Thomas Borrel, chief product officer at Polymath
Blockchain has been an extremely hot topic in 2021. With companies and financial institutions internationally having to adapt to an increasingly digital world, the true potential of blockchain is becoming increasingly clear. We have seen hospitals using the technology to track vaccine distributions, major blue-chip companies floating digital assets or ‘stablecoins’, even progress made by central banks in piloting and adopting digital currencies
When it comes to the world of finance, much of the attention has focussed on the booming price of Bitcoin, and there has been much excitement around using cryptocurrencies as an alternative investment. However, the real potential of blockchain technology stretches far into traditional finance and beyond.
Improving access to investment options
Security tokens created and issued on the blockchain are already being used to improve efficiency in a variety of more traditional asset classes, ranging from real estate to green bonds. The Sustainable Digital Finance Alliance (SDFA) and HSBC Center of Sustainable Finance recently joined forces to highlight how security tokens for green bonds can reduce management costs and increase operational efficiency by up to ten times. And in early 2020, RedSwan CRE Marketplace tokenised $2.2B in commercial real estate, making it one of the biggest tokenisations we’ve seen so far.
However, the potential of tokenisation does not only stand to improve the process of trading traditional assets; blockchain can also open up the pool of investors able to participate. To date, the focus has been on how fractionalisation brings benefits to retail investors by lowering the bar to entry. However, the retail regulations are still very stringent, which is important to protect non-professionals from disproportionate losses.
Tokenisation can be used to enable large institutional investors to buy into smaller projects. Referred to as aggregation, this process can be used to bind assets together so that they meet an institution’s minimum investment threshold. Because of the transparency of blockchain, the investor is still able to inspect each individual offering and ensure each element meets their quality and risk requirements, but by packaging it into one larger token, an institution can diversify with assets that would have otherwise flown under its radar.
Optimising efficiency and minimising risk
Risk management and operational efficiency are usually at the core of any financial institution’s wider strategy. However, no matter how much firms optimise their own processes, there are a range of financial instruments that are still very prone to issues in these areas, especially those that are traded ‘over the counter’ (OTC). The best example of this is likely the bonds market – a multi trillion-dollar market, where OTC trades are still common practice.
When an OTC trade is conducted, it is often so over the telephone – one person calling another to make a deal. This introduces significant information risk with securities operations teams reporting error rates as high as 40%. When instructions for the trade are passed on to the custodians, they will spot the discrepancy. They then have to investigate and find out what has gone wrong, often resulting in very long delays to settlement times.
Blockchains go a long way to solving this problem, providing transparent access to trade and clearing information so that operational issues can be caught earlier and help mitigate settlement risk (i.e. settlement failure). For example, on Polymesh settlement instructions must be affirmed prior to settlement, in a case where an OTC trade has been improperly captured by one counterparty, the counterparty which has affirmed the instruction can see that the other counterparty has not affirmed the instruction within a defined period. In this way, the affirming counterparty can reach out proactively prior to the settlement date to rectify the situation and avoid settlement failure.
Trading on blockchain also generates an easily accessible, secure ledger of trading information. When it comes to reporting in traditional asset classes, the process is highly manual and often expensive. But, with a blockchain solution, reporting is built into the ecosystem from the ground up. There are no significant additional costs or resources required to extract this data and share it where necessary, and the number and complexity of the steps required to complete reconciliations between different entities are reduced and simplified.
Is tokenisation a ‘cover all’ solution?
Fundamentally, certain traditional asset classes are not right for the blockchain yet. Instruments with well-established frameworks, like publicly traded stocks, already have very well-formed, rigorous rails in place, and so transferring to a blockchain could cause disruption and incur unnecessary costs.
It is very common to hear blockchain advocates claiming that blockchain technology should be introduced into every corner of the finance space, which is misguided. Blockchain should be introduced where it brings value to investors or institutions. It should be about augmenting and supplementing the marketplace – not overhauling it, or at least not until the incumbent systems no longer keep up with demand.
The costs and infrastructure associated with capital markets have made some assets – like green bonds or real estate – too expensive to bring to market and service, or too difficult to invest in. These use-cases are examples of where tokenisation can really shine.
Blockchain is an extremely powerful tool, with a range of exciting applications and potential benefits for businesses and financial institutions, ranging from risk management and efficiency through to enabling new investments. However, as with any product, it isn’t the answer to all problems, and must be treated as a powerful enabler – not as an agitator.
