After the brutal 2022 that saw billions of dollars wiped out from the digital asset market and the collapse of several prominent crypto companies, 2023 is proving to be a year of recovery.
This year, capital markets players ranging from product issuers to commercial banks to index providers to legacy transfer agents, almost all are exploring the forward-looking digital ecosystem, noted Security Token Advisors in its latest report, “State of Security Tokens 2023.” Security Token Advisors (STA), which is a leading consulting and research company, helps issuers, investors, and managers with security token offerings.
“We've already seen banks involved in primary digital bond issuances on both private and public blockchains… but that was just the tip of the iceberg,” stated the report.
Authored by Peter Gaffney, head of research at Security Token Advisors (STA), the report noted a significant trend that started late last year: investment banks continued to be most active with digital bond issuance in tokenization. This trend has carried into this year with the likes of Goldman Sachs, UBS, HSBC, and others launching several offerings.
This trend is further gaining traction, with, most recently, the financial giant JPMorgan Chase revealing that it is in the advanced stages of developing a blockchain-enabled digital deposit token for cross-border transactions. However, the initiative is currently awaiting the green light from US regulators.
But despite the ongoing uncertainties in the digital asset market, institutions like JPMorgan have been working on leveraging the advantages of blockchain technology, especially in facilitating instantaneous payments between institutional accounts. JPMorgan, in particular, has been working towards this vision since 2019, and all this time, it has been steadfast in its plan to “tokenize” traditional financial assets, which it recognizes as a “killer app.”
The bank has actually processed more than $700 billion in transactions in short-term loans using its Onyx digital-assets platform, a permissioned version of the Ethereum blockchain, where customers can trade tokens that denote ownership rights to US Treasurys. The Onyx-based repo service is used by the likes of Goldman Sachs (GS), BNP Paribas, DBS Bank, and many more banks and broker-dealers.
As has been mentioned by Tyrone Labbone, the head of the Onyx program, private markets — private credit, private equity, and private real estate are about double the size of public markets but many orders of magnitude less liquid, creating a “huge disparity.”
This is where tokenization offers the benefit of democratizing finance and bringing broader investment opportunities to the general population through “fractionalized” investments in global opportunities. The forecasted value of real-world assets expected to be tokenized is $16 trillion by the end of this decade, a significant increase from a mere $300 billion in 2022. $3 billion in assets are already tokenized, as per on-chain analytics.
In a recent interview, Lobban said using blockchain technology to process transactions not only saves on cost but also adds new utilities. “All of a sudden, you can use your assets in a way that you couldn't use them before,” he said.
Lobban talked about how asset management giant BlackRock is “looking to tokenize money market fund shares” and “provide utility to their investors who are actually looking to potentially pledge those shares as collateral.” By opting for getting access to cash instead of redeeming out of the fund, investors can then post that as collateral and stay invested, using “those shares in a way that they couldn't have” before.
Asset Tokenization: A Growing Trend
Asset tokenization, which is now commonly referred to as Real-World Asset (RWA), has swept across a much wider range of uses than simply fractional investment products. Today, everything from individual private assets to equity and debt portfolios to ETF products to money itself is becoming tokenized with the end goal of decentralized finance (DeFi) interaction.
This trend of asset tokenization has grown a lot over the past few years. It is an extended use case of blockchain technology that enables the purchase, sale, and exchange of digital assets on the distributed ledger. The tokenization of assets is the process of issuing security tokens representing real digital tradable assets. The use of blockchain here guarantees that once you buy tokens representing an asset, no single authority can change your ownership.
The idea with real-world asset tokenization is to create a virtual investment vehicle on the blockchain linked to tangible things like real estate, art, and precious metals. Keeping the ownership of the real-world items on-chain lowers the cost by removing middlemen and allows fast, efficient, 24/7 trading of items. Moreover, this transparent process increases trust and accountability between involved parties and lowers the barrier to entry, creating more liquidity. By leveraging blockchain technology and smart contracts, tokenization further fosters trust and efficient management of assets.
Traditional finance firms are excited by the idea of tokenizing assets they already trade, such as gold, stocks, currencies, and commodities.
According to STA's Q1 2023 extended report, the industry landscape has come a long way since the secondary markets were sub-$1 billion, and institutions were still pouring resources into crypto trading desks. Now, with multiple banks and organizations like Citi, JP Morgan, Bank of America, and BlackRock directly getting involved in tokenization and regarding it as the “killer use case for blockchain technology,” institutions are scrambling to determine their tokenization strategies.
Talking about the secondary market activity of security tokens and listed assets, they are currently being traded through broker-dealers (BDs), alternative trading systems (ATSs), multilateral trading facilities (MTFs), digital securities exchanges, and sometimes compliant decentralized solutions internationally, noted the report.
However, much of the trading is facilitated on a singular venue basis, with the vast majority of assets only listed on one venue. This means liquidity is limited to the activity of each individual venue until these marketplaces and players better support multi-listed offerings with each other.
Now, looking at the secondary market numbers over the past twelve months ending March 31, 2023, reveals that real estate grew 10% in market cap and recorded mostly steady increases in trading volume, signaling an “upwards and to the right” trend.
Private investment fund tokens also picked up volume, though slowly, before spiking in March 2023, while market cap value decreased 60%, signaling selling pressure. In contrast, Pre-IPO Equity tokens significantly dipped in volume, as much as 80%.
From Bonds to Private Equity & Publicly-traded Funds
At the beginning of the year, institutions have been all about bonds. However, this institutional interest in the tokenization space has spread far beyond just bonds and into the publicly traded product field and private markets since then. Between February and April 2023, the money market and fixed-income yield funds and private equity and private credit developments dominated the headlines, as per STA's report.
If we take a look at the volatile realm of digital assets, investors grapple with the daunting challenge of ensuring stable returns. Now, through tokenized money market funds, which invest in the most liquid and secure assets in the traditional finance space and are also under the diligent management of trusted asset managers, investors get access to potentially high-yielding but secure alternatives.
Franklin Templeton is a prominent example in this space. In 2021, the $1.4 trillion asset manager introduced a money market fund that used a public blockchain to record transactions. Its OnChain U.S. Government Money Fund (FOBXX) trades on the Nasdaq and has over $290 million in AUM. The company is actually working with the SEC to unlock “a rich set of features,” including efficiency gains and lower fees. Franklin Templeton expects such funds to be used alongside stablecoins or even as an alternative to them.
The combined market cap of tokenized money market funds is currently around $500 million and has quadrupled in size this year. Currently, this trend is not yet widespread, but they've certainly started to capture the attention of investors and institutions alike. Demand for tokenized versions of US Treasury bonds, in particular, has been soaring thanks to rising yields in traditional financial markets.
The tokenization of private equity, an industry that has experienced remarkable growth to surpass $13 trillion in AUM, is also gaining interest from institutions. Private equity tokens, which serve as digital representations of ownership in private equity investments, enable fractional ownership, improved liquidity, and simplified management. That's why most fund managers believe that alternative asset classes, such as private equity, are highly likely to be targeted for tokenization due to long lock-up periods, limited exit opportunities, and lack of liquidity, transparency, and accessibility compared with traditional asset classes.
By democratizing access to the private equity market, tokenization breaks down barriers to entry for retail investors and creates opportunities for smaller investments through fractional ownership.
However, according to the report, while fractional private equity access to a wider range of investors is gaining traction and “solidifying,” it hasn't reached the retail level yet. It is actually finding ground on the accredited and qualified purchaser side with up to 99% reduced minimum subscriptions and streamlined investor management solutions.
Here, Hamilton Lane is the frontrunner, with the capital market company now on its sixth global tokenized offering. The company has been particularly active in the US and Singapore, with a mix of private equity offerings across numerous service providers and multiple blockchains.
Now, when it comes to the tokenization of private credit, STA notes that there is an “extreme opportunity” for some of the major alternative asset managers. As per S&P Global, six of the largest alternative asset managers, viz. Apollo Asset Management, Ares Management, Blackstone, Brookfield Asset Management, The Carlyle Group, and KKR & Co., working with private credit, doubled their assets under management devoted to credit since the end of 2019, reaching approximately $1.4 trillion.
Debt instruments, after all, make for potent investments and are recommended by most portfolio managers, though several investment barriers have precluded most investors from investing in this financial instrument. Not to mention, the traditional issuance process is weighed down by unnecessary manual processes, high intermediary fees, and long settlement times. Tokenized private debt alleviates these inefficiencies through automation and allows fractionalized primary issuance, opening the market to smaller investors.
Now, given the expanse of the market and the likes of Hamilton Lane, Apollo, BlackRock, and Carlyle getting involved in tokenization, this field is a promising near-term vertical to make use of blockchain-based securities, said Gaffney. Besides private credit, fixed-income funds are yet another option that presents more attractive or suitable products to investors who are still weary about private equity's ability to navigate the macroeconomic picture, thus finding investor demand, he added.
The Parties Involved: Inside & Outside Crypto
While institutions are pouring in to take advantage of tokenization, it is leading to new lines of business popping up and expanding the playing field. As per the STA report, crypto-native firms are also realizing that compliant tokenized products are becoming a huge segment within the digital assets space, which is heating up the competition for distribution channels and qualified investors.
When it comes to the function of service providers, the space is witnessing the involvement of transfer agents, broker-dealers, alternative trading systems, custodians, and third parties, as well as issuers, blockchain foundations, asset managers, and investment banks.
Banks and asset managers, in particular, are targeting digital settlement with tokenized deposits. Settlement is one of the key facets that major players have been evaluating, and it underpins the digital assets and tokenization ecosystem. However, Gaffney notes that many commercial banks, investment banks, asset managers, and other institutional players are hesitant to utilize generalized public stablecoin to facilitate and support transactions and settlement across tokenized assets and within the associate infrastructure.
This has resulted in discussion and development around deposit tokens, money market fund tokens, Central Bank Digital Currency (CBDC), and blended alternatives like the Regulated Liability Network (RLN). Making the foundation of the infrastructure, this is a critical discussion that brings forth further questions of open versus closed ecosystem solutions. As STA noted, stablecoins offer great open ecosystem capabilities, but tokenized deposits and similar solutions provide superior compatibility with current banking models.
While settlement is the focus of banks and asset managers, investment banks and broker-dealers are pushing for security tokens and tokenized asset distribution. Investment banks have been busy this year launching bond tokenization platforms, issuances, and syndications such as Goldman Sachs Digital Asset Platform, UBS's SIX Digital Exchange, HSBC's Orion Platform, Deutsche Bank's Digital Assets Management Access, and Credit Agricole & SEB's green bond network.
This further evolved to now include new broker-dealer approvals and entry on the accredited and retail investor private placement distribution channels, including Dalmore Group, Castle Placement, and Bosonic Securities, becoming more hands-on with tokenized offerings. Interestingly, Jefferies ended its three-year hiatus from the blockchain world by underwriting a $237 million Figure HELOC with Goldman Sachs and JP Morgan.
“Incumbent investment banks and broker-dealers contributing to product distribution on a retail, accredited, and institutional basis is a necessity for the prospective issuers currently on the sidelines,” noted STA in its report.
The Matter of Public and Private
In the world of tokenization, private blockchain solutions continue to gain traction among institutions. According to STA, private blockchains have merits for institutions when it comes to tokenization. As a result, numerous investment banking tokenization platforms are currently underpinned by private blockchain solutions.
With private blockchains, the purpose is clear: to improve operations, reduce risks, and ultimately increase the bottom line. Being on the institutional side of capital markets, these blockchains don't even need to access the general public or be facilitated in a decentralized manner.
This can be seen in the case of Goldman Sachs with Digital Asset's Daml language, HSBC with Hyperledger Fabric, and Deutsche Bank with Memento blockchain, and as per STA's report, these solutions are helping these banks save asset issuance and servicing costs. While the savings can be just in the 10-20 basis points range, it can translate into millions of dollars added to the bottom line.
Another prominent example is the Canton Network, an interoperable privacy-enabled infrastructure solution launched by Digital Asset for institutions across the board. The network has institutional node operators like BNP Paribas, Goldman Sachs, Deloitte, Cboe, S&P Global, and Broadridge, who already work with Daml on its distributed ledger repo network, transacting over a trillion dollars a month. Given its potential, Canton has the capability to compete with public blockchains, at least in the eyes of institutions, thanks to offering a blend of decentralization and scalability while maintaining that key privacy and security, as per the report.
Private blockchain solutions are currently used primarily for internal and external institutional transactions that reduce execution time and labor and offer yield savings to the parties involved, making them suitable for use cases like digital bonds, fund administration, and publicly traded product transactions and settlements.
That is not to say that public blockchains are falling behind or not getting any use at all. STA noted that Ethereum (ETH), Polygon (MATIC), Stellar (XLM), Avalanche (AVAX), and Provenance Blockchain (HASH) are some of the most active public blockchains within the tokenization space.
“Over time, it is expected that certain chains begin specializing in financial segments (i.e., public mutual funds, private debt, real estate, tokenized deposits) based on issuer satisfaction and traction, although it is much too early to determine that,” said STA.
To put it succinctly, asset tokenization is still in its infancy, with challenges in the form of uncertain regulations and technological integration to be surmounted before it is widely adopted. However, the tokenization of real-world assets such as government bonds is clearly seeing growth, having emerged as one of the hottest trends in crypto this year.
Tokenization actually has the potential to upend several industries and can especially be a potential game-changer for the financial sectors. Established players have started to realize this, too, and have been making an entry into the space, albeit slowly. This traction is only going to grow in the coming years, helping the tokenized asset market to reach trillions of dollars.