Assets. Digitization. Tokenization.
Security Tokens: A New Market Paradigm for Europe
Swen Werner, managing director at State Street Digital, views the European Union Digital Finance Package as a step toward ensuring that EU capital markets can benefit from technological innovation.
The tokenization of assets promises to deliver enhanced operational efficiencies, a stronger emphasis on peer-to-peer trading and the emergence of new business models due to the programmability of assets and the emergence of decentralized finance constructs.
Some studies suggest that the global tokenization market could grow to about 5 trillion USD by 2025.
Therefore, in the long run, all financial markets will have to digitize their processes and tokenize their assets to remain relevant. Yet the vast majority of securities market activity in the EU today is still taking place through traditional channels. There are a number of reasons for this:
- The current Central Securities Depository Regulation (CSDR) limits the introduction of publicly listed securities for book entry settlement only to a regulated CSD, making many tokenization platforms unviable or forcing them to shift their focus to private markets.
- There is uncertainty as to how depository duties and the resulting liability under the AIFM and UCITS provisions apply to digital assets and security tokens.
Current measures in the EU Digital Finance Package do not address those issues fully, focusing instead on a number of other important matters such as the regulatory framework for crypto assets and cyber security standards. Resolving the open issues for tokenized assets and allowing the emergence of a more decentralized, distributed market place would help create many opportunities for investors. It would allow the emergence of new digital first, mobile first, self-servicing distribution channels that could appeal to a new generation of emerging tech-savvy investors.
The original vision of digital assets emphasized the concept of censorship-resistant assets providing for the ability to organize economic exchange without a central intermediary. The successful deployment of blockchain technology to securities markets needs to reflect on this principle, while also supporting other secular trends such as;
- The shift in consumer preferences towards service models that operate real time – all the time;
- The growth of private markets whereby tokenization could be used to create liquidity in historically illiquid assets (e.g., private equity); and
- The development of a circular economy, using tokenization to enable broader peer to peer interactions and distribution.
Assets issued in a digital or tokenized format also bring the opportunity to automate financial lifecycle events, such as corporate actions or performance fees, through the use of smart contracts. Additional technical oversight and new governance processes will be needed to ensure that these applications operate as expected and that the data feeds triggering these activities are reliable and accurate. Over time, the market should adopt common standards to determine who bears responsibility for the due diligence processes of different tokenization platforms, and what conditions should be imposed for firms acting as a trusted data provider (so-called data oracle) that drive the ‘state’ of a smart contract, i.e. the data applied to execute its code.
Individual EU member states have started to take the lead in terms of defining a regulatory framework for tokenization. For example, the recent German law on electronic securities defines a number of conditions as to how a tokenized security should be issued, including:
- The applied source code must be made available for relevant stakeholders to allow for due diligence
- The ability to reverse transactions must be in place, if needed
- The ability to migrate tokens to other platforms muse also be available, if needed.
There is an open question as to what extent these efforts should be harmonized, or even be subject to a EU framework, as at the moment national law determines the definitions and requirements to issue securities.
In contrast to security tokens, there are fewer challenges in the use of Artificial Intelligence and Machine Learning (AI/ML) models in market operations, since existing risk management expectations are well-suited to AI/ML and there are fewer regulatory hurdles to overcome. AI/ML is also used in transaction processing and trade settlement, to automatically read and route client inquiries or to support investment fund compliance with prospectus terms, including pre and post-trade obligation.
The EU Digital Finance Package is a welcome and necessary step forward to ensure that EU capital markets can benefit from technological innovation and has the potential to enhance financial market integration in the banking union and the capital markets union. However, more work remains to be done. In particular, asset management regulation and ensuring a level playing field in the ability of firms to tokenize securities remain open challenges.
This article originally appeared in the Eurofi Views Magazine, September 2021