The tokenisation of physical assets refers to the creation of a tamper proof, unique and legally enforceable digital representation of a physical object. It opens a world of opportunities as the physical objects which were earlier consigned to specific markets are now available to global investors. The earliest example of the tokenisation of an asset was when a $30 million luxury Manhattan condo development was tokenised on Ethereum. Ernst and Young in the paper ‘Tokenisation of Assets – Decentralized Finance’ state that “the process of tokenisation creates a bridge between real-world assets and their trading, storage and transfer in a digital world” (https://assets.ey.com, 2020).
There is widespread excitement regarding the huge potential that tokenisation offers especially with regards to the value it can unlock in illiquid assets. One of the primary drivers is the ability to reduce value chain by eliminating intermediation in the trading of tokenised assets. Traditionally investment in big ticket opportunities were largely confined to institutional investors whereas with tokenisation the same opportunity becomes opened to the retail space. By digitising an investment (e.g., real estate), part ownership of a fractionalised asset becomes possible. With initiatives like the Fnality Payment System, investors can fully digitalise the cash settlement leg of the transaction as well, enabling near-instant settlement, 24/7 trading and smart contract-based payments. Other benefits also include improved end to end processes and cost savings.
Experts believe that the tokenisation of assets can disrupt many sectors including real estate, securities, and commodities. Estimates of future market size are enticing for this nascent sector as a report from BCG and ADDX puts the total size of illiquid asset tokenisation globally at $16 trillion by 2030 (https://web-assets.bcg.com, 2022) .
Are we there yet?
While there is considerable excitement in the market, the reality on the ground remains challenging. An important aspect that needs to be understood is that the traditional process for exchanging physical assets has become entrenched and standardised over many decades and, in some cases, centuries. Disrupting the current process with a new one, irrespective of how efficient it would be, will certainly require huge time, effort, money, and most importantly clear success in meeting investor’s objectives.
There are a host of challenges which would need to be addressed to realise the benefits of Asset Tokenisation. These can be grouped into three broad areas:
- Adoption – While on paper, and in test scenarios, the idea sounds disruptive, the real test would be the large-scale adoption by the stakeholders. The traditional mechanism of trading assets is well cemented, and users are well versed with the rules of the game for trading and settling asset deals. Any disruptive change involving tokenisation of assets and related trading opportunities will have a high learning curve and will take time to become mainstream.
- Legal / Regulatory - Legal and regulatory requirements around traditional physical asset trade have been iterated and matured over time. Some of this legal framework has been implemented in response to various economic issues like the financial crisis of 2008. Adapting these rules for a tokenised world will need a considerable amount of deliberation and refinement. Given one of the key benefits of tokenisation is to expand or rather eliminate the territories where assets are traded, it is imperative there is collaboration across jurisdictions to lay a common legal framework.
- Interoperability – Currently, there are multiple initiatives which are being driven to facilitate the tokenisation of physical assets and related trades. For widespread adoption, interoperability between platforms is critical. Success of the tokenisation of assets will be limited if there is lack of seamless technical interaction of platforms as well as the establishment of legal, regulatory, and operational procedures.
An important driver for the adoption and commercial success of asset tokenisation will be the strategy for the rollout. Among the options available, one would be to leverage traditional market infrastructures by directly integrating new tokenisation solutions, however tokenised assets would still be encumbered by the same constrains of other traditional assets.
An alternative option would be to establish a distinct ecosystem with no dependency on existing processes. With no legacy constraints, it would be possible to trade these assets automatically using smart contracts, on a 24/7 basis and have them settle near instantly.
The primary consideration for choosing an option will involve users’ risk appetite, level of customisation needed, backward compatibility, and the true net value that will be realised from the disruption. It is also important to note that traditional markets have constantly worked on optimising the efficiency and throughput of existing solutions. Users would have to make the decision based on the opportunity cost involved between leveraging augmented existing solutions and new ecosystems.
There is no doubt that the world of tokenised physical assets holds considerable value. However, there is a significant amount of work that remains to be done. The idea is still at a very early stage of the journey. It will require commitment from a wide array of stakeholders like regulators, fintechs, banks, custodians, clearing houses, and investors. This may take some years to bear fruit, however key initiatives are in progress to lay a strong foundation.
If you’d like to know more about the proof of concepts Fnality currently have in play please do reach out, we’d also be interested in your own opinions about how asset tokenisation can be facilitated and ushered into the mainstream.
Written by Stephen Varghese, Director – Product Management at Fnality International