Blockchain is quickly becoming a vast source of potential in the financial industry, with security tokens created an issued on blockchain are already being used to improve the efficiency in more traditional asset classes.
Someone who knows all about this tokenisation is Thomas Borrel, the chief product officer at Polymath, who provide technology to create, issue, and manage digital securities on the blockchain.
Here he shares his thoughts on why It’s time to think beyond liquidity when tokenising assets.
It is widely understood that the potential scope and power of blockchain is vast, especially for the world of finance. Aside from the excitement that many investors have expressed towards cryptocurrencies as an alternative investment, the real impact of blockchain technology stretches far into traditional finance.
Security tokens created and issued on the blockchain are already being used to improve efficiency in a variety of more traditional asset classes, ranging from real estate to green bonds. The Sustainable Digital Finance Alliance (SDFA) and HSBC Center of Sustainable Finance recently joined forces to highlight how security tokens for green bonds can reduce management costs and increase operational efficiency by up to ten times. And in early 2020, RedSwan CRE Marketplace tokenised $2.2B in commercial real estate, making it one of the biggest tokenisations we’ve seen so far.
However, as is often the case with new and compelling technologies, security tokens have been framed by some as the be-all and end-all solution to every problem ever faced by traditional markets. But what if this isn’t the case?
Security tokens: The end of all liquidity problems?
One of the greatest benefits often touted is that tokenisation makes an asset more liquid, which is vital to attracting investors to assets that typically lack liquidity. Much of the discussion around tokenisation is fixated on this point – primarily because it has historically been a major issue for many traditional asset classes.
Practically speaking, tokenisation does make an asset liquid. When an asset is tokenised, it allows investors to buy or trade tokens with greater ease, and only purchase a fraction of its overall value if they wish.
Real estate is a good example. If you wanted to invest in the property market, the most common way would be purchasing a house, which is often very expensive. Tokenisation allows an investor to buy a small stake in a property, both lowering the bar to entry and giving investors options to diversify their investment through buying tokens in multiple different buildings.
However, in some cases, defining an asset by its liquidity can be a fallacy. Like any asset, what ultimately matters is its underlying quality. The process of tokenisation cannot make a weak asset strong merely because it is associated with an expectation of increased liquidity. A house with subsidence still has subsidence – tokenised or not.
Instead, the current way of looking at tokenisation needs to be turned upside down. Rather than focusing only on liquidity, we should first look at the other, far wider benefits tokens can bring.
Efficiency and risk
Maximising efficiency and minimising risk have always been two major pillars for any financial institution. However, even today, there are a range of financial instruments that are still very prone to issues in these areas, especially those that are traded ‘over the counter’ (OTC). The best example of this is likely the bonds market – a multi trillion-dollar market, where OTC trades are still common practice.
When an OTC trade is conducted, it is often done over the telephone – one person calling another to decide a deal. This introduces a huge This introduces a huge information risk with securities operations teams reporting error rates as high as 40%. When instructions for the trade are passed on to the custodians, they will spot the discrepancy. They then have to investigate and find out what has gone wrong, often resulting in very long delays to settlement times.
Blockchains provide transparent access to trade and clearing information so that operational issues can be caught earlier and help mitigate settlement risk (i.e. settlement failure). For example, on Polymesh settlement instructions must be affirmed prior to settlement, in a case where an OTC trade has been improperly captured by one counterparty, the counterparty which has affirmed the instruction can see that the other counterparty has not affirmed the instruction within a defined period of time. In this way, the affirming counterparty can reach out proactively prior to the settlement date to rectify the situation and avoid settlement failure.
The added benefit of officiating a trade this way is that it generates an easily accessible, secure ledger of trading information. When it comes to reporting in traditional asset classes, the process is highly manual and often expensive. But, with a blockchain solution, reporting is built into the ecosystem from the ground up. There are no significant additional costs or resources required to extract this data and share it where necessary, and the number and complexity of the steps required to complete reconciliations between different entities are reduced and simplified.
Unlocking new investments
The potential of tokenisation does not only stand to improve the process of trading traditional assets; blockchain can also open up the pool of investors able to participate. To date, the focus has been on how fractionalisation brings benefits to retail investors by lowering the bar to entry. However, the retail regulations are still very stringent, which is important to protect non-professionals from disproportionate losses.
On the flipside, tokenisation can be used to enable large institutional investors to buy into smaller projects. Referred to as aggregation, this process can be used to bind assets together so that they meet an institution’s minimum investment threshold.Because of the transparency of blockchain, the investor is still able to inspect each individual offering and ensure each element meets their quality and risk requirements, but by packaging it into one larger token, an institution can diversify with assets that would have otherwise flown under its radar.
One especially interesting example of where blockchain could enable an industry to grow is green bonds or alternative energy debts.
There is a very small entry ticket into an alternative energy debt organisation as generally, an investor will buy a small stake in a solar farm, for instance. They will then be paid a dividend based on the money made when the electricity is sold back to the electricity grid. These kinds of investments can be far below the minimum charge for an institution. However, when aggregated using blockchain, the capital distribution from a green bond can be a very attractive way for a larger firm to generate yield.
Furthermore, as blockchain is highly transparent, the token connected to the energy bond holds huge amounts of analysable data for investors. The value of the stake is calculated in almost real-time, using ‘internet of things’ (IoT) technology which constantly monitors all factors impacting green energy production and sales – like light intensity, wind, weather trends or grid demand. As a result, an institution can accurately and efficiently assess the strength of their investment.
The role of security tokens in the market
It is important to note that certain traditional asset classes are not right for the blockchain yet. Instruments with well-established frameworks like publicly traded stocks already have very well-formed, rigorous rails in place, and so transferring to a blockchain could cause greater disruption and costs than benefits.
There is a trend in blockchain circles to claim that blockchain technology should be introduced into every corner of the finance space, which is misguided. Blockchain should be introduced where it brings value to investors or institutions. It should be about augmenting and supplementing the marketplace – not overhauling it, or at least not until the incumbent systems no longer keep up with demand.
The costs and infrastructure associated with capital markets have made some assets – like green bonds or real estate – too expensive to bring to market and service, or too difficult to invest in. These use-cases are examples of where tokenisation can really shine.
Blockchain is a tool to help mature financial markets, not replace them.