With the Royal Mint project officially being placed into cold storage, arguably one of the most high-profile examples of tokenization, the questions on everyone’s minds point to the value of digitizing traditional assets and whether the market is ready to embrace this technology. If tokenization is the future of trading, why are these projects taking so long to take flight?

When news broke in late October that the Royal Mint would be shelving its digital gold project, blaming “market conditions” in a statement for the decision, it was treated as a major blow to the digital space and showcased the reluctance of EU governments to engage with this largely unregulated territory. Until now, the adoption of tokenized assets has largely been driven by the fintech community, with Wall Street keeping a watchful eye on its activity from a distance, and some showing more reluctance than others. 

“It is was designed to remove central control and apply to an industry that is obsessed with central control, for a good reason,” says a managing director at a global investment bank, who asked not to be named.

Distributed-ledger technology (DLT) in itself has seen significant institutional interest with multiple consortia of heavyweight investment firms developing private networks for sharing transactional data. In some cases, other digital instruments, such as cryptocurrencies and derivatives, have spurred more interest on a wider scale across the industry, one recent example being the launch of Fidelity Digital Assets services for bitcoin and ethereum. 

But now as major firms are directing their attention to crypto as an asset class in itself, some are questioning the value proposition of tokenizing traditional assets in a world where digital representations already exist. 

“I think it is interesting to see that there has been a lot of research and techniques and from a mathematical point of view it is very elegant but ultimately the applications seem to be quite elusive yet,” adds a second executive from the same investment bank. “I think it might be interesting to ask why that is, beyond cryptocurrencies, which have their own reason for being [in existence].” 

The Value of a Token

Tokens are used to create a digital copy of traditional assets that are traded and settled on a blockchain, an immutable, transparent database. The ownership of each asset is built into the technology and is represented as a digital key. Many questions have emerged pertaining to the actual value of tokenization, as some view it as an unnecessary alternative to a system and processes that already exist. A counter argument to this is that the process today isn’t fully digitized and is largely inefficient. 

“Today we see a digital representation of the securities but the real documents are actually held at a central securities depository, or a custodian, so it is not truly digital yet and there are some inefficiencies in the system due to that,” says Anja Bedford, head of blockchain for global transaction banking at Deutsche Bank. (For more on custody in the digital-asset market click here).

Whether distributed-ledger technology is designed as open architecture or a private network, tokenization promises a higher level of transparency for all participants. One of the key challenges it claims to tackle is post-trade inefficiencies, through automating the settlement and reconciliations process, and removing intermediaries. Another core selling point marketed by fintech firms is that it will generate liquidity through its decentralized structure and by tokenizing less liquid assets such as art, precious metals or real estate—but this remains to be tested, and some are deeply skeptical of this claim.

“The question becomes what actually is the benefit of tokenization or issuing the share of a security of a decentralized network because you can argue that there isn’t going to be more liquidity available,” says Ville Sointu, head of emerging technologies at Nordea. “Because it is fully regulated on a local jurisdiction there is very little extra liquidity that you would gain by decentralization.” 

Less-liquid assets have been a major driver in this space, with tokenization projects making headlines this year including the Royal Mint Gold project, the Global Markets Exchange Group’s partnership with USAVE in July to create a digital gold exchange, and Muirfield Investment Partners’ announcement in May that it will offer real estate tokens using AlphaPoint’s asset-backed token framework and blockchain technology. Thomas Zaccagnino, founder of Muirfield Investment Partners, explains that the firm is developing what he calls a new private equity structure where investors can have full or fractional ownership of real estate or a real estate investment funds. The tokens will also be accessible to global investors, as permitted by Regulation D and Regulation S from the US Securities and Exchange Commission.

“Value is achieved by investors having access to unique products that they otherwise wouldn’t have had and to access them in a liquid way,” says Zaccagnino. “So it’s taking these illiquid assets such as real estate or real estate investment funds and making them more liquid through a global secondary market. And the fractional ownership helps to democratize some of these products that are more geared towards the uber-wealthy.” 

Beyond the hype, there have been some recognizable steps taken by fintech providers and global exchanges to shift the mood in favor of tokenized products. Japan has demonstrated a progressive approach to the technology in recent months by being one of the first to put a loose regulatory framework in place, and on November 11, the Singapore Exchange and the Monetary Authority of Singapore stated that they had developed two prototypes for delivery-versus-payment settlement of tokenized assets across various blockchain platforms. 

This announcement demonstrates a significant gesture of support from the Japanese government for tokenization, with other jurisdictions such as Gibraltar taking a similar approach to the underlying technology by implementing the Distributed Ledger Technology Regulatory Framework authorized by the local regulator. 

Now although some movement has been made to announce these projects and kick-start the production process, it seems that firms are still faced with multiple challenges before they can attempt to test the value of this technology. 

“If the promises are fulfilled the upside is huge,” says the managing director at the global investment bank. “But the promises have been outstanding for quite a while now.”

The Roadblocks

“There are two primary pieces that give large institutions pause, and a lot of our team comes from that background and know the inner workings,” says Igor Telyatnikov, co-founder and president at AlphaPoint. “Number one, business and financial institutions are fine taking business risks but they are not fine taking regulatory risks”

The Crypto Asset Task Force, put together by members from the UK’s Treasury, the Financial Conduct Authority and the Bank of England, issued a final report in October on its stance on crypto assets. It stated that although crypto assets play a small role in the overall share of the UK market, they have the potential to impact market stability through risks such as financial crime and market manipulation. The taskforce outlined that following its consultation in early 2019, it will provide “guidance clarifying how certain crypto assets already fall within existing regulatory perimeters.” Additionally, the report concluded that “exchange tokens present new challenges to traditional forms of financial regulation” and the taskforce would “consider carefully how regulation could meaningfully and effectively address the risks posed by exchange tokens.”

Nordea’s Sointu explains that, given the rise in activity in this space so far, EU and Nordic regulators are already beginning to understand some of the risks involved. Security token offerings (STOs), a mechanism for raising money for blockchain projects using stricter rules and requirements than an initial coin offering, have also caused regulators to sit up and take notice. Official regulation for STOs is on the horizon and may come out in 2019. 

“If you look at the STO setup, the regulators are starting to understand a couple of things, in that they need to regulate the application and the users rather than the technology,” explains Sointu. “So the token offerings, if they were regulated, there is exactly the same requirement as for any security offerings that apply for the token offering, so each and every stakeholder in the value chain needs to be identified. So there have to be full know-you-customer (KYC) and anti-money laundering (AML) sanction screenings in place.”

Additionally, he adds that regulation would also mean that both exchanges and token offerings would need to be licensed by the local regulator, and each firm issuing these products would be required to execute a high level of due diligence to comply. For some, regulation may be too slow to catch up with the pace of the technology and waiting would do little to inform regulators of future risks.  

“We are seeing a lot of different activities and I do think it would be wrong to say let’s wait for the regulation,” says Deutsche Bank’s Bedford. “Because regulators only regulate activities, but not the technology itself, and the regulations itself are based on the existing availability of technologies. We are not there yet to say this is how the future looks, this is how the risk of the future looks.”

Tokenization projects are faced with multiple other technical and practical roadblocks to overcome. As the concept of trading or settling tokens is embedded in an open architecture, it can only work by adding multiple ledgers to the network. This can be a difficult sell when trying to convince highly regulated institutions to sign up to a system that is based on trust and uses majority voting to settle transactions. 

“The problem is if I own a house or a bond or anything and I am going to agree to tokenize it, I am de-facto agreeing to have an open architecture where potentially a majority could vote against me owning it,” says the executive at the global investment bank.

To tackle these risks, many firms are implementing higher security measures and carrying out screening procedures, such as KYC and AML at entry points for each participant given access to the blockchain network. AlphaPoint’s Telyatnikov explains that the biggest concern surrounding security pertains to the custody and ownership of the token. The risk of cyberattacks and lost keys has become one of the leading causes of hesitation among heavyweight buy-side and sell-side firms. 

“The risk of having the private keys of a wallet hacked and stolen, or having those funds stolen and unrecoverable, is not a situation that financial institutions will really accept—that custody risk, that security breach,” says Telyatnikov. “And rather than just losing end-user data, which also has serious consequences, but actually losing financial assets and instruments, is a huge roadblock.”

This year, a number of global institutions have announced their bid to provide custody services and offerings for cryptocurrencies and assets, to help mitigate some of the risks involved. Among those included are Japanese investment bank Nomura, SIX and Fidelity Digital Assets. The Swiss Stock Exchange, a subsidiary of SIX, is set to launch a trading, settlement and custody infrastructure based on DLT for digital assets and tokens, with the first set of services set to be rolled out in mid-2019. 

“We decided to actively go into the market—what we believe is a very unregulated Wild West setup—and bring some order into that space because we believe that this is an additional segment that is important for financial institutions,” says Valerio Roncone, head of product management and development, securities and exchanges, at SIX.

Hold Tight

According to most of the sources contacted for this article, 2019 is expected to bring a new set of changes to the digital space and see the entrance of many more heavyweight firms. A number of projects covering pre- and post-trade services that are currently being built are also expected to go live next year. Most of those spoken to for this story also say there is some application of digital assets, blockchain or tokenization that will become an important part of the market structure in the future. 

“I do think that in some shape or form this is the future but it also depends on how much it will impact and make the market more efficient and it depends on how the regulation will change and also what kind of technologies will be employed,” says Deutsche Bank’s Bedford.

One concern is that this space may be developing too quickly, which could leave the technology open to bad actors and market manipulation. The introduction of a decentralized structure for some use-cases would ultimately remove some regulated processes and open firms up to a new risk profile, and unchartered territory. The wider consensus is that although the space is developing at a significant rate, business decisions should always be driven by customer needs over the latest trending technology. 

“If I were to say there was a challenge, I would say that this whole space is moving so quickly,” says Tom Jessop, president at Fidelity Digital Assets. “So even in the nine months that we started trying to pull these pieces together into a business, the whole institutional view has changed and accelerated and I think that it is at a point in time where we are trying to make sure that what we are building is in sync with what customers want and because it is such as new field, what customers want is constantly evolving.”