Tokenized Traditional Assets: A Practical Guide for Asset Managers Part 1

Part 1

Why this guide

In recent weeks and months, we have engaged in discussions with institutional asset managers, overseeing a combined $4tn in total AuM, focusing on the subject of tokenized assets.

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To some, cryptocurrencies themselves may be less relevant at this stage, but tokenized assets particularly tokenized traditional ones like equities, bonds, and investment funds, present interesting opportunities. We prioritize these 'traditional' assets as they are likely to be the first and most relevant cases where traditional asset managers engage with tokenized assets, as opposed to, for example, a tokenized Picasso painting or classic cars. These ‘traditional’ tokenized assets may also appeal to purely crypto-native investors seeking diversification without leaving the blockchain ecosystem - for example, as a stablecoin alternative during periods of high volatility, allowing them to transition into tokenized money market instruments rather than merely holding tokenized cash.

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With tokenized assets still being a relatively new sub-class of Digital Assets, existing literature, and conversations often either focus on one specific aspect of tokenized assets or on rather futuristic ideas of what they could do from a theoretical perspective. However, we found it hard to find information that specifically addresses the topic from an asset manager's perspective, taking into account crypto-native technology and asset management principles - both of which are core to our company and our product. So we set out to provide a guide that is a summary of the experiences, learnings, questions, and challenges that resulted from conversations with some of the largest multi-asset managers as well as our own deep DeFi-experience spanning across multiple market cycles all the way back to its origins in 2017. 

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This guide is not intended as a definitive study or market analysis but rather a practical reference rooted in real-world conversations and research, reflecting the current state of the market.

But first: Let’s be realistic

Before we dive into the specifics of this guide, we would like to be clear that despite its many benefits, tokenized traditional assets still have to overcome a number of challenges and clarifications. We have experienced that the benefits and mechanics of tokenized assets are often praised and discussed, but the challenges usually only come to light upon practical involvement (i.e., once you get your hands dirty). Since this guide is meant to give a practical view for asset managers we also want to shed light on and openly discuss some practical issues that are still lingering within the market.

1. Regulatory and KYC concerns: The predominant hesitation regarding tokenized assets lies in regulatory clarity. Unlike other digital assets, tokenized assets are deemed securities that come with a number of regulatory requirements. Particularly, KYC/KYB—identifying a token's buyer/seller—is paramount. Given blockchains' inherent global reach, harmonizing regulations internationally becomes crucial. While some jurisdictions, like Switzerland, Germany, and Luxembourg, have clear guidelines, there is still a need for global consensus-albeit significant strides have recently been made in this regard.
2. Market infrastructure and liquidity: Given its relatively short existence so far, tokenized asset markets are still shaping their supply-demand balance. A certain lack of liquidity is sometimes cited as a negative attribute while it is a natural part of a developing market. From our perspective, liquidity will initially develop in lock-step until a certain level is reached, after which adoption (and therefore additional liquidity) will follow. A number of projects for tokenized traditional assets are executed by issuers in collaboration with investors. More of these initiatives will help drive and attract further liquidity. Certain assets, like bonds or real estate—with their long-term and fragmented nature—may serve as early adopters.

• A pivotal yet under-discussed point affecting liquidity is the prevalent requirement for pre-funded trading in many tokenized assets (in essence, to trade $1m in assets, your account needs to be fully funded for $1m). Traditional finance often operates without pre-funding, rather relying on central counterparties responsible for clearing and settlement as well as providing credit guarantees. Balancing between pre-funded trades and the credit risks of trading without pre-funding is essential. Solutions are emerging to emulate traditional market trading experiences without central counterparties—which is effectively the purpose for which blockchains were designed and, therefore, are perfectly suitable for.
• One final aspect that plays into the infrastructure considerations is anonymity. In open-source blockchains, generally, all market activities are transparent. If a wallet address is identifiable, its transactions become traceable—a stark contrast to traditional markets where most transactions remain undisclosed to the general public but rather disclosed to the regulator only and mostly in the name of intermediaries. Ensuring transaction discretion will be crucial, which might be addressed through agents or permissioned protocols which provide discretion in the public realm but still ensure KYC compliance.

1. Fragmentation and interoperability: This is a challenge that comes in various forms. 

• Technical interoperability: Tokens, bound to specific blockchains, face transfer issues between different networks. Though solutions like Bridges and Layer 0 blockchains exist, enhancing interoperability to prevent market isolation remains vital.
• Legal and regulatory interoperability: This necessitates universally accepted regulations and implementation timelines (as discussed previously).
• Fundamental interoperability: The industry requires consensus on definitions, such as "decentralized" (i.e. when is a protocol or asset really decentralized) or the genuine nature of what constitutes a stablecoin.
• Financial interoperability: This involves adopting common means of exchange for the settlement's payment leg (e.g., stablecoins, CBDCs) and possibly a universal lender of last resort to introduce credit across markets, aligning with the push for standardized regulations. However, this will need further evolution.

In summary, while these challenges are significant, they're not insurmountable barriers. They're being addressed, with some solutions already operational. Patience is needed for them to reach broader adoption.

Background and Overview

For many asset managers, cryptocurrencies might not be front and center due to limitations in their mandates, and therefore Digital Assets, in general, are less of a focus. Yet, it's in the realm of tokenized assets where asset managers are most likely to engage with Digital Assets for the first time. Given the anticipated upward trajectory of tokenized assets as a whole, even those managers grounded in fundamental, long-only equities may soon find themselves purchasing a tokenized share. It's crucial to grasp that this isn't some distant future scenario – it's unfolding now. Renowned institutions have already rolled out tokenized shares, bonds, and stablecoins (essentially tokenized cash) which command a market cap exceeding $120bn at the time of writing.

Tokenized assets are expected to grow into a double-digit trillion-dollar market within the next 5-7 years. Dramatically improved price discovery, capital use, and post-trade efficiency are some of the key benefits that will likely drive institutional adoption. While anything from stocks to art paintings can potentially be tokenized, for traditional asset managers, the immediate relevance lies in familiar territories like bonds, equities, cash-like instruments, and investment funds.

There's no shortage of discussion on the pros and cons of tokenized assets. However, this article endeavors to illuminate the subject specifically from an asset manager's point of view, focusing on key questions such as:

• What are tokenized assets from a conceptual, process, legal and technical point of view
• Why does this matter to the asset management world or capital markets in general
• How do they get issued and traded
• How does the investment process differ from the traditional process
• What are legal and technical considerations to take into account
• What are the current challenges for tokenized traditional assets to gain wider adoption in the asset management community 

To adeptly tackle these questions and offer a comprehensive asset management lens, we've segmented our discussion into three core domains:

1. The investment process: primary and secondary markets
2. Market- and asset management infrastructure
3. Legal, regulatory, and technical considerations

Primary Market

There are many ways to explain tokenization and multiple ways of actually tokenizing something. However, we will focus on a more relatable and probably more familiar use case for asset managers: Issuing and trading tokenized shares and bonds. 

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Broadly, there are two principal mechanisms to tokenize shares, which draw parallels with traditional primary market issuances and American Depository Receipts (ADRs) or ETFs.

Purely Tokenized Issuance: The Primary Market Issuance Equivalent. 

In the case of a completely new issuance, i.e., a share that has not traded before, we can conceptually compare the process to a regular primary market issuance. Technically, issuing a tokenized asset means deploying a smart contract on a blockchain. This, in turn, mirrors the act of registering a share with a central security depository (CSD). The share is recorded somewhere, but it hasn’t changed hands yet. It can then, of course, be distributed to investors' wallets which again is comparable to assigning primary market allocations to investors. Certain countries, especially Switzerland, have issued regulatory rules that allow companies to issue tokenized shares that are legally equivalent to traditional shares. On a high level, the regulation lays the foundation for, amongst other things, which standards and components the design of the smart contract has to follow (e.g., the Swiss CMTA standard for equities and bonds) in order to be regarded as regular shares from a legal perspective.  This underscores the fact that, already today, the legal and technical infrastructure is in place to transition from traditional to tokenized equity/debt issuances. 

Tokenizing Already Issued Assets: The Crypto Equivalent of ADRs

In the case of issuing a new token of a share that’s already trading on an exchange, we can conceptually compare the process to American Depository Receipts or ETFs. The tokenization provider would buy a share on the traditional market and issue a token on a blockchain that represents ownership of the share. This is similar to the process of ADRs where e.g., a share listed on the London Stock Exchange is transferred to a Depositary, which then lists an ADR on the New York Stock Exchange representing the underlying shares. So with tokenization, instead of issuing an ADR on the NYSE, the issuer deploys a smart contract (i.e., a token) on a blockchain. 

Secondary Market

Trading

Just as in traditional financial markets, once a share is issued (or tokenized in this case) it can be traded. Similar to TradFi, assets can be traded bilaterally, i.e. OTC, or via organized marketplaces. However, tokenized assets bring their unique considerations.

Contrary to cryptocurrencies, tokenized assets such as equities or bonds represent securities and therefore are treated in a similar manner. Therefore the trading of tokenized assets on permissionless decentralized exchanges (DEX) is restricted. Trading would usually occur on a permissioned, regulated marketplace or through a permissioned provider, which, similar to an ETF, would issue (i.e. “mint” in blockchain terms) and redeem tokens. 

From an asset manager's point of view, this means navigating a myriad of venues, providers, and counterparties. Connectivity can take the form of traditional communication protocols such as FIX (e.g. in the case of the Swiss Digital Exchange) or, as in most cases, actual blockchain connectivity (through a self-hosted wallet or crypto custody account). On a technical level, this requires connectivity of an asset managers Investment Management System (IMS) or Order and Execution Management System (OEMS) to the crypto custody solution as well as the blockchains and their respective marketplaces, providers or counterparties. Although existing systems might be well suited to handle bonds, equities, etc. In general, the connectivity layer will likely pose a challenge. Even for an advanced OEMS, this can be tricky since blockchain connectivity, transaction structuring, and smart contract interaction are vastly different from the wiring of traditional financial markets. At Alloy, we’ve been working with multiple institutional asset managers facing this problem which is why we’ve built a solution to connect existing traditional systems to our standardized execution layer. Thereby the connectivity and execution are greatly simplified and allow asset managers to continue using their existing systems and environments but still benefit from access to tokenized traditional assets.  

Post-Trade Clearing, Settlement, and Corporate Actions

Post-trade and middle office processes in general, are probably the area that is most heavily impacted and simplified through tokenized assets. In fact, this is where some of the biggest gains in efficiency and the biggest reduction in error rates can be achieved. While trading in traditional assets has its merits, especially for equities, challenges persist in post-trade, reconciliation, and corporate actions due to errors, data mismatches, and capital inefficiencies. It's this domain where there are potential immediate, measurable impacts, and hence there is such a strong interest from the institutional community and the broader financial industry. 

Once a trade has taken place, i.e., it’s matched and confirmed or bilaterally agreed, clearing and settlement processes follow. Typically, blockchain transactions simultaneously cover both clearing (ledger updates) and settlement (wallet credit/debit). Organized marketplaces or OTC market makers might still segregate these, allowing trade and clearing throughout the day and deferring net position settlements to the day's end. However, unlike the traditional T+1 / T+2 settlement norm, blockchain settles instantaneously (or at least block by block).

Comparing the traditional Delivery-vs-Payment (DvP) with its tokenized counterparts, we have Token-vs-Token (TvT) and Token-vs-Payment (TvP). In TvT, tokenized shares or bonds are swapped for stablecoins (essentially tokenized cash equivalents). This is already a major difference to the DvP process in traditional finance. Here Delivery is processed through the securities markets (involving custodians, exchanges, central clearing systems, and central security depositories (CSD)), whereas the Payment is processed through the central banking system (involving custodians, central banks, and payment clearing systems). In a, less common, TvP transaction, the tokenized asset is exchanged, i.e. sent via the blockchain, whereas the payment is done through the traditional banking payment system. This suits stakeholders inclined towards digital securities but favoring fiat over digital currencies for transactions. 

Therefore some of the most significant differences (and advantages) of transacting on a blockchain are that each participant has access to and can see the same information on the settlement layer, and the number of involved parties in a transaction is cut significantly. Thereby frictions, errors, reconciliation efforts, capital use, and - ultimately - costs may be substantially reduced.

In terms of corporate actions (dividends, stock splits, coupon payments, etc.) tokenized assets have two key attributes: As a smart contract, they can communicate and initiate transactions automatically, thereby automating and streamlining a large part of the corporate action process. Finally, since both transactions as well as communication can happen through the same settlement layer, corporate actions can be processed in a much more efficient manner than in traditional finance, where market participants often require multiple systems and data streams to properly consume and act on corporate actions.

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