In recent years, the momentum behind the creation of a so-called “token economy,” in which financial investments are made more efficient through the deployment of distributed ledger technology, has gathered pace and has attracted widespread interest. State Street looks at the terrain.

In the second article from US financial services conglomerate State Street, it examines what is known as the “token economy” - a reference to the new worlds of distributed ledger technology such as Blockchain and the associated features. We hope this article maintains scrutiny on a topic that can sometimes be overwhelmed by the never-ending COVID-19 drama, the US elections and Brexit. 

As always, the usual editorial disclaimers apply. Jump into the debate! Email the editors at tom.burroughes@wealthbriefing.com and jackie.bennion@clearviewpublishing.com

In recent years, the momentum behind the creation of a so-called “token economy,” in which financial investments are made more efficient through the deployment of distributed ledger technology, has gathered pace and has attracted widespread interest.

What is tokenization?
In principle, tokenization is the process by which assets such as equity, debt and real estate are represented on distributed ledger systems. By representing the value of tangible or intangible assets through digital tokens, they can be owned, stored and transferred on the blockchain.

Early applications have looked to tokenize cash and the digital payments process in order to provide an alternative to the current market model of account-based systems. What is the difference between the two models? Today’s account-based payment systems rely on the verification that someone has been authorized to make a transaction. Tokenization works differently. Here, the participants in the network prove knowledge of an encrypted value in order to initiate a transaction.

This idea of a token-based model would, however, come with implications. Whilst participants could broaden their direct access to financial networks, and the concept of programmable money may garner broader acceptance, the privacy of data in a distributed environment may also come into question. 

Beyond cash
The growing appetite to tokenize other assets has led to tokens being categorized in a few different ways. The likes of Bitcoin and Ethereum are sometimes referred to as “payment tokens”, as they can be used as alternative forms of payment - but on the blockchain.

One application of cash tokenization from the private sector involves stable coins. These are a type of digital coin designed to peg the price of a cryptoasset and negate price volatility. Such models can also be used for international payments involving foreign exchange, and could encourage wider adoption by institutional investors. 

Security tokens, on the other hand, are simply securities which happen to be issued using blockchain. What makes them unique is that they could be issued and settled in electronic form without the need for central market infrastructures. 

Tokens find a wider ecosystem 
These innovations are not limited to the private sector. The public sector also recognizes the potential of tokenization and is starting to come up with ways to support a future token ecosystem. 

Central banks, particularly across Asia Pacific, are looking at issuing fiat currencies as tokens with the view to improve the availability and use of central bank money in either retail or wholesale payments, or even both. There are implications for the asset management community too. A shift to tokens offers the chance to invest in new asset classes or change the dynamics of existing asset classes once they migrate into blockchain environments. 

Meanwhile, having digital assets on the blockchain could allow asset managers to track changes in investment patterns more carefully and generate better data insights. More radical proposals involve digitizing a fund’s overall structure, making it easier for investors to come on board by creating a portfolio that is tailored to their risks and interests. 

Tokenization holds promise: greater liquidity, more transparency and faster transactions. If its potential can be exploited fully, the world of assets will be more accessible than ever.