Tokenization, through its utilization of blockchain and other distributed ledger technologies, has begun revolutionizing the digitalization of assets and is emerging as one of the most prominent use cases for the asset class. Real assets, such as real estate, infrastructure, and precious metals, are increasingly adopting tokenization as a means to access investment opportunities from a diverse range of investor groups. The momentum of this adoption is expected to continue, as indicated by a report from BCG and ADDX, which forecasts a potential market worth $16.1 trillion by 2030. However, as with any emerging trend, along with its advantages tokenization also brings forth new challenges that need to be approached pragmatically to ensure safe adoption.
There are three major benefits of tokenization for managers of real assets, including greater transaction speed, liquidity, and transparency. Transaction speeds have long been an area with room for improvement in alternative assets. With tokenization, many processes are automated, which greatly increases the speed of settlement and clearing. Employing tokenization means settlement times are nearly instantaneous, contrasting the current T+1 settlement cycle.
Aside from quicker transactions, tokenization also offers a solution to the liquidity concerns of investing in real assets, an issue which has become increasingly topical as U.S. money supply falls at its fastest rate in almost a century. This change in supply is creating greater competition for smaller pools of investment capital, but tokenization can assist by providing a bridge to a wider pool of investors and creating a new source of financing for private markets, according to the Chartered Alternative Investment Analyst (CAIA) Association.
Tokenization also provides transparency to real assets, through distributed ledgers that are often publicly available and store every transaction on them, for easy retrieval. Furthermore, the underlying technology of distributed ledgers offers investors access to the transaction history of their counterparties, which helps to prevent tampering and mitigate counterparty risk.
While tokenization brings fresh opportunities for capital efficiency and transparency, tokenization is still in its infancy, and as a result, there are several hurdles to its implementation and maintenance. At its foundation, tokenization opens up assets to anyone with access to the internet, presenting unprecedented contingencies and significant regulatory implications. As explored by CAIA, the process of tokenization is no simple feat and involves several steps, including deal structuring, digitalization, primary distribution, post-token management, and clear regulatory standards to enable second market trading.
With wider access to previously exclusive assets, ensuring investor protection and addressing differences between tokenized and traditional fund investors requires careful examination. Different investor classes and adjusted responsibilities for fund boards may be necessary to accommodate the unique characteristics of tokenized investments.
The industry faces disruption due to this level of accessibility, necessitating regulatory adjustments and comprehensive frameworks to effectively govern the tokenization process. These legislative frameworks could take years to develop, and the tokenization and decentralized finance (DeFi) industry will encounter regulatory hurdles and potential legal disputes until they are established. Security measures and robust resolution protocols will be required to address issues such as lost private keys, tokenized asset loss, and potential fraud. Resolving these challenges will take time but will be crucial for building trust and confidence in tokenized assets.
Alongside these regulatory needs, advancements in technology and substantial investment in tech infrastructure are necessary to address scalability and establish global frameworks. Tokenization demands advancements in technology, and continuous development is necessary to keep up with the rapid evolution of blockchain and related technologies, ensuring they can handle increasing transaction volumes and diverse asset classes. Such high demand for technological advance will likely present challenges for directors of real asset funds and senior management in the industry who will need to get up to speed with distributed ledger technology to remain competitive.
Fraud is also a significant concern in the tokenization space. Smart contracts, the cornerstone of tokenized assets, are only as reliable as the underlying code. Poorly written smart contracts can be exploited by hackers, leading to substantial financial losses, as seen in December 2021 when a hacker stole $31 million due to a bug in blockchain startup MonoX Finance’s smart contracts. Additionally, there have been several smaller yet noteworthy hacks that resulted in the loss of millions worth of crypto assets. These incidents have further emphasized the need for robust security measures and rigorous code auditing, which are essential to mitigate fraud risks and safeguard investor assets.
It has become clear to several managers that tokenization offers significant opportunities for firms and the fund industry at large. Despite the challenges, the growth potential of tokenization remains immense, and the benefits have outweighed costs in forecasts for the growth of asset tokenization, which are universally bullish. As the tokenization opportunity set continues to expand, investors should be optimistic about its practical use cases, but remain cautious when considering the risks associated with a sector in its early stages.