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Reasons for the Failure of Tokenization


Despite Blockchain's disruptive promise, it's still business as usual on the NYSE. (Spencer Platt/Getty Images)

Spencer Platt Getty Images

Crypto tokenization was supposed to be a killer app for financial services. So why after nearly a decade and top tier backers like Goldman Sachs and McKinsey, hasn’t it gained any traction?

VIDEO: Tokenization: A Failing Promise?
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On July 17, 2023 two partners from the McKinsey consultancy took the stage at the New York Stock Exchange to tell dozens of government regulators and financial executives about the charms of the blockchain, insisting that its utility goes far beyond the scandal-ridden cryptocurrency market.

Bitcoin, ether, solana and the more than 10,000 other cryptos are down 60% from their November 2021 peak, a loss of $2 trillion in market value. Crypto platforms have been riddled by regular hacks and its most important firms have come under attack by regulators. Still the consultants insisted, the technology underlying this digital money was still viable and had a bright future.

“This is blockchain, not crypto, and there is real utility to this," insists Julian Sevillano, partner at McKinsey.

The consultants ran through the basics, defining digital terms like “smart contracts” (transactions that are automatically executed when specific conditions are met), and they explained how traditional financial assets—like stocks, bonds and property–could be “tokenized”, given a blockchain code that would allow them to be transferred around the globe in seconds rather than hours or days, as is now the case.

But for all their talk of “improved capital efficiency,” “operational cost savings” and “enhanced compliance and transparency,” there was a certain hollowness to the presentation. Excluding a few references to the cataclysmic crypto price plunge last year, the talk could have been given in 2015, when the first tokenization platforms such as R3CEV were announced. Few businesses have adopted it since, and many projects still face the same challenges and debates of yesteryear. Tokenization may still be the future of financial services, but it seems very far away.

To illustrate this point, one need look no further than a subsequent presentation to the Commodity Futures Trading Commission’s Global Markets Advisory Committee. Per von Zelowitz of the New York Federal Reserve’s Innovation Center told the audience that a pilot project for wholesale deposits run on a private network in conjunction with banks such as Wells Fargo and Citigroup was still a “science experiment” of “theoretical financial-market infrastructure.”

When it came time for a question-and-answer session, another speaker, Sandy Kaul of $1.5 trillion asset manager Franklin Templeton, asked if the Fed had considered running the test on an open system to take advantage of the various benefits that a blockchain-like environment could provide.

“Such as what?” Zelowitz replied.

Crypto technology has had a rotating set of supposedly killer applications since it burst onto the scene on Halloween night 2008 with the circulation of Satoshi Nakamoto’s white paper that described bitcoin. Candidates have included instant real-time payments anywhere in the world for pennies on the dollar, tools to protect identities and personal information from the prying eyes of regulators and corporations, and a hedge against inflationary government policies.

On this merry-go-round also sits tokenization, digital receipts for real-world assets such as real estate, art, bonds or even intellectual property. Early efforts at tokenization have focused on private ledgers, which are blockchains controlled by an entity or consortium of corporations without the element of public verification. This alternative ostensibly offers blockchain’s speed and transparency without the risk of criminals putting the platform to illicit uses.

Things really kicked off in 2015 when a flurry of these high-profile permissioned ledgers launched with lofty ambitions–and often with the backing of big banks–to make use of blockchain technology to streamline everything from payments to back-office settlements. International Business Machines also leaned heavily into the blockchain, replete with a glossy marketing program (it has since pivoted to trumpeting its artificial intelligence capabilities).

Nasdaq launched a project to use a permissioned blockchain to facilitate sales of privately issued “tokenized” securities. A 2015 report from Banco Santander’s venture capital division claimed, “Distributed ledger technology could cut $15-$20 billion from banks’ costs for cross-border payments, securities trading and regulatory compliance by 2022.” The year came and went without any noticeable effect.

The most high-profile early dive into tokenization came in March 2015, when a New York-based startup called Digital Asset Holdings (DAH) recruited Blythe Masters to be its CEO. As a 28-year-old executive at JPMorgan in the early 2000s, Masters dreamed up credit-default swaps, a clever tool for bond investors to hedge the risk that borrowers won’t pay them back, which became infamous during the 2008 Financial Crisis. Masters was meant to inspire widespread adoption of blockchain technology to revolutionize financial markets. “You should be taking this technology as seriously as you should have been taking the development of the internet in the early 1990s,” said Masters in a 2015 interview with Bloomberg.

Masters and DAH scored an initial coup in 2017, when the firm won a contract to replace the Australian Stock Exchange’s antiquated clearance and settlement system. But the deal went south, with delays tied to stability, scalability, governance and overall project management hamstrung the project until late in 2022, when it was canceled. The exchange wrote off $165 million from its investment, and Chairman Damian Roche said “We began this project with the latest information available at that time, determined to deliver the Australian market a post-trade solution that balanced innovation and state-of-the-art technology with safety and reliability. However, after further review we concluded that the path we were on will not meet ASX’s and the market’s high standards.”

For all the industry tokenization bluster in the last decade, the best-remembered project was the sale of a stake in the St. Regis hotel in Aspen, Colorado, for $18 million, which is seen as a bit of a joke in the industry. “No one's actually looking to hold a floor of a hotel or 1/1,000 of a painting in tokenized form,” says Will Peck at WisdomTree Investments.

Fast forward to today, and tokenization proponents are still trying to get the concept off the ground. Projects run the gamut from hundred-million-dollar bond issues in Europe to Robinhood-esque investment apps that let couch potatoes buy tokenized shares of U.S. Treasuries with no more effort than it takes to change a television channel. The best that can be said right now is that they work in small doses and controlled environments, but none has cracked the code for generating broad demand.

Take institutional markets. In November 2022, Goldman Sachs launched a tokenization platform that processed a $100 million eurobond from the European Investment Bank in conjunction with Santander and Societe Generale that was “groundbreaking in many different ways,” says Managing Director Matthew McDermott. The settlement cycle was 60 seconds, as opposed to EIB’s traditional five days, reducing the risk of clerical errors and making the assets more liquid.

The system can even process the bond’s interest payments. “We actually represented the derivative cash flows on chain and proved that you could be interoperable with the Bank of France and Bank of Luxembourg’s payments rails, who both minted wholesale digital currencies for the project,” says McDermott. But there have only been two small deals done to date.

McDermott told Forbes that the bank is looking to package the EIB issue with others to create a liquid secondary market. Easier said than done, as such a feat will require even more infrastructure and the corralling of industry participants around a single set of technologies, something that has been a major inhibitor since it requires competitors to work together.

“Everybody from Blackrock to Goldman, Citi and JPMorgan is saying that tokenization is the future,” according to Nadine Chakar, then CEO of tokenization firm Securrency who used to run State Street’s digital-assets division. Her firm was recently acquired by the Depository Trust and Clearing Corporation (DTCC) for $50 million, at a 50% discount from the company’s value in March 2021 when it raised its last round of venture funding. “The problem is interoperability and liquidity,” said Chakar in July “Banks team up with company XYZ, do an issuance, and then post a press release. What happens next? Nothing. They become Pet Rocks because they cannot go anywhere.”

Before the acquisition Securrency took a different approach. It partnered with WisdomTree to launch a series of tokenized funds and an app called WisdomTree Prime on public blockchains such as Ethereum that offers a low-cost approach to equity index-tracking funds and Treasuries with wide accessibility. These funds come with a $25 minimum investment and a low 0.05% expense ratio. While this is still more expensive than the zero-fee trading available through platforms such as Robinhood that benefit from the controversial pay-for-order-flow model, WisdomTree is betting that customers are looking for this kind of alternative. As of now these funds are still in operation but the nine funds have combined assets amounting to a mere $12 million, and neither Chakar or Peck from WisdomTree have responded to questions about their future.

Franklin Templeton offers something similar through a retail investing application called Benji that offers exposure to a money-market fund backed by U.S. government securities in addition to digital assets. Franklin Templeton’s product has $295 million of assets under management.

Alternative assets, such as private credit and equity, may be the best hope for tokenization. CFTC Commissioner Caroline Pham says private credit is expected to become a $10 trillion market in the next 10 years.

Some initial tests have proven successful at speeding up issuance and lowering investment thresholds–for instance KKR partnered with a tokenization firm called Securitize to issue a portion of its $4 billion Health Care Strategic Growth Fund II (HCSG II) on the Avalanche blockchain, but the companies will not disclose how much has been invested that way. Avalanche appears to be pushing particularly hard into the world of tokenization with the launch of a testnet in conjunction with asset managers T. Rowe Price, WisdomTree, Wellington Management and Cumberland DRW to let traditional finance firms practice clearing and settling trades on a cordoned off portion of a public blockchain.

But plans have a long way to go before making major inroads with industry incumbents that do not feel the need to go the tokenization route. For instance, iCapital created a series of feeder funds with $25,000 minimums that finance alternative investments but sees no need to use blockchain in the process. “The business has reached scale, and we haven't tokenized anything,” says CEO Lawrence Calcano. “The idea that someone needs to tokenize in order to grow isn’t true; but they are not mutually exclusive."

The only moderately successful use for tokenization to date has been stablecoins. The global stablecoin market has swelled to $127 billion in just a few years, yet the primary use for tokens–which are usually 100% backed by collateral and meant to maintain a $1 value – has been to facilitate speculative trades at unregulated crypto exchanges around the world, many of which do not accept payments in traditional currencies. Moreover, the market is dominated by Tether, a shadowy outfit that has long operated outside of regulatory scrutiny. Tether, which has $84 billion in U.S. dollar stablecoin assets, has never been audited and refuses to name the banks that it uses to hold funds.

Still, tokenization pilots and press releases continue to roll off the assembly line. In just the last few weeks the payments messaging service Swift released the results of an experiment with BNP Paribas, the DTCC, BNY Mellon and Lloyd’s Banking Group to determine if their backend systems could connect with public and private blockchains that support tokenized assets; Citi announced a plan to start tokenizing customer deposits at the bank so that customers can send funds instantly anywhere in the world regardless of the time. The initial pilot was conducted in conjunction with shipping giant Maersk, a client of the bank.

The London Stock Exchange also wants to launch a business tokenizing trades, which is likely to first focus on opaque private equities. Like a broken record, Murray Roos, head of capital markets at LSE Group echoed comments made by the ASX years ago, saying the technology had reached an “inflection point” and “the idea is to use digital technology to make a process that is slicker, smoother, cheaper and more transparent . . . and to have it regulated.”

“In the next 18-24 months something's gotta give,” says Securrency CEO Chakar.

Insanity may be defined as doing the same thing over and over again and expecting different results. From a technical standpoint the future of blockchain tokenization of trillions in real world assets is just around the corner, but it will never happen so long as trust in crypto markets is nearly non-existent.

Sources


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