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In the past few years, conversations around the adoption of distributed ledger technologies (DLTs) have increased in f requency across financial services. Blockchains are the most visible variant of the technology; however, a use case that has come to particular attention recently is asset tokenization – the process of converting traditional assets into digital tokens.
The most significant benefit of tokenized assets is their ability to democratize finance and open more investment opportunities for everyday investors. While applicable to both public and private markets, the heightened transparency provided by the public nature of DLTs, coupled with the ability to trade private assets on exchanges like stocks, makes it easier for investors to enter and exit private markets and tap into investment opportunities.
However, key to maximising these operational gains is interoperability – the ability for different DLT networks to readily connect and exchange information with each other without restriction. As different networks continue to emerge, collaborators must find a way to communicate and integrate effectively if tokenization is to reach its true potential.
Asset tokenization is now at a critical juncture as the potential investment opportunities in the tokenization of real-world assets in private markets are being realized.
The benefits of democratizing private assets
Asset tokenization is now at a critical juncture as the potential investment opportunities in the tokenization of real-world assets in private markets are being realized. With a potential investment pool of $8-12 trillion available for alternative investments, tokenization enables these funds to be effectively deployed into various assets, unlocking new opportunities for investment and innovation.
Enhanced access to this capital pool has several potential benefits for private markets. With untapped individual investor funds available to be invested in alternate asset classes, asset tokenization opens a large pool of opportunities for private equity firms and asset managers to pitch for these funds.
This increased democratization and accessibility will improve the liquidity of digital assets, in turn creating more effective pricing discovery and achieving better efficiency in pricing. In facilitating fractional ownership, tokenization allows market participants to re-value assets that cannot be liquidated more efficiently, bringing them closer to a fair market price.
For investors, this increased liquidity enables the faster buying and selling of asset positions, allowing for more efficient capital allocation, and ensuring resources are directed most productively. Meanwhile, the ability to acquire fractional ownership in a broader asset range also enhances risk diversification, insulating investors from sudden fluctuations in the market.
The heightened transparency provided by the public nature of DLTs, coupled with the ability to trade private assets on exchanges like stocks, makes it easier for investors to enter and exit private markets and tap into investment opportunities.
With changes to shorter settlement times on the horizon, tokenization can help facilitate settlement in a matter of minutes, helping reduce costs for investors in high-interest rate environments. The immutable nature of the DLTs behind tokenization protocols allows investors to make better-informed decisions when purchasing assets, minimizing the time taken for compliance checks and due diligence before a purchasing decision.
Barriers to widescale adoption of tokenization
To date, the potential for asset tokenization to increase liquidity has generated the most excitement among asset managers on the buy-side. However, this is a double-edged sword, as it holds the potential to increase fragmentation between disjointed networks which rather than working together, operate in isolation.
It could also add confusion to the regulatory landscape by reducing the prevalence of large-scale projects on which comprehensive and clear regulatory frameworks can be based. This could destroy value, damage trust and subsequently long-term investment from financial institutions as the lack of clarity will make operations such as compliance more complex and costly.
Fragmentation threatens the core benefits of tokenization discussed above. To prevent this outcome, the market should take a collaborative approach embracing three key principles: regulatory alignment; the creation of non-exclusionary including all major stakeholders in the value chain; and most importantly facilitating interoperability across markets and networks.
Interoperability enables different DLT networks to readily connect and exchange information with one another without restriction. As different networks emerge, interoperability will be even more important for tokenization to reach its true potential and proliferate from small regional pilots between banks, FMIs and regulators, to industry-wide initiatives.
As the market evolves, the successful integration of asset tokenization into private networks will open new frontiers for investment and financial efficiency. A key development for the private sector could be the widespread use of CBDCs or large-scale tokenization of deposits by Tier 1 banks.
Led by larger institutions and exchanges, such initiatives will help drive standardized methods and procedures across domains and market participants. For example, DTCC, Clearstream and Euroclear released a paper highlighting the importance of collaboration to advance the digital asset ecosystem and calling for progress on limiting factors. This included addressing fragmented standards, varying regulatory treatment, limited integration and siloed liquidity.
So, where does this leave us and what comes next?
Asset tokenization offers significant potential for private markets to unlock capital, improve liquidity, and foster interoperability in private markets. While challenges such as regulatory clarity and technical infrastructure remain, developments and industry partnerships in the industry are making this vision increasingly realistic, with a bright future ahead of us.