The Tokenization of the Assets: the keys for a digital and more inclusive ecosystem.
Antonio Lanotte, Chartered tax adviser and Senior auditor
Vernewell Mangement Group — Panel of Experts at EUBOF — Blockchain for Europe
The repercussions of these innovations, which led to a democratisation of capital markets, can still be felt today. We are currently witnessing new developments that are likely to be as revolutionary as the establishment of the S.p.A. and stock exchanges: the tokenization of assets. This new concept will unlock huge funds globally, helping to create more efficient and fairer capital markets.
DISTRIBUTED LEDGER TECHNOLOGY AND TOKENIZATION.
DLT is a database construct that brings together existing approaches around distributed computing networks and data encryption. It enables a new way to record state updates and transactions of assets between participants on a network. A leading technology provider notes: “DLT enables everyone involved in a transaction to know with certainty what happened, when it happened, and confirm other parties are seeing the same thing without the need for an intermediary providing assurance, and without a need to reconcile data afterwards.” Separate participants in different locations, known as nodes, each maintain a copy of a common ledger, proposing new transactions and verifying proposed transactions to be appended onto the ledger. The verification of transactions requires the consensus of participating nodes. Verified transactions form a record that is protected by cryptography so historical transactions cannot be altered, known as immutability.
If properly operated and maintained, the main advantages of a distributed ledger over traditional databases used by financial institutions are the potential for near-instant settlement, reduced operating costs, data integrity, enhanced automation, and operational resilience. DLT is enabled by an underlying computing network, protocols, services, and interfaces — which can have varying degrees of centralization or decentralization. A distributed ledger is accessible either through a private network (where access is permissioned to predefined users, similar to infrastructure used today in capital markets), or a public network (which includes either permissionless access or permissioned access).
DLT consists of two foundational concepts that work together. First, a distributed database architecture across participants that provides a new infrastructure and method to capture and update data on a near real time and shared basis. Second, this architecture enables the digital representation of assets (or other forms of value) as data on this infrastructure, which is referred to as Tokenization. Although Tokenization on DLT infrastructure was pioneered by public, permissionless distributed ledger networks with native cryptocurrency tokens (e.g., Ethereum), the same concepts can be applied to a broad range of asset classes on other public or private networks. This includes regulated financial instruments that are frequently traded (e.g., equities, fixed income including asset-backed securities, and derivatives), additional financial instruments (e.g., private debt and unlisted securities), and cash.
With the advent of tokenized assets, it can be argued that we are at the dawn of a development similar in scope to the establishment of joint-stock companies and the opening of the first stock exchange in 1602. Asset tokenization converts the rights to an asset into a digital token. Although the process is in itself similar to asset securitisation, tokenisation is based on Distributed Ledger Technology (DLT), specifically blockchain. DLT offers five main advantages over traditional technologies used by financial services companies. First, it provides greater transparency for all parties, as they share identical documentation that can only be updated through a clearly defined consensus process. Second, this innovative technology provides better tools for traceability, as each transaction is recorded and stored simultaneously on a large number of nodes and is, therefore, verifiable. The third advantage, increased security, goes hand in hand with the first two. DLT technology is more secure than traditional recording systems; before recording, it is necessary to agree on the operations that cannot be changed afterwards. The fourth advantage also derives from these features: in general, DLT increases efficiency and speed, as it eliminates most paper documents and human errors. Last, but not least, is the frequent reduction in costs as it speeds up processes and limits the number of parties involved.
Digital Assets.
Since the advent of paper certificates to represent real-world assets, such as banknotes, tokenization has existed across various form factors in finance. This report defines tokenization as the digital representation of regulated financial instruments and money on a distributed ledger, reflecting an ownership right of the underlying asset (e.g., securities, cash). Assets tokenized on a distributed ledger are commonly referred to as digital assets. For tokenization to occur, units representing a digital asset, known as tokens, are added to the distributed ledger, and exchanged through transactions. This initial process is known as minting. Minted tokens can either be fungible (interchangeable and divisible — like securities, cash, or commodities) or non-fungible (unique and indivisible like real estate, fine art, and other nonfinancial assets). The ledger can be used in primary issuance, secondary trading, Custody, and other back-office activities.
APPLYING DISTRIBUTED LEDGER TECHNOLOGY TO FINANCIAL MARKETS.
As abstract as the benefits of DLT technology may initially seem, they become more tangible in the context of capital markets. The implementation of such technology in the financial universe offers numerous benefits, including the following five: firstly, an increase in disintermediation and thus fewer intermediaries. In theory, we will no longer need banks, brokers and stock exchanges, as buyers and sellers can interact directly with each other. Second, speed of execution will increase, as DLT involves fewer intermediaries and shorter settlement times. Third, any investment opportunity can count on global market exposure. In fact, anyone with Internet access will be able to take advantage of almost any investment opportunity, within the legal limits and regardless of geographic location. Fourth, investment projects will appeal to a wider pool of investors, as new investor segments will be reached. Investment opportunities currently reserved for a few wealthy individuals, e.g. in the fields of art or precious stones, may become available to everyone. Finally, DLT technology has the potential to significantly reduce market manipulation; every transaction is transparently recorded in real time and is shared, immutable, verifiable and always accessible to all interested parties, including regulators.
At the same time, one should not underestimate the advantages inherent in the marketability of an asset. In his influential essay “Marketability and Value: Measuring the Illiquidity Discount” (July 2005), Aswath Damodaran explained that listed companies have a 20–30% higher liquidity premium than unlisted companies. This premium is attributable to the higher market efficiency resulting from an increase in the number of participants all other things being equal, larger transaction volumes, smaller spreads and a lower impact on prices. In light of all this, the tokenization of assets assumes a certain relevance: if all else fails to change, the value of an asset admitted to trading is bound to increase.
Regulation (EU) 2022/858 — DLT Pilot Regime.
On 30 May 2022, the European Union produced Regulation 2022/858 on Market Infrastructures based on Distributed Register Technology. The Regulation amends “colleagues” 600/2014 and 909/2014, as well as Directive 2014/65/EU (text relevant for the European Economic Area). The creation of this regulatory set is intended to regulate a field that is increasingly widespread in the countries of the Union. At the heart of the matter is above all the need to guarantee the indispensable protections for investors and markets, pursuing financial stability.
Particular attention is paid to the last point, the issue of stability. The Regulation aims to ensure robust risk management, steering away liquidity problems as far as possible. In addition, an attempt has been made to follow the principle of proportionality and a level playing field regardless of technological support. In simple words: the institutions want to ensure that both the investor in standard shares and the investor in tokenized shares share the same rules and risks.
The Regulation, which is also available in Italian on the European Union´s portal, entered into force on 23 March 2023. Since it is a regulation, there is no need for a law to transpose it into the laws of each country, as is required of directives. However, each State should have created a set of complementary regulations, which are indispensable for Regulation 2022/858 to work properly. This is the case with the “Fintech Decree” in Italy that became law last 16 May.
Real Examples.
Already today, there are various examples of tokenized assets in various areas such as real estate (Property Coin), commodities (Oil Coin), diamonds (D1 Coin), gold (digix coin), art (Maecenas), luxury goods (Tend) and national currencies (Tether). The blockchain-based platform Bitcar, which gives fractional ownership of a portfolio of exclusive cars, is a further example. Instead of owning a single classic or sports car, it is thus possible to invest in an entire car fleet. What at first glance would seem to be a rather eccentric investment is actually based on solid economic foundations: in the last 10 years, collector cars have been one of the best asset classes in terms of performance. Tokenisation allows a segment of investors, unlike before, to access this asset class. However, investors are not the only ones who benefit; asset sellers also benefit from this. Take for example the owner of a work of art who is in urgent need of liquidity: she can now sell half of her painting to a large group of fans. The same applies to the owner of an SME who would like to gradually retire. Thanks to tokenization, he will now be able to make a public offering whose price, in the past, would have been set at prohibitive levels by investment banks. Through a so-called Security Token Offering (STO), the owner of the framework and the owner of the company could now sell its assets, or part of them, to any investor in the world. New offerings in the security token universe are also complemented by a whole range of companies, such as STO GlobalX, which offer tokenisation, issuance and trading of assets. In addition, more and more relevant players are entering the industry, thus providing the necessary infrastructure elements to create a lasting ecosystem for tokenised assets and security tokens. For instance, Fidelity Investments announced the establishment of a subsidiary for the custody and execution of digital assets. Falcon Bank now offers a digital portfolio for tokenized assets. The Swiss Stock Exchange announced that it intends to establish a regulated trading platform for digital assets1. Lloyd’s of London has expanded its product range to provide its clients with custodian banks for their digital assets. This list of innovations is not exhaustive.
The Eu Digital Single Market.
For the EU crypto-assets sector, the MiCA represents a game changer. With the entry into force of the MiCA, unregulated “offshore” companies will no longer be able to proactively target EU consumers, this will result in MiCA-regulated crypto-assets firms gaining significant market share in the EU over their otherwise unregulated offshore competitors.
The creation of regulatory clarity in the midst of global uncertainties could attract capital, talent and companies, especially those that want to trigger the so-called “tokenization” process, in which sense this type of so-called emerging industry could become a huge opportunity for the economic and technological revival of the European Union.
MiCA is destined to play a huge role as a reference “standard” especially with regard to those jurisdictions, especially those that do not have much experience in financial regulation and supervision, will think about their own framework for crypto-assets. In addition to rules for crypto-asset issuers and service providers, MiCA also introduces rules against market manipulation (“Market abuse rules”) and insider trading. Using insider information to benefi t from trading activities will be illegal, as will activities that give false or misleading signals to the supply of, demand for, or price of, a crypto-asset. The EU market is the largest domestic market in the world, with more than 450 million consumers; due to the size of its market, MiCA will play a crucial role for all those companies around the world that are ready to adapt MiCA’s operational standards, possibly even on an international scale, in order to maintain streamlined operations and products globally. If MiCA, which is arguably the most comprehensive regulatory framework for crypto-assets on a global scale to date, proves to be “enforceable” for the entire industry, consumers and regulators, it will certainly have a global impact. Furthermore the European Union is working on “The Data Act” which includes an article on the regulation of smart contracts used for data sharing; “The AI Act” is a proposed European law on artificial intelligence (AI). Lastly the EU has proposed a digital ID (“DID”) that would give citizens a personal wallet with which they can access public services.
Conclusions.
In total, current global wealth amounts to USD 317 trillion. Excluding exchange-traded financial products and thus assuming only a 10% liquidity premium, more than USD 30 trillion in value can be generated by increasing asset trading. In the coming years, tokenization will become the preferred method of doing this. Moreover, countries that choose this new option and democratise their capital markets will gain a strategic advantage over other states. By supporting asset tokenization, they can indeed shape the future of the world, just as those who, in the past, first bet on corporations and stock exchanges.
