1. First, what is Tokenisation?
A conventional asset in digital form: A tokenised asset is a conventional asset — a bond, share, or property interest — where ownership is recorded by a token on a shared (or "decentralised") digital ledger. This ledger is often based on blockchain technology, and may replace the current system of multiple private databases operated by banks and other intermediaries. The token itself is a piece of software - a small program that defines what the asset is, who holds it, and what may be done with it.
Not a cryptocurrency: A tokenised asset is still the underlying conventional asset. It has the same rights and contractual terms, and (in the UK), broadly the same regulatory framework as its conventional equivalent. It is not a "cryptocurrency" like Bitcoin, which has no intrinsic value - a tokenised bond has the value attributed to the underlying bond.
2. What is the point?
The potential benefits of tokenisation fall under three broad headings:
Speed of settlement. Standard settlement takes one to two days, and the gap means needing to hold capital idle, as well as generating risks to counterparties and market prices during the settlement period. Tokenised settlement can be same-day or instant ("atomic" in the jargon). Faster settlement reduces those risks and therefore frictions in funding and treasury activity, and in the provision of collateral.
Programmability. Because the token is software, the tokenised can be programmed to have its own rules. A bond can pay its own coupon, or a fund unit won't transfer to a buyer who has not cleared eligibility checks. In principle, procedures currently held in manual and back-office processes can be coded into the token.
Lower transaction costs. The shared ledger and token can replace the existing chain of intermediaries, reducing the need for reconciliations and transaction fees. Combined with the reduced need for manual processes and the speed of settlement, this should drive cost efficiencies.
3. If it sounds too good to be true….
Use of the technology at scale is in its infancy. Key challenges include:
The payment leg: Both speed and programmability depend on the payment for the tokenised asset being able to use the same system as the tokenised asset itself. Paying via a conventional bank transfer largely removes the benefits of tokenising the asset in the first place. Three main forms of digital money can potentially solve this problem – stablecoins (a type of cryptoasset fully backed by a reserve of liquid assets); tokenised deposits (a tokenised version of an ordinary bank deposit) and a digital pound (a digital banknote issued by the Bank of England or other central bank) – but all have challenges.
Liquidity and scale of adoption: Transaction volumes and liquidity remain low, which is a key concern. The current lack of consistent technical and operational standards risk systems being built which don't easily interoperate ("walled gardens" in the jargon), trapping liquidity into smaller pools. Whether tokenisation (or any specific version of it) is ultimately a VHS or Betamax will depend on the level of adoption across the financial system, including the buy-side. For most firms, this will be dependent on the delivery of cost savings compared to their existing processes, and the ease with which the technology can be incorporated into their operations and risk controls.
Legal certainty: The legal and regulatory framework for tokenisation is in the process of being finalised, but key uncertainties remain. These include clarity about when a transaction can be unwound ("settlement finality" in the jargon), liability when things go wrong, and how novel operational risks should be managed.
4. Action points
Tokenisation has the potential to have a profound effect on the UK and cross border financial systems. This is what we recommend firms consider now:
Consider across your organisation. Tokenisation will impact treasury, legal, company secretarial, tax, audit and technology. Bringing the affected parts of organisation into the discussion is a key part of any feasibility, analysis or implementation project.
Examine your own use cases. Some key questions include: Where does settlement delay cost you? Which processes involve you taking risk on the delivery by your counterparty? Which internal processes could be reduced or eliminated using tokenised assets? This will help identify use cases that may benefit your firm.
Explore with your counterparties. Your banks, custodians, registrars and payment providers will already be working on this technology. Ask what they offer now, what is coming, and what their own transition timetable is.
Speak to us. At Addleshaw Goddard we have a cross-disciplinary team – including ex-senior regulators - able to advise on all aspects of tokenisation.
