What are tokenized securities? What is tokenization in securities?
Table of contents
- Introduction- Tokenized Securities.
- What is a Tokenization?
- What is a Token?-Tokenized Securities
- What is a Security Token?- Tokenized Securities
- Why Finance Industry is interested in Security Tokens?
- What are the Security Tokens?- Tokenization
- What are Tokenized Securities?
- Security Tokens- Present Scenario – Tokenized Securities
- Why the Difference is important?
- Tokenized Securities
- Blockchain Security Tokens
- The Future of Financial Instruments – Tokenized Securities
- Benefits of Tokenized Securities
- Capital Markets
Introduction- Tokenized Securities.
Hey! Are you as confused as I am with this terminology of tokenization?
Some of you may remember the heyday of 2017-2018 when everything was going to be tokenized and put on the blockchain.
Banks were lining up to launch proofs of concept but clients were thin on the ground.
Now, experimentation has spread well beyond the initial cohort, and even regulators are turning their attention to the topic.
But along with greater interest comes greater confusion. You have probably noticed, that sometimes the assets in question are called “security tokens”. And sometimes they are “tokenized securities”.
Now most people won’t care what they are called. It is the idea that matters, right?
We will sort out the terminology later.
Perhaps like me, however, exist to point out that ‘nope’, terminology does matter’, even from the beginning.
Essentially, the two terms do not refer to the same thing. So, let’s try to find out what is.
What is a Tokenization?
Basically, tokenized securities are when the ownership of security is materialized through the issuance of a token that is registered on a Distributed Ledger Technology.
It is the process of converting ownership rights to an asset into a token. A tokenized security is essentially a blockchain-based tradable financial asset that can represent an investment in another asset.
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What is a Token?-Tokenized Securities
Tokenization is one of the notions that have become more popular as blockchain has become more widely used.
Tokens are being looked at by groups from many different industries and communities as a way to start new businesses and projects.
Everyone is thinking about how this new technology could be used to do things that were not possible or did not work before.
Before going into more details, let’s see what a token is. A token is, in its most basic form, a product or a unit of value that a business offers or issues.
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What is a Security Token?- Tokenized Securities
Tokens that can be traded are called security tokens. The term “securities” is derived from the economic term.
That shares the same name and refers to a fungible, tradable asset, with an attached monetary value.
A security token might represent a share in a corporation, a right to vote on the firm’s operations, a unit of value, or all three.
The primary distinction between a security token and a security is that the token supply is organized and handled automatically via smart contracts.
But we should be careful. Often when we say “security token”, we mean “tokenized security”. Both are compelling concepts, but they are not the same thing.
Using them interchangeably is both confusing and misleading. They imply different constructs, different investors, and potentially different regulations. And conflating the two is not doing justice to either.
Why Finance Industry is interested in Security Tokens?
The financial industry is very interested in security tokens because they can reduce the costs of generating and maintaining securities.
Additionally, they can eliminate brokers from the trading process and increase transparency by recording all transactions on a decentralized ledger.
These token sales are now known as security token offerings or STOs, and they were created with institutional investors in mind.
What are the Security Tokens?- Tokenization
First, security tokens are tokens that share some characteristics with securities. Second, security tokens are a new concept. They are created on-chain, for on-chain purposes.
Basically, they do things that have not been done before on rails that did not exist until a few years ago.
Third, they enable new forms of financing user engagement, investor reward, project governance, and much more.
We have not even begun to scratch the surface of how the concept can influence the evolution and implementation of ideas.
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What are Tokenized Securities?
Basically, these are old concepts in a new wrapper. They take existing formats and add additional convenience.
Mainly, improved settlement, greater transparency, more flexibility, and a broader reach.
Essentially, they are also undergoing a dizzying burst of experimentation over the past couple of months.
As we have seen financial institutions and official organizations not just trialing but actually issuing shares, credit notes, municipal bonds, funds, commercial paper, and gold on blockchains.
Security Tokens- Present Scenario – Tokenized Securities
Chiefly, security tokens, are struggling amid a lack of clarity, and the all-too-familiar regulation-by-enforcement approach of the US Securities And Exchange Commission (SEC).
For example, starting in 2016 LBRY which is a decentralized protocol and a media service, has financed its development through the issue of LBC Tokens.
Which would enable access and engagement once the platform was up and running.
For many, these were obviously utility tokens since they enabled the use of service. But for SEC, they were security tokens since their issue financed the project.
In 2021 the regulator brought an enforcement action against LBRY. The issuer pushed back, but in November a judge ruled in the SEC’s favor.
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Why the Difference is important?
First, tokenized securities are unlikely to attract much attention other than classification tweaks and requirements that custody practices.
Second, international regulators are working on explicit rules to deal with the adaptation of securities to blockchains.
And along with official support will come even more establishment experimentation and eventually client demand.
Essentially, security tokens are somewhat contentious, however. The SEC’s case against Ripple for allegedly issuing unregistered securities is solved in its year.
In the U.S. judicial system precedents matter, but imagine the sheer consumption of legal resources should more SEC targets decide to push back.
This is, unsustainable, but until the U.S. regulators understand this, progress will be hindered.
All tokenized securities could be classified as security tokens, but not all security tokens are tokenized securities.
By lumping the terms together we may hinder classification attempts, which in turn impacts both regulation and investment.
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These are putting a new wrapper around a familiar asset, with a view to broadening the market and enhancing liquidity.
It’s not so much a new product for the regulators as it is a new distribution channel, which is much easier to approve.
But security tokens on the other hand are a new product. The challenge for regulators and investors is much greater, in that the ramifications and the risks are harder to figure out.
This is not to belittle the innovation behind tokenized securities. On the contrary, their relative simplicity means that we are likely to see many enter the market in the short term.
And while supply is likely to outstrip demand, at least at first, their trading will help investors and regulators to get familiar with blockchain-based markets.
That should help us all to get our heads around the concept of security tokens. That’s when the innovation truly gets unleashed.
Basically, tokenized securities are already here, and we are likely to see a lot of progress on this front over the coming months.
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Blockchain Security Tokens
First, blockchain security tokens bring new benefits to financial markets that stand to revolutionize the world of finance.
By providing better transparency, efficiency, compliance, and market availability, among many others.
These are radically fungible through the use of public and permissionless distributed ledger technology.
Their independence from third parties offers global and instant settlement at minimal costs.
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The Future of Financial Instruments – Tokenized Securities
Chiefly, tokenization on a blockchain and DLT has gained significant traction across the world.
Emerging countries like China are remarkably boosting blockchain implementation by experimenting with and developing Central Bank Digital Currencies (CBDC).
Whereas, developed countries such as Germany are introducing game-changing regulations to ensure wider institutional adoption of blockchain and digital assets in their financial systems.
Consequently, new financial instruments such as tokenized securities, NFTs, and crypto-assets in general, have become popular and desired by investors and financial institutions.
What makes this terminology of tokenized securities so attractive?
Let’s assume that, in the traditional setup, the ownership of security is still represented by a paper certificate. The process of asset tokenization de-materializes securities, meaning the proof of ownership is now represented by a digital token.
This digital token runs on DLT and executes automatically on smart contracts.
Issuers are now able to reach a wider group of investors. Access to global audiences becomes significantly cheaper with tokenized security.
The processes are carried out mainly digitally and keeping records becomes “paperless”.
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Benefits of Tokenized Securities
Issuance of tokenized securities
The transaction fee is dramatically reduced due to the ability to carry out a direct relationship with a global audience without the need for third parties.
Which are replaced by DLT and represented by a token (e.g.ERC-20), tokenized securities are held in a digital wallet.
Issuing traditional security requires at least 5 different parties to be involved in the whole process of issuance.
a.One or several investors
b.The related investor Bank
c. The issuer
d. The payment agent is usually covered by the issuer bank. Its role is to channel payments between issuers and investors.
e. Clearing house also known as the Central Securities Depository (CSD), which is responsible for holding securities in order to easily transfer ownership.
Paired with fiat-denominated stablecoins, tokenized securities enable settlement payments to be executed instantly and automatically. This process is described as a token Swap.
Tokenized securities allow global transferability of tokens which, provide access to an international investor base.
Instant real-time settlement is a key feature of tokenized securities as they eliminate settlement risk for all parties involved.
Custody of tokenized securities
Custody is an important aspect of securities as it ensures their safekeeping from theft or loss.
As tokenization allows for the elimination of CSO as the decentralized ledger replaces the idea of a centrally managed registrar to keep track of ownership.
The ledger takes out this function by recording all transactions automatically and irreversibly.
Just like securities are stored in highly secured vaults managed by banks, tokenized securities are stored in such wallets.
Therefore, respective key management is of high importance, especially when storing millions and billions worth of funds.
Demand for third-party custody services is on the rise. Mainly, by big institutions that are getting more and more involved in the crypto and digital assets space.
Settlement and Payments in the tokenized securities
It is very important to understand that having payments settled on-chain is also necessary to unleash the full potential of tokenized assets.
On-chain payments allow for instant delivery vs payment transactions. The asset and the coin are directly exchanged within the protocol. This eliminates counterparty risk.
Historically, these processes were paper-based where the investor would hand in the security certificate in exchange for cash or a check.
Nowadays, it is completed through electronic fund transfer (EFT). An EFT is basically a transfer of money from one bank account to another electronically, commonly known through SWIFT.
As tokenization now paves the road for so-called stablecoins to be introduced. These stablecoins are e-money that is backed by assets or fiat currency, they are “Tokenized Funds”.
Backed by funds, that is commercial money, e-money, or central bank money which an issuer or custodian holds for safekeeping; this implies that there is a commitment to ensuring that tokenized funds can be redeemed in full.
Additionally, the use of stablecoins allows instant settlement of investments and payments automatically and globally.
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In capital markets, tokenized securities offer substantial efficiency gains in the issuance process.
a.Digital end-to-end investment flow
c. Reduced complexities
d.Global transferability and instant settlement of funds.
This is achieved thanks to features offered by blockchain technology, such as automatically verifying and recording ownership on a distributed ledger technology publicly accessible.
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The two concepts on the surface may appear similar but lift the lid and you can see that the difference is stark.
It’s about clarity and establishment support versus the lack thereof. It’s also about development.
With security tokens, the fear of SEC reprisals is holding back many worthwhile projects from testing out ideas in the market. While tokenized securities are getting busy.
Essentially, the tokenization of securities is exciting, and the recent activity around the concept is the welcome result of years of solid behind-the-scenes work by developers, market infrastructure firms, banks, and financial overseers.
The tokenization of securities is one of the main vectors through which crypto markets will transform traditional markets.
According to speculations, more service providers and licensed exchanges are presumed to bring about a more robust industry. Where regulations and security measures would be put in place, all thanks to what is offered by tokenized securities..
It is the process of materializing the ownership in a security through the issuance of a “token”. Which is registered on a distributed ledger technology (DLT) infrastructure. Therefore, a tokenized security can be equity, a bond, or an investment fund.
These examples might include tokenized stocks, tokenized bond funds, or even tokenized real estate. Today, you can buy shares in a real estate investment trust through a brokerage. But at some point, perhaps you will just buy tokens instead, safely stored in your ETH wallet.
In federal court documents, the SEC deemed the following tokens as securities.
SOL, ADA, MATIC, FIL, ATOM, SAND, MANA, ALGO, AXS, and COTI.
The benefits of tokenization include increased liquidity, faster settlement, lower costs, and bolster risk management. Even private securities or illiquid assets such as fine art are tokenized and traded on the secondary market.
It is often used to protect credit card data, bank account information, and other sensitive data handled by payment processors. Payment processing use cases that tokenize sensitive credit card information include the following mobile wallets, such as Google Pay and Apple Pay, and e-commerce sites.
It is the process in which certain types of assets are pooled so that they can be repackaged into interest-bearing securities. The interest and principal payments from the assets are passed through to the purchasers of the securities.
Lewis “Lew” Ranieri is a former bond trader and former vice-chair of Salomon Brothers who is credited with popularizing the concept of securitization in the finance world.