tokenization-policy-paper-2023

Tokenization of Traditional Assets
and their trading

Katya Malinova and Andreas Park

Relevant features of blockchains
Possible features of tokenized stocks
How would you issue/tokenize stocks?
What challenges arise for tokens vis-a-vis traditional stocks?
Trading of stocks
Use in other blockchain applications
The public offering landscape
Impact on the financial sector's IO

Background and Overview of this Policy Paper

Idea: Think through the process and implications of tokenizing common shares on the Ethereum (or similar) public blockchain

My perspective: an economist, not a lawyer!

Source: "Relevance of on-chain asset tokenization in ‘crypto winter’"
By Sumit Kumar, Rajaram Suresh, Darius Liu, Bernhard Kronfellner and Aaditya Kaul, Sept 2022

(South-East Asian countries)

Key Institutional Differences

Key Institutional Features of Equities

listed equities are
- securities by definition
  - restrictions on who can hold them
  - exchange and trading rules
  - knowledge of ownership
  - reporting requirements
- well-established custody and ownership transfer with regulated roles
- difficult for beneficiary owner to "use" asset other than transfer

If held on a blockchain, what challenges arise and what would need to change?

Institutional Differences: Crypto Asset Ownership, Accounts, Wallets, and Self Custody

Smart contract accounts

controlled by code
decentralized applications
tokens

Externally owned accounts

controlled by private keys

private
key

public
key

(seed phrase)

public
address

wallet = software to keep and use private keys

Blockchain Ownership Attribution

for the blockchain, an asset is always owned by
- externally owned account
- smart contract
externally owned accounts can be "reached" by, e.g., blockscan
smart contract ownership is trickier

Institutional Differences: Asset Creation

token = smart contract (piece of code) registered on the blockchain
can be created by anyone (incl me):
- check 0xfaefacacc53d718bf4f14634f50040a1310d17f6
- creation code: https://etherscan.io/tx/0x0c3987c0d9ce90c02124bb62824ba9f651c6db467bda395dc7c299adb2a96471
can pretty much be used by anyone

Use smart contract (incl tokens)?
- must pay blockchain validators in native crypto-currency
\(\Rightarrow\) you always need to hold the cryptocurrency

Institutional Differences: The Investment Process

issuers

investors

funding
record-keeping
instruments

custody
advice
trading

services
needed & provided

takes care of custody and allows self-custody
allows instrument creation
enables record-keeping
allows circumvention of existing institutions

A general purpose value management infrastructure:

intermediaries

separate institutions

asset custodians
broker-dealers
trading platforms

The blockchain reality:
new institutions
will emerge

Institutional Differences: Trading and Asset Registries

payments network

Broker

Stock Exchange

Clearing House

custodian

seller

buyer

beneficiary ownership record

Institutional Differences: Trading and Asset Registries

seller

buyer

Application: decentralized trading with automated market makers

deposit = asset ownership transfers to a smart contract
depositor gets a receipt token

Application: Decentralized Borrowing & Lending

borrow

provide collateral

deposit = asset ownership transfers to a smart contract
different models for interest accounting (usually based on receipt tokens)

UniSwap Lab supports development

a website app accesses the code

token holders control contact features

don't own the code

operation = decentral

control = decentral

anyone can use the baseline code

core code runs on the blockchain

tokens used as rewards

Institutional Differences: Blockchain Project Operation

Asset Tokenization or
"The Creation of Asset-Linked Tokens"

Tokenization of stocks is nothing new: American Depository Receipts

foreign investor/
issuer

domestic bank with foreign representation

ADR issuing bank handles

shareholder communications
dividend payments
other recording-keeping

Is this a workable model for blockchain- tokenization of existing assets?

foreign representation of domestic bank/ its custodian

domestic depository bank

S.E.C.

registration with form F-4

domestic broker

issues and cancels ADRs

domestic investor

lets investors own and trade ADRs

domestic
market

deposits shares

Blockchain Tokenization has many options

existing investor/
issuer

token issuance platform

investor
wallet

instruct to create tokens

deposits shares

custodian bank

deposits shares

creates tokens and sells to investors

centralized or decentralized
market

S.E.C.

registration

Token Standards

ERC-20 = fungible token with minimal features such as
- balanceOf: how much does an address own?
- totalSupply: how many is there?
- approve: (contract owner allows token withdrawal)
- transfer: allows a holder to send a token).
ERC-721 = non-fungible (has meta-data to describe the token; e.g. website URL or data hash)
ERC-1155 = limited units of non-fungible
there are other standards that allow e.g.:
- ERC-1726 dividends
- ERC-4626 interest payments
- ERC-1400/1404
- ERC-3643/ERC-621: restricts initial distributions

Some basic facts

Fact 1: Ownership of tokenized asset can be

a person/legal entity
a smart contract

Fact 2: By default issuers do not know who owns their tokens

Fact 3: Investors who hold tokens in DeFi smart contracts have fluctuating holdings.

Fact 4: General ownership restrictions are almost impossible to enforce, and transfer restriction would negate advantages of tokenization

Problems that require solving

ADR issuing bank handles

shareholder communications
dividend payments
other recording-keeping

How are these functions performed with crypto-assets?

Fact 2: By default issuers do not know who owns their tokens

It is possible to determine block-by-block EOA holders
\(\to\) can send dividends directly
but not very economical

One can reach holders via EOA chat functions and disseminate information (e.g., chat.blockscan.com)
\(\to\) opt-in for communcation

good practice from DAOs is to lock tokens in contract and then do voting and dividend payments
can also administer splits/reverse splits

Some remedies for communication and dividends

All this needs a legal framework that adapts to a decentralized, digital world

Problems that require solving

ADR issuing bank handles

shareholder communications
dividend payments
other recording-keeping

Remaining FIs handle

trading and transfer rule enforcement of ADRs

Fact 4: General ownership restrictions are almost impossible to enforce, and transfer restriction would negate advantages of tokenization

Legal and regulatory frameworks currently rely on intermediaries and are not prepared for self-custody

Banned addresses (usually by OFAC order)

criminals don't use USDC - why are we so worried?

Broader Implications for the Financial Industry and the Financial System

Asset tokenization would likely create a massive expansion in demand for stablecoins

max TVL:
top 20

max lending:
top 50

current lending:
top 100

Asset tokenization would likely create a massive expansion in demand for stablecoins

Stablecoins and Deposits

DeFi applications for "real" finance
- DeFi Lending?
  - Lending club on blockchain? (incl. personal loans etc)
  - pools would be mostly stablecoin-based
- DEX & CEX trading?
  - tokenized stocks require cash and stock deposits
  - on chain FX require stablecoins in multiple currencies

\}

huge demand for continuously available "high quality" money

Broad Blockchain Risks to Financial Stability

Lending capacity & Monetary transmission

Deposit mobility

AML/CFT/Sanction evasion

Dollarization

Failures/runs

New cyber-risks

Broad Blockchain Risks to Financial Stability

Stablecoins require deposits that are invested only in HQLAs

\(\to\) restricts balance sheet lending
\(\to\) reduced monetary transmission

stablecoin deposits \(\not=\) sticky

Crypto-assets facilitate sanction evasion, money laundering, ransonware attacks, terrorist financing

USD stablecoins

cause currency substitution in smaller countries
Increase dollarization and threaten monetary sovereignty

Stablecoin failure/runs could lead to

firesales of HQLA that disrupt markets
social unrest

a host of unknown, highly scalable attack vectors

Lending capacity & Monetary transmission

Deposit mobility

AML/CFT/Sanction evasion

Dollarization

Failures/runs

New cyber-risks

Business risk for existing FI: super-easy entry

idea: create new mutual fund like asset

Business Risk to FIs: Customers choose what's best for them

"yield aggregator:" push capital where rate of return is highest

Yield Aggregators are very mobile liquidity

Source: "Phantom Liquidity in DeFi Lending", Park and Stinner (2023) working paper

FIs would lose the role of providing access to the financial infrastructure
less sticky capital
new asset managers

Investors continue to need advice

breakup of bundled services is tricky

Effects on the IO of Financial Services

paying for advice is tricky

losing income sources will affect equity valuations and room to maneuver for FIs in liquidity provision

Last Words

Summary

From a conceptual and efficiency standpoint, the advantages of tokenization are a no-brainer
The current legal and regulatory environment needs to adapt
There are still many tech problems to be solved
There will be impacts on the movement of money \(\to\) financial stability

Application: decentralized trading with automated market makers

Banned addresses (usually by OFAC order)

tokenization-policy-paper-2023

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