Tokenisation - Charting a course

July 5, 2023

Blockchain and Distributed Ledger Technologies (DLT) are growing rapidly in popularity, and are starting to disrupt the financial services sector. This is particularly true in asset tokenisation, whereby asset ownership is converted into a unique digital representation – a token. This could be through representation of physical assets on distributed ledgers, or the issuance of traditional asset classes in tokenised form. The financial services industry is embracing this change and is bullish on tokenisation – a strong foundation for building a digitally native financial market.

To shed more light on what this means for financial services and what institutions should consider in response, my colleagues and I will be sharing a series of articles covering the key steps to explore tokenisation in the coming weeks. Let’s start with some basics and an overview of the challenges institutions face.

What’s driving demand for tokenisation in financial services?

The rapid emergence of digital assets makes it vital for financial institutions to revisit their existing business models. At the same time, there are the current limitations that make the financial services system ripe for digitisation and tokenisation of real-world assets.

Firstly access to premier financial services is limited to few participants, which creates opportunities for greater inclusion. Secondly, high-value assets are illiquid in nature due to entry barriers such as minimum investment amounts, making it difficult for investors to get instant access to their capital, especially during financial stress. Thirdly, traditional finance often experiences inter-operational inefficiencies and operational frictions (such as excessive intermediation) or territorial limitations (such as jurisdictions requirements).

However, as traditional financial organisations consider how tokenisation can help address these issues, they face intense competition from crypto natives and FinTechs who already have the structure and resources in place to implement the solution.

What can be tokenised?

Within capital markets, there are three broad applications of tokenisation.

No alt text provided for this image

In theory, since everything can be tokenised – from traditional financial instruments (e.g., equity securities, cash/deposits, bonds, loans, currencies) to real-world assets (e.g., commodities like real estate, art, gold) – it is clear much of the interest around tokenisation stems from its broad spectrum of possible applications.

What we are observing in the market

We have already seen significant growth. The global market volume of security tokens – which includes all kinds of tokens that are asset-backed or represent a kind of value – was c2.7 billion Euros in 2019 with 25% issued in Europe, representing only 0.35% of the total crypto market value. Given any traditional financial assets can be tokenised, financial institutions will now have a huge opportunity to capitalise on the growing market with increased consumer adoption in coming years.

Growth of the security token market:

No alt text provided for this image

Tokenisation benefits

Below are some of the core benefits that asset tokenisation offers. In order to capture these benefits, infrastructure changes may be required.

· Increased liquidity for illiquid assets: It allows previously exclusive assets to be traded on a secondary market, giving access to more traders and dramatically increasing liquidity, especially during economic stress. However, this increased liquidity can only be achieved if enough players join the market, so it is not only an illusion with a virtuous network effect.

· Speed and cost efficiencies: Smart contracts and digitisation of assets via DLT reduces the cost of issuance and reconciliation, eliminates the need for trusted centralised intermediaries and increases the speed of execution. However, operating on a non-permissioned blockchain to achieve a “Trustless” state might expose it to criminal and illicit activities.

· Transparency: Increased transparency comes from better data integrity and enhanced record sharing. There is also no single point of failure for any transactional data stored in blockchain-based systems.

· Fractional ownership leading to increased retail access: Asset tokenisation could mean the “slicing up” of assets, dividing ownership into smaller claims, similar to securitisation. Investors, particularly retail, may therefore gain access to assets that may have been traditionally beyond their capacity.

· Real-time clearing and settlement: 24/7, near real-time settlement, would be a direct result of asset tokenisation, reducing counterparty and operational risks in permissioned blockchains. It is estimated this could save 35 to 65 percent across the settlement value chain, including cost savings of up to $5 billion for equity-post trading.

Key steps financial institutions should undertake

For financial institutions, embracing these benefits can come with a degree of risk, and they must carefully consider how they are going to adapt to a tokenised economy. Time to adoption will be key, and there are key steps financial institutions should consider before adopting tokenisation. It is important these steps are part of a coordinated process and end-to-end plan, and not carried out in silos.

No alt text provided for this image

1. Strategy and change: Financial institutions will have to revisit their business model strategy and organisational objective in a few areas:

a) Identify the assets to tokenise: Financial institutions must identify the assets to tokenise, considering client demand, time to market and capability within the organisation.

b) Identify the role in the value chain: Opportunity exists in various forms in the lifecycle of assets:

No alt text provided for this image

Each financial institution should be clear on their role in the value chain and define a target operating model, based on asset classification and business model design.

c) Define the product and use-cases for initial launch: Financial institutions must identify their optimal products and use cases, helping ensure these are in alignment with their business model and organisation objective.

d) Confirm the ecosystem participants: Institutions should consider how they will operate with other participants in the ecosystem. Firms should outline a list of competitors and potential partners/targets and make decisions on partner/acquire/build per capabili2.

2. Legal and regulatory: There is an increasing impetus amongst global regulators to develop laws and regulation around tokenisation/DLT. It is therefore critical to understand the current regulatory landscape across multiple jurisdictions. It is also expected that new rules or legislation might be enforced for tokenisation, which will require organisations to rethink how they can comply and what will be the potential impact.

3. Technology enablement: To build a secure, resilient, and scalable platform for tokenisation, organisations should consider the impact on their existing technical infrastructure and solution architecture and IT and information security. That includes the integration of multiple new DLT related capabilities, such as smart contracts and token issuance.

Technical dependencies and upgrades should also be considered and integrated into the new tokenisation platform. Additionally, a full proof integration capability is required, helping ensure compatibility with backend systems and processes.

4. Risk and controls management: Managing new digital asset specific risks is critical to secure the trust of market participants and to capitalise on the true potential of the market. Governance structures and control frameworks should be designed that produce robust risk management. This may include:

a.     Identifying applicable risks in the process lifecycle.

b.     Embedding a risk culture as set by leadership.

c.     Defining clear roles and responsibilities across the lines of businesses, for managing tokenisation risks.

d.     Updating risk management processes with sufficient controls and ensuring integration at enterprise level.

5. Assurance and validation: Independent validation of the financials and technical capabilities will provide essential assurance to investors and consumers:

-      Compliance with accounting standards and internal controls will help investors make an informed decision.

-      An independent review of technical capabilities (e.g., performance of underlying infrastructure) will be key to mitigate any operational risk and demonstrate business resilience.

To accelerate the development of numerous capabilities outlined above – particularly given the complexity and speed of change around tokenisation – we expect institutions will need assistance. EY has built a digital asset tool, EY Digital Assets Insights and Assessment Platform (EY DAIA), to help firms navigate the key considerations and conduct an end-to-end assessment of their capabilities against the desired target state.

Acting quickly and being joined-up will be key

Financial institutions are still in the early phases of the adoption of blockchain and DLT. However, the clock is ticking as the industry develops products and looks to access new assets. This momentum has been mirrored by increasing interest from regulators around what the shape of regulation could look like in order to be “fit for purpose”.

To help capitalise on the opportunity, financial institutions should be proactive in navigating the complexity and impacts across multiple dimensions of their business model, such as strategy, legal, regulatory, technology, risk, compliance, control and the need for assurance.

Our aim through the upcoming series of tokenisation articles is to help our clients navigate through tokenisation journey, potentially transforming who they are, what they do and how they do it.

To find out more, please refer to the ‘Contacts’ section below

The views reflected in this article are the views of the authors and do not necessarily reflect the views of the global EY organisation or its member firms.

Key contacts: Strategy & Change Pierre Pourquery, Eric W. and Emanuel Vila, Legal & Regulatory Monica Gogna and Christopher Woolard CBE, Technology Muneeb Shah, Risk & Control Mark Selvarajan Richards, CFA, Prateek Saha, FRM, and Rupal Thakrar, Assurance Amarjit Singh 💙 and Laeeq Shabbir and Digital Assets Insights and Assessment (EY DAIA) Mely SOMKHIT and Bronwen Bedford