
By:
Cecilia
(Qi) Feng
&
Conor
Keville
Tokenization is transforming global finance, turning assets into blockchain tokens. Offering 24/7 trading and fractional ownership, it reached a $310B market in 2022. Institutions must adapt to this shift. We take a deep dive into this topic and how it is shaping the future of finance.
Tokenization, positioned at the intersection of finance and technology, emerges as a transformative force with sweeping implications. This groundbreaking process converts both physical and financial assets into digital tokens on a blockchain, fundamentally altering the dynamics of global finance.
By doing so, it not only establishes a new paradigm for investors but also unlocks opportunities for 24/7 trading, fractional ownership, and addresses challenges such as the complex and expensive operational processes reliant on intermediaries, liquidity fragmentation, and protracted settlement times for financial institutions.
In a broader context, it is gaining remarkable momentum within Medium (M), Institutional (I), and Banking (B) institutions. The tokenization market, spanning various asset classes, has witnessed exponential growth and reached a staggering $310 billion in 2022. Notably, tokenizing existing assets in both wholesale and retail markets emerges as a linchpin for driving mass adoption in blockchain participation.
As the tokenization market evolves, traditional intermediaries like banks and asset managers face the prospect of disintermediation. To remain relevant and actively participate in this new ecosystem, these institutions are adapting and embracing tokenization. At a high level, a comprehensive tokenization stack comprises blockchain networks for processes and settlement, a tokenization platform for issuance, an institutional-grade blockchain wallet for asset custody, and additional secondary market infrastructure.
In the subsequent sections, we embark on an in-depth exploration of the tokenization landscape, its benefit and risk, diverse applications, what can be tokenized, a case study, the tokenization stack, and its adoption by key players in the financial industry. We meticulously examine all facets of the subject, arming you with the knowledge to navigate this ever-evolving landscape.
What Is Tokenization and Why It Matters?
Traditional financial infrastructure faces notable constraints, relying on intermediaries with isolated proprietary infrastructures and jurisdiction considerations. This inherent structure can lead to potential fragmentation of liquidity and friction for capital flow. Additionally, the system involves complex processes with high operational costs and extended settlement times. These challenges drive institutions to explore more agile and efficient alternatives, making the case for tokenization highly compelling.
Figure 1: Limitations of Existing Financial Systems (Source: Blockdaemon)
Tokenization takes an asset's value or ownership rights and encodes it into a digital token on a blockchain. This translates to seamless buying, selling, or trading in a digitized environment. Far from mere industry jargon, tokenization holds significant weight in the development of Institutional Decentralized Finance (DeFi), serving as a catalyst for transformative financial solutions.
Tokenization Benefits and Risks
Benefits of Tokenization:
Ease of Trading and Expansive Ownership - Tokenization revolutionizes the investment landscape by ensuring a continuous 24/7 trading market and democratizing asset ownership. By breaking down assets into smaller, tradable tokens, it opens opportunities for a more diverse set of stakeholders. Additionally, tokenization enables fractional ownership of costly assets, such as commercial real estate or rare collectibles, further expanding investment possibilities for a broader investor base.
Interoperability, Liquidity, and Democratized Access - Tokenization resolves jurisdictional challenges and fosters both technical and financial interoperability, hence enabling heightened global liquidity and broadened access to investment avenues previously limited to an elite few. The tokenization of traditionally illiquid assets, like real estate or fine art, significantly expands the investment landscape. The introduction of these newly accessible assets enhances market liquidity, offering institutional investors a more diverse range of options for portfolio diversification.
Figure 2: Tokenized Capital Flow (Source: Blockdaemon)
Streamlining and Automating Operations - Tokenization leverages smart contracts to eliminate intermediaries and streamline financial workflows with a great deal of customizability, enabling instant/atomic settlement and regulatory adherence. The automation of complex financial operations using smart contracts results in a significant reduction in transaction costs. These efficiency gains empower financial institutions to pass on cost benefits to end investors.
Enhanced Transparency and Security - The blockchain technology underlying tokenization offers transparent, immutable record-keeping. This feature minimizes the risk of fraud and brings a new level of integrity to asset ownership and trading.
Risks: Navigating the Complex Terrain of Tokenization
Regulatory Maze: While tokenization offers a slew of benefits, it also presents complex legal challenges. Securities laws differ across jurisdictions, and failing to comply can result in severe penalties. Additionally, Know Your Customer (KYC) and Anti-Money Laundering (AML) regulations must be meticulously adhered to, adding another layer of complexity for institutional players.
Infrastructure Overhaul: Adopting tokenization is not merely about implementing new software. It demands a fundamental shift in trading infrastructure. Legacy systems often struggle to integrate with blockchain networks, requiring significant investments in both time and capital to modernize.
Cybersecurity: Tokenization shifts assets to a digital format, making them susceptible to cyber-attacks. While blockchain itself is secure, other elements of the ecosystem, such as wallets or exchange platforms, can be vulnerable, thus warranting robust cybersecurity measures.
Volatility: Tokenized assets, particularly those in nascent markets, can be subject to intense price fluctuations. While market volatility can create lucrative trading opportunities, it also amplifies risk. This volatility can be especially consequential for institutional investors accustomed to more stable assets.
Tokenization Market Pulse: Capturing the Escalating Momentum
We observe that recent data emphasizes the importance of tokenization in the institutional landscape, considering both sentiment and market size. According to a BNY Mellon report, 97% of institutional investors believe that, "tokenization will revolutionize asset management" and view it as, "good for the industry." This statistic highlights the rising adoption rates and underscores the competitive advantage tokenization provides. The on-chain asset tokenization market, surpassing $2.3 billion in 2021, is projected to reach an impressive $5.6 billion by 2026, signaling not just financial viability but also paving the way for broader economic transformation. Notably, BlackRock and State Street express confidence in tokenization's transformative capabilities.
Figure 3: Tokenization of global illiquid assets estimated to be a $16 Trillion business opportunity by 2030 (Source: BCG and ADDX Report)
We have also observed that tokenization picked up steam in 2022 despite the market downturn. In the context of a dynamic global geopolitical and macro environment (i.e. Russian sanction, global inflation and rate hikes, USD global dominance challenged), various financial institutions have started experimenting with tokenization as on-chain infra building blocks.
Figure 4: Tracker of Tokenization from Large Institutions in 2022 (Source: Blockdaemon)
What can be Tokenized?
In this section, we outline our vision of the tokenized economy mirroring the structure of the real economy with money to transact and assets to be bought and sold. We provide an overview of the assets eligible for tokenization and delve into various types of tokenized money, distinguished by issuing methods and associated risks.
Assets
The tokenization landscape encompasses diverse asset classes. In the realm of securities, both equity and debt instruments contribute to a market cap surpassing ~$100 million. Real estate, too, sees significant tokenization, with a market cap reaching ~$200 million. The trend extends to funds, where tokenization is gaining traction among asset managers, with notable players such as KKR and Hamilton Lane entering the space. Commodities, including gold and grain, are also subject to tokenization, while forms of tokenized money include bank deposits and stablecoins.
Below are several real-world examples highlight the increasing trend of asset tokenization in 2023:
In January, significant tokenized bond issuances occurred, with ABN Amro launching a €450k bond on the Stellar platform and the City of Lugano issuing a substantial CHF 100 million blockchain bond on SDX. Moving into February, Siemens made a noteworthy contribution with a €60 million digital bond on Polygon. The Hong Kong Government also participated in the tokenized bond space in February, issuing $100 million in tokenized green bonds on Goldman Sachs’ GS DAP platform.
The tokenized gold market has witnessed significant growth, reaching a market cap peak exceeding $1 billion as of April.
Money
Programmable on-chain money tailored for a tokenized economy mirrors the functionalities of fiat currency, facilitating domestic and global payments, as well as activities like borrowing, lending, and investment. It functions as a seamless bridge between on-chain and off-chain economies. This section specifically explores Deposit Tokens and Stablecoins, among various types of on-chain money like CBDCs.
Figure 5: Utility of various on-chain money (Source: Blockdaemon)
Deposit Tokens involve the tokenization of a bank's deposit, backed by claims against the issuer and subject to existing banking regulations. The risks associated with Deposit Tokens are influenced by the bank's balance sheet and the broader domestic/global banking system. The on-off-ramp is controlled by the issuing bank, resulting in endogenous risks within a closed system.
Real-world examples include the MAS <> JPM Project Guardian, a collaboration between the Monetary Authority of Singapore (MAS) and JP Morgan, focusing on institutional DeFi through the tokenization of deposits and bonds starting from November 2022. Additionally, the Swiss Bankers Association has proposed a Swiss franc "joint" deposit token, potentially built on a layer-2 solution for institutional DeFi with self or bank custody.
Stablecoins are issued against a basket of collaterals, including cash and liquid assets, by centralized or decentralized entities. This involves portfolio management from the issuer, encompassing earning, liquidity, and system design risk. The stability of the stablecoin is informed by the types of collateral and the associated ratio. The on-off-ramp for stablecoins is controlled by the issuer, introducing exogenous risks within an open system.
Real-world examples include Tether and USDC, with a combined market cap of $109 billion and a 24-hour trading volume of $33.6 billion as of 10/18/23. USDC is utilized for trading various digital assets on Decentralized Exchanges and serves as an early form of payment settlement. Notably, Visa is experimenting with USDC payments and payouts on Ethereum and Solana.
Case Study: KKR Healthcare Fund on Avalanche Blockchain via Securitize (September 2022)
KKR, a global investment firm, set out in September 2022 to unlock broader access to private market investing. Their multifaceted goal aims to unlock broader access to private market investing, improve digital investor onboarding, compliance protocols, and increase potential for liquidity through a regulated alternative trading system. KKR partnered with Securitize, a tokenization platform seasoned in KYC/KYB and user on-off ramping. Here is a high-level tokenization stack, encompassing an asset issuer, a tokenization platform, a wallet for custody, and an execution platform/blockchain.
Figure 6: KKR Tokenized Fund Stack (Source: Blockdaemon)
Essential factors worth highlighting include the division of responsibilities and prospective advantages:
KKR, as the issuing entity, made a forward-looking move to tokenize one of its funds.
Securitize, as the Tokenization Platform, plays a pivotal role in managing KYC/KYB processes and establishing essential infrastructure to connect with chosen blockchains. It facilitates user on-off-ramping and provides primary and secondary market infrastructure. Users can opt for self-custody through their own wallets or external custody solution. Funding methods encompass USDC stablecoin or USD via wire/ACH, contingent upon the chosen investment option and blockchain. Operating within a closed-loop system, it does not co-mingle user funds with other on-chain capital, featuring a direct primary market and a platform-centric order book for the secondary market.
Avalanche, as the blockchain of choice for Transaction Execution and Finality (Scalability), is tailored for institutions. It offers blockspace, on-chain security through validators, high throughput, and swift finality owing to its DAG architecture. It facilitates parallel processing and verification through partially sequential ordering, in contrast to the arbitrarily sequential ordering seen in traditional blockchains. The choice of Avalanche aligns seamlessly with KKR's objectives of enhancing efficiency and potentially boosting liquidity.
The dominance of tokenized funds in primary markets signals a thriving space ripe for diversification and expansion. This case study offers a compelling glimpse into how traditional financial institutions can and probably will evolve in the emerging landscape of asset tokenization. As such, it is worth keeping an eye on similar initiatives that aim to shape the future of investment in this digital age.
Why Does an Institution Need to Get Involved and What is Needed?
To further enhance an institution’s leadership role in a highly efficient, interconnected and automated global financial system, an institution will benefit from a more seamless transaction flow and wider reach, and tokenization presents itself as the first building block towards such a vision. Here is our proposed tokenization stack with Blockdaemon’s Institutional Wallet to facilitate a customizable end-to-end on-chain journey for buying, selling, and storing tokenized assets, enabling institutions to retain a central role in this burgeoning ecosystem.
Blockdaemon specializes in providing MPC wallet infrastructure, catering to both self-custody and custody scenarios, along with offering expertise in blockchain infrastructure.
The Tokenization Issuing Entity, typically a bank, collaborates with a chosen Tokenization Platform for a closed-loop Primary Market Offering. They facilitate user on-boarding and on-chain transactions with various options, including using traditional currency (USD) or deposit tokens/stablecoin, depending on the Tokenization Platform selected.The utilization of on-chain money, such as deposit tokens and stablecoins, serves to streamline operational processes, reducing complexity and laying the groundwork for payment systems and potential secondary market offerings.
The choice of blockchain for transaction processing and finality involves careful consideration of factors such as throughput, scalability, security, costs, and interoperability, especially in the context of intra-bank interoperability.
It is also worth noting that secondary markets currently operate on the tokenization platform's Orderbook, incurring higher costs, complexity and liquidity friction due to lack of interoperability between systems. Depending on technology maturity and liquidity factors in volume and depth, future adoption of Automated Market Maker (DEX) and Smart Contract Automation Platforms could further enhance capital flow and operational efficiency.
Conclusion
Tokenization is not a fleeting trend—it's a technological revolution that financial institutions can't afford to ignore. Whether it's enhancing liquidity or automating processes, tokenization offers a gamut of benefits with minimal downsides if navigated carefully.
If your business is considering exploring tokenization, book a call with Blockdaemon today. Our team of industry experts are on-hand to help you navigate the intricacies of the blockchain landscape.
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