Tokenization for Dummies — or the Questions you always wanted answered
Tokenization is heralded as the next big thing in finance. I would argue that is true. Yet, the real significance of this technology-enabled development for finance is not well understood yet.
This compilation of Q&A for beginners and experts alike, is meant to provide an introduction, a basis for a healthy debate, and provoke more thinking among practitioners, finance professionals, and tokenization maxis.
I am welcoming some controversy and will respond to any comments.
Why is tokenization important?
What is every “thing”?
What assets live on a balance sheet?
Which assets are easy to tokenize?
Which assets exist in natively digital form?
Which assets are difficult to tokenize?
Why is tokenization of assets so important?
How will tokenization drive credit expansion?
What is Finance?
What is a financial contract?
What is a financial asset?
What (investment) bankers must understand about tokenization of financial assets.
Why is tokenization of financial assets important?
What are the current use cases in Financial Asset tokenization implemented on scale?
Why are dumb tokens the biggest threat to the financial system?
Why is tokenization of financial assets headed for disaster?
What is a precondition for tokenization of debt, structured instruments and derivatives?
What is the most important aspect of a tokenized financial asset representing debt, structured instruments and derivatives?
What is a Smart Financial Contract?
What programming language is best for tokenized financial contracts?
Is a tokenized financial asset more liquid than a non-tokenized financial asset?
How will tokenization of financial assets with smart financial contracts change the value chain in finance?
How will tokenized financial assets with smart financial contracts enable capital markets?
How will tokenization of financial assets impact private equity players and asset managers?
How will tokenization of financial assets change financial regulation?
How will Delivery vs. Payment change with tokenized financial assets?
Why is reconciliation such a big problem in finance?
How will tokenized financial assets solve the reconciliation problem?
What is the open source ACTUS Financial Standard?
What is a smart contract?
How will tokenization of financial assets impact securitization?
Who will be driving tokenization of assets on balance sheets?
How can interoperability of tokenized financial assets be achieved?
Which standards will drive tokenized financial assets?
Is a tokenized financial asset a regulated security?
What is a digital security?
How will tokenized financial assets change the mid-office and back-office?
How will tokenized financial assets change the front-office?
What is a Real World Asset?
What is a bond?
What is a tokenized bond?
What do USDC, JPM Coin, FOBXX, EURC, DCHF have in common?
What is a computer game asset (like a shield, or skin)?
What is a tokenized computer game asset (like a shield, or skin)?
What is a collectible baseball card?
What is a tokenized baseball card?
What is a bored ape?
What is a chemical formula?
What is tokenized Intellectual Property (IP)?
What is tokenized real estate?
What is tokenized equity?
What is Decentralized Finance or DeFi?
What use cases exist in on-chain Decentralized Finance?
What is a token in the context of tokenization?
LINKS TO RESOURCES
Why is tokenization important?
Because every “thing” will be tokenized.
What is every “thing”?
Any “thing” that exists on the balance sheet of a person, a firm, a country or the world. In other words, any asset (or obligation) can be tokenized.
What assets live on a balance sheet?
Financial Assets, Tangible Assets, Intangible Assets. These asset categories have been well defined by finance and accounting professionals for many decades, if not centuries (e.g. FASB, etc.).
Which assets are easy to tokenize?
Any asset that exists in (natively) digital form.
Which assets exist in natively digital form?
- Financial assets: They are natively digital. They consist of one or more financial contract(s), i.e. of pure numbers (digits) and mathematical definitions of payment obligations.
- Many intangible assets: Consider for example chemical formulae, digital art, graphics, music, video, text, etc. If an intangible asset does not exist in digital form, it may be digitized and then tokenized.
Which assets are difficult to tokenize?
Tangible assets: A secure, observable, verifiable, and (legally) enforceable connection between the tangible asset and the digital token representing a tangible asset must be established. In order for the token representing a tangible asset to be used as collateral in financial transactions, a significant level of certainty must be achieved. A number of technology solutions together with blockchains with their function as an assurance layer thanks to immutability, have the potential to drive down costs for creating a secure, verifiable and enforceable connection to a physical object (tangible asset).
Why is tokenization of assets so important?
Because tokenization will allow for easy and efficient collateralization of many more financial assets, tangible assets and intangible assets. It will also allow for the creation of more assets and significantly expand the asset base of individuals, firms and the world, which can be used in financing transactions. Tokenization will make significantly more intangible and tangible assets bankable and financeable.
Financial Assets are by nature digital. In order for tokenization of financial assets to truly deliver on the promise of blockchain technology in finance, finance must first understand that financial contracts are the basis of finance and that they can and must be standardized at the lowest granular level, i.e. the cash flow level.
How will tokenization drive credit expansion?
Easier collateralization will drive the extension of credit to many more actors of economic transactions. Expansion of credit to individuals, firms, and governments which currently have only limited or no access to credit will drive economic growth on a scale currently unimaginable.
What is Finance?
The exchange of cash flows over time by two or more parties based on a financial contract.
Let’s review some definitions:
- Payment = exchange of cash or cash equivalents, now. Payments are at the fringes of finance at best
- Finance = exchange of cash over time by parties according to a financial contract
- Financial Contract = the agreement of two or more parties to exchange cash flows over time, i.e. the financial contract is defining the payment obligations of the parties
Everything of interest in finance is derived from Cash Flows.
Link: Future of Finance with or without blockchain https://medium.com/p/787586e0fd0a
What is a financial contract?
Financial Contract = the agreement of two or more parties to exchange cash flows over time, i.e. the financial contract is defining the payment obligations of the parties.
Link: Introduction to Financial Contracts: https://www.nasdaq.com/articles/smart-financial-contracts-should-be-basis-for-innovation-of-financial-systems
What is a financial asset?
Deposits, stocks, bonds, notes, currencies, and other instruments that possess value and give rise to claims, liabilities, or equity investment. Financial Assets typically consist of one or more financial contracts defining the payment obligations of one or more parties to the financial contract.
What (investment) bankers must understand about tokenization of financial assets.
See “Why is tokenization of financial assets is important”.
Why is tokenization of financial assets important?
Tokenization of financial assets will result in the following dramatic step changes in Finance:
- Significantly more financial assets can be issued
- Financial assets, which previously could not be securitized, can be securitized
- Massive expansion of all kinds of Asset Backed Securities
- Financial Assets can be securitized at higher risk adjusted yields
- Granular portfolio construction based on any risk/return profile; i.e. portfolio of one
- Firm wide risk management and systemic risk management will be possible again (cf “What is a Smart Financial Contract”?)
Financial Assets are by nature digital. In order for tokenization of financial assets to truly deliver on the promise of blockchain technology in finance, finance must first understand that financial contracts are the basis of finance and that they must be standardized at the lowest granular level, i.e. the cash flow level.
What are the current use cases in Financial Asset tokenization implemented on scale?
- Cash and Cash Equivalents are tokenized on scale. The attractiveness for this use case is the simplicity of the underlying instrument: Cash or cash equivalents (e.g. Cash on a bank account, money market funds or U.S. Treasuries, deposits on a bank account at a bank). Once tokenized, collateralization in Repo contracts or netting operations can significantly be simplified, as they are executed on distributed, but shared ledgers. Also, the underlying asset (i.e. cash, money market fund, U.S. Treasury) itself is easily understood by many market participants.
- Fund tokenization. This is an administrative efficiency and process improvement play. It appears that some of the largest players in banking, asset management, and private equity like reliably shared ledgers a lot. They appear to be intent to run substantial amounts of their future infrastructure based on the inherent operational value distributed shared ledger technology holds.
Why are dumb tokens the biggest threat to the financial system?
The current state of tokenization of debt, structured instruments and derivatives is abysmal. This is a problem, as these asset classes are much larger than cash.
First, many players simply store a reference to the PDF of the term sheet or prospectus in the token and call this a Bond token. The level of innovation here is underwhelming, basically zero. And the token itself is quite dumb (let’s call a spade a spade: stupid).
Second, even worse, some players try to code certain aspects of the underlying instrument into the code of tokens. However, more often than not, only the asset side is represented. Any Finance 1.0 class however teaches that every financial asset has to have an asset and liability side.
Therefore, these tokens are not only dumb, they are also violating basic rules of finance. Not a good basis for innovation.
Link: Current Problems in Tokenization: https://www.globalinvestorgroup.com/articles/3698016/blockchain-and-the-future-of-the-capital-markets
Link: How to avoid Disaster in Tokenization: https://www.youtube.com/watch?v=nMmxZYBf0Vg
Why is tokenization of financial assets headed for disaster?
Because only dumb tokens and tokens which violate the first principles of finance are currently created.
Link: Current Problems in Tokenization: https://www.globalinvestorgroup.com/articles/3698016/blockchain-and-the-future-of-the-capital-markets
Link: How to avoid Disaster in Tokenization: https://www.youtube.com/watch?v=nMmxZYBf0Vg
What is a precondition for tokenization of debt, structured instruments and derivatives?
The key precondition for successful tokenization of financial assets is the true and native digitization of the financial asset itself. As any financial asset consists of one or multiple financial contracts. The financial contract itself must be digitized in the form of
1) data model AND
2) mathematical (algorithmic) functions which calculate the cash flow stream(s).
In other words, the term sheet defining the financial contract must be machine readable, machine executable and, most importantly, standardized, based on an open source financial standard, the ACTUS Financial Standard.
What is the most important aspect of a tokenized financial asset representing debt, structured instruments and derivatives?
The definition of the cash flows. Everything of interest in finance is derived from cash flows.
In other words, the payment obligations of the parties to the underlying financial contract must be clearly defined BEFORE tokenization of the financial asset occurs. Without such definitions, only dumb or incomplete tokens will be created.
Cash flows over time are calculated based on term sheets which include the explicit definitions of the calculations related to cash flows.
Thus, the language of finance is mathematics. There is no need for a domain specific language when tokenizing financial assets.
Tokenization of debt, structured instruments and derivatives requires Smart Financial Contracts.
What is a Smart Financial Contract?
A smart financial contract requires two ingredients: Real Finance in the form of ACTUS and Blockchain enabled verification and enforcement;
Start with Real Finance: ACTUS based machine readable, machine executable Term Sheet
ADD
The unique properties of blockchain: Observability, Verifiability, Enforceability, Privacy
=
Smart Financial Contract
A programming language is a necessary, but not sufficient condition for a smart contract. The conditions described by Nick Szabo for a piece of software to be a smart contract must also be met.
For a SMART FINANCIAL CONTRACT, the payment obligations of the parties, i.e. the cash flows must also be deterministically defined and the logic and the state of the financial contract must be available in the token, i.e. the definition of the asset side and the liability side.
The observability and verifiability enables enforceability.
Privacy (privity in the words of Nick Szabo) in traditional financial system environments is achieved by permissioned environments and calculations in Trusted Execution Environments. In public and hybrid blockchain environments, privacy will be achieved by Zero Knowledge Proofs and calculations executed in Zero Knowledge Virtual Machines.
Link: Introduction to Financial Contracts: https://www.nasdaq.com/articles/smart-financial-contracts-should-be-basis-for-innovation-of-financial-systems
Link: The Future of Finance with or without Blockchain: https://medium.com/p/787586e0fd0a
What programming language is best for tokenized financial contracts?
First, financial contracts must be defined with a proper data model and mathematical transition function to define the calculations of the cash flow streams. The definitions of such financial contracts are available from the open source financial standard ACTUS, including reference implementations in programming languages.
Second, Cash flows over time are then calculated based on term sheets with mathematics (algorithms).
The language of finance is math.
No domain specific language is needed in finance, also not for tokenizing financial assets. Domain specific languages increase the risk in the financial system in numerous ways (lack of expertise, scarcity of engineering resources, lack of testing environments, non-turing complete languages, etc.)
Link: ACTUS, the financial contract standard: https://www.actusfrf.org/
Is a tokenized financial asset more liquid than a non-tokenized financial asset?
Maybe. Many actors claim that the lack of secondary markets for tokenized financial assets is the cause for the lack of liquidity.
However, liquidity is still about finance, i.e. the cash flow streams related to the underlying asset. Therefore, if the underlying financial asset which is tokenized is not attractive for investors, then it makes no difference if the asset is tokenized or not. This will be the case regardless of the depth and breadth of trading venues.
Of course, the assumption is that the new blockchain based rails, trading venues, settlement infrastructure, etc. will be much more efficient than today’s systems. Which implies more efficiencies and hence more liquidity of a given financial asset.
However, I would argue that the inherent features of blockchains/DLT such as perfect collateralization thanks to private keys, atomic settlement, etc. are NOT enough to bring about a fundamental improvement in capital market efficiency (see “Delivery vs. Payment”).
How will tokenization of financial assets with smart financial contracts change the value chain in finance?
The role of every actor in the financial system will be challenged. Tokenized Financial Assets with Standardized Smart Financial Contracts will provide a granular, transparent machine readable and executable understanding of the financial asset itself. The impact of such objects and information on the business models of all actors in the financial services industry will be profound.
Issuers will become extremely important.
The role of bankers (in the sense of JP Morgan, Alfred Escher, Brown Brothers, etc.) and analysts will be greatly enhanced.
Providers of financial information will be challenged.
Trading venues, custodians, lawyers, and other functions will, in large parts, face complete and utter commoditization.
Commercial Banks and Investment Banks will dramatically slash IT expenses and reduce complexity. These banks will be full of bankers again, rather than overpaid IT system administrators.
How will tokenized financial assets with smart financial contracts enable capital markets?
Tokenized financial assets based on smart financial contracts based on the open source ACTUS Financial Standard will significantly change two critical areas of capital markets:
- Price discovery: With near real time position data, AND the standardized machine readable and machine executable understanding of the cash flows of the underlying asset, analysts and capital providers of all kinds will be able to make investment decisions with much higher fidelity, granularity and sophistication on the modeling side.
- Post-trade automation: Due to the algorithmic nature and deterministic definitions of all aspects of the financial contracts, true and reliable automation in post-trade environments will be possible. Adding zero knowledge proofs and zero knowledge virtual machines to the mix here, will result in today unimaginable efficiencies and innovation in business models in finance.
How will tokenization of financial assets impact private equity players and asset managers?
I predict that large multinational asset managers will basically eliminate the current large private debt business of private equity firms. There is NO reason why investors should continue to finance the palaces of and the rich compensation at private equity firms to manage large private debt portfolios. Franklin Templeton, Fidelity and other asset managers are already building a much more efficient tokenization infrastructure which will be so competitive that large institutional investors will not be able to justify the high costs of private equity firms when deploying capital to asset managers in private debt. Private equity firms will be forced to go back to the original business model: Identify value in firms and make them more valuable over long periods of time.
Once the financial industry understands the ACTUS Financial Standard and the (magic) powers that innovative financial firms suddenly have, many overhead costs will be dramatically reduced and many more innovative financial products will be marketed.
Also, the office parks in Luxembourg will be empty in 10 years time. Asset servicing, executing corporate actions, etc. will be the task of a few lonely servers and distributed applications.
How will tokenization of financial assets change financial regulation?
It could not be said better than by a regulator in charge during the financial crisis (see links).
Also, financial firms, which are regulated, will be sharing near-real time position data and financial contract data through APIs with regulators, eliminating billions of expenses for expensive internal and external regulation staff and consultants.
For the first time, systemic risk assessments are possible on scale with a high degree of automation.
Link: The Future of Blockchain and Regulation: https://youtu.be/PcpLK-DIXEo
Link: Looming Revolution in Regulation: http://www.brammertz-consulting.ch/wp-content/uploads/2022/06/THE-LOOMING-DIGITAL-REVOLUTION-IN-FINANCIAL-REGULATION.pdf
Link: Silicon Valley Bank Failure Reconstruction — What a Regulator could have seen with ACTUS: https://youtu.be/1OxFWdxF0LE?feature=shared
How will Delivery vs. Payment change with tokenized financial assets?
Many actors correctly argue that settlements where both the Asset/Security to be Delivered and the (cash) Payment are on-chain, will be much more efficient. There is a lot of experimentation going on between banks, regulators, central banks, and cross-border settlement providers. Awesome to hear that the new plumbing seems to be working!
However, the crisis in 2008 was not caused by problems with the plumbing. The actors in 2008 could not trust what was on the balance sheets of their counterparties. Why? Because they were unable to determine on scale and with some kind of degree of automation what exactly the cash flows (past and future obligations) of the underlying assets were.
Hence, just making the plumbing more efficient and introducing atomic settlements will simply not solve that what is Delivered and what is used for Payment must be well understood, in a standardized, machine readable, machine executable format with certainty on the state of the financial contract, i.e. the cash flows.
Absent this understanding and the exclusion of cash flow logic in the tokens which travel in this new plumbing and on these new rails, the full promise of blockchain/DLT based systems in finance will remain unfulfilled.
[Note: Tokenized cash and cash equivalents has already proven its value — see “use cases”]
Why is reconciliation such a big problem in finance?
Because the financial industry, large parts of academia, and most regulators have not yet understood that the central building block of finance is the deterministic financial contract.
Why? Because in the 1960s when computers were introduced in banks they entered through the accounting function, ensuring that credit and debit was balanced at the end of a period, instead of starting at origins where liquidity and value are derived from: Cash Flows.
Financial intermediaries continue to work on standardization of data models, with little success. Why? Because everyone has a different opinion on a standard, but more importantly, a data model alone is not sufficient for the determination of cash flows over time (i.e. finance as defined above, everything of interest in finance is derived from cash flows).
A TRANSITION FUNCTION, i.e. the pattern of the cash flows and the respective calculation also must be included and standardized.
So, many functions inside financial firms recreate cash flows for the same financial assets that live on their balance sheets. There is rarely a single source of truth on the data model and especially the calculations (algorithms) of Cash Flows of financial instruments in the disparate systems environments, enhanced by excel sheets and proprietary calculation engines mushrooming in financial firms everywhere.
In other words, the calculations by different functions will invariably produce different results, making reconciliation a time consuming, brute force effort.
It does not help that data warehouses and similar infrastructure in financial firms record values, but not the logic of how these values were calculated.
Link: ACTUS Standard on Wikipedia: https://en.wikipedia.org/wiki/Algorithmic_Contract_Types_Unified_Standards
Link: SVB Failure Reconstruction — What a Regulator could have seen with ACTUS: https://youtu.be/1OxFWdxF0LE?feature=shared
How will tokenized financial assets solve the reconciliation problem?
Because tokenized financial assets based on the ACTUS financial standard will contain both the state of the financial contract (i.e. what has been paid how by whom), and the logic of the future cash flows in a standardized machine readable data model and algorithmic definitions, any actor with rights to accessing the information of the tokenized financial asset has the same, indisputable basis for calculation.
It is important to note that the VALUE of a cash flow in the future will depend on each actor’s assessment of input/risk factors. However, each actor looking at a given tokenized financial asset will arrive at the same calculation results with identical input values.
What is the open source ACTUS Financial Standard?
Algorithmic Contract Types Unified Standards, abbreviated to ACTUS, are a set of royalty-free, open standards for representing financial contracts. The standards combine (1) a concise data dictionary that defines the contractual terms present in financial contracts with (2) a simple but complete taxonomy of fundamental algorithmic contract type patterns that incorporate elements from that data dictionary that apply to a given contract type such that (3) the cash flow obligations that are established by the contract can be accurately projected, analyzed and acknowledged by all parties to the contract over the life of the contract.
Link: ACTUS Foundation: https://www.actusfrf.org/
Link: ACTUS on Wikipedia: https://en.wikipedia.org/wiki/Algorithmic_Contract_Types_Unified_Standards
What is a smart contract?
What is generally called a smart contract, is neither smart nor a contract. It is helpful to refer to the definition of Nick Szabo, who defined what a smart contract is. Unless your piece of software meets the definitions established by Nick Szabo, it is most likely not a smart contract and in the words of Vitalik Buterin “a script” or similar type of code.
Link: Nick Szabo on Smart Contracts, 1996: http://www.alamut.com/subj/economics/nick_szabo/smartContracts.html
How will tokenization of financial assets impact securitization?
Expansion of credit will result in more securitization.
Blockchain and Distributed Ledger Technology will serve as an assurance layer, allowing for many more assets to be used as collateral in tokenized form.
Securitization based on Smart Financial Contracts will be highly automated and allow for near real time, high fidelity, analytics and risk management on a granular and any aggregation level.
A very large percentage of the busy work of analysts will disappear, enabling financial firms to use talented resources to drive innovation in finance like never before.
In other words, the universe of financial assets which can be securitized will grow dramatically.
Link: Solving the Credit Gap: https://medium.com/@RRKUBLI/solving-the-sme-credit-gap-what-needs-to-change-to-drive-growth-2da04216e678
Who will be driving tokenization of assets on balance sheets?
CFOs of large non-financial firms.
First, CFOs of large non-financial firms will demand that any netting operations and as many counterparty payments as possible will be based on the efficiency of ultra low cost tokenized deposits moving around in closed or interoperable DLT systems within banks or between banks, including cross border operations.
Second, CFOs of large non-financial firms will understand that they can immediately expand the use of tokenized intangible assets, such as IP and others, in financing. They will recognize the dramatic expansion of bankable assets they can generate by tokenizing, i.e. reliably represent tangible assets, intangible assets, and financial assets to investors which are owned by the firm to be used as collateral for financing.
They will demand that banks and non-bank custodians provide infrastructure for creating and depositing tokens representing digitally native assets which already exist on their balance sheet in tokenized form, in order for these tokens to be used as collateral in financing transactions. Those investment banks which will provide the most efficient securitization vehicles and expertise in structuring of such asset pools will dramatically expand business and margins.
Third, large non-financial multinationals do have significant financial operations already. Should banks and financial intermediaries hesitate to meet the needs of their clients, they will simply go ahead and build those infrastructures themselves, possibly jointly in collaboration with other large industrial firms, locating substantial operations and capital in tokenization friendly jurisdictions, bypassing banks and non-bank financial intermediaries.
Looking for precedents in financial services? Consider what the origin of the largest leasing firms in the world is.
Link: [Article on balance sheet optimization for non-financial firms with tokenization forthcoming]
How can interoperability of tokenized financial assets be achieved?
It is important to distinguish between the financial asset itself and the rails on which the financial assets travel.
First: Financial assets must be understood based on the the lowest common denominator: Thegranular understanding of cash flows, i.e. the payment obligations of the parties to the financial contract in machine readable and machine executable form. It is really about Financial Asset Interoperability, i.e. the common and indisputable understanding of the payment obligations, i.e. the cash flow.
Second: Near Real Time Position Data, i.e. the current and actual state of the financial contract must be known. This means that it must be clearly understood what the cash flows were in the past, and what the agreed upon cash flows going forward are. Finance is only another state machine.
Third: Rails, which are standardized and can move digital items back and forth in a secure manner, are also important, but not as important as the machine readable, machine executable definition of the cash flow streams, and the reliable current state data of the financial contract. Secure and efficient rails have been built and the plumbing of Capital Markets is surprisingly efficient, even though built on top of technology dating back decades.
Without machine readable and executable, deterministic definitions of the cash flows of the financial contract(s) which make up the tokenized financial asset, I predict there will not be any meaningful adoption of blockchain/DLT based infrastructures for debt, structured instruments and derivatives. Without the logic of ACTUS, the new systems would just be a bad copy of the existing infrastructure, with little to no increased value when compared to existing infrastructures.
Link: Current Problems in Tokenization: https://www.globalinvestorgroup.com/articles/3698016/blockchain-and-the-future-of-the-capital-markets
Which standards will drive tokenized financial assets?
ACTUS Financial Standard: For defining the payment obligations and cash flow patterns in a deterministic way.
Custody standards: For defining what secure and best practice standards are.
Token standards: For defining who can access certain functions how, when, where, etc.
Regulation: The usual, who can be a depositary, who can be a dealer, what is an MTF, etc.
No one can build a car without respecting the engineering standards set by DIN, ISO, ASTM, JASO, SAE, etc. It seems somewhat crazy that in finance, a truly global and digital industry, no algorithmic standard defining the payment obligations of parties has been adopted.
How else can we create and rely on the enforceability of financial contracts?
Is a tokenized financial asset a regulated security?
That is possible. I am referring to the principle application of the definition of what is underlying the token. A bond is a bond is a bond. Whether the bond exists in the form of a handshake agreement, on a piece of paper, in an excel spreadsheet, a core banking system or on a blockchain in the form of a token. So the nature of the financial instrument simply does not change based on whether it lives on a babylonian tablet, a piece of paper, in a core banking system or on-chain.
Therefore, the ideal scenario is for regulators to realize that tokenized financial assets are still financial assets, and that looking at the underlying characteristics of the instruments being tokenized, allows them to determine whether these are to be classified as a regulated security, financial instrument, etc.
In some jurisdictions, debt issued by a company itself is not a regulated activity. Why should a new electronic form of issuance suddenly be a regulated activity?
What is a digital security?
The term digital security is gaining in popularity, as the UK Treasury has started a process for a Financial Market Infrastructure Sandbox, generally referred to as Digital Securities Sandbox (DSS).
The definition appears to imply that any financial instrument, defined as a security by UK Regulators, which will be represented in digital form in this sandbox, is defined as a digital security.
Link: https://www.gov.uk/government/consultations/consultation-on-the-digital-securities-sandbox
How will tokenized financial assets change the mid-office and back-office?
The promise of efficiency and cost savings in mid- and back-office operations will remain elusive, if the financial assets are not defined at the outset and at genesis with a standardized data model AND an algorithmic transition function, as available with the open source algorithmic financial standard ACTUS.
The promise of post-trade automation by new blockchain/DLT infrastructures can only be fulfilled if as much of the underlying financial assets, including the financial contract, corporate actions, etc. are natively digitally available and machine readable, machine executable and standardized.
For the financial contract, the work has been done by the ACTUS Foundation. Payment obligations and especially the current state, i.e. what payments have occurred by whom, how, when, must be available in machine readable form by way of smart financial contracts that encode not only the information about the tokenized financial asset, but also clearly define all payment obligations of the parties to the financial contract, i.e. actual and future cash flows and as a result define the asset and liability side.
For cash on-chain enabling atomic settlements, a lot of experimentation, projects and tests have been done.
In short, unless we can more efficiently, with higher fidelity and more granularity, understand what is being Delivered (a security/financial asset) and with what this Delivery is being Paid (cash, a security/financial asset) the system will not be the step change that we all hope for.
Future innovation around zero knowledge proofs and zero knowledge virtual machines, will enable book building, issuance, distribution, and automation on a completely new level of documentation, fidelity, reliability, security and anonymity (where required).
Link: Current Problems in Tokenization: https://www.globalinvestorgroup.com/articles/3698016/blockchain-and-the-future-of-the-capital-markets
Link: How to avoid Disaster in Tokenization: https://www.youtube.com/watch?v=nMmxZYBf0Vg
Link: The Future of Finance with or without Blockchain: https://medium.com/p/787586e0fd0a
How will tokenized financial assets change the front-office?
Tokenized financial assets will allow for portfolio construction of one. These new environments will allow financial intermediaries to offer the kind of sophisticated risk/return portfolio construction available to High Net Worth Individuals and institutional investors to any investor client of any size.
This ability will be supported by the massive cost reduction due to the highly automated, high fidelity, and granular understanding of all financial assets consistently constructed based on the ACTUS financial standard.
In addition, many more financial assets will be securitized with a high degree of automation at very low cost, increasing the options for the front office to meet any given client’s needs.
What is a Real World Asset?
Who knows! For sure, whatever you now elaborately want to describe in your answer to this post can be classified as a Financial Asset, Tangible Asset, or Intangible Asset. So why invent another term.
What is a bond?
A financial asset. A bond. A financial contract defining the payment obligations of the parties with a certain cash flow pattern. Financial contracts are the basis of finance as they granularly define the obligations of all parties to the exchange of cash flows.
What is a tokenized bond?
A financial asset. A bond on a blockchain. A financial contract defining the payment obligations of the parties with a certain cash flow pattern living on a blockchain.
What do USDC, JPM Coin, FOBXX, EURC, DCHF have in common?
They appear to be tokenized cash or cash equivalent.
What is a computer game asset (like a shield, or skin)?
An intangible asset living inside a computer game.
What is a tokenized computer game asset (like a shield, or skin)?
An intangible asset on a blockchain.
What is a collectible baseball card?
A tangible asset.
What is a tokenized baseball card?
A token representing a tangible asset.
What is a bored ape?
An intangible asset. Certain financial regulators may have a different opinion and compare it with orange groves.
What is a chemical formula?
Intellectual property. IP.
What is tokenized Intellectual Property (IP)?
Cryptographically secured ownership of IP, for example a chemical formula, in the form of a token.
Link: IPwe — Tokenization of IP: https://ipwe.com/
What is tokenized real estate?
Who knows. Do you? You mean a house I can live in on the blockchain?? If that’s what you mean, please explain.
If that is not the case, most likely and typically, tokenized real estate refers to tokenized equity of a Special Purpose Vehicle (SPV) which holds ownership in real estate in some legally enforceable form. So, please, there is no tokenized real estate. And if you talk about tokenizing equity of an SPV holding real estate, then please say what it is, tokenized equity of an SPV holding real estate.
What is tokenized equity?
A form of tokenization of a financial asset.
Lawyers like tokenized equity as it allows for certainty of its existence and whereabouts.
Some financial actors have started to use tokenized equity of companies as collateral in proof of concepts of new DLT rails.
What is Decentralized Finance or DeFi?
I would argue that the only difference between traditional finance and decentralized finance, is the nature of the counterparty. A protocol or piece of software for example, instead of a centralized institution. However, Finance remains finance, regardless if it happened/happens in the middle ages, on paper, with a verbal agreement or on a blockchain.
Now, then the question is, what is Decentralized Finance? Well, one could argue that much of finance is already run by decentralized platforms. Many exchanges in the world are run by members, with equal rights, under certain binding charters. That sounds quite decentralized to me. And those structures are probably more decentralized than many of the DAOs which govern certain financial applications on public blockchains.
What use cases exist in on-chain Decentralized Finance?
Overcollateralized lending. Happy to learn about others, but I have yet to see any other instrument other than over-collateralized lending. And since there is no such lending happening in the rest of finance, it is, unfortunately, irrelevant.
What is a token in the context of tokenization?
The ultimate bearer instrument. Whoever holds the private key, controls the token. This functionality makes it ideal for collateralization.
Think of this as a cryptographically secured piece of code on a blockchain or distributed ledger, which may contain a reference to other objects, for example a certificate of ownership, a document in another database, or reference to another piece of software. This ownership may or may not be legally enforceable (e.g. financial obligation of another party in the form of a bond, equity, an entry in a land registry database, or Intellectual Property like a chemical formula, a patent).
A token may also represent certain rights and functions on the blockchain itself (e.g BTC, ETH).
LINKS TO RESOURCES:
The current problems in Tokenization and the Future of Capital Markets: https://www.globalinvestorgroup.com/articles/3698016/blockchain-and-the-future-of-the-capital-markets
Introduction to Financial Contracts: https://www.nasdaq.com/articles/smart-financial-contracts-should-be-basis-for-innovation-of-financial-systems
Silicon Valley Bank Failure Reconstruction — What a Regulator could have seen with ACTUS: https://youtu.be/1OxFWdxF0LE?feature=shared
How to avoid Disaster in Tokenization: https://www.youtube.com/watch?v=nMmxZYBf0Vg
Oliver Wyman report on the Future of Money: https://www.oliverwymanforum.com/future-of-money/2023/nov/inside-the-competition-for-big-money.html
McKinsey Report on Tokenization and Finance: https://www.mckinsey.com/industries/financial-services/our-insights/tokenization-a-digital-asset-deja-vu
Closing the Credit Gap: What Banks, governments and fintechs do not understand: https://medium.com/@RRKUBLI/solving-the-sme-credit-gap-what-needs-to-change-to-drive-growth-2da04216e678
Looming revolution in Regulation with ACTUS: http://www.brammertz-consulting.ch/wp-content/uploads/2022/06/THE-LOOMING-DIGITAL-REVOLUTION-IN-FINANCIAL-REGULATION.pdf
Link to video explanation of Actusfrf.org: https://clipchamp.com/watch/8Aposaw90dQ
Link to the Financial Standard ACTUS: https://www.actusfrf.org/
Video summary of the future of regulation and blockchain — Allan Mendelowitz: https://youtu.be/PcpLK-DIXEo
Video on the leasing use case with Nucleus Finance: https://www.youtube.com/watch?v=33SHj9_CPAs
Academic Presentation on Financial Asset Tokenization: https://www.blockchain.uzh.ch/events/industry-talk-actussmart-financial-contracts-the-future-of-capital-markets/
