New research issued by the CFA Institute Research and Policy Center reviews the use of distributed ledger technology to tokenise financial and real-world assets.
The first of a two-part series, An Investment Perspective on Tokenization: Part I, analyses the benefits of tokenisation relative to traditional practices and delivers a primer on the topic exploring how tokenisation works, a technical overview, its value proposition, and current limitations for investors.
The research draws on interviews with leading digital finance practitioners and includes use cases to evaluate the opportunities for tokenisation through real-world scenarios. Tokenised assets and instruments discussed include art, whisky and wine, gold, equities, mutual funds, private market funds, and repurchase agreements (repos).
Olivier Fines, CFA, Head of Policy Research and Advocacy at CFA Institute, comments: “Tokenisation can bring many benefits, but it’s not without risks. While benefits may include streamlined clearing and settlement, improved transparency and compliance controls, or greater market access through fractional ownership, there are significant challenges relating to cybersecurity, investor education, and regulation uncertainty.
“We believe that regulators will need to develop an approach to digital finance that encourages innovation while safeguarding investor interests and market integrity. Different regulatory approaches are emerging: The United States appears headed towards a digital finance regulatory framework that fosters innovation and experimentation. The European Union seeks clear and consistent rules as well as standards to promote interoperability and compatibility across member states. The UK intends to bring regulation of digital assets into existing securities laws.
“With varying regulatory regimes, industry innovators are likely to favour the simplest regulatory environment when setting up shop, potentially resulting in regulatory arbitrage risks. In the current geopolitical context, it is not unreasonable to anticipate that the centre of digital finance innovation will move further in favour of the United States, at least until a clearer international regulatory standard is established.”
Key findings
· Operational efficiency: Tokenisation can lead to cost and time savings, particularly where a system of intermediaries and manual processing is currently required, e.g., middle and back-office operations, clearing and settlement, distribution, and regulation compliance.
· Cybersecurity risks: Distributed ledger technology can be vulnerable to attacks, given its inherently decentralised nature. Vulnerabilities include malicious actors, fraud, deception, and the potential for the loss, theft or misuse of private keys, which give access to assets digitally represented on the network.
· Regulatory uncertainty: Different jurisdictions have varying regulations, which can create challenges for global implementation and compliance. The borderless nature of digital finance calls for a progressive alignment of regulatory frameworks, or the risk of regulatory arbitrage and market failures will rise.
· Market infrastructure: Nascent market infrastructure for distributed ledger technology implies a continued degree of fragmentation across public and private blockchains, which is adding potential hurdles for a seamless experience in navigating tokenised assets. Developing a robust and scalable infrastructure is essential for the widespread adoption of tokenisation.
· Access to private markets: Tokenisation has the potential to widen access to private markets via higher levels of operational efficiencies and lower minimum investment requirements. However, questions about investor protection and suitability persist, especially in a context where information asymmetry may result in an information disadvantage for retail investors.
Olivier Fines adds: “Private market access for retail investors remains a contentious proposition. Private market investments usually involve high levels of sophistication regarding their approach to investment strategy, liquidity restrictions, time horizon, fee structure, or performance measurement. Fractionalising private market investments doesn’t change the complexity and suitability of the underlying products and further brings added challenges around cybersecurity. Investor education and suitable regulation will be of the essence.”
