An Investment Perspective on Tokenization

In recent years, growing interest in cryptoassets has brought attention to distributed ledger technology (DLT), aka blockchain, which enables faster transactions, reduced operational and administrative frictions, transparency, and automation. This raises the possibility of using blockchain to improve how financial and real-world assets are managed. The potential benefits include greater efficiency, cost savings, and easier access to private or alternative markets for retail investors. This report starts by explaining DLT, the foundation of tokenization, and explores the process, benefits, applications, and challenges of tokenization. 

"An Investment Perspective on Tokenization" is a CFA Institute research project that explores the tokenization of real-world and financial assets. The research covers the processes involved in tokenization in a two-part series, aiming to provide investment practitioners with a comprehensive understanding of tokenization's benefits, limitations, and transformative potential in the financial landscape. 

Part I of the research series is a primer on tokenization in which we look at the technical process — what tokenization is, how it works, its value proposition, and current limitations. We also consider the impact this process could have on various asset classes. Based on a series of interviews with practitioners who have experience with tokenization, we aim to explain asset-specific implications of tokenization, presenting its effects through use cases and examples of specific investment products or assets. 

Part II of the research, in a forthcoming report, will present an analysis of the policy implications related to the digitalization of finance in general and tokenization in particular. We will consider the policy and regulatory issues at stake from an international perspective, comparing various regulatory regimes in different markets. Our objective is to determine how to address current and forthcoming challenges that will inevitably arise between a burgeoning industry and regulators that wish to control its development. 

Our report stresses the importance of a balanced regulatory approach that supports experimentation and innovation while ensuring consumer protection and financial stability. Clear and consistent rules, interoperability, and collaboration among stakeholders are vital to achieving this balance. 

We believe our report will be of particular interest for general investment management practitioners interested in the impact digital finance is having on real-world and financial assets, as well as the regulatory and policy implications of such developments in key jurisdictions around the world. 

The Benefits and Limitations of Tokenization 

We consider the benefits and limitations of tokenization regarding clearing and settlement, transparency and compliance, and fractionalization and market access. The limitations and challenges we highlight include security risks, regulatory challenges, market infrastructure, and limited retail investor access to private markets.

Finally, we conducted interviews with firms and digital finance professionals to gauge the real impact of tokenizing investment products on asset managers and investors. The results of those conversations are delivered as case studies and include such assets and processes as art and collectibles, commodities, equity funds, private funds, interbank transfer activities, and repo (repurchase agreement) financing. Within these case studies, we provide a brief overview of the business, the investment process, the regulatory framework, the process of tokenization, and the benefits and limitations for the users or clients of the platforms.

We find that the immediate benefit of tokenization is represented in an increase in operational efficiency with either cost or time savings for end clients and investors. We endeavored to focus particular attention on the private-market sector. In this area of investment, tokenization has shown the potential for operational gains related to the management of, or even a reduction in, lockup periods, the tradability of tokenized units on secondary markets, and a wider spectrum of minimum investment requirements, all of which can help in managing portfolios more efficiently.

However, the notion that technology can facilitate access to a wider spectrum of investment options does not resolve the issues related to fiduciary duty, marketing rules, or suitability assessment, all of which form part of a necessary conversation on the quality of advice, or the intermediation offered to investors as they get exposed to such novel solutions. 

Currently, regulation remains inconsistent in key jurisdictions, with choices usually made along a spectrum of policy opposites — at one end, integrating digital assets within existing securities laws, and at the other, creating an entirely new framework. 

Tokenization requires a balanced and holistic approach that fosters innovation and experimentation while ensuring consumer protection, financial stability, and market integrity. Such an approach entails developing clear and consistent rules and standards, promoting interoperability and compatibility, enhancing education and awareness, and fostering dialogue and cooperation among all stakeholders.

Key Takeaways:

• Tokenization creates digital representations of assets on distributed ledgers, which vary in centralization, access (permissioned vs. permissionless), and source (open vs. closed).
• Tokenization improves clearing, transparency, compliance, fractionalization, and market access.
• Hybrid models tokenize parts of an asset's value chain, ranging from fully off-chain stocks to entirely digital assets like bitcoin.
• Challenges include cybersecurity risks, regulatory uncertainty, immature infrastructure, and investor protection issues arising from retail access to illiquid and sophisticated investments.