Market participants and policymakers have shown strong interest in distributed ledger technology (DLT)-based financial applications such as tokenization. However, despite growing enthusiasm by market participants and the emergence of a clearer divide between crypto-assets and regulated tokenized assets, adoption of tokenization remains scarce.
A recent report from the Organization for Economic Cooperation and Development (OECD) analyses possible reasons for the absence of a market for tokenized assets and puts forward policy considerations for financial supervisors and policy makers.
The vast majority of tokenized transactions are part of pilots or other experimentation by the private and public sector (e.g. proofs-of-concept or sandboxes), with few private-led live projects developed by financial institutions to service primarily their own clientele in a fragmented manner, without interoperability, thus not reaching meaningful size as of today.
Some of these initiatives include products that support tokenized intraday repo transactions for banks; products that enable the tokenization of shares of money market funds for posting as collateral to support repos; the use of tokenized deposits; and trade solutions that would leverage smart contract-based bank guarantees.
There are currently limited comprehensive and consistent public data available around tokenization activity, including around the market share of different types of token types and their underlying assets.
Key role of custodians for the onboarding of assets
The lack of maturity or limited availability of digital assets-related services by custodians could be one key parameter in the limited development of markets for tokenized assets. Custodians in these markets onboard customers to DLT platforms because investors are unlikely to onboard to DLT platforms directly.
The role of such trusted parties is not limited to onboarding and transitioning/connecting the off-chain to the on-chain world, but importantly, involves the safeguarding of the asset where off-chain assets are involved. For example, custodians can help investors enjoy the potential benefits of DLT-based systems for repo transactions.
It should be noted that programmable repo and tokenized collateral management transactions are prime use cases of post-trade DLT-based finance, that do not necessarily require the primary issuance of the security to be done on-chain by the issuer.
For that to be achievable, custodians would need to have the necessary infrastructure to tokenize collateral and participate in DLT-based repo platforms, reaping any purported benefits of back-end friction reduction, costs savings and settlement fail reduction.
The second dimension to the key role of custody in the context of tokenized assets relates to the need for a trusted and credible central party that will guarantee the backing of tokens issued with ‘real world’ off chain assets as the reference assets, as well as hold such assets in custody, in addition to custody of natively digital tokenized assets.
The former involves the custody of underlying assets held in reserve to collateralize tokenized asset issuance and to ensure that assets such as real estate are being tokenized only once. In essence, such custodians guarantee the connection of the off-chain world to the distributed ledger environment, ensure that the digital representation of the asset on the ledger is unique and that the same asset is not being represented by multiple tokens in multiple platforms.