Markets
The dark side of tokenization
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Roula Khalaf, editor of the FT, selects her favorite stories in this weekly newsletter.
The writer is a professor of law at American University Washington College of Law
There are more and more traditional financial institutions show interest in the “tokenization” of real-world assets, meaning they are curious about how these assets could be digitally represented by programmable tokens recorded on shared ledgers. There may be real efficiency gains associated with tokenization, but the push towards it could also take a dark turn.
The most dangerous outcomes would occur if tokenization of real-world resources were pursued simply to fuel what has been described as “the perpetual motion machine that is cryptocurrency trading.” Regulators around the world have done so expressed concerns on the integration of cryptocurrencies and traditional financial markets, due to the high levels of volatility, leverage, concentration and operational risk associated with cryptocurrency markets. This integration would be accelerated if ownership of real-world tokenized assets were recorded on so-called permissionless public blockchains. The cryptocurrency industry’s favorite type of ledger, these blockchains are accessible from any computer running the software needed to host them, without the need for identification or auditing
Tokenization of real-world assets can and should proceed without the use of these blockchain issues. Their inefficiencies are Well documentedand experimentation to resolve problems in scaling their use it tends to focus on processing transactions outside of the blockchain (defeating the stated goal of decentralization).
Perhaps less appreciated is the fact that this type of blockchain is also appreciated afflicted from governance problems. We cannot simply trust the blockchain code. Permissionless public blockchains are “designed by people, maintained by people, and governed by people,” as research paper put it on. but we don’t necessarily know who these people are, who pays themor if they will show up in an emergency. This is an untenable position for critical financial infrastructure.
Unfortunately, BlackRock chose to do this guest its Buidl fund tokenized on the public Ethereum blockchain without permission. The good news is that other financial institutions have done this too taken a different path and are experimenting with other types of ledgers to see if tokenization produces efficiency in their markets.
Efficiencies can to show up by programmability, meaning that software known as “smart contracts” can be integrated into tokens to allow the automation of functions, such as interest payments. Smart contracts can also be used to create bespoke financial products from multiple tokenized assets – this is known as composability. Ownership of tokenized assets can also be split into smaller pieces in a process known as splitting. When ownership of all tokenized assets used in a single transaction is recorded on the same ledger, the transaction can be settled.”atomically“, or at the same time, 24 hours a day, 7 days a week.
Cross-border payments they seem particularly ripe for improvement through tokenization, but we shouldn’t rush to tokenize everything. Some purported benefits (particularly those related to financial inclusion) are overstated. And where the efficiency gains are real, they can to invite corresponding fragilities. Even when separated from cryptocurrencies, there is a dark side to tokenization.
Tokenization promises to bring more real-world assets into financial markets and transform them into new categories of tailored financial products, both large (through composability) and small (through fractionalization). This might unlock liquidity and efficiency in good times, but we learned in 2008 that illiquidity, deleveraging and fire sales will be on the menu when things get bad. Discretion and forbearance (e.g., regarding margin calls) are often key to containing damage in these circumstances, but obligations automated with smart contracts will inflexibly self-execute regardless of context.
Additionally, smart contract software provides another attack surface for hackers, and the more complete the underlying ledger, the more attractive a target it becomes for cyberattacks. The atomic solution also deprives the markets of the possibility of benefits of transaction clearing.
As we look back on 2020, we learned the hard way that supply chains could become fragile when unexpected events occur; there is now growing interest in less efficient, but more resilient manufacturing strategies. We should explore tokenization with the same mindset. We need to ask ourselves “when something is sufficiently efficient, will making it more efficient introduce too many fragilities and be counterproductive in the long term?” At best, experimenting with tokenization will stimulate the financial sector to start thinking intentionally about this question.
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