What a rollercoaster of a year 2023 turned out to be for the digital asset industry. It had everything; court cases, regulation, innovation, a smattering of political jostling and, amongst all the noise, even a few pricing tailwinds for the crypto fanatics out there. 

Tokenization had an opportunity to creep in from the cold, too. It shook off the damage inflicted by a few Bored Apes two years ago and rubbed shoulders with the elite. In March, BlackRock’s Larry Fink set the tone when he declared that “tokenization will be the next generation for markets.”

This, then, was the year when institutions around the world started talking seriously and publically about tokenization, a technology that has the potential to open up the private markets to individual investors. It was also the year that laid the groundwork, bringing tokenization credibly into real world scenarios and paving the way towards mass adoption. 

Reaching critical mass

Private market assets have a few characteristics that make them traditionally rather unfriendly to your average individual investor. Huge capital requirements, lack of liquidity, and the need for extensive due diligence are all top of the list when it comes to investor barriers. Behind-the-scenes, operational challenges for asset owners and fund managers can be just as crippling (Blackstone discovered this the hard way last year). 

Tokenization offers a solution for both sides. It supports fractional ownership, decreasing capital requirements, boosting liquidity and enabling investors to buy and sell tokens easily. Once physical assets are tokenized and recorded on the blockchain, the broader advantages of distributed ledger technology (DLT) kick in, enabling asset managers to automate much of the operational challenges stopping them from scaling meaningfully into retail markets, such as capital calls and the distribution of returns. 

Many of the current use cases for individual investors and tokenization centre on ‘democratisation.’ Fractional ownership and instant settlement increase liquidity, choice and access to traditionally illiquid assets, such as real estate, art, infrastructure and private equity. 

Last month’s Digital Asset Week (DAW, 2023) provided a good overview of the institutional uses for the technology. The conference brought together big names from financial institutions and fintech to discuss what the future has in store for digital assets more generally – and it was liquidity that dominated. The focus for the industry at large going into 2024 will be faster, cheaper products and more liquid markets. 

JPMorgan is doubling down on DLT with its intraday repo trading product, which will support DVP (delivery vs. payment) transactions from January. Developed in partnership with Ownera, HQLAx and wematch.live, the world-first will allow settlement and maturity times to be negotiated to the minute and negate the accrual of interest overnight, limiting it to the duration of the repo contract. HSBC also announced plans to tokenize bullion, facilitating trading between the bank and institutional investors. 

With two in five banks now either engaged in a DLT proof-of-concept or product implementation, the tech is fast emerging as a core component in the digitisation of financial services. As the likes of BlackRock and JPMorgan prove innovative use cases, DLT will become more desirable and accessible, and adoption will pick up pace. Quite when we’ll reach a tipping point – the critical mass where tokenization is more common than not – remains up for debate. At Hedgehog HQ, we don’t see this as a distant future point, but something to expect in the near to medium term. 

Welcome to the grown-ups’ table

Of course, technological capabilities and industry support are only part of the equation. This year European and Asian regulators created space for experimentation and the US’s Securities and Exchange Committee (SEC) probed regulatory grey space in court, all ably demonstrating the inability of change and technology to outpace regulation.

The EU’s 2022 DLT pilot regime acted as a blueprint of sorts for the UK’s Financial Services and Markets Act (FSMA), passed in June 2023. This creates provisions for the integration of DLT into banking operations by introducing a sandbox similar to the EU’s. Intended to promote the use of DLT and blockchain to issue and trade tokenized stocks, bonds and funds, the sandbox is designed to determine whether DLT-based infrastructure is a viable, long-term alternative to traditional financial rails.

But does it go far enough? The second UK cabinet reshuffle of the year welcomed Bim Afolami into the role of Economic Secretary to the Treasury, overseeing policy for crypto and central bank digital currency (CBDC). Less than a week after his appointment, the new minister took the City by surprise when he announced that “there’s no point having the safest graveyard”, signalling a higher risk tolerance from the UK Government and a desire for regulators to promote innovation, growth and competition. 

At the same time as FSMA was passed, the Monetary Authority of Singapore (MAS) released a report detailing a new framework for designing open, interoperable networks called Project Guardian. Referencing earlier innovations and designed in collaboration with the Bank for International Settlements' Committee on Payments and Market Infrastructure (CPMI), with input from participating financial institutions, it provides a framework for trading digital assets across various networks and liquidity pools. 

Incumbents were quick to jump on the opportunities afforded by Project Guardian, with Apollo and JPMorgan announcing a partnership at the start of November. Billed as ‘portfolio management by tokenization’, the joint project aims to establish a proof-of-concept for the use of blockchain to manage large-scale client portfolios, execute trades and automate the management of tokenized assets. 

Over in the US, the SEC spent the year in and out of court, with the regulator suing both Coinbase and Binance for securities violations. These suits followed hot on the heels of December’s fraud allegations against crypto exchange FTX’s now infamous CEO Sam Bankman-Fried.

In July, the SEC’s two year battle with Ripple finally concluded with a US District Judge ruling that the payment protocol had not breached securities law by selling XRP to retail investors. With Binance’s CEO pleading guilty to money laundering allegations in November, the last major legal fixture in the SEC’s diary from a crypto standpoint is January’s oral arguments regarding Coinbase’s motion to dismiss its lawsuit. The outcome, together with the Ripple ruling, will be key in determining how US law defines digital securities. 

What’s on the cards for 2024? 

When it comes to the adoption of tokenization and DLT by financial institutions, 2023 has been something of a landmark year. Regulation has picked up pace and incumbents have thrown their names – and resources – behind a raft of promising use cases; all of which speak to a broader acknowledgement of the transformative potential of the technology. But the route from this point to mass adoption is far from clear, and there are a number of hurdles we’ll need to overcome to get there. 

Interoperability issues are the obvious sticking point, with a lack of seamless communication and collaboration across blockchain networks impeding the full potential of tokenization. This hurdle requires a nuanced approach that bridges the gaps between public and private blockchains, establishing a unified ecosystem that enables smooth transactions and data transfer in a compliant manner.

Custody of security tokens is another challenge, particularly when it comes to individual investors. As tokenization gains momentum, we’ll need robust security measures for the safekeeping of assets, as well as standardised custody solutions that encourage investor confidence.

Settlement is a more practical roadblock and one that has the potential to stall or even derail adoption. The desire for instant settlement (T-0) is hampered by the fact that existing payment rails are not inherently atomic. Realistically, a solution might well require a complete overhaul of payment infrastructure to accommodate the swift settlement of tokenized assets.

Needless to say these are BIG challenges, and resolving them won’t fall to just one or two key players. Charting a path to financial services that routinely leverage DLT and tokenization requires a collaborative effort from a committed, diverse ecosystem. Meaningful change and innovation in 2024 and the years to come will require an industry working together to explore the potential of the technology; experiment, learn and innovate. A tokenized future will be built by and for the many.

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