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Keep It Real (tokenization edition)

Consultant: $7 trillion by 2023, $11 trillion by 2024 and then $15 trillion by 2025. Look at this McKinsey chart below!


CEO: That is fantastic!


Consultant: Yes! Your company would benefit immensely by being at the forefront of this financial, technologic and social transformation.


CEO: Great! So what are the steps to get there?



I find it curious that incredibly large numbers often get thrown around when people talk about the potential of tokenization but there is no mention of the challenges people who are executing that vision face day to day.


Perhaps it is for marketing reasons or perhaps it is just very difficult to understand and pinpoint these challenges without being a builder in the space. 


My last newsletter on how institutional tokenization adoption will NOT take place on public blockchains initially seems to have struck a chord judging by the reactions from people involved in the space. 


So in this week’s newsletter, I want to follow up with key practical challenges facing our tokenization space, so people who have interest in the topic get a no clear-eyed no BS perspective on the state of things.


After all, it is only by facing the truth, and overcoming the challenges that come with it, we can reach the promised land. Let’s dig in.



Builder’s Framework


I use a simple 3 layers framework when it comes to thinking about what needs to click in any tokenization effort.


  1. Legal/regulatory compliance

  2. Technological & operational capability

  3. Project specific operational and distribution competence



Compliance and Costs

When it comes to the legal/regulatory challenges, it is all about jurisdiction, compliance and cost.



The first question is whether a jurisdiction has a comprehensive and well designed framework that confers property rights to tokens representing assets that a traditional legal contract does. Singapore, Hong Kong, Abu Dhabi and Switzerland are four commonly cited names that are first movers on this issue. 


However, even if a jurisdiction does offer a comprehensive legal framework, it may not be sufficient for stakeholders. The level of confidence and comfort each offers is not the same. If you are a giant US financial institution dealing with US based investor capital and US based security issuers, going to Abu Dhabi may not be the solution that will further enhance your securitization business. Particularly if you have other parts of business measured in billions that rely on SEC’s approval, who may take issue with your jurisdictional arbitrage. 


As we all know, the biggest capital market in the world is the US. Until the US Congress pens a comprehensive bill about sensible digital asset regulation, the doors to the biggest prize of them all remains shut and people resolve to workarounds or suboptimal solutions.


Also, even if an issuer is indeed happy about going to Singapore/HongKong, the more jurisdictions a security transaction involves, the more lawyer fees it commands. Unless the transaction is of significant size, shelling out extra 50k-60k lawyer fee to set up just the legal part of the transaction may not be economically viable in many cases.


Now suppose you have the buy-in from both investors and issuers, you still have to source custodian and fund admin who have the capability to deal with digital assets and are comfortable with your operation and risk processes. And don't forget the average custodian fee in traditional finance measures in single digital basis points whereas in crypto it measures between 40bps-50bps per annum. 


From an investor’s perspective, if accessing tokenized products means they have to bear higher fees, the transaction most likely doesn’t make sense. While tokenization offers visibility, faster transaction and other benefits, in the current state, these come at a cost that is often too high for the transaction.


Chains, Wallets & Smart Contracts


Blockchains consist of underlying chains (or networks), wallets (or accounts) and smart contracts (computer programmes that enforce predetermined rules). Consider the oldest blockchain in the world, Bitcoin, is only 15 years old. Much of the concepts related to blockchain technology remain relatively new. Or put it another way, there are no battle-tested best practices governing various aspects of a blockchain operated business that have sufficiently long track records demonstrating successful risk mitigation. 



In addition to financial risks that are inherent in securities, when it comes to blockchain, additional risks related to the failings of the technology or the human interaction with the technology pose serious problems from technology and operational risk perspectives. Potential smart contract hacks, blockchain specific outages and wallet mismanagement can all lead to significant losses that are simply unacceptable and without course of remedy. 


For example, imagine you are being put in charge to convert $50 million worth of Ether, on Polygon, into the private stablecoin USDC on Arbitrum and sending it to an OTC trading deck’s wallet for the money to get offramped into various bank accounts. For those audiences who find what I just described foreign, rest assured. You are not alone. 


One of perhaps surprising things I have learned is that despite one’s corporate job title containing blockchain or digital assets, many people haven’t actually used a wallet or interacted with different blockchains or smart-contracts. It would be incredibly difficult to convince these corporate managers to move their financial operations onchain given blockchain’s lack of ubiquity. 


Of course there are digital asset custodians who offer integrated wallet management products that mimic a traditional investment process but as we mentioned earlier, it comes with an additional cost for the investor.


Apart from wallet management and potential security issues, another key issue has to do with the ability of blockchain technology to replicate basic traditional financial functions. 


For example, although smart-contracts are great at automation of waterfall payment disbursement, replacing paying agents, the actual recording and ingestion of cash flow data from loan repayments made outside the blockchain environment depends largely on issuers own controlled inputs. And given the relatively small size of most private securitization issuers, their corporate governance, operational control as well as financial reporting standard have much less scrutiny than for example investment grade credits.


Of course in a permissioned blockchain setup, one that is mostly used by financial institutions such as JPMorgan or Standard Chartered to interact with each other, only trusted parties can input data backed a traditional trail of transaction reconciliation and payment records. However that is not the reality for tokenization startups operating in the public blockchain space.


Deals, Money & Customers



Depending on the value proposition, tokenization startups need to solve a combination of deal sourcing, capital sourcing & complex technical product requirements in a fast evolving technology and regulatory environment. 


If the key value add is operational efficiency gain, then being able to build, onboard, integrate and customer serve corporate clients is the ultimate measuring stick. Navigating complex enterprise sales cycles, mapping out product solutions with complex technical and legal requirements and dedicating resources to provide sufficient customer service level are all non-trivial challenges.


The most common go-to-market strategy in this case seems to be getting funded by big banks and then dedicating your resources in building and serving your big backers. Archax, Libre and Fnality are some examples. 


If however the USP happens to be access to onchain capital market, then issuer deal and capital allocator sourcing plus building a regulatory compliant legal set up are top challenges. Most startups building on public blockchain fall in this category. Think Centrifuge, Maple and Ondo.


Selling technology products that enable 24/7 streamlined global payment rail products to banks is very different from selling access to the nascent onchain capital markets and having to bootstrap it yourself. After all, our financial markets today are the result of a hundred years plus evolution.


Conclusion


Although the promised land of tokenization indeed is full of benefits and possibilities and is likely to exceed $10 trillion in value, the road leading there is a bumpy one, containing many pitfalls and challenges. 


Some of which can be solved by pioneers themselves, while others have dependency on the broader market dynamics and regulatory climate. Challenges associated with legal and technology determine to a large extent the available customer pool at any one time. In other words, these macro factors influence the extent to which a particular commercial application of tokenization makes sense financially.


In the current stage, the set-up cost for stakeholders to be on blockchain rail is non-trivial when added legal, custody and operational costs are considered. This does not however mean there is no market for tokenization. On the contrary, I believe these costs will go down significantly with time as the market matures. 


In my view there are several big unlocks that could accelerate the adoption cycle.


  • Major financial hubs (the US, the UK and EU) getting regulatory clarity and support

  • Financial institutions across the value chain, including exchanges, custodians, banks and trading desks, funds, gaining operational expertise

  • Formation of deep capital pools on crypto native side that have the incentive to leverage offchain assets for investment or treasury management purposes


The point of this post is not to invalidate tokenization as a key adoption trend, but to provide a clear eyed perspective on the day to day challenges facing the industry. Not only is it important to understand the size of the addressable market, it is even more important to understand the obstacles that need to be overcome to get there.


Disclaimer: This content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.

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