US Federal Reserve releases paper on tokenisation

The US Federal Reserve, the central banking system of the USA, has released a paper on "tokenization" (technically spelled tokenisation in Australia) considering the benefits and risks of tokenization.

First up, tokenization is defined a:

the process of linking reference assets to crypto tokens via design features that link the token’s price to the value of the token’s reference asset

And the Fed highlights 5 key design features:

1. a blockchain;

2. a reference asset;

3. a mechanism to assess the value of the reference asset;

4. a means to store and/or provide custody for the reference asset; and

5. a mechanism to facilitate redemptions of the token and/or the reference asset.

The market for tokenized assets is estimated by the Fed to be only USD$2.15M as of May 2023 with approximately $700M of that locked in DeFi protocols. Gold is highlighted as the largest tokenized asset, accounting for nearly half the estimated market, and real estate as a very challenging asset to tokenize, due to all the legal requirements around the transfer of ownership.

The Fed highlights the benefits of tokenization as including:

• granting investors access to markets that might be inaccessible;

• programmability of crypto tokens and smart contracts to access additional features not currently available;

• facilitating the lending against new collateral types in cheaper ways;

• faster settlement in tokenized assets than in real-world counterparts;

• improved liquidity, in the same way that ETFs have improved liquidity of the assets in those ETFs.

Financial stability implications are an area of concern in the paper, with a clear concern being a linking of volatile crypto prices and the traditional financial markets in the longer term. The concerns of crypto and traditional price linking is again compared to ETFs where academic literature has found a strong correlation between liquidity, price discovery and volatility of ETFs and the underlying assets. Other stability concerns raised include automatic margin sales by smart contracts or inaccessibility of markets if there is a run on a weekend.

The fact that the US Federal Reserve, one of the most watched central banks in the world, is building it's institutional knowledge around tokenisation and crypto-assets, is a positive step and signal to the increasing growth and spread of blockchain technology.

By Michael Bacina