Will the Tokenization of Debt Trend Gain Momentum in 2024?

The tokenization trend continues to gain momentum in 2024 with the primary focus being on digital assets and payment systems. The tokenization of debt, derivatives, and structured products requires converting these instruments into digital tokens on the blockchain or distributed ledgers and remains overlooked.

Tokenizing traditional assets has caught the attention of legacy financial institutions. To put things into perspective when it comes to tokenization, there are several investment banks involved in tokenization, primarily in the context of digital assets and payment systems. JPMorgan has been actively exploring blockchain technology and tokenization through initiatives.

“2023 saw several debt tokenization initiatives, including Goldman Sachs Digital Asset Platform and HSBC’s introduction of the Orion platform,” explains Ralf Kubli, board member of the Casper Association.

Goldman Sachs has been involved in various blockchain and digital asset initiatives, including participating in tokenized securities offerings. HSBC has been exploring blockchain technology for several use cases such as trade finance and digital identity, which could involve tokenization.

Citigroup has dabbled in blockchain technology and tokenization for various financial products and services, including cross-border payments and trade finance. DBS Bank has explored tokenization in areas such as trade finance and securities trading.

In October 2023, Sygnum Bank, partnered with Float and Fasanara Capital, to release a new tokenized private debt instrument, giving access to private debt. The token was launched by Float on the Polygon blockchain. Tokenization for private markets and particularly interest in private debt has seen increased interest.

Why the Lack of Interest in Debt Tokenization?

Tokenization in the lending space whether this involves debt, derivatives, and structured products is still in early exploratory stages. When addressing delivery versus payment, banks have discovered tokenization increased efficiency in the payment, settlement, and the cash component of transactions, explains Kubli.

“Bank’s operations teams have found that if the delivery side is not clearly defined, the amount of cost and effort to complete a transaction is still the same, or even greater when factoring in the new tokenization platforms involved in the process. These limitations account for the lack of interest in debt tokenization,” said Kubli.

Understanding Debt, Derivatives, Structured Products

Debt tokenization involves converting traditional debt instruments, such as bonds or loans, into digital tokens. These tokens can then be traded or transferred on blockchain-based platforms, providing benefits such as increased liquidity, reduced settlement times, and enhanced transparency in the debt market.

Derivatives tokenization involves representing derivative contracts, such as options, futures, or swaps, as digital tokens on a blockchain. By tokenizing derivatives, parties can trade these financial instruments more efficiently, automate aspects of contract execution and settlement, and improve transparency and auditability in derivative markets.

Structured product tokenization involves digitizing complex financial instruments that package multiple underlying assets or financial products into a single investment vehicle. These structured products can include asset-backed securities, collateralized debt obligations, or structured notes. Tokenizing structured products can streamline issuance, enhance accessibility to a broader investor base, and improve the transparency and traceability of underlying assets.

For there to be interest in the tokenization of debt products what is needed is not a secondary market, but instead both the mechanics of price discovery of these financial assets living on blockchain infrastructure and also greater efficiencies in the post-trade processes, explains Kubli.

“The most important aspect of a tokenized financial asset representing debt, structured instruments and derivatives is the definition of the cash flows. Everything of interest in finance is derived from cash flows,” said Kubli.

Lack of Clarity  

Kubli stresses more clarity is needed.

The tokenization of debt has faced several challenges that have hindered its widespread adoption and growth. This includes regulatory complexity and the lack of standardization. This in turn impacts issuer confidence. Then there are a number of infrastructure challenges.

Building robust infrastructure for debt tokenization, including secure custody solutions, trading platforms, and settlement systems, requires significant investment and technological expertise.

“In other words, the payment obligations of the parties to the underlying financial contract must be clearly defined and standardized before tokenization of the financial asset occurs. Without such definitions, only dumb or incomplete tokens will be created. These tokens must contain machine readable and machine executable term sheets of the financial terms to change the game,” said Kubli.

Tokenization Debate at Davos 2024 

During the World Economic Forum (WEF) held in Davos-Klosters between 14-19 January 2024, there was a discussion on tokenization and how it introduces a new ownership dynamic that is hosted on a blockchain with the potential to impact multiple sectors of the economy. Due to lack of regulatory clarity in the sector defining where tokenization sits in the finance sector remains ambiguous

Wall Street and Tokenization 

There has been a strong push among Wall Street firms to ramp up their efforts to tokenize assets on the blockchain, as reported by Benzinga. Tokenization is when tangible as well as intangible assets are converted into digital tokens — everything from shares, and bonds to gold bullions, real estate as well as digital and physical art.

In March 2023, BlackRock CEO Larry Fink also commented in his annual letter to shareholders that there is operational potential of some of the underlying technologies in the digital assets space which could have exciting applications. The tokenization of asset classes “offers the prospect of driving efficiencies in capital markets, shortening value chains, and improving cost and access for investors,” he said.

Factors Contributing to the Growth of Tokenization

There is increased adoption of blockchain technology as the sector matures and gains wider acceptance across industries, more companies and financial institutions are likely to explore tokenization as a means of digitizing assets and improving efficiency in various processes.

Regulatory clarity and frameworks around tokenization are expected to evolve, providing more certainty for businesses and investors interested in tokenizing assets. Clearer regulations can spur adoption and investment in tokenization initiatives.

Then there is the demand for liquidity and accessibility. Tokenization offers benefits such as increased liquidity, fractional ownership, and access to a global investor base. As traditional asset classes become tokenized, demand for these benefits is expected to drive growth in the tokenization market.

There is no doubt that tokenization has the potential to disrupt traditional markets and business models by allowing fractional ownership, improving liquidity, reducing intermediaries, and streamlining processes. This disruptive potential has attracted attention from investors, entrepreneurs, and innovators seeking to capitalize on new opportunities.