The World Federation of Exchanges (WFE), the global trade body for stock exchanges and clearing houses, today published a paper on tokenization. On balance it was critical of the concept, although it concluded that it “may be the next phase for traditional assets”. It found that the primary benefit of tokenization is fractionalization. And by making fractional assets available to a larger pool of investors, there’s potential to enhance liquidity. However, it dismissed several other tokenization benefits.
Some might conclude that as incumbents, the WFE members could view tokenization as either a threat or a potentially significant cost. The paper notes that few exchanges have embraced the technology. However, there are a few exceptions. For example, Switzerland’s SIX and the Deutsche Börse are WFE members and early adopters.
Notably, the primary benefit acknowledged by the WFE doesn’t impact most of its members. Fractionalization often relates to private or illiquid markets in which they don’t have a significant presence.
Critical omissions re tokenization
Regarding ‘overexaggerated’ benefits, some of the WFE arguments have merit. However, a couple of omissions stood out. For example, in a paper from exchanges, it was surprising to see no mention of the terms ‘delivery versus payment’, ‘DvP’ or ‘atomic settlement’, one of the key benefits of DLT, not to be confused with instant settlement.
It is not the first to dismiss instant settlement as an advantage. Others have highlighted the benefits of netting and the disadvantages of needing the cash upfront to settle trades instantly.
With tokenization, settlement does not need to be instant. It offers far greater flexibility to mutually agree settlement times versus what’s currently offered in most jurisdictions. Hence, that can include batching and netting. More importantly, it offers the option of atomic settlement, the DLT equivalent of delivery versus payment, which eliminates counterparty risks. By eliminating counterparty risks, the need for central counterparties is reduced.
However, There was no mention in the paper of the elephant in the room – that the nature of the role of central securities depositories (CSDs) and central counterparties (CCPs) may evolve significantly in the face of tokenization.
Blockchains can supplant several of the tasks of the CSD, including acting as the definitive record keeper and automating corporate actions. However, there’s an argument that CSDs make the logical operators of blockchains, provided they don’t retard adoption to protect their turf. At the same time, the European Investment Bank is not convinced that doing away with CSDs would be a significant gain.
Exaggerated benefits
The WFE argues that the prospect of continuous 24/7 trading can be achieved without tokenization, but there’s a lack of demand given that the costs outweigh the benefits.
It goes on to say that 24/7 activity confers advantages to institutional investors over retail investors.
On the one hand, they have a point that institutions are more likely to have branches that are awake around the clock to take advantage of movements. However, what if a volatility alert awakes a retail investor in the middle of the nigh? Without 24/7 trading, they are unable to act on it. In contrast, today institutions may be able to trade via foreign branches, depending on the financial instrument.
It also asserts that disintermediation can create conflicts of interest, which is true in the absence of regulation and supervision. It hones in on the potential for self custody, which many agree is probably not ideal for the masses but is a nice option. However, it sidesteps the potential disintermediation of CSDs and CCPs.
Finally, it outlines some of the reasons for a lack of adoption to date, many of which have some truth to them. Depending on the asset class, DLT may not currently be sufficiently scalable for trading. Too many blockchains are creating fragmentation. Other blockers are the cost of transitioning infrastructure and the need for regulatory clarity. In combination this has meant insufficient market depth to trigger network effects.
However, several points have counterarguments. For example, fragmentation is a feature of most nascent innovations and is often followed by consolidation. It’s an issue that industry participants are attempting to address with Unified Ledger-style concepts. Others, such as WFE member SIX, is addressing interoperability by integrating its digital CSD with the conventional one to successfully address fragmentation.
Conclusion
All in all, the WFE paper makes some decent points. However, the lack of balance in some aspects and crucial omissions paint a somewhat biased picture.
