The Tokenization of Everything

In this episode, Paul Davis speaks with SRM’s digital assets expert Larry Pruss about the digitization of money, how financial institutions and other industries continue to innovate on blockchain, and how the tokenization of everything is inevitable going forward. Our guest explains how real-world assets – including deposits, bonds, real estate, and securities – are becoming tokenized through a variety of blockchain applications. Whether you’re new to the world of blockchain or an expert looking for different perspective, this episode offers useful insights into the state of digital assets in May 2023. 

Transcript

The Tokenization of Everything

Welcome to Firmer Ground from SRM, where we explore trends and strategies impacting the current and future state of financial institutions in North America and across the globe. My name is Paul Davis, host of today's podcast and director of Market intelligence at SRM. Every episode features experts from the world of banking and financial services, including thought leaders here at SRM, executives at future thinking financial institutions, and other experts from all corners of the industry. In this episode, I speak with SRM's digital assets guru, Larry Press on another emerging topic of financial services tokenizing assets. When discussing digital assets, most financial experts are aware of cryptocurrency. But today we're going to look at how tokenization leverages blockchain technology to represent the ownership rights of real-world assets. We hope you enjoy this conversation. Hi, everyone. Paul Davis here, director of Market Intelligence at SRM. My guest in the studio today is Larry Press, managing director and in-house expert on the blockchain and its many applications. Prior to joining SRM, Larry spent years in a variety of executive and advisory positions, including key roles at National Bank of Canada and bank of America. Today we're going to discuss Larry's assessment of asset tokenization and how financial institutions can leverage it to better serve their clients. Thanks for joining us today, Larry. 

You're welcome. Looking forward to it. 

So, let's get into the technicalities and the terminology. First of all, Larry, what exactly is tokenization and what types of assets can be tokenized? 

Yeah. So what tokenization is, it's probably best to start with what it's not. Tokenized assets are not cryptocurrency. Larry Fink recently said the next generation of securities will be tokenized securities. So, tokenization is really more of a process than a thing. It's a process of replacing items of value with tokens that reflect that value. Pretty much any can be tokenized, whether that's digital or real-world assets. So, things like artwork, bonds, securities, commodities, anything that has value. Music could be tokenized; digital art could be tokenized. 

Is that kind of tie into the term NFT, Larry? Or is that separate?

Non fungible token could be considered a token of sorts. It's more of a digital title to a real or digital asset. But it's similar. Most of the time when we talk about tokenization, we're talking about security tokens or tokenized securities. It's kind of like an IOU for that underlying asset. 

Okay, help us understand what are the benefits for tokenizing real-world assets? 

Yes, the benefit, if you think about real world assets, and again, those things being like bonds, even deposits, real estate, commodities, securities, et cetera, the benefit would be those things exist today and we trade them. We trade them on today's traditional rails which have lag times, may or may not be global. And what tokenization does is puts those things on chain, so puts them on the blockchain. So, it has a number of advantages. One is growth and liquidity. So as a result of lowering the threshold, rendering the market in minimum transaction size, you can get growth in liquidity because you can offer much smaller tranches of that item, attracting retail investors with smaller amounts of capital, trade what would be traditionally expensive and low liquid assets. So again, think about bonds. It's impotently divisible. So, you can fractionalize items because it is on the blockchain, it has less intermediaries. So, you may not need a trader or a broker to trade that item. It can trade on the blockchain. So, less intermediates mean, generally faster settlement and less expense. Also, you have improved security. Information can be recorded on the blockchain that cannot be changed or deleted. You also have improved transparency. And then you can also automate those activities via smart contract. So, the idea of automating tokenized assets is very appealing. And then finally, like with anything blockchain related, you can trade 24 7365 and you can trade worldwide. 

So, it would also seem like the transactional nature of this, it would be a much faster way to transfer ownership of those assets?

Yeah, that's right. In fact, there's a couple of examples of companies already doing that. So, JPMorgan is using blockchain and tokenized assets to do billions of dollars of repo trades weekly. Um, may have seen recently Franklin Templeton announced that they've got an on-chain money market fund, tokenized securities, which operates on the platform. Polygon, Tacit and Figure are companies kind of in the banking space that are looking at tokenizing deposits as an alternative to stablecoin. So those would be some recent examples. The blockchain that these things typically run on are high speed blockchains. So, Polygon, Algrand, Stellar, you're talking about blockchains that have high transactions per second. Most of those are up near 50,000 transactions per second. Because again, you're talking about trading. And trading platforms have to be fast. I do want to kind of interject here, too, Larry, just because of terms and trying to avoid confusion. I mean, you mentioned stablecoins. 

What are the differences in the distinctions between, say, a tokenized asset and a stablecoin? 

Yeah. So maybe draw a better distinction between tokenized deposits and stable coins. Stable coins could be averse. I mean, you could say stablecoins are a version of tokenizing. The US. Dollar tokenized deposits are a little bit different. So, the difference would be stablecoins typically operate on public permissionless blockchains, meaning anyone can join, anyone can transact. There are no limitations. Whereas a tokenized deposit would operate on a permission blockchain that would be secured, that would have limitations in terms of knowing your customer. Those would be two big distinctions. Permission blockchain may be domestic, whereas a permission one might be international. So, there are some differences there. And so, when I said stable coins versus, say, tokenized deposits, those would be two different types of, say, tokenized assets. The deposits could also be rehypothecated, whereas stable coins typically would not be, and would be required to be fully backed one for one. Whereas tokenized deposits could be lent back out on a fractional reserve basis. 

Okay, that sounds good. Okay, so I'm looking at this and you're looking at a tokenized asset. How do you determine the underlying value of an asset? And do you have to do periodic audits or just occasionally assess, reassess those assets over time? How does that work exactly? 

So, if a digital asset, and it already exists on chain, it's pretty easy to see the value. If it's a real-world asset, it becomes a bit more difficult. I think the real value is tokenizing of real-world assets. And in fact, Citi, there's a number of predictions, and all of these were predictions by 2030. So, let's see, seven years from now, Citi estimates that four to $5 trillion of real-world assets will be tokenized. There's a trading firm. They've estimated 16 trillion. Boston Consulting Group has estimated 30 trillion, with a best-case example of 68 trillion. Those are some big numbers, and just for comparison purposes, ETFs in 2020 were about $7 trillion. So, we're talking really large numbers of real-world assets eventually coming on chain. Your question as to how these things would be validated. Well, think about if we were tokenized commercialized real estate. The things you'd want to know as an investor in that tokenized real estate would be things like what's a percent of Occupancy is rent being collected, what's that amount? Are there any liens, taxes, those sorts of things you'd want to be able to get information on? And the way those things you typically get information is through something called an Oracle. A good example would be Chain Link. There are other types of Oracles out there, but that's a platform that would feed real world information to those digitized or tokenized assets. So, the tokenized assets and benefits could be trading 24 7365 at a much lower cost. There still are real world contracts and real-world attributes associated with those that have to be validated and have to be audited. So, none of that goes away. It just happens at a later point in time, a little bit slower. But the actual trade can happen instantaneously.

And exactly how do those attributes for, say, a real-world asset, how do they get loaded onto the blockchain? How does that work? 

Yeah, so chain link basically links to the blockchain that those real-world assets would be residing on. And chain link, via various APIs, will constantly update the information about those underlying assets. It's a bit more complicated, probably, for this conversation, but it's worth knowing that those underlying assets of those physical items do change. And you have to have some way of providing updates to those investors in those digital assets or tokenized assets. 

You mentioned JPMorgan Chase, you mentioned Templeton, but are there other use cases that you're seeing both within the financial services industry as well as outside the industry? I mean, anything that people should really take note of? 

Yeah, so, I mean, a lot of companies have been experimenting with these things. Again, tokenizing bonds, tokenizing securities. There's a European company called Signum or European Bank that's they tokenized fractional reserves or fractional ownership of a piece of art of a piece of Picasso. Goldman Sachs has been playing with, ah, digital issuance registration settlement, custody of various digital assets. BNP Parabas is another one that's done some tokenization of ESG bonds. You mentioned JPMorgan before. They utilize Polygon to issue tokenized JPM deposits as part of their project or part of MAS's Project Guardian. So, I mean, there's a lot of use cases out there. Again, the reason these companies, most of them banks, are getting involved in tokenizing real world assets is ability to reduce the cost of those trades, to speed those trades up, to allow people to allow more people to participate in those trades, to improve the security, and then ultimately to automate these things via smart contracts. And that's a big one. 

So, Larry, earlier in our conversation, you brought up the concept of tokenizing deposits. I've heard that there are banks out there that are exploring that, and I'd be curious to know your thoughts on what are the associated benefits with offering that kind of service or that kind of product? 

Yeah, probably one of the largest benefits would be able to conduct trades with US dollars outside of traditional banking hours. So, if you had, say, a commercial client that wanted to conduct trades and you had a bank holiday or it was on a weekend, they would have to wait till the next day to conduct trades there's. Again, a number of companies out there, tacit and Figure Technologies being two of them, that are working with banks and financial institutions to tokenize deposits. In fact, the CEO of Figure Technologies or the USDF Foundation, Robert Morgan. He's going to be at one of our future tech talks, but recently heard him speak again and talked a lot about improving liquidity, improving speed of settlement, reducing costs, and as opposed to, say, the Fed. Now, it's something that banks can do today at arguably even a lower cost. They can have more control over it. The integration efforts are a lot less daunting than they are with, say, Fed now. So, it gives a similar sort of performance as Fed now, but at much lower cost and something they can do immediately. One of the other benefits would be if you're like a correspondent bank or you've got international banking. In theory, you could transact internationally depending on what blockchain you use and how you set that up, whereas without necessarily having to use a correspondent bank to do that international transaction, whereas Fed now, at least for the foreseeable future, is domestic transactions only. 

Obviously Fed Now when it launches and should it gain traction, I mean, that would provide just an alternative avenue for doing some of the similar tasks?

Yeah. And it could be very much complementary with a diesel or tokenized dollar. 

But they would also run sort of separately if I would understand it correctly. For example, I know RTP network isn't in sync with Fed now. I assume this would be the same thing with the tokenized deposit?

I know some of the CEOs of the kind of tokenized deposit offers have talked about Fed Now and integrating that into their offering. Now, as to how that is integrated and what additional benefits that provides, they'd probably be best to answer that. Sure. 

Let's look at the regulatory environment. What are you hearing from Washington in terms of what they're looking at? Will there be any kind of legislative or regulatory intervention, involvement, oversight of this? What's the lay of the land there? 

Yeah. So tokenized, real-world assets or tokenized securities are running into much the same headaches that cryptocurrencies are. A lot of it because the regulators aren't drawing a distinction between the two. We saw the SEC early on go after with enforcement actions on some of the earlier kind of security tokens that were out there. I think as they get more familiar with the landscape and realize these things provide a very different sort of solution than cryptocurrency, I think they'll get more comfortable with that, and they may or may not be deemed securities right now. A lot of the financial institutions that could benefit from this, primarily banks, are nervous about getting involved in anything blockchain or digital asset related. A lot of it, because the recent joint letters from the fed and the OCC and FDIC, and I believe there were two of them, one in February and one in January,  both didn't do a very good job. Differentiating between involvement in crypto assets, which is still totally legal, and blockchain. Blockchain really is that underlying technology. There's no reason that financial institutions shouldn't be pursuing it, but I think a lot of them that may not understand those distinctions, saw those letters, just got frightened by them, and as a result aren't pursuing the technologies, but those benefits are coming. If you look internationally, that's where we see most of the activity. Singapore, Europe, Israel, Brazil. I mean, all of those countries are pursuing tokenizing of real-world assets. They're experimenting with it. They're finding ways of reducing costs. I mentioned in this country, JPMorgan onyx Franklin Templeton and others, they're doing it here. So, it's definitely the future. When regulation catches up to it is probably when we'll really see it take off in this country. But I can't imagine we're any farther than a year and a half away from that. 

So, with that in mind, Larry, what's your advice to financial institutions that are intrigued and interested in this space? What should they be doing now to evaluate or even go as far as setting up the infrastructure to do this? 

I'd say reach out to someone like SRM to talk through different use cases, because there are some better use cases than others. For tokenized real-world assets. One good example would be  cross border or trade finance. Trade finance is an excellent example where something like that could be useful. And tokenizing of real-world assets may or may not be as advantageous as, say, tokenizing a deposit. Or maybe you've got a securities business. And so, tokenizing the securities could be a benefit. There are a lot of companies right now that are looking at tokenization of real estate as investment opportunities. And we've seen some interest from financial institutions in offering self-directed investment offers. So, the likes of Robin Hood or Acorn, and we're starting to see those type of companies look at alternative asset classes. And some of those alternative asset classes are tokenized real world assets. So those could be tokenized music, it could be tokenized real estate, it could be something else. And that provides a younger clientele an opportunity to get into investment class that historically they haven't been able to get access to. So, we've also seen a lot of tokenizing of money markets and US treasuries where they are providing more access to clientele that historically haven't had access to those types of asset classes. 

And then lastly, just again, looking at it through the regulatory lens, Larry, I mean, are there particular just types of general banking regulations that folks should be just kind of double checking, triple checking with potential transactional use cases? Are we looking at BSA, AML or anything like that? Are those things that people should just be keeping an eye on as they try to put a program in place? 

BSAM, AML licensing, money transfer laws,  securities regulations those are all things that we would help our clients certainly consider talking with, whether it's your state or federal regulator, whether it's if you're a bank OCC or FDIC or Fed, if you're credit unions, NCUA really just letting your regulator know what you're looking to do and reasons for it. A financial institution is going to find the regulators a lot more friendly. If you're looking at using blockchain or tokenizing real-world assets as a way of lowering transactional costs or providing additional access to finance, then they may say launching a speculative trading platform for cryptocurrency. So not to say that that isn't something you'd want to do, but you have to be able to explain it properly to the regulator as to what your use cases are and where you're planning on going with it. And then I would also just leave with look overseas to what number of international banks are doing, because that's where we see an awful lot of tokenizing of bonds, securities, artwork, commodities, those sorts of things. And what the underlying benefits are. They're having some really good success cases around the world. And don't just look to the US. For example, look at the nationally as well. 

That sounds good. And it certainly seems like this is going to be an evolving area where there will be opportunities for innovation over time, and we'll probably see increased use cases as people find more ways to apply the underlying technology. 

Agreed. 

Well, thank you, Larry. I appreciate you making the time and look forward to having you back onto the podcast soon. Very good. 

Thanks, Paul. 

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