Tokenization is on the rise, but risks lurk beneath

A growing number of companies have been turning to tokenization, but, alongside its rise, potential risks are emerging.

Tokenization involves converting real-world assets, such as property or stocks, into digital tokens that exist on a blockchain. But such a process “could have implications for financial stability if it scales up significantly, if it is used to create complex and opaque products that trade in automated fashion, and if identified vulnerabilities are not adequately addressed through oversight, regulation, supervision, and enforcement,” Klass Knot, chair of the Financial Stability Board, wrote in a letter to the Group of 20 nations.

The FSB released a report Tuesday unveiling several vulnerabilities of tokenization: the underlying asset being tokenized, the participants involved in blockchain-based tokenization projects, and the challenges posed by integrating new technology with existing legacy systems.

The financial system watchdog isn’t the only international institution flagging tokenization risks. The Bank for International Settlements highlighted in a Monday report that traditional risks, such as credit, liquidity, and cyber risks, could extend to tokenization. However, it also pointed out that tokenization offers several advantages, including minimizing the friction associated with using various systems to trade assets.

“These risks may materialize in different ways due to the effects of token arrangements on market structure, eg due to a change in the roles played by intermediaries when previously separate functions are combined on one platform,” the BIS said. “Risks may also emerge owing to conflicts of interest due to the combination of functions within a single entity, or a concentration of activity in one or a few arrangements.”

The upshots

Beyond price-stable stablecoins, the crypto ecosystem lacks reliable collateral. Consequently, when traders use volatile assets like bitcoin (BTC-USD) or ether (ETH-USD) as collateral for loans, staking, or liquidity pools, it creates notable risks, given that the value of such assets can experience dramatic fluctuations in a very short period.

That’s where tokenized treasuries, vis-à-vis blockchain technology, come into play. Fully on-chain tokenized treasury funds facilitate quick issuance, immediate redemptions, and direct peer-to-peer trading. That, in turn, boosts the efficiency of traditional assets in the crypto landscape, potentially creating access to new capital opportunities.

The recent completion of the U.S. Treasury collateral network pilot, which focused on leveraging distributed ledger technology applications to support market connectivity across the collateral management lifecycle to enhance mobility, liquidity and transactional efficiency of tokenized assets, “successfully demonstrated the power of tokenization – and its potential to enhance collateral mobility and unlock liquidity,” Nadine Chakar, global head of DTCC Digital Assets, had said.

The findings come as a slew of traditional financial heavyweights, such as JPMorgan Chase (JPM), Charles Schwab (SCHW) and Fidelity Investments, have shown growing interest in the blockchain space.

In August, custodian bank State Street (STT) teamed up with Swiss crypto firm Taurus to provide digital asset services, including tokenization and custody, to institutional clients. HSBC (HSBC) and IBM (IBM) in 2021 had successfully tested an advanced token and digital wallet settlement capability with direct transactions between two central bank digital currencies. And crypto exchange Coinbase Global’s (COIN) asset-management arm is creating a tokenized money-market fund, following the footsteps of BlackRock’s (BLK) successful tokenized treasury product.