The Next Blockchain Megatrend: Financial Asset Tokens

Since I will be moderating a panel on Security Tokens at the Paris Fintech Forum tomorrow, I thought it would be a good idea to briefly discuss financial asset tokenisation and mention a few creative use cases. I will also attach some useful links in case you wish to dive deeper into this extremely interesting and relevant topic.

Different Types of Financial Asset Tokens

Tokenisation of a financial asset is the process of issuing a financial asset token on an underlying blockchain/DLT platform that digitally represents that tradable asset. Financial asset tokens can be either Asset Backed Tokens or Native Asset Tokens.

• Asset Backed Tokens represent an underlying asset or obligation held by a custodian and registered on a blockchain for the purposes of ownership tracking and transfer — I think of them as ‘depository receipts’. In other words, these security tokens move from owner to owner on the blockchain platform according to the rules set in their smart contract, while the underlying asset remains at the custodian. Asset-backed tokens will, in my opinion, solve the problem of trading illiquid assets such as real estate, oil, gas, wheat or other commodities.
• Native Asset Tokens are, on the other hand, issued directly on a blockchain platform by participating parties — so, they are entirely dematerialised and not custodied by a third party elsewhere. Here, the security token itself is the asset, for instance a bond or a stock.

To sum up, financial asset tokens are designed to represent or serve as financial instruments and securities. They are programmable and can therefore imitate the economic behavior of the underlying assets. Thus, there is no need for a third party. For example, smart contracts can define trading and governance rules as well as dividend mechanisms — a loan tokenised on a blockchain can automatically make payments without a bank acting as a traditional middleman.

For a more detailed analysis, I sincerely recommend Todd McDonald’s excellent paper titled Digital Assets: Transforming Capital Markets.

Advantages of Tokenisation

Tokenisation addresses some of the most fundamental challenges of the financial markets, namely lack of liquidity, high transactions costs and limited transparency. So, how is this achieved?

As already mentioned above, the blockchain smart contract technology enables financial asset tokens to execute, regulate and govern themselves — thereby increasing the speed of settlement and lowering transaction costs. The technology also allows more liquidity to come into the market by enabling fractional ownership of securities and by lowering minimum investments. On top of that, since they are executed on a blockchain, the transactions are transparent, traceable and immutable. Hence, regulators will be able to drastically reduce their compliance cost.

Security Tokens’ Architecture

We have already established that smart contracts within the financial asset token architecture can define the rules around an agreement in exactly the same way as traditional contracts, and will also automatically enforce the obligations like client KYC/AML compliance, legal compliance requirements, redemption terms and payments, etc.

To understand the concept better it is worth mentioning that, technically speaking, there are two parts of a tokenised security: token register and events manager.

• The token register is a smart contract that creates the financial security on a blockchain.
• The events manager is another smart contract that enables the interaction between the token issuers and holders, and facilitates their transactions.

Of course, different securities will have different types of events. For example, a bond will have events like the bond’s coupon, redemption and default. Please note that more complex instruments will require a larger number of events and amount of information to be managed.

To Tokenise or not to Tokenise?

As you know, Security Token Offerings (STOs) are fully regulated events and broadly classified in two categories: private placements and public offerings. Depending on its complexity, an STO can cost the issuer at least EUR200,000. This number compares favorably to the cost of traditional securitisation and is expected to go down over time.

Native Asset Tokens, as new tokens issued directly on a blockchain platform, are perfectly suited for STOs due to the following two reasons: firstly, the blockchain serves as the book that maintains the ownership register. Think about the benefits to private placements and uncertificated securities, which are currently registered on the issuer’s books only. Secondly, there is a multitude of financial securities laws or exemption requirements in different jurisdictions that securities have to comply with. They can now simply be built into the securities’ smart contracts.

If you are thinking of tokenisation, you might want to check the latest STO legal requirements in France: https://cms.law/en/INT/Expert-Guides/CMS-Expert-Guide-to-Security-Token-Offerings/France. (For other countries, please scroll to the bottom of the page.)

However, before you rush to tokenise, I would urge you to carry out a careful cost benefit analysis of your project in order to find out if it is worth issuing a security token. Ask the following questions: What are the benefits to the issuer, investor and regulator? What are the blockchain’s technological and operational challenges? I would also like to point out that legal structuring should be a very important consideration when developing smart contacts.

Although end-to-end tokenisation solutions are the future of financial markets, the entire security token space is about one year old and still immature. For security tokens to become a viable financial asset class, the following conditions need to be met:

• blockchain platforms need to evolve,
• clear regulations need to be developed,
• international standards need to be established, and
• the whole ecosystem needs to be built — from issuance, to infrastructure, and exchanges.

It will likely take some time for the security token market to fulfill these conditions but there are some early bold moves — check the SIX Digital Exchange (SDX) of Switzerland, a newly launched prototype version of a blockchain digital assets platform. Their aim is to build a fully integrated issuance, trading, settlement and custody infrastructure for digital assets.

The following two use cases, which I hope you will find interesting, are very different: the first one deals with private credit investment products and the second one with collateral swaps in the securities lending market.

Use Case #1: Cadence, Securitisation Platform for Tokenised Structured Debt

Cadence has developed the first digital securitisation platform for private credit investment products from end-to-end by using blockchain technology. The company was also the first to list their digitised assets on the Bloomberg terminal. Its ticker symbol is CDGRP and it carries the smart contract address on Ethereum together with the standard metadata such as interest rate, maturity schedule and instrument type. Check for instance this 90-day structured note yielding 2.5% issued by Cadance on 24 Jan 2019 which successfully raised USD500,000. (Scroll to the bottom of the page for the investment summary and Ethereum contract details.)

By transforming structured private securities into financial asset tokens, Cadence has solved a lot of problems for both investors and originators. The platform has streamlined the whole process of structuring the underlying assets into securities, and made their execution and servicing efficient — thereby greatly reducing the associated frictional costs and ultimately passing on higher yields to investors.

Through the smart contracts all the information like the real-time status of borrowers, underlying assets, external factors, investor allocations, and security characteristics are stored on the ledger and made completely transparent to investors. The platform also offers real time performance data on each and every underlying asset in their structured note offerings.

For more details about their unique selling proposition, check this short interview with Prath Reddy, Director Of Cadence.

Use Case #2: Collateral Swaps in the Securities Lending Market by HQLAx and Deutsche Börse Group

HQLAx went LIVE in December 2019. It is a securities lending platform/marketplace that uses Corda to facilitate efficient and high-speed trading of High-Quality Liquid Assets (HQLA) by enabling tokenised baskets of securities to be instantaneously exchanged through atomic delivery-versus-delivery transactions.

Both trade execution and post-trade processing are supported by Deutsche Börse. It plays a leading role in the custody and post-trade processing layer, which is designed to interoperate with multiple collateral agents and custodians.

Unlike in traditional settlements, there is no actual movement of securities between custody accounts. Instead, the ownership of securities is transferred via the token transfer, while the underlying securities are kept off DLT and remain in the custody location of the collateral giver. This results in more efficient collateral management across siloed collateral systems and locations by significantly reducing the settlement cycle and avoiding resource-intensive collateral movements. The shorter securities settlement cycle and reduced risk of ‘failures-to-deliver’, in turn, offer significant cost savings.

For regulators, the platform provides a ledger of the entire digital history of the transaction, from where it originated to its ownership and attributes.

Commerzbank, Credit Suisse and UBS executed the first transactions. Currently, more than fifteen other institutions are at various stages of onboarding to the platform. They include CIBC, Citi, Goldman Sachs and ING.

HQLAx is planning to develop other features in the future, such as instant delivery-versus-payment (intraday trades), digital collateral record re-use and support for various types of pledges.

What is Your PoV?

Now, it’s over to you:

• From your point of view, is this the right time for tokenisation of public securities and other assets that currently trade on exchanges — taking into account that the market infrastructure is well-developed and there is sufficient liquidity?
• Should we first start tokenising illiquid assets to improve their liquidity?
• Where do you see the biggest business opportunity for the application of tokenisation?
• When do you think that asset tokenisation could take off?