Tokenisation: Real assets for all?

As tokenisation continues to face complications pertaining to an increasingly complex regulatory landscape and still-maturing technologies, what does the future look like for the industry?

When tokenisation programmes first hit the market five years ago, many believed the technology would rapidly and drastically reshape the financial landscape. Yet today, the size of the industry has somewhat fallen short of initial expectations, with growth dropping off considerably after an initial surge.

What is tokenisation?

Tokenisation refers to the process of digitally representing an existing “off-chain” or “real world” asset onto a distributed ledger, such as blockchain. By extension, tokenisation can also designate native issuance and distribution of securities in the form of tokens on a blockchain. There are several different types of digital tokens, including payment tokens, security tokens and utility tokens. Payment tokens – such as Bitcoin and Ethereum – are used to buy and sell goods and services; security tokens represent ownership or rights associated with an existing off-chain asset or of a native tokenized security; and utility tokens provide access to a service or product run by a token issuer.

Through tokenisation of real assets, however, a higher degree of fractionalisation can be achieved, giving a more diverse pool of investors access to the market and, in turn, improving market liquidity. What’s more, blockchain mechanisms promote transparency and smart contract integration offers investors more streamlined solutions in addition to a significantly shorter time to close a transaction.

With this in mind, it is apparent that the pace of growth has considerably slowed as the regulatory landscape has matured and complexified.

Focus on Real Estate

Illiquid industries, such as real estate, perfectly lend themselves to the revolutionary world of distributed ledger technology (DLT). To date, real estate represents over two-thirds of tokenised assets, and since 2018, we estimate that between US$15 and US$20 billion worth of tokenised real estate has been issued. Yet in the space of five years, if just 5% of all institutional and private real estate was to enter the blockchain, we estimate this figure could stand at up to US$350 billion.

Regulation: friend or foe?

As discussed, there are different types of digital tokens on the blockchain, and these can present problems when it comes to regulation. Security tokens, for instance, are governed by securities laws rather than crypto-asset regulation, and these frameworks can be inflexible and time-consuming.

Currently, most jurisdictions adopt a technology-neutral approach to regulation for financial services, meaning the use of DLTs does not affect regulatory assessment. As such, laws rarely fully accommodate the specificities of securities trading on the blockchain, which can limit the pool of potential investors entering the market.

In the US, for instance, new securities offerings must be registered with the Securities and Exchange Commission (SEC) unless they qualify as an exemption. Given registration is notoriously long and arduous, many issuers seek to structure their offering as an exempt transaction.

Two of the most common exemptions are Regulation D and Regulation S. The former, which applies only to accredited US investors, limits access to the richest 10% of US households, while the latter limits access to foreign investors – meaning these tokens remain inaccessible to the vast majority of the population.

Similarly, in Europe, security tokens fall under European securities laws and must comply with EU Prospectus Regulation. Again, the approval process is complicated, and information may even need adapting to address the nuances of blockchain. While exceptions apply, these again significantly limit the pool of investors that can enter the market and are largely dissuasive – if not impossible - for non-professional investors.

Slow but steady progress

In both regions, existing regulation has made it difficult for the tokenised market to really take off. These issues are further compounded when tokens with multiple features are brought into consideration. For instance, a football club looking to tokenise its stadium might include a mix of both utility and securities features, and it is unclear which frameworks would be applicable.

That said, frameworks are evolving, and regulators have shown a willingness to facilitate a broader adoption of real asset tokenisation. And individual jurisdictions are starting to make progress: in 2020, Switzerland passed the Distributed Ledger Technology Act, which allows for the legal transfer of ledger-based securities through the blockchain without any need for physical documentation. Its model is a good example of collaboration between stakeholders and could serve as an inspiration to others looking to improve their own legal structures.

Is the technology ready?

In addition to regulatory hurdles, the technological application of DLT has also presented setbacks for the growth of the tokenisation market. Indeed, when it comes to blockchain ecosystems, investors and financial institutions are debating whether public or private is best.

Depending on the transaction’s intended investment base – and their comfort with the blockchain ecosystem – both come with their own advantages and drawbacks.

Thus far, private blockchain networks have been favourable to professional clients due to their ability to process high volumes of transactions per second (TPS) and strong compliance with regulation.  The user-selective onboarding system streamlines Know Your Customer (KYC), whitelisting, and anti-money laundering (AML) monitoring, while a centralised governance system can provide a clear point of contact should law enforcement operations require transactions to be suspended or accounts to be frozen. In addition, by limiting access to those with a legitimate need to know, data confidentiality is maintained according to global data protection regulations. Combined with specific frameworks, confidentiality of transactions can also be ensured (while Public Blockchain can often ensure pseudo-anonymity at best).

Conversely, public networks are often criticised for their payment latency, in addition to charging disproportionate fees as a result of network saturation. In addition, decentralisation supersedes privacy, meaning data privacy and transaction secrecy remain challenging – though this is rarely an issue for bankers, market operators and investors that trust centralised regulators.

Despite challenges with public blockchains, however, the industry is updating its technology. Ethereum's move to a Proof of Stake consensus, followed by the implementation of sharding on 64 sidechains, for instance, is expected to achieve 100,000 TPS by 2023. What’s more, cryptographic solutions such as Zero-Knowledge Rollups are also enhancing the security of public blockchains. This, paired with smart contract standardisation such as the ERC-1400 and ERC-3643 – which provide greater control over who can invest in public networks – should bring them closer to private network standards.

Bridging the gap

In addition to discrepancies between private and public ecosystems, issues of blockchain interoperability pertain, which risk splintering market liquidity. Currently, no single tokenisation platform attracts more than 2% of global liquidity, and the exchange of data and transfer of assets between ledgers remains a major technological challenge.

To date, transfers are largely conducted via “bridges”, which may involve intermediary chains. This is not only inefficient but also introduces additional points of vulnerability. And even when intermediaries are removed, security is not guaranteed. In February 2022, the Wormhole bridge connecting Ethereum, and Solana was the victim of an attack, whereby a hacker stole 120,000 wETH, worth US$326 million. This attack came just a week after the Qubit Ethereum-Binance Smart Chain bridge following a very similar US$80 million exploit.

In light of these vulnerabilities, fintechs are investing in new technology to circumvent current issues. Notably, Ownera has proposed the establishment of a routing network whose role would be to link member blockchain ecosystems – whether public or private – and organise ownership through a unified set of application programming interfaces (APIs) without moving assets from one platform to the next.

Securing keys

In addition to vulnerabilities posed by bridges, investors may also be concerned about the safety of their assets in a digital wallet. These can either be ‘hot’ or ‘cold’.

Hot wallets are linked to the internet and are therefore vulnerable to hackers. Storing large sums of money in hot wallets can be compared to carrying large sums of cash on one’s person. Cold wallets, on the other hand, are small USB stick-like devices that can be stored offline. While they are more secure than their hot counterparts, cold wallets are slower to operate. In addition, liability for the safety of the wallet is placed on the holder, as the destruction or loss of the wallet would lead to the loss of the underlying asset.

In a bid to improve the security of wallets, professional investors are increasingly turning over control of their private keys to specialist third parties. While a high level of trust in the service provider is required, this option can provide insurance against theft, allows for multi-signature (Multisig), and renders keys recoverable through various mechanisms in the case of loss.

Alternatively, newer forms of storage such as Secure Multi-Party Computation (MPC) – which enables a group of different data owners to jointly compute a function of their private inputs, without requiring them to share their private data with one another or any other party – could make it possible to use multiple signatures quickly and securely. This minimises the risk associated with using public blockchains by eliminating the need for keys to be stored in one place.

Looking ahead, we expect markets will continue to make adjustments to their infrastructure in order to accommodate the tokenisation of real assets – particularly as regulation evolves and technology continues to progress. Having been involved in this space since 2015, Natixis will continue to closely monitor the landscape, and we are ready to accompany our clients on their respective journeys into this market.

To go further by Natixis CIB Research

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