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Interoperability and Standardization Are Key to Unlocking the Potential of Tokenization

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Driven by a demand for more efficient liquidity management and cost-savings, the value of the asset tokenization market is expected to reach $16 trillion by 2030. Todd McDonald, Co-Founder, and Chief Strategy Officer at R3, outlines the factors driving the growth of tokenization and how financial institutions can make the most of this opportunity.

Tokenization is the process of representing real-world assets, illiquid assets, or data as digital tokens on distributed ledger technology (DLT), and it is gaining momentum in the financial world.

According to a June 2023 report from Bernstein, $5 trillion in assets could be tokenized on blockchains in the next five years. This will have a huge impact on how assets are created, traded, and managed, in addition to democratizing access to financial markets, improving cost efficiency, and enhancing collateral mobility.

However, open collaboration among various stakeholders across both public and private industries, including financial institutions, regulators, and technology providers, will be key to unlocking the full potential of this transformative technology.

With tokenization set to continue its upwards trajectory, how can financial institutions make the most of this opportunity?

Why does tokenization matter? 

Tokenization is crucial for financial institutions because it can facilitate numerous efficiencies in the way assets are managed and transferred. These include real-time settlement, 24/7 global market access, programmable and immutable transactions, reduced transaction and asset servicing costs, and increased liquidity sources.

Additionally, tokenization facilitates fractional ownership, and enables investors to access assets previously considered out of reach. By democratizing investments and expanding market access, tokenization drives product innovation and streamlines asset life cycles, reducing administrative costs and operational inefficiencies.

In recent months, key global bodies have increased the discussion surrounding the importance of collateral management, which tokenization can also support. For example, the Eurosystem’s Advisory Group on Market Infrastructures for Securities and Collateral (AMI-SeCo) is working towards developing a Single Collateral Management Rulebook for Europe (SCoRE), which defines common rules for managing collateral.

By tokenizing assets, their mobility as collateral is enhanced. This has implications for borrowing, lending, and risk management in the financial ecosystem.

Encouraging innovation through interoperability and standardization

The financial world is rocketing towards one filled with digital assets. If the correct tokenization solutions and frameworks are in place – such as control location services, custody, and control frameworks, and most crucially, interoperability – the potential is huge. This will all depend on the evolution of industry standards.

Establishing known ownership and beneficial ownership is vital to build trust and manage risks in tokenized assets. Custody and control frameworks are equally critical for secure asset management, and building standardized structures will maintain transaction and ownership integrity.

The interoperability of previously siloed ledgers is a potential key market structure and would enable wholesale institutions to tokenize once illiquid assets. In recent years, blockchain or DLT interoperability has come to the forefront. As different distributed ledger technologies are used to solve various tokenization use cases, interoperability can connect the pieces and enable seamless asset exchange.

Although there is an understanding of what technical protocols must be in place to unlock the full potential of digital assets, industry standards remain vague. Private industry players can play a critical role in shaping these standards from the inside through open collaboration.

Regulatory sandboxes, such as the EU’s DLT Pilot Regime or the UK’s FMI Sandbox, also offer certainty and encourage experimentation. They support new technologies that enable tokenization, contributing to enduring industry standards.

More recently, the DTCC, Clearstream, and Euroclear published an industry paper on how financial market infrastructures can enable DLT’s transformational benefits. Individual and private explorations of DLT’s potential now need to become an industry-wide effort to consolidate and connect digital liquidity, based on common standards and processes.

Promoting the right protocols, exploratory frameworks, and secure interoperability fosters digital market growth and scalable innovation for market participants.

What are the challenges that remain?

Despite the advantages of tokenization, distribution complexity and industry standards remain core challenges. Integrating tokenized assets into financial systems requires collaboration among regulators, institutions, and technology providers.

Regulators strive to keep up with the pace of tech innovation, posing hurdles for the banking industry. For instance, Basel rules place exposure limits on crypto assets, necessitating careful adherence to compliance guidelines. Ongoing fragmented private blockchain infrastructure also creates interoperability challenges across financial institutions.

There must be close collaboration between government and industry to develop a regulatory regime that can encourage innovation, the interoperability of solutions, and the development of international standards that will regulate industry activity globally. This will be crucial in giving industry participants the confidence to interact with tokenized securities.

The future of finance

Overall, tokenization is sparking innovation and driving significant changes in how financial products are created, traded, and managed. From central bank digital currencies (CBDCs) to tokenized deposits and regulated digital assets, tokenization will have a profound impact on our future financial landscape.

Nevertheless, addressing challenges such as distribution complexity and regulatory compliance will be vital in realizing these benefits. The DTCC, Clearstream, and Euroclear have emphasised that we must support market development by enhancing operational resilience and enabling greater interoperability across DLT protocols through the adoption of standards.

By working together and adopting comprehensive frameworks, the finance industry can harness the benefits of tokenization and create a more inclusive and efficient financial ecosystem.

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