Why do we think tokenized securities will create new investment opportunities? First of all we are not sure, that it would be created immediately. But while there are multiple scenarios of how to apply blockchain to financial markets, the most critical case at the moment seems to be if applied to liquid stocks and bonds.
Let’s break down the explanation into three categories: finance, technology, and legal.
What’s the Financial Angle?
While there are multiple assets that can be tokenized, we believe that stocks and most liquid bonds (such as US Treasuries) would be the most useful for tokenization right now to support market development.
The reason for that is that they are some of the most liquid assets tradable. Consider an exchange issues a tokenized stock as a depository receipt: the deal is settled in cryptocurrency, and an investor holds a token, but then an investor is able to change the token to an underlying stock at any time.
What qualities would such an asset bring? First of all, the fundamental value of the underlying stock. The current choice of digital investment assets is skewed towards unpredictable or illiquid assets with high correlation, and once BTC falls in price, nearly everything else crashes down too. Once you have a digital asset traded in cryptocurrency but backed by real stocks, you appear to have a hedging instrument against the current basket. That is especially important if an investor is unwilling to exit cryptocurrency markets.
Second, it represents the liquidity issue. If an underlying asset has enough trading volume and is liquid enough, an investor can always count on a strong order book for the token, and a relatively big order won’t make the whole book fall through. And it’s usually the case with cryptocurrency - just try bidding more than $100,000 on one trade. More to that, if the demand is growing, an exchange can always issue more tokens (with regard to the legal side of it).
Third, if an exchange can easily convert asset tokens to underlying stocks, an investor is able to trade currency & asset arbitrage (similar to trading stock & stock ADR in the US versus UK stock exchanges).
What’s the Technological Angle?
Technology, in this case, is a rather straight-forward token issuance (smart contract) with regards to cybersecurity. Token emission should be connected to the custody that is holding the underlying assets. The custody should be able to hold a registry of all assets in the financial system against all tokens on the distributed ledger. And then the technology helps to create and manage fractional shares and lower the entry threshold for investors. It also allows to transfer the token instead of the underlying stock and cut down the costs of broker-dealers and custodians.
The last one is important for the business as much as for the investors, because it means that an investor can trade European stocks in Asia, with no need to move the European stock, and the company needs a partnership broker in Europe instead of additional licensed vehicles.
What’s the Legal Angle?
The regulatory side to issuing tokenized public stocks is generally the same as for ADRs, ETFs and similar instruments, with the only difference being that the token is issued on the blockchain. The legal framework for such an instrument already exists, and it can be applied to tokens as well as to any other asset classes.
A more curious question here is how the voting rights and dividend rights are managed. We argue, that while dividends might be calculated based on the underlying stock and transferred per unit, the voting rights cannot yet be provided via token, due to multiple regulatory and tax reasons. Or rather, it’s a very difficult thing to provide at the moment. At the same time, this limitation doesn’t undermine other qualities of the tokenized stock.
All in all, tokenized assets backed by standardized issuing products such as stocks and bonds are expected to create liquidity in crypto markets, offer hedge and arbitrage opportunities, and cut down costs for market participants, while meeting regulatory compliance.
And we believe that these assets, (and a few more, such as some stablecoins, futures and ETFs on cryptocurrency) are the key assets that may gain traction, recognition and demand big enough to establish the first stages of development for the future fintech markets.