Banks find intriguing ‘data play’ via tokenization efforts

Tokens, blockchain, bitcoin, ledgers—all are technological and financial table stakes in the tumultuous world of crypto. The crypto realm moves faster and tends to break more things than its traditional finance counterpart, but more and more, its byproducts are bleeding into the latter. Tokenization—the act of digitally representing a security via a token, typically stored on a blockchain—gave rise to an entirely new asset class, and with it, came implications for existing asset classes, data management, and liquidity.

Today, custodian banks, regulators and various industry bodies are exploring the potential of tokenization. What many are finding, though, is a spaghetti of legacy and closed-off technology platforms standing in the way. The result is an integration and infrastructure nightmare. One senior bank executive who did not have permission to speak publicly on the subject says the bank considered creating a subsidiary to custody banking customers’ digital assets, but clients insisted they preferred the institution they already trusted, as well as its credit rating and balance sheet. And so, the burden was and is on the bank to meet clients where they are.

“It’s a big challenge for us to integrate any new technology with our existing legacy technology. And we could have chosen very early on not to do that, to stand up a wholly separate entity to stand up a new technology stack, to do this kind of outside of the bounds of the bank,” says the exec. “That would have made my life so much easier in so many senses. But that’s not what our clients or the market want, and that wasn’t the right thing to do.”

And what some early explorers are finding is that for those that can get their infrastructures in order, there are unique data management opportunities to be realized.

Data play

The most common arguments in favor of digital assets include liquidity and transparency because they increase market participation and, consequently, market data dissemination, according to the Corporate Finance Institute, an online training and education platform for finance and investment professionals. Tokenization also facilitates fractionalization, allowing for better pricing and greater accessibility for retail investors and smaller, lesser-capitalized trading shops.

“We’re taking the most impactful approach to tokenization that will enhance traditional private assets, address pain points we hear from our clients, as well as offer more attractive product offerings for our clients’ end-users through the ability to offer customized investments,” says Katey Neate, COO of digital assets at Bank of New York Mellon, which released a digital asset custody platform to select institutional US clients last year.

She adds that the 240-year-old banking institution is currently looking at the tokenization of assets, such as bonds and funds, and the liquidity and product distribution benefits that tokenizing these types of assets might bring.

The US Securities and Exchange Commission’s Rules on Issuance, Offering Platforms and Custody of Digital Assets, defines digital assets as “a digital token that represents assets such as a debt or equity claim on the issuer”. Virtual assets are defined as “a digital representation of value that can be transferred, digitally traded and can be used for payment or investment purposes,” marking a clear distinction from crypto. A July 2022 report from consultancy PwC identified digital assets as an “emerging trend” in the capital markets, though it also noted increased investor and market risk stemming from this nascent market, including direct exposure to fraud, theft, and cyber attacks, as well as market manipulation, market abuse, and insider trading.

Sometime in the last couple of years, though, the narrative focus around digital assets in the institutional space shifted to tokenization, which is the first stage in the digital asset lifecycle, says Justin Chapman, who leads Northern Trust’s Digital Assets and Financial Markets group.

Aside from the usual benefits espoused by proponents—increased liquidity, enhanced transparency, immutability, the same attributes that harken back to early blockchain zeal—Chapman says the main tokenization use case—which it has applied to fixed-income securities, private equity, and carbon credits thus far—for the organization is a data management one.

With a tokenized asset—such as a bond—relevant data to the asset class and the asset itself can be programmed into the token at issuance, including benchmark data, credit ratings, and ESG scores, Chapman explains.

“You’re actually adding value to the end investor by providing as much data digitally in the form of tokenization up front,” he says. “It actually becomes a data play, rather than an asset class play.”

Northern Trust recently began working with the voluntary carbon market by unveiling a new platform that connects institutional buyers with carbon credit suppliers that are focused on solutions to reduce greenhouse gases, including carbon dioxide. The digital platform allows purchasers to transact tokenized carbon credits directly with project developers and retire these against their carbon footprint.

Because carbon credits are commodities, the firm doesn’t offer custody services for them, but it does offer recordkeeping services. If you have an OTC carbon trade between a project developer and a buyer, Chapman says, the developer can record all the scientific measurements that demonstrate the reduction in carbon dioxide and attach it to a token.

“You’ve got material evidence that can actually demonstrate value and governance by just purchasing an asset class that has been tokenized,” he says.

State Street is following a similar path, but the ability to embed material data into tokens is greenfield as of today. Nitin Gaur, State Street’s global head of digital asset and tech design, notes that there are some standards currently evolving to bring the idea to life, but there are processing implications that go to the very core of how trade settlement is done.

Because tokens have no understanding of their value and are representative of an underlying asset, it’s on the bank to reconcile tokens and their corresponding regulated securities in its book of records. Tokens must be able to be resolved into what they represent, so if a token represents gold, or cash, or a bond, State Street needs the ability to settle it in its respective traditional class. It’s a process that Gaur describes as a “burden”.

But embedding data into a token—a bond’s corresponding Cusip number, for instance—makes a token itself self-descriptive, which in turn makes its processing more aligned with traditional settlement and eliminates the need for parallel systems that have to reconcile and tag tokens and their underliers.

“We need not only to verify and validate the assets; we also need to figure out the value of those assets and translate that token into the value and what it represents,” Gaur says. “That’s where data comes into play; if the token itself has data embedded into it, I don’t have to perform those additional steps—which is something we have to build from an infrastructure perspective. That’s essentially where things stand and what we need to invest into.”

Blocked and chained

Despite the use-cases that have excited these banks, sources concede that structural and design issues in the market can dampen tokenization’s effectiveness—namely blockchain and distributed-ledger technologies, the bogeymen of capital markets technology. Despite a zealous hype period around blockchain that dominated tech investments between 2015 and 2018, WatersTechnology last year found that many projects and startups that launched in that timespan were either defunct, acquired, or had morphed into a new type of business.

In the end, tokenized assets may follow the same underwhelming road as blockchain—what’s possible isn’t always what is necessary or even desired.

“There are some design decisions that we, as an industry, have got to make and get over in order for full adoption to occur,” says the senior bank executive. “And I’m sure everyone’s used the interoperability argument with you—all of these use-cases existing in isolation is great, but they won’t move on from being a proof-of-concept until you can genuinely create a secondary market.”

Jay Biancamano, head of digital commercialization at State Street, says that on a recent industry panel he participated in, he was asked the question, “Why hasn’t tokenization taken off yet?”

And he says he doesn’t think that anyone doubts that tokenization can eliminate various processes, but the field has been hindered by the fact that one single use-case, or focus, hasn’t emerged as a major incentive to implement it. As a result, disparate experiments and projects in many corners of finance has made blockchain a jack of all trades and a master of none.

Nevertheless, everything is going digital, and the ability of State Street—and, crucially, its clients—to maintain a competitive advantage perhaps lies in following suit and creating the lacking digital infrastructure anyway.

“I think it’s a huge, very unique opportunity. And an opportunity that, quite frankly, I think rests with State Street and our competitors to create that new asset class and to figure out a way to make that more liquid and more useful to our clients,” Biancamano says.