Tokenization refers to the process of converting the right to an asset into a digital token, issued, stored, and transferred on a blockchain (the latter of which we've covered previously). Many real world assets can be tokenized, including fine art and real property.
Of particular interest in corporate finance is the tokenization of securities, such as bonds, stocks, and derivatives. A crucial feature of security tokens is that they would be issued in full compliance with securities laws and regulations, making them more appealing to institutional investors.
Lower costs, higher liquidity
Private securities are often significantly less liquid than public ones, given the restrictions on secondary trading of private securities, and the often required intermediaries (e.g. brokers). As such, there are numerous costs associated with facilitating such trades, and ensuring their compliance with the law. A significant percentage of such costs are often transferred to the investors, deterring many from investing.
Tokenized securities can be created, issued, traded, cleared, and settled on a digital infrastructure, all with much less assistance from third party intermediaries such as brokers, depositories, clearing houses and transfer agents, decreasing the costs associated with such services. Additionally, blockchain technology can potentially automate some regulatory compliance functions, including verifying an investor's accredited investor status. Accordingly, tokenized securities can ease the secondary trading of such securities, and reduce the price for investing, thus encouraging more participants to buy and trade and increasing the securities' liquidity.
Important considerations
Security breaches remain a serious threat for blockchain, especially for smaller private blockchains, with numerous potential ways to 'cheat the system'.
Additionally, companies issuing security tokens must make the arrangements necessary to ensure that the information stored on the underlying blockchain allows their security tokens to be fully compliant with securities regulations. Moreover, reducing intermediaries shifts many responsibilities to the securities issuers themselves. Traditional roles (and their associated risks) of financial institutions and other intermediaries, such as underwriting the deals, and monitoring security and regulatory compliance, could now shift to the issuer.
Finally, in order to unlock the full potential of security tokens, new and integrated technical and regulatory market infrastructures need to be established. Technologically advanced infrastructures that allow for the regulated creation and trading of security tokens should be developed. Some countries are already moving closer towards creating such an ecosystem. For example, Switzerland's stock exchange announced in June that it is building a specialized exchange that offers a fully integrated trading, settlement, and custody infrastructure for digital assets. The exchange's service will be mainly based on Distributed Ledger Technology (blockchain's underlying technology), fully regulated, and meant to encourage the tokenization of existing securities. Such a specifically tailored, unified, and comprehensive, technological and regulatory system is very promising, and is an exciting development to track.
Conclusion
The considerations discussed above should not be viewed as deterrents, but rather as opportunities. There are, for example, many investment opportunities associated with developing new technology products and solutions to support the creation and exchange of security tokens, or to facilitate their regulatory compliance. Developing a new infrastructure for security tokens also provides regulators with opportunities to address some of the longstanding issues faced in the current financial markets.
While their potential to increase asset liquidity, improve transactional speed and efficiency, and decrease costs, are all inviting, the selling feature of tokenized securities lies in their compliance with securities laws. As such, companies considering tokenization should examine whether they currently have the capacity to set up tokens with the necessary technical infrastructure required to ensure the tokens' compliance with the laws, and whether doing so would significantly reduce the companies' costs in the long run. Tokenization in and of itself does not inherently add value, and as such, companies should ensure embarking on the tokenization process suits their individual circumstances.
The author would like to thank Ahmed Labib, articling student, for his assistance in preparing this legal update.
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