Tokenisation

Definition & Example

A token is a representation of an asset or bundle of rights that can be issued, traded, distributed and tracked on a blockchain [1].

There are two main activities that are meant when the term tokenisation is used in securities markets at time of writing:a) Tokenised Assets. Tokens that represent ownership of an existing asset or bundle of rights, such as bonds, stocks, other types of securities, real estate [2], artwork, or even tractors [3]. These tokens can be traded on a blockchain platform, providing increased mobility and fractional ownership.For example, tokenising bonds can enable investors to buy and sell fractions of bonds, allowing for greater liquidity by providing accessibility to a wider range of investors. Tokenising custodied assets, such as gold, can enable investors to hold fractional ownership of the asset without the need for physical custody or storage. This raises the possibility of these tokens being borrowed, lent, and used as collateral in a similar way to traditional securities.Datonomy [4], which classifies digital assets, further breaks down this category into:

• "Asset-Backed Tokens: Tokenized assets that are backed by other assets, such as cryptocurrencies, securities, or commodities. The underlying assets backing these tokens are typically held in a segregated account on or off-chain." 
• "Synthetic Tokens: Tokens that mimic the one-to-one value or price of another asset, such as cryptocurrencies, securities, or commodities. These tokens provide exposure to a particular asset without having to hold or own the asset itself.”

Tokenising some currently indivisible assets such as real estate, is effectively akin to securitisation, whereas for divisible assets such as bonds the tokenisation process is simply the transformation to reside electronically on a blockchain.

b) Natively Digital Issuances. This involves creating tokens that represent ownership of a new security, such as equity or debt, that is natively digital and issued on a blockchain. These tokens can be sold in security token offerings (STOs), providing investors with a new way to participate in capital raising and ownership. Native digital issuances have accelerated, with digital bond issues announced denominated in CHF [5], EUR and GBP [6], amongst others.

These two forms of tokenisation are largely treated separately at the current time, but it is likely that in the future their usage will converge. Some issuances also combine digital and traditional issuance characteristics [7].

• [1] Available here.

• [2] See here for example.

• [3] Sandner, P. (2022) Tokenization of Industrial Goods: 'Tractor-as-A-token', Forbes. Forbes Magazine. Available here. [Accessed: February 27, 2023].

• [4] Available here.

• [5] Six (2021) Six launches its six digital exchange by successfully issuing the world's first digital bond in a fully regulated environment, SIX. SIX. Available here. [Accessed: February 27, 2023].

• [6] EIB (2023) EIB issues its first ever digital bond in Pound Sterling, European Investment Bank. European Investment Bank. Available here. [Accessed: February 27, 2023].

• [7] Hong Kong Monetary Authority (2023) Eddie Yue on tokenised bond: Huge potential to be unlocked, Hong Kong Monetary Authority. Available here. [Accessed: February 27, 2023].

There are multiple potential methods of achieving and maintaining a tokenised asset, but the diagram below provides a high-level overview of the concept. More detail is given on the possible methods in the operational section of this paper. [See Figure 1 'In Pictures' below for a visual representation].

A tokenised version of a conventional asset should in principle have the same economic, legal and risk characteristics as the non-tokenised version of the asset. There are however two key differences that create a number of important implications from both the operational and the collateral management perspectives:

• The existence of a tokenising party: the party that issues the token and arranges for the safe keeping of the underlying asset. Either on their own account or using some form of custodian It is likely such a party will charge fees for performing this service.
• The use of some form of Distributed Ledger Technology as opposed to conventional financial market infrastructure to record ownership and manage the transfer of ownership.

The tokenising party will need to enact controls and systemic methods of ensuring immobilisation of securities (see section 'Implementation Considerations’ within the Commercial Opportunities & Practical Considerations for Tokenisation for the Securities Financing Market paper for more). These could be analogous to current methods of administering pledged collateral within custody accounts for the purposes of the 2018 GMSLA Security Interest ('Pledge').

ISLA’s Digital Asset in Technology paper Commercial Opportunities & Practical Considerations for Tokenisation for the Securities Financing Market outlines in more detail multiple commercial opportunities for securities finance including:

• Increased mobility of trapped assets
• Increased accessibility to investors for illiquid assets
• The ability to optimise asset utility across fragmented asset pools
• Reduced operational processing timeframes
• ‘Securitisation’ of fund structures
• Reduction of delivery risk through a combination of tokens with smart contracts
• Improved supply chain transparency including Environmental, Social & Governance (ESG) markers
• Potential for more exotic use cases in the future including decoupling of asset rights into individual packages, and the transfer of contractual rights of a transaction separately to the assets themselves

Tokenisation has the potential to enable full use of all available assets across multiple custodial accounts through a Distributed Ledger Technology (DLT) layer. Fractionalisation enables the divisibility of hitherto discrete assets. Combining these two features provides for a powerful method of fully optimising asset use. In times of market stress, such as the recent liquidity volatility during the Liability-Driven Investment (LDI) crisis, the increased mobility and optimisation of collateral that tokenisation enables should result in greater resiliency. Adoption of the technology can assist market participants in ensuring that the correct collateral is in the right place at the right time. [See Figure 2 'In Pictures' below for a visual representation].

The use of smart contracts in conjunction with tokenised assets allows for true delivery vs. delivery transactions, with transaction durations in minutes rather than days or weeks being realistically achievable. Combining this with the 24/7 nature of the technology, means that intra-day financing, with its connotations for reduction of financing costs currently accrued due to assets or cash not being in the right place at the time of settlement cut off, again represents potential for more efficient use of financial resources available to a firm.Using tokenisation as a way of ‘securitising’ certain fund structures is another use case explored in the paper. Facilitating the ownership transfer of funds without the processing of redemptions and repurchases would again reduce operational burden, as well as having the potential to reduce impact to liquidity during times of stress.

ISLA’s Digital Asset in Technology paper Commercial Opportunities & Practical Considerations for Tokenisation for the Securities Financing Market outlines in more detail the challenges to adoption of tokenisation within wider financial markets as a whole.

Key challenges that are currently preventing the widespread adoption of securities financing on DLT include:

• No widely used solution for cash on chain. Many lending transactions typically involve cash collateral. However, there are multiple potential solutions to process cash on-chain including CBDCs, stablecoins, blockchain-based deposits and trigger solutions. 
• Establishment of trusted digital asset custodians. Digital asset custodians are responsible for holding and managing digital assets on behalf of their clients. As securities lending on DLT involves the lending of digital assets, the establishment of digital asset custodians is a key step in the widespread use securities financing on DLT, at least where lenders do not wish to self-custody.
• Cross-chain connectivity and infrastructure. Many different DLT platforms are currently in use, and securities financing on DLT will require the ability to connect these different platforms in order to facilitate lending transactions, collateral upgrades and so on. Use of standard methods of representing transactions and lifecycle events such as the Common Domain Model (CDM) [8] developed by ISLA, ISDA and ICMA, would provide the ability to have smart contracts that are equivalent on separate chains.
• Liquidity on-chain and re-usability of collateral. Until DLT networks gain in momentum and have sufficient parties on-chain, there can be a lack of liquidity on-chain, which makes it difficult to reuse collateral. Re-usability of collateral is also a concern where it remains unclear how collateral can be reused in different transactions on different platforms. Without liquidity and re-usability, it naturally becomes harder for borrowers to secure loans and less attractive for lenders.
• Legal and regulatory uncertainty. The legal and regulatory environment surrounding tokenisation is uncertain. This uncertainty makes it more onerous to implement securities lending utilising tokens, depending on risk appetite or indeed existing compliance constraints, as it is unclear what regulations and laws will apply to these transactions. Notwithstanding this, publication of guidelines by the Basel Committee on Banking Supervision (BCBS) and statements such as that made by the UK Jurisdiction Taskforce [9] demonstrate that regulators, legislators and advisory bodies are actively working to remove uncertainty. Additionally, other use cases utilising existing regulatory and legal frameworks are possible, and with time and ongoing work on industry standard documentation this barrier will become smaller.
• Integration with existing technology. For firms with existing technology platforms and enterprise level risk management, financial accounting platforms, collateral optimisation dashboards, there will be a need to integrate the new networks and systems. This will take time, cash, and skills investment.
• Agreed taxonomies. Categorisation and definition of the various digital assets is not widely agreed upon. As mentioned earlier in this paper, in 2022 Goldman Sachs, MSCI and CoinMetrics created Datonomy to start providing structure in this area [10]. Integration of such categorisation into standardised industry models such as the CDM could also help embed taxonomies throughout the ecosystem.

Tokenisation, as hinted at above, does not remove all current operational and financial risks, though it does offer potential for improvement upon many. It can also introduce some new ones of its own. Risks expanded upon in ISLA’s paper on tokenisation include: cybersecurity, smart contract, reputational, credit and operational risks.

It is recommended that firms use their existing new product proposal processed to analyse al new processes and system flows, implementing the appropriate controls, in particular at the points where these interact with existing technology stacks or operational processes. It remains good practice to operate new product flows in parallel or in nursery phases in which they are closely monitored for any risks not identified prior to implementation.

• [8] Common Domain Model on FINOS. Available here.

• [9] LawtechUK (2023). UKJT legal statement on Digital Securities, LawtechUK. Available here. [Accessed: February 27, 2023].

• [10] Datonomy methodology - msci.com (2022). Available here.