While tokenization can bring many benefits, the capital market’s new frontier is not without risks, with regulatory uncertainty, investor education and cybersecurity remaining key challenges to its development, according to a recent report.

Benefits may include streamlined clearing and settlement, improved transparency and compliance controls, or greater market access through fractional ownership, finds new research published by the CFA Institute Research and Policy Center in its An Investment Perspective on Tokenization: Part I report, which reviews the use of distributed ledger technology to tokenize financial and real-world assets.

The research draws on interviews with leading digital finance practitioners and includes use cases to evaluate the opportunities for tokenization through real-world scenarios. Tokenized assets and instruments discussed include art, whisky and wine, gold, equities, mutual funds, private market funds and repurchase agreements.

The report’s key findings include:

• Operational efficiency – Tokenization can lead to cost and time savings, particularly where a system of intermediaries and manual processing is currently required, for example, middle and back-office operations, clearing and settlement, distribution and regulation compliance.
• Cybersecurity risks –  Distributed ledger technology can be vulnerable to attacks, given its inherently decentralized nature. Vulnerabilities include malicious actors, fraud, deception and the potential for the loss, theft or misuse of private keys, which give access to assets digitally represented on the network.
• Regulatory uncertainty – Different jurisdictions have varying regulations, which can create challenges for global implementation and compliance. The borderless nature of digital finance calls for a progressive alignment of regulatory frameworks, or the risk of regulatory arbitrage and market failures will rise.
• Market infrastructure – Nascent market infrastructure for distributed ledger technology implies a continued degree of fragmentation across public and private blockchains, which is adding potential hurdles for a seamless experience in navigating tokenized assets. Developing a robust and scalable infrastructure is essential for the widespread adoption of tokenization.
• Access to private markets – Tokenization has the potential to widen access to private markets via higher levels of operational efficiencies and lower minimum investment requirements. However, questions about investor protection and suitability persist, especially in a context where information asymmetry may result in an information disadvantage for retail investors.  

“We believe that regulators will need to develop an approach to digital finance that encourages innovation while safeguarding investor interests and market integrity,” says Olivier Fines, the CFA Institute’s head of policy research and advocacy. “Different regulatory approaches are emerging: The United States appears headed towards a digital finance regulatory framework that fosters innovation and experimentation. The European Union seeks clear and consistent rules as well as standards to promote interoperability and compatibility across member states. The UK intends to bring regulation of digital assets into existing securities laws.

“With varying regulatory regimes, industry innovators are likely to favour the simplest regulatory environment when setting up shop, potentially resulting in regulatory arbitrage risks. In the current geopolitical context, it is not unreasonable to anticipate that the centre of digital finance innovation will move further in favour of the United States, at least until a clearer international regulatory standard is established.”