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The Future Of Banking: Building A Token Collection


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The Future Of Banking: Building A Token Collection

Investor interest in tokenization has increased over the past few months after the COVID-19 pandemic highlighted the importance of digitalizing the financial services industry. Although S&P Global Ratings has seen a primary focus on retail banking disruption (see "The Future Of Banking: Will Retail Banks Trip Over Tech Disruption?," published May 14, 2019, on RatingsDirect), we think the ongoing pandemic will push greater financial innovation.

In our view, tokenization offers several benefits including the fractioning of assets, which enhances their liquidity and opens the door for investors or borrowers that may have been excluded from existing options. In addition, we believe the technology could allow new players to enter the market, further challenging incumbent banks' and asset managers' revenue. As a result, and due to the new digital normal of high-speed transformation, we now expect banks to pursue new products or collaborations much faster than before the pandemic.

With that said, the industry faces several hurdles including the different speed and willingness of regulators to implement a regulatory framework for tokenization. Whether tokenization will replace some financial products remains to be seen, but it may have positive effects on specific business lines, such as capital raising exercises, SME financing, and liquefaction of illiquid assets. Furthermore, tokenization of assets might offer convenient and more cost efficient access to new clientele than current asset-management products, which are mostly offered to only high-net-worth individuals.

What Is Tokenization?

Tokenization is the process of creating one or several digital representations of a physical or nonphysical asset (including financial assets) and managing it on distributed ledgers. There are several types of tokens including payment tokens, utility tokens, and asset tokens. In this article, we will focus on the latter.

So long as the legal environment allows it, any nondigital asset--real estate, private companies, art, and luxury items to name a few--could potentially be transformed into one or several tokens (potentially an infinite number). These would represent the right to the asset (right to use the asset, proof of ownership of a fraction or the totality of the asset, etc.), and would need to be placed with a trustworthy custodian to protect holders, meaning tokens on distributed ledgers are in a sense similar to asset-backed securities on financial markets. However, the underlying quality of a token will always be related to its original asset, while in securitization this link could be blurred by combining different types of assets or through over collateralization.

According to a study conducted by Greenwich Associates and based on the responses of 109 executives active in the blockchain and financial technology space across the globe, equity raising for start-ups and private placements are perceived as the best applications for tokenization. Securitization of cash flows and real estate products, along with private debt placement, were also in the top five application domains. Given the large volumes of transactions in some of these segments, tokenization could quickly attract attention if it were to take off.

Chart 1


Why Tokenization Is Attracting Attention

We see several benefits of tokenization:

Fractionalization, liquidity, and financial inclusion

The creation of a large numbers of tokens out of an expensive asset would make it more accessible to a higher number of users (owners) than previously. This would open the door for broader involvement of retail investors, for example, owing to lower minimum investment size, and enhance the liquidity of illiquid assets. However, this assumption is based on distributed ledger and real world trading not coming into conflict, which could see liquidity transferred from one market to another. Higher liquidity also means lower illiquidity premiums and lower cost of funding for some instruments. This could prove beneficial for SMEs if a tokenized financing product (disintermediated and listed) is cheaper than bank financing (intermediated and over the counter). We think tokenization could also increase available noncash collateral in financial transactions and improve collateral management. There are several examples of tokenization of illiquid assets including the recent partnership between a commercial real estate firm in the U.S. and a platform to tokenize $2.2 billion of properties.

Market efficiency

Tokenization allows for the exchange of assets in an efficient manner due to the absence or limited number of intermediaries involved and streamlining of back-office operations. This shortens clearing and settlement times, which ultimately reduces counterparty risk and frees up collateral. The combination of tokenization and smart contract protocols could also help reduce the cost of administering the asset and reinforce compliance with regulation. Having a real-time standardized view of transaction data without needing to conduct multiple reconciliations would remove many of the inefficiencies that hinder the financial system, and could reduce costs. Compliance could also be reinforced through the automatic transmission of information to regulators. However, this may affect market making activity, and price volatility, since orders would need to match to be executed.

Higher transaction security

The use of distributed ledger technology could enhance data integrity and security and provide a more secure exchange of assets or information for utility tokens. On June 17, 2020, MasterCard announced that it tokenized the card credentials for Amazon shoppers in 12 countries including the U.S., Canada, the U.K., Brazil, France, Germany, Italy, Mexico, the Netherlands, Spain, Turkey, and the United Arab Emirates. The replacement of card numbers with tokens allows higher security, since the token can only be used by the specific merchant and is updated regularly. The transition to similar systems may accelerate in the future as the COVID-19 pandemic highlights the importance of electronic commerce and transaction security.

Transparency of ownership

Tokenization would allow the registration of the token holder's ownership, increasing transparency for transaction partners assuming anonymous dealing is not permitted--not least from an anti-financial crime perspective--and clarifying the rights of different stakeholders.

Five Prerequisites For Success

For tokenization to become a usable route for fund raising, a number of hurdles need to be crossed, including:

Regulatory environment

The existence of a regulatory and legal framework that recognizes the rights of token holders is one prerequisite to success. This includes claims to the income produced by the asset, proof of ownership, a dispute resolution mechanism, and recognition of smart contract protocols. The lack of a proper regulatory environment was recognized as the top challenge faced by security tokens in the 2019 study by Greenwich Associates. To date, a handful of regulators have already started to build a token framework. In Switzerland, the Swiss Financial Market Supervisory Authority (FINMA) published guidelines regarding initial coin offerings where it recognizes the three nonmutually exclusive categories of tokens (payment tokens, utility tokens, and asset tokens). Assets tokens and certain utility tokens are treated as securities by FINMA. In Europe, tokens can reportedly be seen as transferrable securities, which are part of the financial instruments definition under the Markets in Financial Instruments Directive II. Furthermore, several other countries around the world are reportedly setting up new regulatory environments to cater for future tokenization development.

Chart 2


The right technology

Network stability, scalability, settlement finality, interoperability, and immunity to cyber risks are all challenges that distributed ledger technology is still facing and might reduce the attractiveness of tokens to end users. Another challenge is the absence of an ultimate owner responsible in case of technology failure or other issues.

Anti-money laundering and counter financing of terrorism

These risks could emerge if anonymous dealing is allowed. They could even make it easier to launder money or finance terrorists, since transactions could be fractioned and spread across a multitude of tokens, which may make reconciliation extremely difficult.

Asset custody

A central entity would need enough credibility to act as the custodian for the assets and protect them against theft or any other form of alteration, for example.

Complex ownerships of assets

Potential restructuring might be considered more complex if ownership is divided among several token holders, although each can be identified and reached on the distributed ledger, which somewhat reduces this risk.

How Tokenization Might Change Financial Systems

Based on all these factors, we think that tokenization will have a limited effect on financial institutions' profitability in the next few years, with the largest impacts in SME/corporate banking, asset management, and clearing/settlement business.

But that's not to say tokenization can be ignored in the long term.

If tokenization becomes a natural and more efficient means of raising capital or debt, banks could lose business in areas like private equity placement, SME financing, and real estate financing or refinancing. In addition, we see both opportunities and potential threats for the asset management business. The former include offering a wider and more convenient product set to a broader customer base and the latter tokenization's higher efficiency and purely digital nature.

More broadly, we do not think that the technology would significantly disrupt private debt placement or mainstream mortgage financing, since it is still not developed enough to attract the attention of money purveyors. However, collaboration around tokenization between the old and new bank economy is only likely to increase. So far, this has materialized through the creation of the InterWork Alliance (IWA) in June 2020, which includes 36 members (Microsoft, IBM, Nasdaq, and other technology and financial organizations). The main objective of the IWA is to create global standards to drive tokenized ecosystems.

Other companies that could be challenged by tokenization are clearing and settlement businesses. This is because the reduced time and cost necessary to settle token-based transactions and the lower administrative burden would decrease the need for collateralization, freeing up some assets that could be used elsewhere.

Given these potential use cases, and the digital push prompted by COVID-19, we think a new wave of collaborations may be just be around the corner.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Mohamed Damak, Dubai (971) 4-372-7153;
Secondary Contacts:Salla von Steinaecker, Frankfurt (49) 69-33-999-164;
Markus W Schmaus, Frankfurt (49) 69-33-999-155;
John Wright, London (44) 20-7176-0520;

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