How the global pandemic will speed up the digitalisation of financial services

Tokenisation could help to make the purchase of expensive assets more affordable by spreading ownership across a greater number of investors

Non-digital assets such as real estate and even companies can be tokenised. Mona Al Marzooqi / The National

The Covid-19 pandemic has reinforced the need for innovation across a number of key industries – and this is especially true for the financial services sector.

Tokenisation, in particular, has been a hot topic for a number of years; however, as many banks look to expedite their digital transformation efforts, we can expect them to pursue new products and collaborations much faster than before the pandemic. The result has been an increased interest in tokens, especially from smaller investors and borrowers that are looking to enter the market, having been previously excluded from accessing existing financing options.

Tokenisation is the process of creating one or several digital representations of a physical or non-physical asset (including a financial asset) and managing it on a shared database. There are numerous types of tokens including payment tokens, utility tokens and asset tokens.

So long as the legal environment allows it, any non-digital asset such as real estate, private companies or other items, could be transformed into one or several tokens. Simply put, a token represents a right to the asset and requires a trustworthy custodian to protect holders and guarantee this right. Tokens on distributed ledgers (a consensually-shared database) are, in a sense, similar to asset-backed securities on financial markets. It is important to note that the underlying quality of a token will always be related to its original asset. However, once securitised, this link could potentially be blurred by combining different types of assets, or through over-collateralisation.

Tokenisation offers several benefits. The creation of a large number of tokens out of an expensive asset could make it much more accessible, bringing the cost down by spreading ownership across a greater number of investors. This could also enhance the liquidity of illiquid assets.

However, this is dependent upon distributed ledger and established trading systems not coming into conflict, which could see liquidity transferred from one market to another. Higher liquidity also means lower illiquidity premiums, which is especially beneficial to small businesses if a tokenised financing product is cheaper than bank financing.

In our recent report, The Future of Banking – Building a Token Collection, we highlighted how tokenisation could also increase available non-cash collateral in financial transactions and improve collateral management. In fact, there are several examples of tokenisation of illiquid assets including a partnership between a commercial real estate firm in the US and a platform to tokenise $2.2 billion (Dh8.08bn) of properties.

Increased market efficiency is another potential benefit of tokenisation. Having no, or a limited number, of intermediaries and more streamlined back-office operations shortens clearing and settlement times, which ultimately reduces counter-party risk and frees up collateral.

Users can also benefit from higher transaction security. The use of distributed ledgers could enhance data integrity and provide a more secure exchange of assets or information.

The Covid-19 pandemic has certainly highlighted the importance of electronic commerce and transaction security. In June, MasterCard announced that the card credentials for Amazon shoppers in 12 countries would be tokenised. Looking ahead, we can expect more merchants to transition to similar systems to further bolster security.

A further advantage of tokenisation is that it supports owner registration, which increases transparency for transaction partners from an anti- financial crime perspective, while clarifying the rights of different stakeholders.

Yet despite the many benefits, there are challenges that must be overcome to allow tokenisation to become a useful route for fund-raising. Establishing a regulatory and legal framework that recognises the rights of token holders is one important prerequisite for success; this would include dispute resolution mechanisms, proof of ownership and claims to the income produced by the asset and recognition of smart contract protocols.

A number of regulators around the world have already begun to set up new domestic regulatory environments to cater to tokenisation, but much still needs to be done globally to support its widespread use. Technology is also a barrier to the broad uptake of tokens. Network stability, scalability, interoperability and immunity to cyber risks are all challenges facing distributed ledger technology.

Also, the absence of an ultimate owner that is responsible in case of technology failure is a key concern for potential users.

Although tokenisation can increase transparency between transaction partners, this only applies if anonymous dealing is forbidden. If allowed, anonymous dealing could make it easier to launder money or finance terrorism. Asset custody also poses potential challenges; a central entity would need to be credible enough to protect tokens against theft or any other form of alteration. Potential restructurings could also act as a barrier, especially if ownership of an asset is divided among several token holders.  However, as each owner can be identified and reached on the distributed ledger, this risk is somewhat reduced.

Despite its many advantages, in the short-term tokenisation will have a limited effect on financial institutions’ profitability.  Over the next few years, the largest impacts are likely to be felt in SME/corporate banking, asset management and in the clearing/settlement business.  However, tokenisation should not be ignored in the long-term.

If tokens succeed in becoming a more natural, efficient and secure means of raising capital or debt, then we could see banks lose business in areas like private equity placement, SME financing and real estate financing or refinancing.

Collaboration around tokenisation – between the old and new bank economy – is crucial to creating global standards to drive tokenised ecosystems and ensuring that tokens complement existing products to ultimately increase financial inclusion.

Mohamed Damak is a senior director covering financial institutions at S&P Global Ratings, a member of the Gulf Bond and Sukuk Association