Tokenization is one of the hottest topics in the crypto and blockchain space, and increasingly outside of it. It’s also a key part of the structured products on digital assets topic. Tokens are the infrastructure for digital assets, and they’re increasingly going to be the bridge between the digital assets world and the traditional securities world where structured products live.
That said, tokenization is nothing new. Already back in the first wave of mainstream interest in blockchain around 2016 it was clear to many people that blockchain was a technology that could replace many parts of the financial services infrastructure, and that tokens, the containers of value on a blockchain, could replace securities as financial wrappers. Fast forward ten years, however, and the call to “tokenize all the things” that was so prevalent then has yet to be fulfilled. Instead, tokenization continues to gain ground incrementally, though at what seems to be an increasing pace.
For these and other reasons, we dedicated the fourth session of our Summit to the subject of tokenization, with an eye to uncovering what the term really means, what the state of tokenization really is today, and what potential “tokenizers,” in our context, issuers of tokenized financial products, really need to know.
Nick Cogswell is the Head of Institutional Partnerships at Archax, the UK’s first regulated digital asset exchange, broker and custodian.
What Is Tokenization, Really?
The session opened with the seemingly simple, but still often misunderstood, question of what tokenization and cryptographic tokens really are. Cogswell said a token is essentially a digital record of ownership or entitlement to an asset. It’s recorded on a digital ledger rather than on the traditional register you would have for things like equities or bonds. That makes it really just another wrapper. Importantly, Cogswell added, “it doesn’t change the asset, it doesn’t change how it’s issued. It still sits within securities regulation if it’s a security.”
The point of tokenization then is not what the tokens contain or represent, but what can be done with them. Thanks to blockchain technology, tokens can offer many operational advantages over traditional financial infrastructure.
“It’s hugely quick to settle,” Cogswell said, “with much fewer reconciliation points. It’s decentralized, so you don’t have a centralized settlement agent in the middle like you would with normal funds or equities or bonds. That makes transferability much easier. We think the ability to borrow and lend against assets is going to become a huge part of what sets tokenization apart. You’ll be able to hold an asset, for example a share, and borrow against it much quicker than you can currently.”
Thanks to tokenization, Cogswell thinks it will become a lot cheaper to bring assets to market, to move them around, to trade them (including the prospect of 24/7 markets that never sleep). And being digital, these wrappers can also be programmed.
“With smart contracts you can embed different things to happen when people send, say, stablecoins to buy an asset. Imagine a traditional product like a fund, where you buy the fund but then have to pay money across separately from the fund units being delivered, and then settlement involves multiple teams liaising to settle. With a token where you have that embedded, it reduces the cost significantly in the long run.”
Much of that cost sits in settlement, and Cogswell walked through where it comes from today.
“When we look at structured product issuances, when you’re issuing notes you need a paying agent, you need a custodian, and the notes generally settle through a centralized business like Euroclear,” Cogswell said. “You pay fees to settle through that centralized entity. When you don’t have to do that, you have a more direct route to settling, you no longer have to use that centralized business. You still need a place where the assets are registered, so you need a digital CSD to know who holds what. It’s just with the blockchain you can make it a bit simpler to move, because it all happens over the blockchain rather than needing to be set up manually by ops or settlement people.”
For all of that, the advantages are not yet fully in hand. We are still in a partially on-chain, partially off-chain world, and getting the full benefit depends on the rest of the structure, technical and legal, catching up.
The Bond Beneath the Token
The legal bit is extremely important, of course. For that record to be worth anything, the link between the token and the thing it stands for has to be ironclad. If the underlying asset can be moved or sold elsewhere while the token still circulates, the token stops referring to what it claims to, and the structure is worth nothing.
The mechanism behind the bond is custody. Cogswell explained how it works at Archax, which holds a custody license alongside its exchange and brokerage permissions.
“We can hold the assets ourselves, whatever the asset is, within our custody, and then we immobilize it so it doesn’t get moved around, and we tokenize it from that point on,” he said. “You always have a single point where the asset is held, and the asset itself doesn’t move. That’s the key point. You can’t then also move or sell the underlying asset, because that increases the chance that the token doesn’t reference exactly what it’s supposed to.”
For a structured product the same principle applies one layer up. “In the case of an SPV, if you’re doing a structured product, at the moment it would generally be an SPV that issues notes,” Cogswell said. “We’d hold the notes of that SPV and then tokenize those notes.” The note is the asset held in custody, and the token references the note.
Who’s Knocking
Another topic we were keen to talk to Cogswell about was the demand side of the equation. As he works on the front lines of this world, he has a good sense of what the market is actually like today. And so we asked him who’s coming to Archax right now, and what are they asking you for.
“We have a lot of regulated businesses, asset managers and banks, that are looking to tokenize different sorts of assets, deposits in the case of banks, funds as well for asset managers,” he told us. “There was a huge amount of demand initially for money market funds. There are a few tokenized money market funds out there now. They’re a pretty simple product, which is why they’ve been adopted so quickly. But we’re also seeing private equity and private credit. Private credit is probably one of the largest use cases at the moment. A lot of the digital investors we talk to like yield, so a private credit fund fits nicely there.”
Cogswell said they also have a lot of on-chain businesses coming to them. Many of these are digital asset company treasuries that are holding digital assets and want to secure assets that sit outside the digital market. Tokenized money market funds fit really well for that. “We sit in that crossover part of the Venn diagram, where both sides come to us to access the other side,” Cogswell explained.
While there hasn’t been that much demand from end clients yet, there have been a lot of issuers coming to Archax looking to tokenize illiquid assets. Over the last six to twelve months, Cogswell explained, the industry as a whole has seen real, massive increases in issuances. “The number of tokenized RWAs is around USD 30 to 40 billion now, depending on what you’re looking at. Go back two or three years and it would have been very few, single-digit billions.”
That’s changed the conversations he has been having. “Originally people were asking us, should we do this? Now it’s more people saying, we realize we need to do this, because it will become the way that all assets are handled. That’s because it’s cheaper, quicker, and easier to use.”
Originally people were asking us, should we do this? Now it’s more people saying, we realize we need to do this, because it will become the way that all assets are handled. That’s because it’s cheaper, quicker, and easier to use.Nick Cogswell
The Liquidity Fallacy
Quicker, cheaper and easier is always a draw. But it can also lead to misconceptions. In the tokenization space, perhaps the biggest of these is around the subject of liquidity. It’s not uncommon to find people wanting to tokenize a product on the assumption that that will automatically create a market for it.
“That’s probably one of the biggest fallacies of tokenization, that tokenization increases liquidity,” Cogswell confirmed. “It allows liquidity to be built, but it doesn’t bring liquidity. There are a lot of real-world assets that are very illiquid, where within our infrastructure we can issue on the primary and secondary market as tokenized securities. Right now, most of those securities in the secondary market are traded on what’s called a bulletin board, which is more like an expression of interest to buy and sell. Once the asset is sold, people put expressions of interest to buy or sell more onto a board, and we put those parties together.”
Cogswell said it’s very important that people understand where the distribution is going to come from when they start looking at tokenizing. “We still have a lot of people who come along and say, we want to tokenize this asset, we think it’s a great asset. And one of the first questions is, okay, but who is actually going to buy this tokenized version?”
That said, reducing friction can support liquidity to a degree.
“If you consider something like a private equity fund, where you have pages of documents around limited partnership agreements and quite complex structuring, by putting it all into a token you can move the legal title to that asset very quickly, which you wouldn’t normally be able to do as there is so much overhead, lawyers and that type of thing. So it helps to drive liquidity, but you need the demand in the first place.”
If you consider something like a private equity fund, where you have pages of documents around limited partnership agreements and quite complex structuring, by putting it all into a token you can move the legal title to that asset very quickly. So it helps to drive liquidity, but you need the demand in the first place.Nick Cogswell
The Walk-In
In order to bring this all to life and make it clear, we then simulated a typical issuer’s journey if they work with Archax.
Supposing, we said, you were an independent European asset manager with a specialty in commodities who was able to source a rare commodity (we used uranium in this example). The problem you are trying to solve is straightforward: you want to give your clients exposure to this commodity and do it quickly and efficiently. A fund is overkill. You are looking at wrapping the exposure into an AMC and making it bankable in that way, but you’ve heard a lot of talk about tokenization and want to understand it better. So you walk into the Archax office in London and ask if this is an interesting option as well.
As Cogswell explained it, the conversation would then turn on a number of key points.
First, to tokenize Archax would need to secure the asset. That means in most cases that Archax would want to custody it. Next it’s important to understand the investment case and potential market for the product. “What kind of payoff are you looking to provide? Who is actually going to buy this?” Then there is the question of distribution. “You really need strong ideas or relationships in place as to how these products are going to be distributed,” he said. “Then that’s the point where we talk about whether you want a secondary market.” Finally, and unsurprisingly, there will be a discussion about regulation. “You need to know which jurisdictions you want to focus on. Different jurisdictions have different regulations.”
Where the Money Lives
The reward, particularly for a first-time tokenizer, is gaining experience in what many expect will be the financial rail of the future, with a lot of operational upside. And while Cogswell has been clear throughout that tokens don’t create liquidity, being on chain can at least in theory expose product sellers to on-chain liquidity pools they might not otherwise be familiar with.
“There is a lot of on-chain wealth,” Cogswell said. “We deal with a lot of foundations that issue different chains, for instance. And there’s a lot more wealth management happening on chain.”
In other words, money that used to sit in purely crypto-native yield strategies is increasingly reaching for real-world assets it can hold on chain, and we can expect that shift to be a tailwind for tokenization. Right now, Cogswell said, that on-chain money is reaching for the liquid, income-producing end first. Tokenized investment products, particularly those with a yield or income profile, could increasingly be seen as a logical next step.