In a seminar in late August 2022, Mr Ravi Menon, Managing Director, Monetary Authority of Singapore, spoke about a high potential digital asset ecosystem and how this is different from speculating in cryptocurrencies.
In the ecosystem, ownership of a valuable asset, which can be tangible or intangible, is computerised or tokenised into a digital token. Distributed ledgers record the ownership and transaction activities of these assets. In Mr Menon’s words, “It is this crypto or digital asset ecosystem that supports use cases which can potentially facilitate more efficient transactions, enhance financial inclusion, and unlock economic value.”
Benefits of tokenisation depend on market adoption
Although I agree with Mr Menon that the tokenisation of assets can potentially facilitate more transactions by enabling a larger pool of investors to enter the market, whether those transactions are efficient depends on the market depth and adoption among other things like clear and transparent regulations. An important caveat is that for tokenisation to have real economic benefits, there will need to be a clear incentive for trade and transactions. We should avoid the magical thinking that simply chopping lumpy assets up into smaller pieces will automatically result in additional liquidity.
In other words, we should not overstate the potential. We already have fractional shares trading available for shares like in the United States. Tokenisation will largely be achieving this same thing. While tokenisation can allow a more efficient transfer of the ownership of assets and allow investors to own, say, 0.142 per cent of a piece of real estate or corporate bond (which can plausibly increase financial inclusion), the platforms allowing such trading and designated market makers will also need to ensure sufficient liquidity in the transactions of these tokens.
As an analogy, the United States Securities and Exchange Commission explicitly states that if the underlying stock with fractional share trading becomes illiquid, the fractional shares will be illiquid as well. In fact, the Commission even adds that some brokerage firms explicitly state that fractional shares may become illiquid even if the underlying shares are liquid.
Market Resiliency
And apart from absolute levels of liquidity, we should also think about the potential implications of adverse news or market outlook on the tokenised market. The liquidation of large positions of digital assets may affect market liquidity. If this large position is defined in absolute dollar terms, avoiding the fire-sale effect may be possible if the market is deep enough with liquidities orders of magnitude larger than that dollar amount. However, if we define “large” in terms of relative to total market size, then the liquidation of such a position will always trigger large price drops. Further, if there are sophisticated derivatives with embedded leverage in such markets, then the unwind may be even accelerated when compared to a simple market with no derivatives.
If tokenisation had enticed less informed traders who may both herd into and out of an asset, the tokenisation itself may amplify bubbles and crashes. In that case, there is even more pressure for governments or regulatory entities to step in to stop trading to hopefully calm down investors (although this can backfire, too, since investors expecting a trading halt may rush for the exit even faster). But again, such interventions with the market can start to cause distortionary incentives such as moral hazard, like in traditional financial markets.
The prospects
While digital assets in financial services look promising, it is important to distinguish between centralised and decentralised digital assets. For centralised digital assets, the use of tokenisation and related financial technology can potentially improve efficiency in current operations. This is more an incremental improvement in technology rather than a drastic new innovation in how finance works.
Meanwhile, decentralised digital assets will eventually face severe competition from central authorities like governments if the market becomes sufficiently large. We see some action by the United States against decentralised finance and “privacy-protecting” services like Tornado Cash. Although the reasons for blacklisting Tornado Cash may be legitimate, it also shows the power of central authorities in affecting decentralised networks.
Along this vein, we can think about one innovation in digital finance which is centralised—Central Bank Digital Currencies (CBDCs). This innovation can boost efficiency in financial transactions and monetary policy but potentially reduces privacy relative to the existing financial system. This makes it more appealing to governments for reasons such as anti-money laundering and “Know Your Customer”. Such a product does not seem particularly innovative and can likely be adopted with little friction as it would have government support or mandate.
Compared to CBDCs, decentralised stablecoins face more regulatory risk as they are particularly useful for bypassing financial regulations such as capital controls. On-chain minting and burning patterns in some stablecoins suggest they facilitated meaningful fund transfers from China to overseas. Whether this is an acceptable use case in the international community is to be determined. More positively, stablecoins can also serve as on- and off-ramps from fiat into the digital space. However, exactly because of this reason (fiat is controlled by the government), stablecoin issuers will probably come under the strict scrutiny of the government and may even become absorbed and controlled by the government.
From digital collections and NFTs to gaming and just the happiness of knowing that you own a link to a “nice” JPEG, there are certainly uses for digital assets. Will the market completely take over as the main means through which people own and enjoy art or gaming? Perhaps. I am fairly optimistic for those use cases with fundamental utility, but a big challenge is that in a decentralised setting, there is no central authority to stop bad actors, and the community must find a way to self-enforce norms and rules, perhaps using new governance structures like decentralised autonomous organisations (DAOs). That hasn’t shown itself to be a spectacular success at present, either. Meanwhile, we should also view the innovation through the lens of existing financial instruments and markets so we can be appropriately cautious before shilling new financial technology as the elixir for all cures.