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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is a law professor at the American University Washington College of Law
Traditional financial institutions are increasingly showing interest in “tokenising” real-world assets, meaning they are curious about how these assets could be digitally represented by programmable tokens recorded on shared ledgers. There could be real efficiency gains associated with tokenisation, but the drive towards it could also take a dark turn.
The most dangerous outcomes would arise if tokenisation of real-world assets were pursued simply to feed into what has been described as “the perpetual motion machine that is crypto trading”. Regulators around the world have expressed concerns about the integration of crypto and traditional financial markets, because of the high levels of volatility, leverage, concentration and operational risk associated with the crypto markets. This integration would be sped up if ownership of tokenised real-world assets were recorded on so-called permissionless public blockchains. The type of ledger favoured by the crypto industry, these blockchains can be accessed by any computer running the necessary software to host them, no identification or vetting required
The tokenisation of real-world assets can and should proceed without using these problematic blockchains. Their inefficiencies are well documented, and experimentation to resolve problems in scaling their use tends to focus on processing transactions off the blockchain (defeating the stated goal of decentralisation).
It is perhaps less well appreciated that these kinds of blockchains are also plagued by governance problems. We cannot simply trust in the code of the blockchain. Public permissionless blockchains are “designed by people, maintained by people, and governed by people”, as one research paper put it. but we don’t necessarily know who these people are, who pays them, or if they’ll show up in an emergency. This is an untenable position for critical financial infrastructure.
Unfortunately, BlackRock has chosen to host its tokenised Buidl fund on the public permissionless Ethereum blockchain. The good news is that some other financial institutions have taken a different path, and are experimenting with other kinds of ledgers to see if tokenisation yields efficiencies in their markets.
Efficiencies can arise from programmability, meaning that software known as “smart contracts” can be built into the tokens to allow for the automation of functions, like interest payments. Smart contracts can also be used to build bespoke financial products out of multiple tokenised assets — this is known as composability. Ownership of tokenised assets can also be split into smaller pieces in a process known as fractionalisation. When ownership of all tokenised assets used in a single transaction is recorded on the same ledger, the transaction can be settled “atomically”, or simultaneously, 24/7.
Cross-border payments seem particularly ripe for improvement through tokenisation, but we shouldn’t rush to tokenise everything. Some purported benefits (particularly those relating to financial inclusion) are overhyped. And where efficiencies gains are real, they can invite corresponding fragilities. Even when divorced from crypto, there is a dark side to tokenisation.
Tokenisation promises to bring more real-world assets into the financial markets, and to engineer them into new categories of bespoke financial products both big (through composability) and small (through fractionalisation). This may unlock liquidity and efficiencies in good times, but we learned in 2008 that illiquidity, deleveraging and fire sales will be on the menu when things turn south. Discretion and forbearance (for example, with regard to margin calls) are often critical to containing the damage in these circumstances, but obligations automated with smart contracts will inflexibly self-execute regardless of context.
In addition, smart contract software provides another attack surface for hackers, and the more comprehensive the underlying ledger, the more attractive a target it becomes for cyber attacks. Atomic settlement also deprives markets of the benefits of netting of transactions.
If we think back to 2020, we learned the hard way that supply chains could become brittle when the unexpected occurred; now there is increasing interest in production strategies that are less efficient, but more resilient. We should explore tokenisation with the same mindset. We need to ask “when something is efficient enough, will making it more efficient introduce too many fragilities and be counterproductive in the long run?” In the best-case scenario, tokenisation experimentation will spur the financial industry to start thinking intentionally about this question.
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