What is tokenization?
In principle, tokenization is the process by which assets such as equity, debt and real estate are represented on distributed ledger systems. By representing the value of tangible or intangible assets through digital tokens, they can be owned, stored and transferred on the blockchain. Early applications have looked to tokenize cash and the digital payments process to provide an alternative to the current market model of account-based systems. What is the difference between the two models? Today’s account-based payment systems rely on the verification that someone has been authorized to make a transaction. Tokenization works differently. Here, the participants in the network prove knowledge of an encrypted value to initiate a transaction.

This idea of a token-based model would, however, come with implications. Whilst participants could broaden their direct access to financial networks, and the concept of programmable money may eventuate (whereby certain processes could be automated through smart contracts), the privacy of data in a distributed environment may also come into question.
 

Beyond cash
The growing appetite to tokenize other assets has led to tokens being categorized in different ways. The likes of Bitcoin and Ethereum are sometimes referred to as “payment tokens,” as they can be used as alternative forms of payment — but on the blockchain. One application of cash tokenization from the private sector involves stable coins. These are a type of digital coin designed to peg the price of a crypto asset and negate price volatility. Such models can also be used for international payments involving foreign exchange, and could encourage wider adoption by institutional investors.

Security tokens, on the other hand, are simply securities that happen to be issued using blockchain. What makes them unique is that they could be issued and settled in electronic form without the need for central market infrastructures.
 

Tokens find a wider ecosystem
These innovations are not limited to the private sector. The public sector also recognizes the potential of tokenization and is starting to come up with ways to support a future token ecosystem. Central banks, particularly across Asia Pacific, are looking at issuing fiat currencies as tokens with the view to improve the availability and use of central bank money in either retail or wholesale payments, or even both.

A key question that currently is being debated is, if there will be central bank digital currencies (CBDC), so-called CBDC cash tokens, of the national currency that is issued and controlled by the national bank in question. And, will these be so-called general purpose CBDC, focused on particular segments (i.e., can only be used for retail payments), or would they also be available for wholesale payments and capital market transactions? As it relates to tokenization, central banks will need to ask whether they are merely trying to replace or complement cash (and, therefore, retail payments) and create CBDC around that purpose, or are they looking at securities markets and wholesale payments? Expect the policy debate around CBDC to take some time on this issue, at least in most developed markets.

There are implications for the asset management community, too. A shift to tokens offers it the chance to invest in new asset classes or change the dynamics of existing asset classes once they migrate into blockchain environments.

Meanwhile, having digital assets on the blockchain could allow asset managers to track changes in investment patterns more carefully and generate better data insights. More radical proposals involve digitizing a fund’s overall structure, making it easier for investors to come onboard by creating a portfolio that is tailored to their risks and interests.
 

Ready to go atomic?
One of the major attractions of tokenization is the promise it holds to transform any asset into a digital one that could be traded instantaneously. The holy grail of instant settlement, also known as “T+0,” “same day,” or “atomic settlement” also has the potential to reduce settlement risk, as well as capital consumption and the need to reconcile potential settlement breaks. (For example, foreign exchange (FX) settlement today generally occurs on a T+2 basis.) More compressed settlement cycles will entail corresponding settlement activities that will need to occur in compressed timeframes as well, meaning current risk standards will need to be updated as we move to a cash token model.