Title: Why Tokenization Is Failing

Author: Steven Ehrlich, Forbes

Compiled by: Luffy, Foresight News

On July 17, 2023, two partners from McKinsey & Company took the stage at the New York Stock Exchange, speaking to dozens of government regulators and financial executives about the allure of blockchain, insisting that its utility far exceeds that of the scandal-ridden cryptocurrency market.

Bitcoin, Ethereum, Solana, and thousands of other cryptocurrencies have dropped 60% from their peak in November 2021, resulting in a loss of $2 trillion in market value. Cryptocurrency platforms frequently suffer from hacking attacks, and major crypto companies face crackdowns from regulators. Even so, evangelists continue to assert that the technology behind cryptocurrencies is still viable and has a bright future.

McKinsey partner Julian Sevillano stated, "This is blockchain, not cryptocurrency; it has real utility."

The evangelists introduced the basics, defining terms like "smart contracts" (transactions that execute automatically when specific conditions are met) and explaining how traditional financial assets (such as stocks, bonds, and real estate) can achieve "tokenization." Blockchain code can allow them to be transferred globally in seconds, rather than the hours or days currently required.

However, despite their talk of "increasing capital efficiency," "saving operational costs," and "enhancing compliance and transparency," their presentations felt somewhat hollow. If one were to omit the catastrophic price crash of cryptocurrencies last year, this speech could have been delivered in 2015, when the first tokenization platforms like R3CEV were announced. Since then, few enterprises have adopted it, and many projects still face the same challenges and debates as before. Tokenization may be the future of financial services, but it seems a long way off.

To illustrate this point, one only needs to look at a report submitted to the Commodity Futures Trading Commission's Global Markets Advisory Committee shortly thereafter. Per von Zelowitz from the New York Fed's Innovation Center told everyone that the pilot project for batch deposits run in a private network with banks like Wells Fargo and Citigroup is still a "scientific experiment" of "theoretical financial market infrastructure."

During the Q&A session, another speaker, Sandy Kaul from Franklin Templeton, a $1.5 trillion asset management company, asked whether the Federal Reserve had considered testing in open systems to leverage the various advantages offered by blockchain-like technology.

"Like what?" Zelowitz replied.

Since Halloween night in 2008, when Satoshi Nakamoto's Bitcoin white paper gained widespread attention, crypto technology has been associated with a series of killer applications that are often recounted. These include instant payments anywhere in the world, tools to protect identities and personal information from scrutiny by regulators and corporations, and hedges against inflationary government policies.

On this merry-go-round, there are also the tokenization of real-world assets, digital receipts for things like real estate, artwork, bonds, and even intellectual property. Early tokenization efforts primarily focused on private ledgers, which are blockchains controlled by entities or consortia without public validation. This alternative superficially offered the efficiency and transparency of blockchain without the risk of criminals using the platform for illicit purposes.

Things really began in 2015, when a series of high-profile permissioned ledgers emerged with grand ambitions. They were often backed by major banks, using blockchain technology to streamline everything from payments to back-end settlements. IBM also heavily relied on blockchain and launched a flashy marketing campaign (the company has since shifted to promoting its artificial intelligence business).

At the same time, Nasdaq launched a project utilizing permissioned blockchain to facilitate the sale of "tokenized" securities for private issuances. A report from Santander Bank's venture capital arm in 2015 stated, "By 2022, distributed ledger technology could reduce banks' costs in cross-border payments, securities trading, and regulatory compliance by $15 to $20 billion." That year came and went, with no apparent impact.

The most notable early tokenization practice occurred in March 2015 when a New York startup named Digital Asset Holdings (DAH) hired Blythe Masters as its CEO. In the early 2000s, 28-year-old Masters was an executive at JPMorgan who conceived of credit default swaps, a clever tool for bond investors to hedge against the risk of borrowers defaulting, which became infamous during the 2008 financial crisis. Masters aimed to spur widespread adoption of blockchain technology to revolutionize financial markets. In a 2015 interview with Bloomberg, she stated, "You should take this technology seriously, just as you should take the development of the internet in the early 1990s seriously."

Masters and DAH achieved initial success in 2017 when the company won a contract to replace the outdated clearing and settlement system of the Australian Securities Exchange. However, due to delays in stability, scalability, governance, and overall project management, the deal became mired in difficulties and was ultimately canceled by the end of 2022. The exchange wrote off a $165 million investment, with Chairman Damian Roche stating, "We launched this project with the best information available at the time, determined to provide a safe and reliable post-trade solution that balances innovation and advanced technology for the Australian market." However, upon further review, we concluded that the path we were on would not meet the high standards of the Australian Securities Exchange and the market."

For all the hype around tokenization in various industries over the past decade, the most memorable project is the $18 million sale of shares in the Aspen Ridge Hotel in Colorado, which is regarded as a joke in the industry. Will Peck of WisdomTree Investments stated, "No one really wants to hold a one-thousandth of a floor of a hotel or a painting in tokenized form."

To this day, supporters of tokenization are still struggling to bring the concept to fruition. Projects range widely, from issuing hundreds of millions of dollars in bonds in Europe to Robinhood-like investment applications. These applications allow couch potatoes to easily purchase tokenized shares of U.S. Treasury bonds without more effort than changing TV channels. The best that can be said for them currently is that they work in small doses and controlled environments, but they have yet to crack the code for generating widespread demand.

Take the institutional market as an example. In November 2022, Goldman Sachs launched a tokenization platform that, in collaboration with Santander Bank and Société Générale, processed a $100 million European bond issued by the European Investment Bank. Managing Director Matthew McDermott stated that the platform "is pioneering in many ways." The settlement period is 60 seconds, rather than the EIB's traditional 5 days, reducing the risk of paperwork errors and making assets more liquid.

The system can even handle interest payments on bonds. "We are actually representing cash flows from derivatives on the chain and proving that you can interoperate with payment channels from French and Luxembourg banks, both of which minted batches of digital currency for the project," McDermott said. But so far, only two small transactions have been completed.

McDermott told Forbes that the bank is looking to bundle the European Investment Bank's issuance with others to create a liquid secondary market. Easier said than done, as such an initiative would require more infrastructure and gathering industry participants around a set of technologies, which has always been a major obstacle as it requires competitors to collaborate.

"From BlackRock to Goldman Sachs, Citigroup, and JPMorgan, everyone is saying tokenization is the future," said Nadine Chakar, then-CEO of tokenization company Securrency, who previously led the digital asset division at BNY Mellon. Her company was recently acquired by the Depository Trust & Clearing Corporation (DTCC) for $50 million, a price that was only 50% of the company's valuation during its last round of venture funding in March 2021. "The issue is interoperability and liquidity," Chakar said in July, "Banks partner with XYZ Company for issuance and then issue a press release. What happens next? Nothing happens. They become pet rocks because they can't go anywhere."

Before its acquisition, Securrency took a different approach. It partnered with WisdomTree to launch a series of tokenized funds and an application called WisdomTree Prime on public blockchains like Ethereum, providing a low-cost investment method for stock index tracking funds and Treasury bonds with broad accessibility. The minimum investment for these funds is $25, with an expense ratio of 0.05%. While this is still more expensive than zero-fee trading offered through platforms like Robinhood (which benefits from the controversial payment-for-order-flow model), WisdomTree believes customers are looking for alternatives to Robinhood. As of now, these funds are still operational, but the total asset size of these nine funds is only $12 million, and both Chakar and Peck from WisdomTree did not respond to inquiries about their future.

Franklin Templeton offers similar services through a retail investment application called Benji, which provides investments in money market funds backed by U.S. government securities in addition to digital assets. This product from Franklin Templeton manages $295 million in assets.

Alternative assets like private credit and equity may hold the greatest hope for tokenization. CFTC Commissioner Caroline Pham stated that private credit is expected to become a $10 trillion market in the next decade.

Some preliminary tests have shown that tokenization has succeeded in speeding up issuance and lowering investment thresholds, such as KKR partnering with a tokenization company called Securitize to issue part of its $4 billion Healthcare Strategic Growth Fund II (HCSG II) on the Avalanche blockchain, but the company would not disclose specific investment amounts.

Avalanche seems to be making strides in the tokenization space, launching a testnet in collaboration with asset management firms T. Rowe Price, WisdomTree, Wellington Management, and Cumberland DRW, allowing traditional financial companies to conduct trading, clearing, and settlement on a public blockchain in a sandbox environment.

However, there is still a long way to go before major progress is made by established industry players who see no need to pursue tokenization. For example, iCapital has created a series of mutual funds with a minimum investment of $25,000 to fund alternative investments but believes there is no need to use blockchain in the process. "The business has scaled, but we haven't tokenized anything," said CEO Lawrence Calcano. "The idea that companies need to tokenize to grow is incorrect, but they are not mutually exclusive."

So far, stablecoins are the only application that has achieved some success in tokenization. The global stablecoin market has ballooned to $127 billion in just a few years, but the primary use of tokens (often backed by 100% collateral, designed to maintain a value of $1) has been to facilitate speculative trading on unregulated cryptocurrency exchanges around the world. Many countries do not accept traditional currency payments. Furthermore, the market is dominated by Tether, a shadow company that has long operated outside regulatory scrutiny. Tether holds $84 billion in stablecoin assets, has never undergone an audit, and refuses to disclose the names of the banks it uses to store its funds.

Nevertheless, tokenization pilots and news continue. Just in the past few weeks, the payment messaging service Swift released experimental results in collaboration with BNP Paribas, DTCC, BNY Mellon, and Lloyds Banking Group to determine whether their back-end systems can connect with public and private blockchains that support tokenized assets; Citigroup announced a plan to begin tokenizing customer deposits at banks so that customers can send funds instantly anywhere in the world. The initial pilot was conducted in collaboration with the bank's shipping giant client, Maersk.

The London Stock Exchange also hopes to launch a tokenized trading business, which may initially focus on opaque private equity. Echoing comments made by the Australian Securities Exchange years ago, Murray Roos, head of capital markets at the London Stock Exchange Group, stated that the technology has reached a "tipping point," adding, "Our idea is to leverage digital technology to create a smoother, cheaper, and more transparent process that is regulated."

"In the next 18 to 24 months, we must make some changes," said Securrency CEO Chakar.

It is nothing short of madness to do the same thing over and over again and expect different results. From a technological perspective, the future of blockchain tokenization of trillions of dollars in real-world assets is just around the corner, but as long as trust in the crypto market does not exist, that situation will never happen.