Securitisation, tokens and blockchain
The asset management industry is waking up to the possibilities that blockchain/distributed ledger technology (DLT) offers. It has the potential to transform asset management through enabling the digital representation of assets using smart contracts.
What is tokenisation?
Asset tokenisation is the process of leveraging blockchain technology to securitise assets. These digitally-tokenised assets, or security tokens, are (or will become) considered securities under local laws and regulation, though it varies from jurisdiction to jurisdiction.
Capital markets are in the early phase of adoption but the tokenisation of real-world assets is beginning to gain more momentum and a range of investments are being made across the industry.
Tokenisation is simply taking an age-old concept and implementing it in a new medium, ‘Securitisation 2.0’, as some commentators are calling it. Tokens are similar to a bond, except they are digital and created and bought and sold on a blockchain. You can tokenise all kinds of assets, ranging from real estate to art to underlying debt.
Tokenisation makes an asset more transferable and highly liquid. Tranching can be achieved through the creation of different tokens for different tranches, whilst waterfalls for payments made on underlying assets can be accommodated easily on the blockchain through the use of smart contracts.
You do not have to look hard for examples of companies that are innovating in the area. Andy Warhol’s 14 Small Electric Chairs (1980) was the first-ever fine artwork to be tokenised and auctioned on the Maecenas art blockchain platform last year.
Germany’s Bitbond is the first global lending platform for small business loans that leverages blockchain technology to connect creditworthy borrowers with individual and institutional investors. Smartlands, meanwhile, brings together asset managers and investors by creating low-risk blockchain-based securities backed by assets in real estate, agriculture, private equity and more.
Why should a company tokenise?
The key benefits of asset tokenisation include increased liquidity, faster settlement, lower costs and improved risk management.
By changing the way these securities move from one counterparty to another, you potentially remove a number of the intermediaries. This, in turn, increases efficiency and opens up new revenue streams by making smaller securitisations economically feasible through reducing the cost of execution. A typical public securitisation might be €350–450m in volume. With a tokenised securitisation, you can go much smaller. Even €10–20m tokenised securitisations can make sense with the increased efficiency and automation of blockchain technology.
Tokenisation decreases settlement risk as transfers should happen instantaneously. It also decreases the risk of something going wrong between collecting from the underlying asset and paying the token holder.
Blockchain does, however, suffers from a perception problem. All the hype, fear and media attention for cryptocurrency has had an unnecessarily negative effect on the benefits of the technology. But you can actually be more confident about cash flow through the digital world than via a traditional loan. With blockchain, you can easily follow the life cycle and see everything that happens along the way. Effectively, blockchain provides a built-in audit trail. There is more transparency and less scope for fraud and money laundering.
How the underlying smart contracts work
A smart contract is a piece of code that can be programmed to replicate the terms of a paper contract. From an operations perspective, there is no fundamental difference between a smart contract and a piece of paper that has a traditional contract written on it.
Both smart contracts and traditional contracts have certain parameters, prerequisites, inputs, and outputs. There is one point to consider. With a traditional contract, you can show some discretion and flexibility in certain circumstances because you have a human to interpret what to do in these instances. Because smart contracts are binary, there can be no discretion. Flexibility can be built in through the correct use of conditions in smart contracts, but only if it can be completely defined in code. For example, you could add a resolution mechanism to kick in when a situation arises that cannot be handled by a simple ‘either/or’ scenario. This may involve another smart contract or require an API with an external data source (also known as an “Oracle”).
Smart contracts will not eradicate the need for lawyers because transaction documentation will still need to be written, or at least reused. The machines will still need to be told what the criteria for the securitised portfolio is, as well as various terms and conditions related to the issuance of the tokens to the benefit of the issuer and the investors.
Settlement and Custody
In order for tokenization to be scalable at institutional levels, it is important to have a market-accepted post-trade settlement and custody system that is acceptable to market participants. ING just launched such an effort, namely Pyctor (https://www.pyctor.com/). Together with partners such as ABN AMRO, BNP Paribas Securities Services, Citibank, Invesco, Société Générale, State Street and UBS, ING has attempted to address precisely this problem. It is early days, but whether it is Pyctor or a new player still to emerge, this is a key part of any viable global tokenization market at scale.
The regulatory perspective
Current regulation around tokenisation is rather fragmented. A number of jurisdictions have taken steps towards clear regulation. Malta, for example, was the first European Union (EU) member state to introduce a complete regulatory framework around cryptocurrency and other innovative technology arrangements and services related to DLT. Italy is also trying to create a strong regulatory framework to level the playing field for all parties that are involved in blockchain innovation.
FINMA in Switzerland has been one of the most flexible and forward looking regulators. They were the first regulator in the world to publish clear guidelines on ICOs and classifications for tokens. This has meant that blockchain startups are not held down by restrictive regulatory hurdles. The canton of Zug is particularly well-suited to blockchain businesses due to the budding ecosystem and low tax environment. As a result, Zug has started to be called “Crypto Valley”.
There is now a push on a European level towards regulatory harmonisation. It is clear to EU member states that tokenisation is here to stay and that it needs to implement regulation to give comfort to investors that they will be sufficiently protected.
That said, there are also significant challenges with current industry legislation, including the need to have physical evidence of debt for Eurobonds under Reg S. You could potentially replicate that through a smart contract program and create an automated securitisation platform. However, in this scenario, you would have to comply with various regulations including MiFID II and perhaps the new Securitisation Regulation (if the smart contracts also perform tranching).
ISO Framework
The international standards organisation ISO is working on a framework to standardize the management and auditing of blockchain/DLT technology and business activities through the creation of a new standard ISU/TC 307 (https://www.iso.org/committee/6266604.html). The standard will not be ready for another year or two but it shows that blockchain and DLT is fast becoming business as usual.
This will be essential in terms of tokenization being accepted by institutional investors as it can provide comfort that the technology is performing as it should and risks are being properly mitigated and controlled.
Summary
There is still work from the perspective of regulation, industry acceptance and standards to help this new technology to reach its full potential but I believe that in the short- to mid-term tokenised securitisation will become the norm. The question is not if but when.
