From Ledger Insights

Yesterday the BIS and Committee on Payments and Market Infrastructures (CPMI) delivered a report to the G20 on tokenization. That paper was both upbeat yet sober, balancing the opportunities, risks and steps that central banks need to take. A separate G20 report published today from the Financial Stability Board (FSB) is far more skeptical on the topic. Currently, there’s little risk because it views the adoption of tokenization as “very low” but growing. It also published a report on crypto-asset policy implementation.

At a more granular level, the risk is limited because most tokenization projects use permissioned blockchains and only use programmability in a limited way. Hence, the transactions are still relatively simple rather than composable. While the sector bemoans the current fragmentation which limits the tokenization benefits, from the FSB perspective, this reduces risk because it limits growth.

The FSB seems unconvinced about the benefits of tokenization, arguing that other current technologies can achieve similar results. It questions the appetite for tokenization adoption and outlines numerous hurdles in its path. Plus, it spends significant time delving into the potential risks.

From a financial stability perspective, those risks increase if the scale of tokenization grows, which will probably happen if the industry addresses the DLT interoperability and there’s greater regulatory clarity. While traditional finance (TradFi) transactions currently are relatively simple (compared to the composability used in DeFi), if TradFi tokenization projects become more complex or opaque, that could increase risks. Finally, if regulators fail to ensure risks related to tokenization are mitigated, this could create financial stability risks.

What are the tokenization risks that need addressing?

First off, the FSB is concerned about liquidity and maturity mismatches with tokenization. Some of the assets being tokenized may have different timelines for convertibility into cash compared to the tokens themselves. This could trigger redemption run risks. The fractionalization benefits touted by tokenization projects “could also raise maturity and liquidity transformation issues similar to those encountered with collective investment schemes.”

Regarding liquidity, while the FSB recognized the benefits of delivery versus payment or atomic settlement, this increases the need for cash, because there’s less netting of payments. While sometimes institutions can borrow funds, the higher liquidity increases the risk that funding might not always be available when needed. This could lead to liquidity stress events. Plus, given the automation enabled by DLT, the spread of such events would be faster.

On the topic of tokenized deposits, it’s particularly concerned that some projects could release bearer tokens that might be traded, deviating from par. Additionally, programmable money could automate the process of bank runs, making them happen faster.

Other tokenization risks

Leverage is another key risk area, particularly the composable nature of smart contracts. For example, someone can borrow tokens from a lending protocol, and use those tokens as collateral to get even more leverage. We’d note that today this is more typical in the DeFi arena.

Next is a concern about asset price and quality. The FSB is worried that a lack of transparency or understanding of smart contracts makes it harder for investors to assess quality and prices of tokenized assets. Composability in particular creates complexity. It also has reservations around data provided by oracles and how current regulations apply to data providers.

The FSB outlines various risks related to interconnectedness. That includes platforms that aggregate traditionally separated roles such as issuance, secondary trading and custody. While it sees the advantages of cross border and 24/7 trading for users, it is concerned this could lead to regulatory arbitrage, or worse. That includes domestic financial shocks spreading across borders.

Finally, it raised many concerns about operational fragility. On the one hand, this includes worries that institutions have to ensure DLT and traditional systems are synchronized. It also sees risks in the adoption of permissionless blockchains and smart contracts. Plus, it has reservations regarding the scalability of DLT.

The report’s focus was the tokenization of traditional assets, so it excluded cryptocurrencies as well as CBDC, but included stablecoins used for settlement. While most of the projects investigated were on permissioned blockchains, clearly some of its concerns relate to permissionless blockchains.

There are certainly risks with tokenization. However, if regulators discourage institutions, then activity will be forced into the unregulated sector. We’d observe that this will raise risks to consumers and reduce the ability to address financial stability risks.

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