In a recent report, UK Finance shared its thoughts on the tokenization of securities and how it believes the UK banking and finance industry should approach/leverage the technology moving forward. It is noted that the report was put together with the goal of answering the following questions.
- What is the UK's position today?
- Why does tokenization (and the UK's position on it) matter?
- What are the next steps for the UK?
This report is particularly notable, as UK Finance “…is the collective voice for the banking and finance industry”. In the United Kingdom, this collective voice is representative of over 300 firms – meaning its opinions and findings provide valuable insight into the general consensus surrounding tokenization and not that of a single firm. With that being said, the following is a brief overview of the findings shared throughout.
The digital representation of real financial assets using distributed ledger technology (DLT) or blockchain, is what is commonly referred to as ‘tokenization'. It is also a process increasingly recognized as an approach primed to transform the existing financial landscape. In its report, UK Finance makes clear that it believes, while the tokenization market is still emerging, with tokenized issuances only forming a small fraction of traditional securities, the UK has an opportunity to become a global hub for this industry.
The UK has shown modest promise in the area of tokenization, despite the perception that it may be lagging behind other jurisdictions. While it may lag in tokenized securities issuance, this is not the only measure of progress. Other factors including legal and regulatory reforms, adequate market infrastructure, and government support are each critical for tokenization adoption. UK Finance makes clear that it believes the UK can catch up to its counterparts if it continues to build momentum and not let progress stagnate.
An example of this progress includes the recent leveraging of the UK's expertise in significant digital issuances, such as the first pound sterling digital bond issued by the European Investment Bank (EIB) in Luxembourg in January 2023. The successful issuance of the sterling-denominated digital securities revealed a clear market demand that is only set to grow.
Overall, the report highlights a few key enablers that will allow the UK to catch up and surpass other forward-thinking nations by establishing the following,
- legal clarity
- regulatory clarity
- trusted market infrastructure
- government support
Beyond the key enablers listed above, it is noted that the UK can learn through examples set by other nations. Abroad, there has been an uptick in the number and variety of issuers and the value of digital bond issuance, despite representing less than 1% of the $20.6 trillion issued in long-term fixed-income instruments in 2021. Key players in this space include Singapore, Hong Kong, Switzerland, France, Germany, and Luxembourg – each of which is supported by clear regulations to attract public and private initiatives.
Meanwhile, in the UK, fintech companies have been involved in pilot debt transactions, with notable examples including Santander and NatWest's successful proof of concept for a tokenized security issued on a public blockchain in February 2022. Other similar activities by JP Morgan's UK Entity, DBS Bank, HQLAX, Fnality, Goldman Sachs, and UBS have also occurred.
Why Does it Matter?
As it stands, the UK is a leading financial center on a global scale. If this is to remain the case, many believe that the adoption and forwarding of tokenization is essential. Estimates of tokenization's impact on financial markets vary, but there is increasing consensus on its transformative potential with projections suggesting that digital assets could represent 5-10% of global assets by 2030, with outstanding tokenized securities between $4-$5 trillion.
Tokenization is poised to unlock a variety of benefits, including,
- Unlocking capital and enabling fractionalization
- Facilitate trade, increasing asset liquidity and potentially unlocking trapped capital
- Fractionalization, letting investors purchase portions of assets, broadening accessibility
- Enhanced risk management by facilitating simultaneous, instantaneous transaction settlements, lowering counterparty, bankruptcy, and performance risk.
However, tokenization also introduces new risks associated with technology such as trading errors, cybersecurity concerns, and operational risks stemming from poor interoperability between DLT platforms. Despite these potential risks, they are typically viewed as being far outweighed by the benefits to be had.
The operational efficiencies stemming from tokenization are of huge value to market participants, with previous analysis indicating that “…widespread use of DLT in the EU could result in annual costs savings of up to EUR 4 billion in the area of reporting and ‘several billion' in the European derivatives market over time in relation to clearing, settlement, collateral management and other intermediary functions.”
These are not just potential scenarios though – successful pilot projects have already demonstrated these benefits. For example, the Hong Kong Monetary Authority noted a reduction in settlement time from five days to one day when issuing a tokenized green bond while Singapore Exchange reported a 60% settlement time reduction on its blockchain-enabled bond issuance platform. As previously alluded to, these improvements surrounding the settlement process are made possible because tokenized transactions require fewer intermediaries. This means that the settlement process can be executed instantly while adhering to automated compliance procedures, in addition to offering a simplified onboarding process and reduced asset servicing costs.
While it is easy to identify the benefits that tokenization can afford, the answer of where to start is somewhat more complex. To that end, UK Finance sees tokenized bonds as the low-hanging fruit; an optimal starting point to gain comfort with the technology and demonstrate its potential.
Some investors, consulted by UK Finance, see a market for tokenized private assets such as private equity, debt, and fund products, with the tokenization of money market funds offering appealing opportunities. While the industry might get the ball rolling with securities like bonds, consensus suggests that the full potential of tokenization will emerge with more complex products like real estate, which suffer from poor liquidity and reliance on a variety of intermediaries. Transforming illiquid assets like real estate into tokens can fractionalize direct property investment, enhancing liquidity, broadening the investor base, and increasing transaction efficiency while reducing costs. Lastly, smart contracts allow for streamlined processing, including compliance, document verification, and trading, minimizing error possibilities and reducing the need for manual input.
What Comes Next?
For the full potential of tokenization to be realized, UK Finance believes that a government and industry alignment around a strategic roadmap is necessary. This will ensure that the UK's financial services industry remains competitive as the tokenized securities market continues to evolve.
UK Finance anticipates that the tokenized securities market might evolve through various structures such as “siloed,” to “interconnected”, and finally “universal.” Initially, industry participants would experiment with siloed ledgers to prove the technology's value. Gradually, these siloed ledgers would shift towards an interconnected ecosystem, and eventually expand in to a universal structure.
In the short term, the report indicates that the government and industry must support the siloed market structure while preparing for more interconnected or universal ledgers. Notably, countries such as Singapore, Switzerland, and Luxembourg have already built momentum in this model.
To keep up and position itself as a global leader in tokenization, the UK needs to accomplish three missions, per the report: enable innovation and experimentation underpinned by legal and regulatory certainty; foster a flourishing UK digital market by promoting interoperability and safe innovation at scale; and become a leader in global standards for the tokenized securities market.
The following recommendations are made by UK Finance for the UK government, regulators, the UK's legal community, and other market participants to ensure these missions are reached.
- Enhancing understanding of the legal status and treatment of tokenized securities in the UK; providing clarity on the regulatory reforms needed to support a market for tokenized securities;
- Ensuring technological neutrality of regulatory reforms while being sensitive to the features of particular technologies and deployments;
- A government-sponsored sandbox, like the FMI Sandbox, would be an ideal forum for such explorations.
If achieved, these missions are expected to boost positive feedback loops, clarify the legal status of tokenized securities, ensure the legal community can comfortably advise clients, and encourage industry participation.
Like many nations, if the UK plays its cards right, it can potentially usher in a revolution within financial markets through the acceptance and adoption of securities tokenization. As a result, UK Finance believes that there is currently a significant opportunity for the UK to boost its capital markets.
However, it notes that a “supportive ecosystem” is crucial to unlock the benefits on offer through DLT and blockchain technologies and that concerted action is necessary to promote experimentation, establish interoperability standards, and initiate requisite legal and regulatory reforms.
Encouragingly, UK Finance note that active engagement between the UK government, regulators, and industry on necessary regulatory reforms is already taking place, and work is ongoing on the FMI Sandbox and legal provisions around securities tokenization.
Overall if the report were to drive home one point, it would be this – The future of financial markets is indeed at hand, and the time to act is now.
To read the UK Finance report in its entirety, click HERE.