The tokenization of assets uses blockchain technology to securitize assets, issuing a blockchain token that digitally represents a real, tradable good. The issued "security tokens" are created through a type of initial coin offering — or in this case — security token offering (STO). These can represent regulated financial instruments (equities, bonds, loans, and funds), tangible assets (real estate, artworks, precious metals), or intellectual property.
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The benefits of tokenization include increased liquidity, faster settlement, lower costs, and bolster risk management. Even private securities or illiquid assets such as fine art can be tokenized and traded on the secondary market, opening the doors to a larger audience of investors. Moreover, thanks to their high divisibility, investors can purchase tokens representing only a tiny percentage of the asset.
With a global market size expected to grow from $1.9 bn. in 2020 to $4.8 bn. by 2025 (19.5% CAGR), and driven by new and upcoming regulations, the demand for contactless payments and cloud-based tokenization is experiencing a rapid upsurge.
KYC crypto compliance and other considerations of financial institutions
Business model: Financial institutions must pick their side in the value chain. They might advise issuers on how to structure their token or act as safe-keepers of the tokenized asset (art, real estate property, luxury vintage car, etc.). They could also leverage their expertise as custodian banks or paying agents, creating life cycle event transactions on the distributed ledger or, in a more advanced model, implementing life cycle processing in smart contracts and deploying them on public blockchain platforms.
At the other end of the value chain, they could offer services to maintain customer accounts in cryptocurrencies and tokens or act as central distributors facilitating their clients' access to different channels. Be sure to take a look at the video below for a deeper dive into building out crypto products and shifting existing business models to accommodate for the integration of cryptocurrencies.
Platform integration: Financial Institutions will implement different operating models depending on the business model they embrace. Since the blockchain is one of the latter's main components, it will be vital to correctly select which platforms to partner with. The choice will depend on local regulations, product or service type, and other platform-related factors, such as product strategy or user community potential. Institutions need to consider an infrastructure that will provide technical and economical solutions to their business model while also considering the effect it will have on downstream systems. If the new platform cannot integrate with legacy systems, institutions may face a partial re-platforming of their information system.
Cybersecurity: Digital payments, which reached US$8.49 trn. in 2021, were not the only ones to grow exponentially: the same can be said about the number of cyberattacks and security breaches, which accounted for billions of dollars in damages in the last few months only.
While the distributed ledgers implement a high degree of cybersecurity measures at their core, thanks to cryptology and consensus among multiple nodes, the whole ecosystem still presents weak points at its edges that need to be secured appropriately. An extremely relevant issue resides in managing the wallets and corresponding private keys, often protected behind weak security layers or victims of men-in-the-middle attacks. This, though, represents yet another prospect for financial institutions, which may offer storage services for crypto wallets and access codes.
Compliance: MiFID, anti-money laundering (AML), Know Your Customer (KYC), and other regulations are at the center of any financial institution's obligations regarding client service. The token economy will render business interactions more direct, expeditious, and irreversible, and operational measures to comply with regulations will potentially become more upstream, factorized, and standardized. Institutions should not reinvent the wheel but collaborate with new actors, such as tech startups, KYC utilities, or blockchain analytics software vendors, to implement new operational measures and demonstrate compliance with regulators while operating in the digital space.
KYC processes can be realized by specialized utilities, encoded in self-sovereign digital identity, and used by customers when they enter a relationship with a new financial institution. Provided they have consent from the customer; financial institutions will transfer the reference to this identity down the value chain so that other institutions know with whom they are dealing. An example of this can be a crypto-exchange transferring the identity to a bank. This will speed up the onboarding process, reduce the overall cost of KYC compliance, and enable more direct and rapid interactions that are fundamental to the token economy. (E.g., Norbloc)
Taxation: Financial institutions responsible for processing some taxes must adapt their information systems and processes to compute and deduct specific tax schemes. Part of that processing might be encoded in a smart contract and automated, and as long as the tax authorities do not accept payment of tax in cryptocurrencies, financial institutions will remain in the taxation ecosystems.
Jurisdiction: With legislative and regulatory frameworks differing from jurisdiction to jurisdiction, financial institutions must ensure tokens remain compliant in both issuer's and investor's (e.g., a Canadian seller and a Japanese buyer). This is especially true for institutions that operate on a global scale and will represent one of the most complex obstacles to overcome.
Opportunities in the asset tokenization space
Greater liquidity: The tokenization of private securities, or typically illiquid assets such as fine art, will allow these to be traded on a secondary market of the issuer's choice. This access to a broader base of traders increases liquidity, allowing more freedom for investors. Due to the "liquidity premium" benefits, sellers can capture greater value from the underlying asset.
Faster and cheaper transactions: Since transactions of tokens are completed with smart contracts (software algorithms integrated into a blockchain with trigger actions based on predefined parameters), exchange processes can be partly automated. This automation can reduce the administrative burden involved in buying and selling by reducing the number of intermediaries needed and lowering transaction fees. This will consequently lead to faster and cheaper deal execution.
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Higher transparency: A security token can have the token holder's rights and legal responsibilities embedded directly, along with an immutable record of ownership. These characteristics promise to add transparency to transactions, allowing users to know with whom they are dealing, their ownership rights, and who has previously owned the token.
Improved accessibility: Tokenization could open asset investments to a much wider audience by reducing the minimum commitments in terms of monetary and time amounts. As tokens are highly divisible, investors can purchase minimal percentages of the underlying assets. This will further reduce costs and increase transaction speed.
KYC crypto challenges of using tokens for assets
Regulations: One of the main issues revolves around regulatory alignment, especially since blockchain-based platforms are de facto decentralized. Security regulations are typically technology agnostic. This means that security tokens, depending on their exact features, can fall under the total or partial scope of relevant security regulations, varying significantly from jurisdiction to jurisdiction. This is true for the creation and initial sale of tokens and secondary markets trading operations.
The advantages of tokenization are undermined if regulations prevent the free and international exchange of security tokens.
Consequently, many of the advantages of tokenization are undermined if regulations prevent the free and international exchange of security tokens. Compliant token creation and exchange methods are necessary for a domestic and, ideally, global scope. International regulatory alignment is an unlikely milestone soon, but adding clarity to the regulatory environment for security tokens and facilitating compliant involvement will be crucial for the market's future.
Additionally, regulations specific to tokens or, at the minimum, clear guidance from regulators would be welcome since there is currently a general feeling of uncertainty about how security tokens should be considered within the law.
While it may seem counterintuitive to encourage regulation of technology with decentralization and independence as some of its core characteristics, it is vital to consider the risks of not providing a legal and safe framework in which the technology can thrive: lack of scrutiny can allow fraud and open the door to security breaches. These phenomena are, unfortunately, hard to miss in the sector's latest news headlines.
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Linkage to real assets and governance: The way tokens will remain linked to the tangible asset they represent is still a point of concern: It is interesting to think what would happen to a token representing a small fraction of 100 gold bars at a bank, if these get stolen, as the value of tokens is significantly undermined if they cannot be proven to be linked to real-world assets.
Another point of consideration is the issue of governance. If the ownership of an asset, such as a building, is split among thousands of people, there is little-to-no incentive for owners to bear the costs associated with it, such as maintenance rent collection.
What does the future of asset tokenization look like?
While new players are tokenizing assets in the market daily, the road to complete adoption still needs to be paved, as uncertainty in rules and a variegated regulatory panorama still represent a considerable obstacle to mass adoption.
Nevertheless, asset tokenization can completely change the industry's competitive landscape, overhauling a system that has known few changes in decades. When common accords on international compliance and regulations are reached, many new, transparent and efficient possibilities will empower everybody to play a part in the future's financial economy.