Tokenization – Potentials, Challenges and Use Cases in the Environment of the Financial Industry – Part 2
This article is the second part of our three-part series on the topic of “Tokenization – Potentials, Challenges and Use Cases in the Environment of the Financial Industry”. The second article was written in collaboration with Markus Abbassi (Head Digital Assets, Kaleido Privatbank), who contributed his technical expertise and critically reviewed the structure and content of the article. We thank Markus for his valuable input and the lively exchange.
In the first part of the series of articles on the topic of “tokenization“, the term was classified, potentials identified and initial use cases outlined. The second part presents concrete use cases in the context of financial institutions, analyzes the value of tokenization for (end) customers, and addresses open issues.
For the purpose of common understanding, the definition of tokenization or the token from the first part is applied[1]:
- A token is a digital representation of rights and obligations that can be assigned to a value.
- The term value is understood to mean, on the one hand, objects of value such as jewelry or works of art. On the other hand, this term also includes securities, access rights (e.g., a concert ticket) or real estate.
- Blockchain technology is used to map rights and obligations in the form of a token.
In the following, three use cases are presented which aim to create additional value for customers and the company by means of tokenization. The use case is outlined, the stakeholders involved are identified and selected challenges are discussed. The positioning of financial institutions in the context of tokenization and the relevant business ecosystems is the subject of the third and final part of this series of articles.
Capital raising and direct investments – tokenization of illiquid securities
The tokenization of securities/effects, or their issuance in the form of a token, promises great potential along the entire value chain. This means specifically in the area of issuance, trading, processing (clearing and settlement) and administration. It is important to distinguish whether existing securities are additionally tokenized or issued directly as tokens on a blockchain (so-called native tokenization). Both variants are practiced today and a hybrid transitional solution is necessary in practice and reality for the enforcement of a technology. For the use case of capital raising and direct investments, it is assumed that securities are issued natively as tokens.
Over the past decade, crowdfunding has become increasingly popular for smaller companies and projects. Investors were often the first to benefit from an initial product solution in return for an investment but could only be tied to the company and the brand to a limited extent in the long term. Participation of early-stage investors via shares was also often not an option due to time-consuming administration in maintaining the share register and transferring the share certificates due to formal requirements. From the perspective of the company with financing needs, on the other hand, capital can be raised comparatively cost-efficiently at first glance by means of tokenization – compared to traditional routes via investment advisors and banks. The lower costs first arise from the elimination of intermediaries (e.g., crowdfunding platform or later even investment banks), but in a second step also from the highly automated processing of the issuance of the securities and usually the distribution via digital platforms. Trading in the secondary market can in turn take place on specialized trading platforms. For example, the Berner Kantonalbank (BEKB) operates SMEX, a dedicated trading platform in the form of an organized trading system for tokenized securities[2] .
Later in the corporate lifecycle, securities issued as tokens offer the additional benefits of keeping the share register blockchain-based and thus achieving a high degree of automation. In the context of DLT legislation, a blockchain-based shareholder register is referred to as a book-entry securities register[3]. Smart contracts form the technical basis for this[4] and legally this can be mapped by means of electronic register value rights in Switzerland[5] . In contrast to a traditional share register, the entries in this register are visible on the blockchain immediately after the token has been traded or issued and make proactive entry on the part of the shareholder superfluous. Companies can thus see at any time who holds how many shares and the transfer can take place by means of tokens. If a company is sold at a later date, there is no need for time-consuming steps to track and update the share register.
At second glance, however, companies also incur new costs for the issuance of tokenized securities. For example, the promotion of the token can be mentioned, which is done by the company itself or by a partner (e.g., the digital trading platform for the issued token) and thus substitutes the sales activity of an investment bank. Likewise, it is in the interest of the company to conduct a comprehensive due diligence on the issuing partners (e.g., technology companies) or the technology used itself or by third parties (e.g., audit of the smart contract, the legal situation by means of a legal opinion, etc.). Especially costs in the technical area can be reduced by standardizing the token smart contract, as for example proposed by the Capital Markets and Technology Association (CMTA)[6] . At the same time, such standards are helpful when it comes to interoperability between different trading venues. Nonetheless, these efforts can often adversely affect the cost efficiencies realized by issuing as tokens.
For investors, tokenized securities offer the opportunity for a direct investment in companies that have not previously been traded on the stock exchange. Motivators for an investment are not only the potential economic return but also the possibility to participate in an emotionally interesting company (e.g., a football club). In this case, a purely financial investment is combined with a marketing effort, for example to strengthen or even expand customer loyalty.
In Switzerland, the companies Daura AG as well as Aktionariat AG (both headquartered in Zurich), among others, offer services along the value chain for tokenized securities. Particularly noteworthy is the fact that established financial institutions and infrastructure operators cooperate with the companies, e.g., BEKB, SIX Digital Asset Exchange (SDX) with Daura AG[7] and SDX with Aktionariat AG[8].
From the perspective of a financial institution, tokenized securities offer a positioning opportunity vis-à-vis end customers as a provider of direct investments in SMEs. The custody of the tokens – and thus the rights and obligations associated with the investment – can be carried out by the financial institution or by specialized third parties. More challenging for financial institutions, however, are the admission criteria for such investments. What kind of due diligence is necessary and also permissible in order to effectively mitigate risks such as investor protection. Research coverage by various financial institutions would of course be desirable, since in comparison to venture capital in this case there is no lead investor with the relevant industry and company knowledge who normally carries out the review in advance. For investors, the purchase of tokenized securities via a financial institution has the advantage that the tokenized security is visible in the context of the custody account statement as well as the performance statement, e.g., for the tax return. On the other hand, it can be assumed that the financial institution charges a fee for the services (e.g., trading of the token, corporate actions such as dividend payments, etc.) in contrast to pure self-custody.
Access to emotional assets – tokenization of art and unique items
A different perspective or motivation for tokenization can be seen when talking about so-called emotional assets. The term emotional assets refers to values to which there is an emotional attachment, such as collectibles like works of art, trading cards or classic cars[9] .
Tokenized emotional assets (TEA) are linked to tokenized securities in that they can be made efficiently transferable, fragmentable or even tradable by means of tokenization. The term fragmentation describes the division of the asset into fragments, e.g., by means of shares. However, shares have a minimum denomination of a single share, whereas tokens can be fragmented almost arbitrarily (e.g., 0.01 tokens). Especially the latter is interesting in this context, because up to now, investors and fans have often purchased the entire asset in order to be able to exercise associated rights and obligations (e.g., to drive the classic car, to trade the trading cards, etc.).
It is already possible to acquire shares in emotional assets in the traditional financial world, for example by setting up a special purpose vehicle (SPV)[10]. The SPV buys the asset and books it on the asset side, while investors in turn acquire the SPV’s shares and thus gain indirect access to the asset. Depending on the asset and how it is structured, tokenization can be more cost-effective compared to acquiring an asset through an SPV, and fractions of the asset can be acquired, traded, and sold. Likewise, the additional costs of a legal shell (the SPV) are often not incurred.
From a sales-oriented perspective, tokenization in combination with the fragmentation of the emotional asset promises a lower cost price per share. Thus, target groups with limited freely available investment capital can be addressed (while complying with regulatory requirements, e.g., investor classification according to Fidleg in Switzerland or Mifid-II in the EU). For financial institutions, the tokenization of emotional assets offers an opportunity to bind existing customers more closely through the additional service. Which asset is to be tokenized is left almost entirely to the imagination of the investor (e.g., rights to music titles, etc.). Likewise, this can open up new customer segments e.g., auction houses, galleries, museums or artists. However, one must be aware that the demand for emotional assets does not automatically increase because it is tokenized. Again, it is primarily about increasing process efficiency and not about increasing the attractiveness of the asset through tokenization.
One challenge in the tokenization of emotional assets involves the custody of the underlying asset e.g., the work of art or the classic car. Different areas have to be covered e.g., the maintenance of the artwork, the insurance of the physical asset or last but not least the pricing. Since tokenized assets often have a high price (e.g., a classic car or a work of art), special security measures have to be taken for the physical safekeeping, which are provided e.g., by bonded warehouses or specialized service providers. This approach has the disadvantage that the asset becomes more of a financial investment instead of an emotional one. Another challenge is the management of this business ecosystem, which consists of different specialists as well as industries. The most efficient and effective cooperation of all parties involved is essential for the value of the token as well as its tradability (e.g., physical custodian of the artwork, technology provider for tokens, appraiser for the condition and value of the artwork, liquidity provider for the secondary market, etc.).
Liechtenstein’s VP Bank offers its clients the opportunity to tokenize various assets[11]. Examples include works of art or watches whose tokens are held in custody at VP Bank. Instead of having to pay each other out or, in the worst case, even having to sell the entire TEA to a third party in order to pay out all beneficiaries, they receive tokens which represent their percentage share of the emotional asset. The token in turn can at best even be deposited as collateral for a financing or loan. Thus, the emotional asset of the community of heirs is preserved and liquidity can be generated in the form of fiat currencies at the same time. Again, in this example, process flows and implementations are made more efficient by technology, but again, an asset does not necessarily become more liquid or even traded. For the latter, again, further steps are necessary. Another advantage of tokenized emotional assets is the mapping of the token in the customer’s securities account. Thus, different assets as well as their possible performance become visible to customers at a glance. In addition, the asset statement can be used for the tax return, saving time and resources for the customer. The legal framework for the mapping of rights and obligations by means of tokens is provided in this use case by the Liechtenstein TVTG[12].
The Swiss bank Sygnum has chosen a slightly different path and is positioning itself as a full-service provider for tokenized assets. In addition to the issuance of tokens via its own infrastructure “Desygnate”, “SygnEx”, a regulated trading platform for the secondary market, is provided[13] , where Sygnum customers can disclose their intentions to buy and sell such tokens. Among others, valuable wines[14] as well as works of art[15] have already been tokenized.
Supporting customers in service delivery – tokenization of money
Tokenization can be used to offer one’s own core competencies in a different form, to new target groups or in combination with other products and services. Trust-based processes in particular can be automated through the use of blockchain technology, thereby realizing scaling potential.
In this context, a financial institution can use its positioning as a central intermediary and point of contact for various customers to support interactions between customers. An example of this is complex supply chain relationships between industrial companies, which process each other’s transactions via the financial institution. The tokenization of value in this context can be pronounced in different ways, starting from supply contracts between companies, invoicing and the associated guarantee services or for effective payment processing via tokenized (book) money. The economic value of a tokenized solution, implementation into the financial institution’s existing infrastructure, and internal change management are initial challenges. In addition, relevant customers must be acquired for the pilot, valid use cases identified and technically mapped using tokens and smart contracts. Subsequently, further questions will arise during the settlement process, in particular with regard to the oracle problem[16], where the financial institution may take on the role of the trusted party.
Commerzbank in Germany has successfully tested such an internal platform for processing payments between industrial companies with BASF and Evonik[17] . Industrial companies face the challenge that maintaining mutual business relationships ensuring data quality or the asynchronous data situation between seller and buyer entail a great deal of administrative effort. Up to now, the ordering and payment processes have been separated from each other, which means that media discontinuities offer attack vectors for third parties, for example. Linking the ordering and payment processes promises to eliminate various inefficiencies, e.g. different data for buyers and sellers. Commerzbank wants to address these with its own platform “Themis”.
Figure 1: Sketched target operating model for pilots of Commerzbank’s blockchain platform “Themis” with Evonik and BASF.[18]
The automated processing of transactions by means of tokenised book money and smart contracts (e.g. invoices, delivery conditions, etc.) offers greater efficiency for all three companies involved. Key elements of Themis are the tokenised book money and the replication of the delivery contents (e.g. payment deadline, discount, etc.) in the form of smart contracts. Both components ensure high availability for customers through automated processing and allow further services, e.g. escrow for the transaction via smart contract or automated invoice verification by the buyer. By using a closed blockchain (permissioned blockchain), aspects regarding data protection and banking secrecy can be addressed[19], but at the same time the advantages of highly automated processing as well as high, user-dependent transparency can be ensured for all parties involved.
Corporate customers benefit from settlement via tokens and smart contracts through higher efficiency, settlement of the transaction or more precise liquidity planning through the almost immediate availability of the (tokenized) book money. In addition, the need of corporate customers is considered that the transaction details (payment and ordering of goods) are only visible to the participants to a limited extent. The bank positions itself as a platform operator for customers, as a trustworthy and neutral intermediary with regard to transactions and can strengthen as well as expand customer relationships through a new offering.
Summary and outlook
Tokenization of value in the context of financial institutions offers promising use cases, starting with direct investment in SMEs, through access to emotional assets, to expanding one’s service delivery to customers via tokenization.
These use cases demonstrate that the use of blockchain technology to map tokenized values can open up new investment opportunities for clients (Daura and Aktionariat), increase client loyalty (VP Bank and Sygnum) or jointly exploit additional opportunities (Themis). It should be noted, however, that tokenization cannot solve all challenges per se, but that process efficiencies are the main focus.
However, it remains to be seen what positioning opportunities exist for financial institutions, how suitable opportunities can be identified, analyzed and evaluated, and what success factors need to be taken into account. These three main topics will be discussed in the third and final part of this series of articles.
Sources
[1] Jocham, D. (2023). Tokenization – potentials, challenges and use cases in the financial industry environment. CC-Ecosystems. https://ccecosystems.news/en/tokenization-potentials-challenges-and-use-cases-in-the-financial-industry-environment/
[2] What is SMEX? (SME-X.ch, 2023); Retrieved 4/14/2023, from https://www.sme-x.ch/
[3] Swiss Code of Obligations, § 973ff
[4] Further information: What Exactly Is “Decentralized Finance”? (Jocham, 2022); Retrieved 5/24/2023, from https://ccecosystems.news/en/what-do-we-mean-by-the-term-decentralized-finance/
[5] Draft federal law adapting federal law to developments in distributed electronic register technology (Swiss Confederation, 2020); Retrieved 4/14/2023, from https://www.fedlex.admin.ch/eli/fga/2020/17/de
[6] https://cmta.ch/standards/cmta-token-cmtat
[7] Berner Kantonalbank joins SIX Digital Exchange and issues participation certificates with Daura (Daura.ch, 2022); Retrieved 4/14/2023, from https://daura.ch/medienmitteilung/bekb-sdx-daura-digitale-aktien/
[8] SIX Digital Exchange partners with Aktionariat (Aktionariat.com, 2022); Retrieved 4/14/2023, from https://www.aktionariat.com/blogs/six-digital-exchange-partners-with-aktionariat
[9] For example, Dimson, E. & Spaenjers, C. (2014). Investing in emotional assets. Financial Analytics Journal. Vol. 70, Issue 2.
[10] What Is a Special Purpose Vehicle (SPV) and Why Companies Form Them (Investopedia, 2023); Retrieved 4/14/2023, from https://www.investopedia.com/terms/s/spv.asp#:~:text=A%20special%20purpose%20vehicle%2C%20also,the%20parent%20company%20goes%20bankrupt.
[11] VP Bank (2023); Retrieved 4/14/2023, from https://ch.vpbank.com/de/privatkunden/anlegen/digitale-vermoegenswerte/kunst-tokenisierung
[12] Token and VT Service Providers Act (Token and VT Service Providers Act, TVTG) (Liechtenstein Official Gazette of Laws, 2019); Retrieved on April 14, 2023, from https://www.gesetze.li/konso/2019301000
[13] Tokenization (Sygnum, 2023); Retrieved 4/14/2023, from https://www.sygnum.com/solutions/tokenization/
[14] Sygnum Bank and Fine Wine Capital issue first tokenized asset under new Swiss DLT law (Sygnum, 2021); Retrieved 4/14/2023, from https://www.insights.sygnum.com/post/sygnum-bank-and-fine-wine-capital-issue-first-tokenized-asset-under-new-dlt-swiss-law
[15] Sygnum Bank and Artmundi tokenize Warhol’s Marilyn Monroe artwork (Sygnum, 2022); Retrieved 4/14/2023, from https://www.insights.sygnum.com/post/sygnum-bank-artemundi-tokenize-warhol-s-marilyn-monroe-artwork
[16] Oracle refers to services that provide information for smart contract applications on a blockchain (e.g., financial data, weather data, etc.). The term oracle problem refers to the difficulty of providing non-Blockchain data for use on a Blockchain (e.g., What Is the Blockchain Oracle Problem? (Chainlink, 2023); Retrieved 4/20/2023, from https://chain.link/education-hub/oracle-problem)
[17] Commerzbank (2021); Retrieved 4/17/2023, from https://www.commerzbank.de/de/hauptnavigation/presse/pressemitteilungen/archiv1/2021/2__quartal/presse_archiv_detail_21_02_97290.html
[18] Adapted from Commerzbank (2021)
[19] Developments such as zero-knowledge proof have not been taken into account when selecting the appropriate blockchain
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