Increasing use of asset tokenisation in financial markets will have many implications in the future: it can affect liquidity, trading, asset pricing, transaction clearing and settlement.
The issue of asset tokenisation and its impact on markets is addressed in the publication OECD (2020), The Tokenisation of Assets and Potential Implications for Financial Markets. Blockchain Policy Series.
When looking at the effects of tokenisation on markets, one has to differentiate between the following two situations:
– the tokenisation of securities that also exist off-chain, i.e., securities traded off-chain that are tokenized and transferred partially or completely on-chain;
– the issuance of securities in the form of tokens directly on-chain, thus native to the blockchain, i.e. without securities being issued in conventional form.
Asset tokenisation: trading implications
DLTs enable transactions in which trust is distributed among the nodes participating to the network, without the need for a central authority or intermediary to validate a relationship between two parties carrying out a transaction. Transactions are validated and confirmed by participants in the decentralised network in exchange for a certain transaction fee. On this basis, it is expected that with an increasing use of tokenisation, the market-making model will be revolutionised with consequences for market structure and the market-maker function.
Disintermediation and the impact on the market-making function
Market-makers provide the price of securities to investors who want to buy or sell them. The role of market-makers is usually crucial in markets with a limited investor base and the need to provide liquidity, particularly in contexts of market crises, when market-makers resolve orders in the absence of a true balance between supply and demand. In contrast, the matching of buyers and sellers in a decentralised market for tokenised securities is automatic and requires no third-party intermediation. In this context, the efficiency gain lies in the elimination of the intermediary.
However, it happens that asset tokenisation operators offer market-making services to clients even in blockchain-based markets, for instance, in cases where the DLT-based tokenisation network in use does not have sufficient liquidity; or that the platform provider has economic incentives that encourage to keep the broker model in a tokenised environment anyway: brokers may still be useful in decentralized environments for the execution of large orders.
A move away from a market-making model could have an impact on the smooth functioning of some markets and the redistribution of risks between them. The resilience of markets could be adversely affected by potential systemic effects due to situations of massive selling that could occur in the absence of market-makers holding traded assets on their balance sheets acting as ‘shock absorbers’ and thus mitigating the volatility that arises.
This risk will be higher for native on-chain securities, while for off-chain securities, the effect may be reduced by the presence of traditional parallel markets.
The presence of intermediaries in blockchain-based tokenised asset markets may cause the efficiency gains of decentralized DLT systems not to be realized to their full potential. The question of what level of disintermediation and decentralisation is actually desirable is still an open issue.
Liquidity implications and benefits
In a scenario of increasing diffusion of asset tokenisation, the number and diversity of assets that would be traded in the markets could increase considerably and consequently liquidity would increase. Platform providers already allow tokenisation of any asset on the same infrastructure, therefore the technology that enables tokenisation is easily available.
The tokenisation of assets such as small and medium-sized enterprise (SME) stocks or private equity/venture capital (PE/VC) funds can provide significant liquidity to nearly illiquid asset classes. Similarly, tokenisation of assets with limited liquidity, such as private placements of unlisted securities; limited liability company holdings; and small bonds, appears to offer a guarantee of improved liquidity for these asset classes as well. Some industry experts estimate that tokenisation could “unlock trillions of euros currently in illiquid assets, significantly increasing trading volumes”(Deloitte, 2019).
Secondary market trading for such assets, once tokenised, would be vital for the liquidity of asset classes such as those mentioned above, leading for example to greater availability of investment funds for SMEs. However, it should be emphasised that this development will only take place if the efficiency improvement brings economic benefits. In that case, it would generate enough increased demand to allow tokenised markets to acquire sufficient depth to allow the benefits described above.
Trading in a tokenized environment would undoubtedly benefit from the increased transparency provided by DLT-based networks. An important benefit of increased transparency is the reduction of information asymmetries, and this, in turn, has the potential to improve the price discovery mechanism, providing investors with incentives to increase their participation and bring additional liquidity into the market, this would also improve the competitive conditions in the market. The key issue for the use of DLT in financial markets is related to the operational efficiencies provided by technology and disintermediation: cost efficiencies can reduce trading costs, costs for investors participating in tokenized markets, provided that the savings obtained are passed on to investors. This could, in turn, promote market participation and increase trading volume in tokenised markets with wider benefits for public markets. The connection between on-chain and off-chain markets for tokenised assets may have further implications for prices.
Trading of tokenized assets in a decentralized world takes place 24/7 across multiple networks. In the absence of interoperability among the various blockchain-based networks and on-chain and off-chain markets, trading of tokenized assets risks to become fragmented with important operational consequences including the need for arbitrage.
On the other hand, the integration of on-chain and off-chain would create a dual listing system similar to the one that occurs when a security is listed on several markets.
The need for arbitrage can potentially occur even in native tokenized assets, when they are traded on different exchanges with limited or no interconnection. This may lead to inconsistencies in the way assets are valued, if there are discrepancies in prices across platforms.
Market fragmentation can also result in the price of the token being different from the price of the underlying asset in conventional markets. This could occur as a result of of the token being traded in multiple systems, or the types of investors participating in the respective markets. In a scenario where tokenisation is prevalent, even if such price dissociations occur for short periods, they could have an impact on the stability of some markets.
The issue of interoperability is not limited to the connection between the on-chain and off-chain worlds or between different blockchains; a further level of integration would be required in relation to links between the legacy infrastructure of financial market participants and blockchain-based infrastructure. Market participants would need to build DLT-based systems as tools on which asset tokenisation can take place.
Given the complexity of the internal and external networks of financial market legacy infrastructures and the multitude of actors, processes and interests involved in even a simple trade, such integration and interoperability may prove to be a challenge with possible consequences on the smooth functioning of parts of the markets.
As abstract as the benefits of DLT technology may initially seem, they become more tangible in the context of capital markets. The development of this technology in the financial universe offers numerous benefits: increased disintermediation and therefore fewer intermediaries and the consequent increase in speed of execution and reduction in costs, In addition, any investment opportunity can count on global market reach: in fact, anyone with simple access to the Internet will be able to take advantage of almost any investment opportunity and even those currently reserved for an élite will become available to everyone. Finally, DLT technology has the potential to significantly reduce market manipulation; every transaction is recorded transparently, in real time and shared, immutable, verifiable and always accessible to all interested parties. Analysts say that in the coming years, asset tokenisation will become the preferred method of generating value, and countries that choose this new option and democratise their capital markets will gain a strategic advantage over other States.