The Challenge of Tokenization: What Makes It Fall into a Cycle of Failure

By Steven Ehrlich, Forbes; Compiled: Pine Snow, Golden Finance

On July 17, 2023, two partners at McKinsey & Company took the stage at the New York Stock Exchange to speak to dozens of government regulators and financial executives about the allures of blockchain, insisting that its utility extends far beyond the scandal-ridden cryptocurrency market.

Bitcoin, Ethereum, Solana, and more than 10,000 other cryptocurrencies are down 60% from their November 2021 peak, losing $2 trillion in market capitalization. Cryptocurrency platforms are often hacked, and their most important companies are also attacked by regulators. Advisors remain adamant that the technology behind this digital currency is still viable and has a bright future.

Julian Sevillano, a partner at McKinsey, insists: "It's a blockchain, not a cryptocurrency, and it has real utility." ”

The advisors detailed the basics, explained digital terms such as "smart contracts" (transactions that are executed automatically when certain conditions are met), and explained how traditional financial assets such as stocks, bonds, and real estate can be "tokenized," giving them blockchain code that enables them to be transferred globally in seconds rather than hours or days, which is currently the case.

Despite their constant emphasis on "capital efficiency improvements," "savings in operating costs," and "enhanced compliance and transparency," there was a sense of hollowness in this presentation. With the exception of a few references to last year's cryptocurrency price crash, these were already there in 2015 when the first tokenized platforms like R3CEV were announced. Since then, few businesses have adopted the technology, and many projects still face the challenges and debates of the past. Tokenization may still be the future of financial services, but it still seems far away.

To illustrate this, we don't need to look further afield, just a later presentation at the CFTC's Global Market Advisory Committee. Per von Zelowitz of the Federal Reserve Bank of New York's Innovation Center told the audience that the large-deposit pilot project running on private networks with banks such as Wells Fargo and Citibank remains a "scientific experiment" in "theoretical financial market infrastructure."

During the question-and-answer session, another speaker, Franklin Templeton Asset Management with $1.5 trillion in assets, asked whether the Fed is considering testing on open systems to take advantage of the various benefits that a blockchain-like environment can offer.

"Like what?" Zelowitz replied.

Since Halloween night 2008, with the circulation of Satoshi Nakamoto's white paper describing Bitcoin, a series of so-called killer applications of crypto have emerged. These candidate applications include instant real-time payments on a global scale that cost much less dollars per transaction, are used to protect personal identities and personal information from the prying eyes of regulators and companies, and serve as a hedge against inflationary government policies.

In this cycle, there is also the effort to tokenize, digitize real-world assets such as real estate, art, bonds, and even intellectual property. Early tokenization efforts focused on private distributed ledgers, which are blockchains jointly controlled by an entity or group of companies, with no elements of public verification. This alternative theoretically provides the speed and transparency of the blockchain while avoiding the risk of criminals using the platform for illegal purposes.

Things really started in 2015 when a slew of high-profile permissioned distributed ledgers were launched, with ambitious goals, often backed by large banks, to leverage blockchain technology to streamline everything from payments to back-office settlements. IBM has also invested heavily in blockchain, with flashy marketing programs (and later turned to touting its AI capabilities).

Nasdaq has launched a project to facilitate the sale of privately issued "tokenized" securities using permissioned distributed ledgers. In 2015, a report by Banco Santander's venture capital division claimed that "distributed ledger technology could reduce banks' costs in cross-border payments, securities trading, and regulatory compliance by $1.5-2 billion by 2022." "This year has gone and gone without any obvious impact.

**The most high-profile early tokenization attempt occurred in March 2015, when New York startup Digital Asset Holdings (DAH) hired Blythe Masters as CEO. As a 28-year-old JPMorgan executive in the early 2000s, Masters conceived of credit default swaps, a clever tool used to help bond investors hedge against the risk of borrowers not repaying, which gained notoriety during the 2008 financial crisis. Masters' mission is to inspire widespread adoption of blockchain technology to revolutionize financial markets. In a 2015 interview with Bloomberg, Masters said: "You should take this technology as seriously as you did when you developed the internet in the early 90s. ”

In 2017, Masters and DAH achieved an initial victory when the company won a contract to replace the Australian Securities Exchange's aging clearing system. However, the deal did not go well, and the project was frustrated due to delays in stability, scalability, governance and overall project management, and was not canceled until the end of 2022. The exchange wrote off $165 million from the investment, and Chairman Damian Roche said: "We launched this project with the latest information available at the time, determined to provide the Australian market with a settlement solution that balances innovation and advanced technology with security and reliability. However, upon further review, we concluded that the path we were on at that time did not meet the high standards of the ASX and the market. ”

Despite a lot of hype about tokenization in the blockchain industry over the past decade, the most memorable project was the sale of an equity stake in the St. Regis Hotel in Aspen, Colorado for $18 million, which was seen as a joke in the industry. Will Peck of WisdomTree Investments said: "No one really wants to hold a thousandth of a hotel floor or a painting in token form. ”

Fast forward to today, and proponents of tokenization are still pushing the concept forward. Projects range from hundreds of millions of dollars in bond issuance in Europe to Robinhood-like investment applications, allowing otaku to easily buy tokenized shares in U.S. Treasuries as easily as switching TV channels. **The best applications that can be said right now are their ability to operate in small doses and controlled environments, but none of them have succeeded in breaking through the challenge of creating widespread demand. **

Take the institutional market, for example. In November 2022, Goldman Sachs launched a tokenized platform that partnered with Santander and Societe Generale to process a $100 million Eurobond issue by the European Investment Bank, which is "groundbreaking in many ways," said Matthew McDermott, managing director. The settlement cycle is 60 seconds instead of the traditional 5 days of the European Investment Bank, reducing the risk of paperwork errors and making assets more liquid.

The system can even handle interest payments on bonds. "We actually represent on-chain derivatives cash flows and demonstrate that you can interoperate with the payment systems of the Bank of France and the Bank of Luxembourg, both of which minted digital currencies for the project," McDermott said. But only two small transactions have been completed so far.

McDermott told Forbes that the bank is looking to package the EIB's offering with other companies to create a liquid secondary market. Easier said than done, as such a feat would require more infrastructure and bring industry players together around a set of technologies, which has been a major hurdle as it requires competitors to work together.

**"Everyone from BlackRock to Goldman Sachs, Citi and JPMorgan Chase is saying that tokenization is the future. Nadine Chakar, CEO of tokenization company Securrency, said she was in charge of State Street's digital asset division. Her company was recently acquired by the American Depositary Trust and Clearing Corporation (DTCC) for $50 million, a 50% discount to the value of the company when it raised its last round of venture capital in March 2021. "The problem is interoperability and liquidity," Chakar said in July, "and the bank works with XYZ Company to make an issue and then issue a press release. What happens next? Nothing. They become pet stones because they can't go anywhere. ”

Prior to being acquired, Securrency took a different approach. It partnered with WisdomTree to launch a series of tokenized funds based on public blockchains such as Ethereum and an application called WisdomTree Prime, providing a low-cost path to equity index-tracking funds and treasury bond investments for wide access. These funds have a minimum investment of $25 and an expense ratio of 0.05%. While this is still slightly more expensive than the zero-commission deals offered by platforms like Robinhood, which benefit from the controversial order-flow payment model, WisdomTree believes customers are looking for this alternative. As of now, the funds are still operational, but the combined assets of the nine funds are only $12 million, and neither WisdomTree's Chakar nor Peck has answered questions about their future.

Franklin Temple offers a similar product through a retail investment app called Benji, which offers money market funds backed by U.S. government securities as well as digital assets. Franklin Templeton's products manage $295 million in assets.

**Alternative assets such as private credit and equity may be the best hope for tokenization. Caroline Pham, a commissioner at the U.S. Commodity Futures Trading Commission (CFTC), said the private credit market is expected to reach $10 trillion over the next 10 years. **

Some preliminary tests have proven successful in speeding up issuances and lowering investment thresholds. For example, KKR partnered with a tokenization firm called Securitize to issue a portion of its $4 billion Health Care Strategic Growth Fund II (HCSG II) on the Avalanche blockchain, but the companies would not disclose how much they have invested in this way. Avalanche appears to be aggressively advancing the tokenization space, with asset manager T. Rowe Price, WisdomTree, Fitch Management and Cumberland DRW have partnered to launch a testnet that allows traditional financial firms to practice settlement and delivery transactions on a segregated portion of a public blockchain.

But these plans still have a long way to go before significant progress is made with industry veterans who don't feel the need to take the tokenization path. For example, iCapital has created a series of investor funds with a minimum threshold of $25,000 to finance alternative investments, but does not see the need to use blockchain in the process. CEO Lawrence Carcano said: "This business has scaled and we have not tokenized. Some people think that to grow you need tokenization, this is not true; But they are not mutually exclusive. ”

**So far, the only moderately successful use of tokenization has been stablecoins. **The global stablecoin market has ballooned to $127 billion in just a few years, however the main use of tokens — typically 100% collateral-backed and designed to maintain a $1 value — is to facilitate speculative trading on unregulated crypto exchanges around the world, many of which do not accept payments in traditional currencies. In addition, the market is dominated by Tether, a mysterious organization that has long operated outside of regulatory scrutiny. Tether, which has $84 billion in dollar stablecoin assets, has never been audited and declined to name the bank used to hold the funds.

However, tokenization pilots and press releases are still emerging. In the past few weeks alone, payments messaging service Swift has released the results of experiments with BNP Paribas, DTCC, BNY Mellon and Lloyd's Banking Group to determine if their back-end systems can connect to public and private blockchains that support tokenized assets; Citi announced plans to begin tokenizing customer deposits at the bank so that customers can instantly send funds anywhere in the world at any time. The initial pilot was conducted in partnership with shipping giant Maersk, a customer of the bank.

The London Stock Exchange also wants to launch a tokenized trading business that may focus first on opaque private equity. Like breaking the record, Murray Roos, head of capital markets at the London Stock Exchange Group, echoed comments from the Australian Securities Exchange years ago, saying the technology had reached an "inflection point" and that "the idea is to use digital technology to create a smoother process". Smoother, cheaper, more transparent, and regulate it. ”

"In the next 18-24 months, something has to happen," said Chakar, CEO of Securrency. From a technical perspective, the future of blockchain tokenization of trillions of real-world assets is just around the corner, but it will never happen as long as trust in the crypto market is almost non-existent. **