Tokenization in financial services: Embracing a new ecosystem

So far, major financial services institutions experimenting with tokenization have been testing on their own permissioned platforms that provide them with a safe space to play out use cases knowing they have complete control from administrative, security, and compliance perspectives. As a consequence, they have been able to avoid many of the challenges they might well face outside of their own carefully controlled platforms.

Yet, to unlock and maximize the potential of these tokenization in financial services use cases, these institutions should go outside their walls and cultivate vibrant secondary markets that trade in tokens. To create those secondary markets, interested institutions should connect their separate environments by relying on shared technical standards for interoperability. While interoperability standards do not yet exist, efforts to achieve it are in progress, and institutions should continue to participate in order to create the needed infrastructure and standards.

Explore the challenges and obstacles that lie ahead on the road to interoperability

While interoperability and secondary markets are important, as we noted earlier, institutions have limited their tokenization efforts to their own permissioned environments so far—and that is for a good reason. Across technology, operations, strategy, tax and accounting, and regulatory compliance, tokenization in financial services introduces a broad range of new risks.

Risks associated with regulatory compliance are likely the largest obstacle to adoption of asset tokenization by regulated financial institutions. One issue is that there are often a large number of regulatory bodies that have a hand in defining regulations, which can make tokenization compliance complex. Today, many jurisdictions lack regulatory clarity where regulators have yet to establish rules for how tokenized securities can operate on asset exchanges and interbank networks. It remains unclear when such rules might be promulgated. Their absence tends to increase regulatory risk for institutions since it remains unclear which risk controls they should implement for compliance purposes.

As a consequence, operators in such jurisdictions may have had to work in a piecemeal fashion—use case by use case. This could help demonstrate to regulators that they can put in place the necessary controls to safeguard transactions, assets, and user information.

Learn why institutions should undertake a comprehensive risk assessment

Distributed ledgers tend to present a special conundrum—a conflict between transparency and privacy. Any institution interested in pursuing tokenization efforts should resolve this problem. Doing so comes down to making design choices about what information tokenization networks will share regarding transactions and how they share it.

Distributed ledgers can provide unprecedented transparency to the financial markets, and this can have a significant benefit for financial institutions and their regulators. Operating from a shared single source of “truth” can streamline the approval of transactions, compliance reporting, and responses to suspicious activity.

That said, transparency can come at a cost to privacy. For instance, the original bitcoin blockchain made visible all transactions associated with any wallet to all users. Yet, it did not reveal the identity of the wallet’s owner. Here’s the rub with tokenization. Greater privacy will be required in order to encourage investors to adopt tokenized assets. And naturally, investors will likely want to protect certain kinds of information from a host of parties, including potential competitors. And they will probably not agree to allow participants to see all of their transactions.

Discover how the designers of interoperable systems might address and meet those expectations

Tokenization in financial services can offer a more efficient method for trading assets and may significantly reduce operating costs for institutions. However, one of the more significant technical challenges facing institutions seeking to adopt tokenization involves integrating the technology of distributed ledgers with legacy back-end systems, while also building in the appropriate smart contracts to facilitate automation.

Here are some of the ways in which tokenization can improve efficiencies. By using distributed ledgers and smart contracts, tokenization offers the possibility of the “atomic settlement” of transactions. That means cash and securities are exchanged simultaneously in an automated fashion governed by smart contracts that also facilitate the irreversible transfer of assets or funds between parties. Consequently, atomic settlement operates on the principle that either the entire transaction succeeds or fails as a single, indivisible unit, eliminating the risk of partial or incomplete transactions. Such a process would tend to accelerate settlement times and eliminate the need for, and errors originating from, manual execution. A number of financial institutions are already investigating or working to implement.

Understand the challenges of the atomic settlement approach

Tokenization in financial services raises a variety of questions and challenges pertaining to accounting, valuation and taxation.

One challenge is that tokenizing certain transactions could result in an increase in the institution’s capital requirements under the SEC’s SAB 121 staff interpretation, which mandates that any SEC registrant safeguarding a crypto asset must record a safeguarding liability and corresponding asset on its balance sheet. When a token is introduced to a transaction, an institution may have to record a separate safeguarding liability and corresponding asset for the token and may also be required to increase its capital holdings depending on any relevant regulatory requirements. Issuing and safeguarding many tokens could require that an institution keep much higher capital reserves.

Additionally, different challenges may arise depending on the underlying asset and the legal construct of the tokenized asset. The seminal question is whether the tokenized asset conveys rights and obligations upon a holder that might differ from a direct holding of the underlying asset. For example, consider a scenario where secondary markets are available for the tokenized asset that are not available in the underlying asset. Unintended tax consequences may result from creating new liquidity, transaction types, or simply by not adhering to the commonly accepted legal form under which tax analysis typically relies. Tokenization may therefore change the character of the asset held and alter the timing, sourcing, or recognition for income earned.

Get familiar with some of the tax and accounting advantages resulting from tokenization