We have seen the future of securities and it is tokenised: The Summary
Security tokens are coming. In fact, they are here already, and have been for a while. Though most of the security token offerings (STOs) in the last three years were hard to distinguish from Initial Coin Offerings (ICOs), several corporates and banks (Banco Santander, Bank of China, BBV, Daimler, Deutsche Bank, Société Générale) have tokenised bonds or loans on public as well as private blockchain networks.
The electronification of the traditional securities market dates back 40 years, and has delivered considerable cost savings in issuance, trading, settlement and custody.
There are still efficiency gains to be made in traditional securities markets, especially in terms of cross-border traffic, liquidity buffers and issuance costs, where underwriting fees are high.
High costs are one reason private capital markets are growing at the expense of public capital markets. Private markets are a large and valuable opportunity for security tokens.
Issuers find they can raise debt and equity capital in smaller amounts at lower cost, and investors gain access to new and uncorrelated asset classes.
The relative inefficiency of private markets creates opportunities for new technologies to deliver operational cost savings that would be hard to achieve in the relatively efficient public markets.
The absence of fiat currency on blockchain networks constrains the operational efficiency of tokenization networks. Central bank digital currencies (CBDCs) will help.
Decentralized Finance (DeFi) experiments indicate other constraints on efficiency, such as lack of netting, margin management and borrowing for settlement, will be solved technologically.
Tokenization also presents opportunities to cut the cost of cross-border trading, by reducing the need for large liquidity buffers and cutting the capital cost of prolonged settlement timetables.
The intrinsic illiquidity of private capital markets is a barrier tokenization can overcome by improving price discovery and through inter-operability (or portability) between blockchain networks.
Though standards such as ERC 20 are facilitating inter-operability and Internet-style network protocols are already making it easy to port assets and transactions between blockchain networks.
Specialist advisers, to help token issuers structure their offerings, have emerged. The major investment banks will do similar work as the token markets become more liquid.
Capital-constrained banks looking to reduce the cost of assets carried on their balance sheets could become an important source of new token issues, indirectly as well as directly.
Regulation lags developments in security tokens. The gap could be narrowed by adopting a different idiom, and conscious effort by tokenization platforms to fit within existing regulatory frameworks.
The institutional preference for private, permissioned blockchain networks is understandable but impedes progress. Zero-knowledge proofs offer a promising solution to this constraint.
In the meantime, tokenization platforms are pragmatic enough to seek regulatory status, recognizing that institutional investors, banks and trading firms will prefer to deal with regulated entities.
The exchange of ideas and technologies between the crypto-currency market (especially the DeFi market) and the security token markets is evidence of convergence on a single model.
Tokenization does open up new revenue streams, and offers cost savings, but its long-term success depends on the ability of tokenizers to create genuine innovations.
Written by Dominic Hobson – April 2021
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