Catalysts and Existing Challenges
Tokenization is a concept that was first introduced in 2001 by TrustCommerce to replace cardholder data with a unique identifier known as a token. Over the past two decades, with the rise of blockchain technology and the token economy, this once siloed use-case has evolved dramatically. With applications spanning nearly every industry, the concept of tokenization and blockchain technology is poised to significantly disrupt the global economy.
In an earlier Medium piece, we explored potential paths to mass adoption of blockchain technology as it relates more broadly to decentralized finance (DeFi). Our intention in this piece is to double-click on tokenization, reflect on the current state of its application and question what it would take for tokenization to assume a key role as part of our financial systems, particularly as it relates to capital markets and investing.
At Anthemis, we are meeting a growing number of entrepreneurs working to build the DeFi ecosystem, and many working specifically on the concept of tokenization. As we explore below, the path to the mass adoption of tokenization in particular still has major obstacles to overcome.
Tokenization is the process through which an underlying asset is digitized and recorded on the blockchain. As is true with the nature of distributed ledger technology, this process is trustless, immutable and completely transparent, reflecting the attractive features of blockchain networks. After an asset is tokenized, that token can be traded without friction peer-to-peer, with each transaction being recorded in the immutable ledger and without any degree of human influence (assuming the token was created on a permissionless network).
In 2015, The World Economic Forum published its report, Technological Tipping Point, a global survey of approximately 800 CEOs who were asked to estimate the timing of 21 major technological shifts, with the adoption of cryptocurrencies and blockchain technology being one of them. The results were staggering, with the forecast that, by 2027, 10 percent of the world’s GDP would be recorded and stored on the blockchain. Furthermore, 58 percent of those surveyed responded that this threshold would be achieved by 2025, now only five years away.
In absolute terms, this would today represent around $8.6 trillion in total assets being digitized on the blockchain, a 300x growth from the current approximately $300 billion crypto market cap. While it is an ambitious target, we are not rejecting the hypothesis outright. Instead, we have spent time considering the catalysts and challenges that need to be understood in order to allow for such exponential growth. These considerations, both catalysts and challenges, are outlined below.
Undoubtedly, there are advantages that could be achieved through tokenization processes though, while these are noted inherent advantages of blockchain technology, they are yet to be proven at an institutional scale.
Removal of intermediaries: As discussed earlier, when an asset is tokenized, it is recorded on the blockchain ledger. This means that it is a completely immutable, auditable and transparent transaction and is, by definition, decentralized. No central authoritative organization is required to validate the transaction; human and machine risks are removed, including errors, frauds and biases.
Further democratization of investing: Fractional ownership is possible through tokenization, with minimum investment amounts and required holding periods seldom imposed. This means that, while more traditional securitization processes can restrict certain investors from participating, tokenization truly is a democratic product.
Market efficiency: Unlike stocks and bonds on existing global exchanges, tokens can be traded 24/7, which means that it is possible to imagine a future where the secondary market will be operating around the clock. This means that time differences and geographies, as well as local market-specific calendar constraints, would not dictate the global trading dynamic anymore. In turn, this means a theoretical approximately 3x extension of the global trading windows, which could lead to a complete redesign of the capital markets and asset management space, where current deal execution and trading desk dynamics are designed around traditional underlying assets, namely stocks and bonds.
Faster and cheaper transactions: As mentioned previously, transactions on the blockchain are executed without intermediaries through smart contracts. This means that there is no administrative burden and no overhead costs through token exchange, with no rent extracted along the way. Transactions are quick and virtually costless. Cheaper operation costs on the sell side, combined with increased disintermediation, most certainly leads to cheaper access (i.e. lower transaction fees), which is beneficial to the buy side. Nonetheless, realization of these benefits does require solutions to some of the issues that blockchain technology faces today, such as scalability concerns leading to high gas fees and network congestion.
More transparency: As is the nature of blockchain technology, all transactions that occur are recorded in the ledger and stored on the blockchain. This means that the process is completely transparent and auditable by all parties. Tracking historical data on an asset then becomes more feasible and reliable.
Despite the catalysts listed above, there are a number of challenges that still exist. Until these obstacles are removed, it is unlikely that we will see a paradigm shift to tokenization as a global economy.
Regulatory and compliance: As is true with the broader securities market, regulatory restrictions for security tokens vary dramatically by jurisdiction. Not only this, but in some cases (the US being a prime example), there is very little precedent to follow in terms of offering a compliant security token. Only recently, through Blockstack’s Reg A+ token offering, was there any precedent at all in the US. In other territories such as Switzerland and Malta, there is clearer guidance, although there is still a long way to go. Issues here involve not only the initial creation and sale of tokens, but also the processes through which they are traded on secondary markets.
Supply and demand: Following the initial coin offering (ICO) boom of late-2017, and subsequent security token offerings (STOs), there is no shortage of supply. It is worth mentioning that, while available, many of these projects offer largely unqualified deal opportunities. In either case, matching supply with demand remains a challenge. This is especially true with larger capital market players, who will not participate unless the supply side matures in size and quality. Based on the current state, especially prior to mass adoption of decentralized finance, the tokenization marketplace will continue to pale in comparison to traditional securities exchanges and will struggle with accurately matching qualified supply and demand.
Investor protection: This will eventually come down to the legislative frameworks designed by regulatory bodies. As mentioned above, one of the major risks investors are exposed to is unqualified deal origination sources. Tokenization, theoretically, allows ‘anyone’ to digitize and sell an asset. As seen during the ICO boom, some investors have lost all or part of their investment to fraudulent organizations and projects. In contrast, not anyone can IPO, set up a regulated investment fund or securitize and sell assets. Beyond the cost considerations that make these traditional operations prohibitive to most, the regulatory frameworks prohibit any bad actors from participating in the system and help to protect investors.
Institutional money: Adoption by institutional investors is still very small, even though approximately20 percent of financial institutions claim having some level of exposure to crypto assets. Beyond the challenges discussed in this section that need to be addressed in order for institutional players to pile in, there is a structural transformation required by the industry — namely moving part of the capital markets infrastructure onto the blockchain.
Blockchain technology: Not to spend a lot of time on the broader issues that exist with blockchain technology but, as tokenization involves what is still a very young technology, the challenges that face blockchain technology also dramatically impact the success of an asset-backed token. Such obstacles include scalability and interoperability challenges, privacy concerns, 51% attacks and security threats, to name just a few.
Connection to the underlying asset: When an asset is securitized, a central authority holds the underlying asset. However, due to the decentralized nature of blockchain technology, theoretically the connection between the token and the underlying asset could be severed without anyone being made aware. Using real estate as an example, let us say that a property is tokenized and ‘home tokens’ are sold. When tokenized, each home token was worth $5,000 (assuming it was a $500,000 property and 100 tokens were distributed). As tokens were sold on the secondary market, they eventually traded at a premium as the property was in a desirable area (or simply due to liquidity premiums). If the house burns down, who is to say that the home token will lose its value, especially due to geographical separation between the underlying asset and the secondary markets, all with no centralized authority overseeing the process.
A potential proxy for tokenization can be found in an analysis of the 1980’s capital markets revolution triggered by asset-backed securities (ABS). ABS emerged in the mid-80s when Sperry Lease Finance created a new type of securitization, one backed by computer equipment leases.
Securitization is the process of pooling similar loans together and selling their cashflows to third party investors as securities — in short, transforming a basket of illiquid assets (i.e. a loan or a receivables) into tradable securities, such as bonds or notes. Catalysts for ABS included lowered risk, added liquidity and improved economic efficiency. Tokenization, looking to become a financial markets revolution of its own, offers many of the same benefits.
The ABS market offered investors a way to diversify their portfolio allocation by gaining exposure to assets which, until then, were impossible to access, including auto loans, credit card debt, equipment leases, student loans, collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs). The ABS market grew to around$2 trillion in 2007, until the sub-prime crisis hit. The market gradually recovered to a figure in the region of $1.6 trillion today. The postmortem analysis of the role of ABS in the 2008 global financial crisis might enlighten us on some of the risks of a token economy, if it were to become a core segment of our capital markets. However, we are still a long way away from tokens presenting a systemic risk to our economies.
Securitization and tokenization do seem to share some similar specificities. In fact, many of their commonalities are what catalyzed asset-backed security (ABS) to become a mainstream asset class. Two main caveats however are that i) securitization was an innovation driven by institutional forces, which can explain the slower growth of asset-backed tokens and token exchanges that have been driven by grassroots DeFi movements, and ii) securitization did not require market participants — buy side and sell side — to go through a technological shift as they were supported on the same capital markets rails as existing stocks and bonds. For tokenization to gain mass adoption, institutional investors will have to move part of their stack onto the blockchain.
Considering these observations, it is clear that, while the asset class has evolved significantly over the past decade, there is still much progress to be made for tokenization to be widely adopted.
The path to mass adoption requires demonstrating in the long run that blockchain technology and tokenization result in superior transaction efficiency; is cheaper compared to traditional modus operandi; and has the ability to scale without breaking. With tokenization in particular, regulatory guardrails and investor protection are also necessary stage gates for mass adoption.
At Anthemis we are interested in continuing to explore this avenue for growth and would welcome dialogue and constructive feedback. Whether you are a builder, investor or just interested, please reach out and share your thoughts around how this new asset class can bridge the void into the established financial system.
Co-written with Marin Cauvas