Asset tokenization, through the use of blockchain technology, has long promised to open new ways for investors to access assets and transform their attributes. While the promise of liquidity, automation, and transparency are improvements over the current system, real financial engineering was not explored — until now.
Most tokenizations are digitizing pre-existing private and illiquid assets and securities. The ecosystem mainly thought that if enough issuers offered primary placements of digitally represented private securities, deep pools of secondary liquidity would spontaneously develop for these illiquid assets. Yet without any market makers or analysts, it has not happened, and the promised liquidity from digital alternative trading systems has not arrived.
“Existing digital platforms have not worked out financial intermediation, including necessary assurance and tax matters,” according to John Beccia, CEO of FS Vector, a leading Washington, D.C. based fintech and blockchain regulatory advisory firm. He went on to state, “There needs to be a dialogue between asset generators and investors, without which it is difficult to create value from financial engineering. The emergence of high quality real digital assets depends on this.”
Financial engineering is a critical driver of value in financial markets by taking illiquid real assets and placing them into a new structure that transforms the risk, liquidity, and returns of the original underlying assets. However, tokenization’s commonly articulated benefits are: lowering costs, fractional ownership, increasing liquidity, faster settlement, immutable ownership records, and automated compliance. All these benefits are significant but do not create new financial products or enhance demand. Notably, while early entrants have solved for access, there is no onward connectivity to perpetuate a chain of events beyond initial asset creation and purchase. Without connectivity, there is no flow, and it is the prospect of unlimited future transactions that creates demand as well as long-lasting value.
To understand the importance of financial engineering, we can look at recent history. Modern financial engineering began in the 1970s in the United States when capital available for homebuyers increased with the introduction of mortgage-backed-securities (MBS). These new securities allowed banks to sell off these loans to new investors, which, up to that point, were confined to bank balance sheets. The Government National Mortgage Association (Ginnie Mae) enabled these first MBS products’ success by guaranteeing the first mortgage pass-through securities.
Debt securitization started growing exponentially in 1983 with the introduction of the collateralized mortgage obligation (CMO). Investors could now choose specific tranches based on their financial return and risk requirements, overcoming the interest rate and prepayment risks innate to the original MBS structures due to the fixed income characteristics of the underlying 30-year mortgages in those earlier vehicles. Notwithstanding the 2008-2009 disruption caused by non-government sponsored private-label CMOs, modern financial products continue to provide critical liquidity, efficiency, and value to borrowers and investors today.
Digitization of private securities has not yet created equivalent value because early entrants have focused on the technology without meaningfully enhancing private assets’ investment attributes. Blockchain’s potential to introduce scalable synchronization of the asset-owners’ objectives with investors seeking investments is another critical innovation. According to Patrick South, the Vice President of Development at the Chamber of Digital Commerce, the leading Washington DC-based industry association advocating for digital assets, “The revolution will be true financial transformation, given the digital tools we have.” For instance, blockchain technology could give investors the ability to self-assemble bespoke investment products dynamically, specifying the assets, and creating tranches or other attributes best suited for their specific needs. Only the companies with the right structured finance expertise, coupled with deep experience in high-grade assets that support liquidity, will succeed in institutional-caliber digital assets.
According to Paul Atkins, former Commissioner of the U.S. Securities and Exchange Commission, and chief executive of financial services consultancy Patomak Global Partners, “There is a long history, in the securities industry, for the private sector to lead the way. Regulators find it more constructive to engage teams with deep expertise in an asset class and a focus on institutional finance.” However, often teams with little institutional financial domain expertise and mostly technology backgrounds are helming digital securities platforms. They also have correspondingly limited knowledge in structured finance regulatory and compliance matters and often focus on retail-grade assets.
As a result of this, retail asset and retail investor focus of early entrants anticipated secondary liquidity has yet to develop for tokenized financial assets. It is hard to value on a secondary basis the retail-type of securities typically being tokenized. Wide gaps in prices between buyers and sellers form, which leads to a disorderly market lacking critical mass, all of which is detrimental to secondary liquidity. Retail investors often do not have the asset valuation expertise or insight from analysts and market makers necessary to support sustainable secondary liquidity. Solving this problem requires in-depth asset domain knowledge to tokenize assets innately low in volatility and easy to value.
It also requires a deep understanding of the types of investors that would buy tokenized assets. Investors are quite varied, from large to mid-sized institutions, mutual funds, pension funds, (multi) family offices, registered investment advisors, ultra-high net worth investors, and retail investors. Improving asset liquidity requires opening access to an asset to a broader spectrum of investors. The considerable potential that blockchain can bring to real asset financial products is best served first to institutional investors where they have the expertise to evaluate these new vehicles and co-create new financial products with this technology. As these new products mature, then retail investors would have more information to act on.
Digitization platform companies need to have a deep understanding and appreciation of securities regulations and take a collaborative approach with regulators to address their concerns to create financial innovation successfully. Only a few digital securities fintech companies are beginning to show a critical understanding of the regulatory landscape, have asset expertise, and complementary proficiency across the investor ecosystem. Arca’s tokenized U.S. Treasury Fund is an example of creating a mutual fund-like structure on blockchain for existing Treasury bonds. INX’s recently securitized its future cash flow streams, which is equally groundbreaking in its compliance with the SEC regulations. These are both positive examples of combining financial engineering with blockchain technology that either creates a new type of investable asset or transforms the liquidity of underlying securities. While these a