WFE aims to “demystify” tokenization in new paper

As the European Commission gathers stakeholders in Brussels to discuss the further tokenization of assets, The World Federation of Exchanges has published a paper: “Demystifying Tokenisation: Embracing the Future”, that provides a reality check: we shouldn’t curtail the further development of tokenisation, nor should we run blindly towards it.

Rather than a radical departure from the norm, tokenized traditional assets should be viewed as nothing more than a modernized and innovative iteration of traditional finance, providing new opportunities for investors and market participants. This is one of the many ways in which exchanges continue to invest serious effort and money in innovation.

Tokenization has many benefits that could make it a natural next step for financial markets. Fractional ownership, allowing multiple investors to own a share of an asset thereby lowering the capital requirement for individuals to invest in high-value assets; enhanced liquidity, which arises from fractionalisation enabling access to investments that may have been out of reach for many; and enhanced trust could all lead to greater financial inclusion, diversification and ultimately economic growth.

Some of the supposed benefits are overexaggerated or frankly don’t exist at all. Continuous 24/7 trading – if truly needed – can be achieved without tokenization. Disintermediated models face conflicts of interest and instantaneous settlement in tokenized trading may have unpredictable timing, affecting market liquidity and trading costs, especially if assets and funding need to be blocked prior to execution.

Tokenization has not “taken off” in traditional markets and there are several reasons why:

  • Distributed ledger technology (DLT) has limitations, particularly in high transaction environments, as the technology is currently not fast enough to execute and settle all the trades running through a highly active exchange in any given moment. There are also other limitations such as storage problems caused by the distributed ledger.
  • The nature of different DLT creations means that there is a fragmented infrastructure with tokenized assets managed on different blockchains which are not interoperable. Financial institutions would have to build connections with each platform, leading to significant operational costs and challenges, meaning there are only marginal efficiency gains in certain markets, particularly those that are already liquid.
  • There are significant sunk costs involved in implementing DLT. It is a capital-intensive investment to move to the new technology and build the relevant infrastructure. These costs would be felt across the market, from infrastructure providers to market participants and end users. Even then, there may not be sufficient demand if customers do not have the correct infrastructure or capital to invest.
  • The lack of regulatory certainty, which is improving thanks to the efforts of regulators and industry, persists. Most jurisdictions’ bodies of law do not reflect the creation of tokenized assets, leaving firms apprehensive. Anything that is, in effect, a financial instrument, should be treated in the same way, regardless of whether it is tokenized.
  • The lack of adoption further inhibits tokenization because, without widespread use, there are no network effects and there is little value to firms and exchanges to update their technology stacks to incorporate tokenized assets.

Tokenization should be seen as a creative and modern version of traditional finance that offers new possibilities to investors and market players. However, current limitations mean that it won’t be right for every type of asset.

James Auliffe, manager of Regulatory Affairs at the WFE, said in a statement: “The fundamentals of tokenization and the infrastructures these assets trade on need to be better understood. Regulation in this area should reflect that tokenization is a natural evolution in the financial industry, rather than a drastic break from the norm. Its usage is suitable in particular environments and for particular assets, but in these cases, market participants can reap great benefits.”

Read the full paper

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