In most cases, when people were talking about blockchain it was as a novel method for transferring cryptocurrency. During this time frame, crypto startup companies were experimenting with digital currencies, wallets and decentralized exchanges while waiting to be involved in the mainstream financial system.
This is starting to happen. Financial institutions (banks and stock exchanges) are actively looking at tokenization to re-design aspects of the financial system. The primary objective is not just to get your stock or cash into a block-chain; the primary objective is to alter how financial transactions occur, are processed, settled and are recorded.
This is likely a greater transformation than faster payment processing. Tokenization may create a single digital platform for all forms of currency, as well as allow continuous trading of financial instruments, with the added benefit of being able to incorporate compliance and regulatory requirements directly into each instrument.
The process of tokenization of a physical asset, is a movement that has moved beyond just the use of blockchain. This process can be defined as the tokenization of an asset.
The previous explanation is accurate; however, it does not represent the bigger picture. Tokenization allows for digital representation of the right to use or own an asset. This process can be accomplished through the use of blockchain technology or other types of distributed ledger technology (DLT).
What makes this new way of handling assets so valuable is that it will allow the asset owner to keep track of their ownership and the ability to transfer ownership directly within the digital asset. Let’s consider a typical financial transaction. There are many different systems that may be involved in executing the transaction, tracking ownership, transferring funds, clearing the transaction, and recording all of the details.
These functions can be combined in many different ways through tokenization. A tokenized asset will contain rules about how it can be transferred. Smart contracts can verify certain things before allowing the transfer of the asset. When you transfer the asset, you can also make a payment.
The Financial Side of Tokenizing Your Assets
For banks to benefit from using tokenized assets to their full potential, it is necessary to develop digital currencies that will allow these banks to transact business with the tokenized assets.
Three different forms are currently in development.
The central bank has full control over the creation of a country’s official national currency in digital format; these are called CBDCs.
A privately issued digital currency with a stable value compared to the underlying reserve asset is known as a Stablecoin. Stablecoins are appealing to many people due to their ability to travel across digital channels and borders, as well as allowing for programmable transactions.
There are also tokenized deposits. A deposit that has been traditionally held at a bank, but is now in digital format. A bank which is regulated can issue a token for each customer deposit that is on a blockchain or on a controlled digital ledger.
The bank will always remain responsible for the fundamental funds. The difference between these types of accounts is significant. Tokenized deposits are more than simply another form of cryptocurrency; they want to combine the long-standing relationships that banks have established with customers, along with the flexibility and programmable capabilities of the digital infrastructure.
Banks see opportunities for profit
The banking system is already moving huge quantities of cash via electronic transactions, therefore why would you tokenise that cash?
The simple answer is that current financial systems can be surprisingly complex. Each institution has its own set of records. These records must be cross-checked with each other and compared. As well as the many different steps and middle-men involved in making a transaction.
The addition of steps results in increased costs, delays and/or potential risks to operational procedures. Shared digital ledger technology can help eliminate many of these additional steps.
Authorized individuals will not be required to maintain their own records; therefore, the need for reconciliation of those records at a future date will also be eliminated. It is possible that the elimination of these requirements may result in reduced processing times and/or lower costs associated with certain financial transactions.
The appeal goes further. The money is able to abide by the rules.
Money that is passed down through conventional means may be transferred via electronic transfer; however, there will usually not be many complex guidelines for its distribution.
The ability to make money “programmable.”
Imagine that there is an organization which buys goods from another nation.
In an ordinary business transaction, the purchaser may make payment upon receipt of either a copy of the shipping document(s), or the confirmation of a third-party intermediary. Once money can be linked to a particular event, payment can occur. After the agreed-upon conditions have been met, the smart contract can initiate the payment.
The same principles may also apply to the use of technology in trade finance, collateral management, lending, securities clearance, and corporate payments. This approach views money differently; rather than moving from one account to another, money may now be integrated into an automated financial workflow.
Exchanges Want To Be More Than Just A Place For Trading
The stock exchanges have motivation to investigate tokenization. This isn’t the first time that we’ve had the ability to separate the trading activity from other functions after it occurs.
An investor purchases a security. The transaction is complete. The transaction has processed. The settlement process occurs at a later date. Ownership of the security is documented. Custody of the security is maintained. Various entities bring the accounting records into balance. With tokenization, these steps could be performed much quicker.
A security represented by a token is a “tokenized security.” Smart contracts can help facilitate transfers of securities, as well as ensure adherence to various compliance requirements. The combination of these two concepts will create a more cohesive marketplace.
But this does not mark the conclusion of conventional exchange. On the contrary, the use of blockchain-based infrastructure may serve as an additional tier that underlies the market operations which are managed by these exchanges.
Markets are open 24 hours a day, 7 days a week
One of the most frequently mentioned benefits of tokenization is the ability to operate 24 hours a day, 7 days a week. In general, trading hours for traditional financial markets are clearly established; however, blockchain networks can continuously operate 24 hours a day, 7 days a week, and do not experience downtime.
The possibility of having 24/7 markets for tokenized assets exists. However, it’s important to realize that networks aren’t always open 24 hours per day/7 days per week; and, the same goes for deep liquidity. There will be plenty of action going on during these times (the night) and that action is driven by market makers, investors, regulatory requirements, and the locations where people trade.
However, in the future, as well as today, continuous infrastructure could allow for more flexibility within financial markets.
Settlement may take place instantly
Another primary factor that makes institutional investors interested is the process of settlement. Settlements do not typically happen on the day of the trade; they usually occur some period after the trade. This lag allows institutional investors to perform actions such as controls, managing liquidity, correcting errors, etc.
Tokenization has the potential to eliminate a majority of the time-consuming processes in the market. As an example, if you wanted to buy a stock, you could pay for it at the exact moment you bought it (this is often called “atomic settlement”). The benefits of tokenization are obvious. Both parties involved in a trade will have less settlement risk, since they will be trading directly with one another.
When the speed is higher, however, another aspect of the problem arises. The financial system will have a shorter amount of time to respond to unexpected occurrences.
Tokenization has many implications for banks
Tokenization isn’t going to replace banks; instead, tokenization might change what types of services are provided by banks. Banks could provide tokenized deposit accounts, provide tokenized asset custody, provide tokenized asset management, provide digital settlement, and develop new financial products.
For example, they may use tokens to improve internal procedures.
Loans may also create an interest change and/or a change based on collateral adjustments
It is possible that the relationship between treasury operations and payment and settlement systems could be closer than it currently is. Such a change would likely transform banks from being part of a less programmable financial infrastructure.
Closing Thoughts
Tokenizing may be able to change how we organize finance; therefore, being “faster” than traditional systems should probably not be the main reason for tokenization on the blockchain.
A compatible digital infrastructure’s server will contain funds and other types of assets; however, there are many different types of programmable transactions that can occur. Settlements may also take place closer to where the transaction occurs. Additionally, records will be able to share information without needing to constantly reconcile them.
The opening of new opportunities is available to banks and exchanges; however, it also comes with increased responsibility.
The financial system needs to be able to interoperate, have a strong security foundation, be transparent, provide sufficient liquidity and operate with effective governance.
In other words, tokenization is more than simply a technological improvement; it may be an entirely new way of operating in the financial markets.