Series 6 Episode 4: Tokenisation - unlocking its transformative power

Transcript

Laura Talvitie: Hi everyone, and welcome to the latest episode of Risk & Regulation Rundown. This is our podcast on financial services risk and regulatory hot topics. I'm Laura Talvitie, and focus on digital assets work at PwC UK, which is why I'm hosting this one episode only on tokenisation. We're going to talk through what it is, and how it's going to deliver value for the FS sector, and of course, we'll also talk about the regulatory landscape in the UK and globally. I've got three great guests in the studio, and online today, to run through all this with me. We've got Matt Blumenfeld online, he's PwC's digital assets lead both globally and in the US. We have John Allan, who is the Head of Innovation at The Investment Association, and we also have Shearin Cao from Citi, and she is EMEA regulatory policy director. It's great to have you here. Let's kick off. We've got a lot to cover today. Before we deep dive into the use cases and benefits, Matt, let's start with the basics. What is tokenisation, and why has it become such a hot topic in the last few years?

Matt Blumenfeld:Thanks Laura, great question, and obviously the best starting point. Tokenisation is essentially just a digital representation of something. In the context of blockchain technology, we're talking about digitally representing an asset on chain, whether that be identity, financial asset, or something like cash. It really could be anything. Why is it popular today? Largely because people are looking to unlock additional value, and tokenisation is a way of doing that for both the issuer, and the ecosystem at large. Both institutions and customers of institutions are always looking for ways to be more capitally efficient, and tokenisation is one of those tools in their tool belt to help them get there.

Laura: Perfect. You mentioned it could be anything, and there's a lot of talk in the industry about how everything can be, or could be tokenised. Do you see that as a sensible or likely way forward in the near future?

Matt: I'll do my best consultant impression here, and say yes, and no. Yes, I believe anything can be tokenised, and we should be experimenting with tokenisation because we want to disrupt different business models, that's the whole point of tokenisation in emerging technology in general. Everyone should be experimenting with tokenisation, but that all being said, it will be very important to realise that not everything should be tokenised. There are certain characteristics of an asset, or a process that make it better suited for unlocking the power of tokenisation, or unlocking the value with tokenisation. We should really only be using tokenisation as a solution when it meets the problem. You should always assess your problem first, and say, 'Is tokenisation the best solution for this?' That's not always the case. Something like cash is a perfect good example of an asset where the benefits from tokenisation are there, and it can act as a foundation for additional use cases. I know some of our guests as well will talk through this, also feel the same about that.

Laura: Thank you Matt. We are going to divide the discussion into two sub-groups of tokenisation, investment products, and tokenised money. On investment products, John, what are the key use cases at the moment, and the key benefits for those?

John Allan: For asset managers, and fund managers, we look at things in two perspectives when it comes to tokenisation. Firstly, there's the assets, the securities that asset managers construct their portfolios with. The stocks, the bonds, the other fixed income instruments, alternative assets, etc., that make up the portfolios that asset managers create the products that they then sell to. So we're interested in looking at the tokenisation of those assets first and foremost. Then secondly, asset managers as issuers of products, i.e. the investment funds, the other products that they manufacture on behalf of the end-customer/the end-investor. Clearly, the shares, or the units in those investment products could also be tokenised, and there's a number of benefits as to why you might do that. Predominately around reducing operational complexity, automating things like corporate actions, distributions, and dividend payments, but also potentially faster and more efficient settlement when it comes to digital money, which I know we'll be talking about later.

Laura: Yes, thanks, John. You mentioned some of the benefits. What is currently in the current market, mainly driving the adoption, or unlocking value?

John: There's been significant interest in money market funds over the past 18 months or so, as we've entered into a more usual, or higher than recent interest rate environment. A number of parties have been looking for greater value, greater yield, and tokenisation has been able to provide that in two perspectives. Firstly, there's been an increase in the number of funds that have been tokenised. Money market funds will have been tokenised, because there's the potential for a new breed of investor to enter into those products because of that high yield. It has attracted a number of digital native investors. Investors who are used to holding tokens, who are used to perhaps the crypto asset market, who have been able to access a more mainstream investment product because those funds have been issuing tokens rather than in the conventional form. Then the second piece has been as I mentioned earlier, the higher yield that's been available within that market recently. That means that firms have been able to offer that to investors in a more streamlined and cost-effective way, which has been very well received. That particular trend has been exacerbated by market conditions, but we'll see other use cases come to the fore over the course of the next few months and years.

Laura: Brilliant. That's obviously supported by digital money if we, Shearin, move on to that now, or tokenised money. What are the key use cases, and the benefits there?

Shearin Cao: Yes, thank you. Just following up on what John was saying, I think it's very interesting to see two sides of the ecosystem. One is about recording the store value, which John talked about, and the pursuit of return. The other side is essentially the linkage towards fiat - i.e. the ultimate, the safe currency, so to speak. That in many ways inspired the starting point of tokenised money from the public sense. I will talk about tokenised money from a private sense a little bit later. Public money, or digital form of public money, is what started this discussion about tokenised money to begin with. Usually we think about it in two sides. One is the retail use case, the other is the wholesale use case. So retail is what everybody can access, and in key jurisdictions, this is what is known as in the UK, digital pounds, in Europe digital euro, and the US digital dollars. You can, in many ways think about it's almost a legal tender of the current money. It's a digital money in a way, and essentially in many ways you think of it as a store value, and a means of payment all in one go.

Although, the complexity is, whilst the use case is very self-evident, so as all of us have online banking, digital banking, the complexity is essentially the access to central bank balance sheet. That's where part of the design feature comes in. I think if I just take a step back away from the retail use case, there's also wholesale use case. So the RTGS systems, for instance in Europe and the UK, is a very good way to think about this is the way of ultimately banks, in central bank money terms, settled on the liability. Then in the context of wholesale CBDC, as we call it, or Central Bank Digital Currency, this becomes another new frontier. Especially, how do we upgrade the current settlement system between commercial banks, and central banks, and upgrading to a potentially DLT platform. Again, there is obviously some strength there, which is about ability to settle 24/7, access to on-chain and off-chain capabilities, and importantly, bypass some of the manual processing, so as we speak, are today facing. On the hand, there's a trade-off. There always will be trade-off because the new infrastructure has a cost towards that. That's what we call the key use cases and benefits.

I did allude to in the beginning about private money, and private money is I think most general public will think about bitcoins, but actually this isn't all we're thinking about, because arguably whether bitcoin can, or cannot be consider a money, or a currency is still to be debated. What I'm referring to here is two things. One is the digital format of banks' liability. In a commercial banks sense we tend to call it tokenised deposit. So essentially it's like a traditional deposit, but in the digital tokenised form. Again, very much in sync with what Matt said, in the beginning, the unlocked opportunity in the sense that, it enables money to move more smoothly across the border, leverages existing ecosystem, but at the same time creates this 24/7 settlement capability. There's a lot of strength there, although, I think, given that this is a new digital format of the existing concept, a lot of the journey is in making customers understand what these design features are and also addressing client demands. Ultimately, there's a lot of excitement associated with this type of private money, but in a well understood format. The other type of private money is what we traditionally call a stablecoin. The reason it's considered as stable is in the sense that it is backed by something. It is backed, quite often by, could be a single fiat currency, all the way to a basket of government securities. So it's itself, as a concept, highly broad. Again, as you can imagine, the well-accepted use case is about cross-border payments, settlement, in some senses, store value, etc.

Although later on we will talk about regulatory alignment, this is something which is undergoing quite a lot of regulatory scrutiny, because it is such a broad product class, and rest assured it has quite a lot of flexibility and design features and exciting cool stuff, but at the same time this also requires a lot of regulatory rigour in this space. Hopefully, this answers your questions, which covers essentially the use case, the benefits, and also the excitement and hype about tokenised money.

Laura: Yes, there definitely is a lot. John, do you see that in your world, with asset and wealth management? How does this marry up with the investments, tokenised money, tokenised investments?

John: Ultimately, things aren't going to work as effectively as they could, unless we have tokenised money as the glue, I suppose, holding capital markets and the buy-side together, and part of the ambition that we have at the investment association is to ensure that the investment funds are at the heart of that innovation, and that asset managers are able to interact effectively with the capital markets. As I mentioned earlier, the product, the relevant products that asset managers create, using cash or near cash, are able to be integrated effectively in the new digital online capital markets that we envisage coming down the track very soon.

Laura: Yes. So it's all linked together.

John: Absolutely. We can't have one without the other, and the number of different aspects that we've already mentioned are progressing at a natural rate which is really good to see.

Laura: Yes, that's a good bridge to bring Matt back from the US. Matt, you work a lot in the space with various PwC clients. What are the biggest success stories you've seen in the market so far?

Matt: I just want to highlight one thing, to go back to what John and Shearin were saying, the biggest thing about tokenisation is that it's a foundational capability to unlock other capabilities and use cases. It's really all about the ecosystem and how all of this works together, to John's last point there, you can't have one without the other, and that's what unlocking cash and the deposit tokens Shearin was talking about, it unlocks this ability for banks to do so much more, by enabling cash to move more quickly. I think to your question, one of the things that we often see is that when folks focus on what their clients desire and their customers are demanding from them, and focus on those use cases, they often get to ROI more quickly. So it's a benefit for them, but they also have their first customer before they even start. What we often suggest with innovation and these emerging technologies is, focus on small wins that meet your client demands, and you'll be able to take that money, reinvest it. What we're seeing work is when folks approach this holistically, so they don't just focus on the business case, but they also look at bringing risk and IA and all these other functions that often get left behind to the table upfront. So they build their use case holistically and think about all these components. It gives you a broader, more comprehensive use case in the end, and you don't get stuck at the end, thinking about risk management, and a lot of the components that people often forget when they're trying to grow quickly. Obviously, financial institutions which we're seeing enter the space quite a bit right now, have always done that, and so that's benefiting them. But now the digital asset natives are also quickly learning to take the good from financial services and just improve upon it, because they can move faster and quicker because they don't have some of the bureaucracy that comes with a large financial institution.

Laura: Yes, you mentioned some of the challenges there and the roadmap that you've suggested to your clients before, but going back to the challenges, what are the biggest operational difficulties in tokenisation at the moment? Why aren't all these best use cases implemented everywhere today?

Matt: Yes, I mean, part of it is a supply and demand issue, where there's no shortage of folks looking to tokenise something, but the demand isn't always there because I don't think we, as an industry have done a good job of explaining the benefits to the demand side. In certain instances, folks just aren't ready to take on the tokenised asset. While a lot of the operational components of settlement or even just the accounting and tax components of it, a lot of them are similar. There are nuances that are different, that require some thought. Obviously, we probably want to avoid the topic of regulation here, but it is a challenge for folks. There isn't clear guidance everywhere and, again, a lot of companies operate globally, and global regulation is not harmonised on this topic at this point. So what works in one region may not work in another, and folks are looking to substituted compliance, which isn't always defined at this point. You have different thresholds across the globe, which can also be operationally challenging to run an efficient and effective business. I'm very hopeful. I think what's happened in Europe with MiCA has been a great step forward. US is starting to catch up. It's obviously become a political issue here and you're now seeing both the government and regulators start to evaluate it in a better manner, and then obviously, in Asia, they're very collaborative over there, especially in Singapore where you're seeing MAS work with the industry to really understand the topic and push forward use cases, with a lot of the large banks and other asset managers, and even the digital asset native companies. I'm hopeful for what's to come, and I do think these challenges can be overcome. We survived '22, and it's improved the industry for the large part, and so I think there's a great future ahead.

Laura: Thank you, Matt. That's a nice gateway into regulation now. So how are the regulatory frameworks developing in the UK and globally? If we start with John, again, on investments.

John: Things are evolving nicely, and evolution is probably the right word, because, obviously although there's significant transformational power in DLT and tokenisation, clearly a revolution overnight would not be in anyone's interest. So a slow and steady evolution is happening. Towards the end of last year, the FCA confirmed that for investment funds issuing tokens to represent ownership in the fund is permitted. That was the conclusion of a collaborative piece of work between the industry, Treasury, and the FCA in the UK, and that confirmed that the existing suite of rules was able to handle the DLT administration of a fund essentially. The FCA has also been very open about how it is keen to see that evolve over time. For example, when we get to the situation of having wholesale CBDC, the FCA will keep that under review, to understand the impact on investment funds and potentially change rules if necessary in order to facilitate that. When we look at assets, again, things are moving. The first UK FMI sandbox has been announced. That's currently in design stage and will be open later this year. That's designed to ensure that the assets that I mentioned earlier, so company stocks, bonds, other types of assets can be tokenised, and the concept of a digital CSD will be enabled within the UK. That's expected to open later this year, will run for a number of years, and enable a very clear and effective run-off into a live production environment. From those perspectives, things are moving. Things are moving in the right direction.

Laura: How about tokenised money then?

Shearin: Yes. Before we quickly talk about that, I actually want to echo what Matt was saying earlier about the ecosystem, and what John was talking about as well because we have been in quite a lot of round-tables with the buy-side and sell-side, with regulatory presence as well, and also with the legislators in the room, both in the UK and Europe and also globally, understanding the supply and demand of this. Understandably, everybody is excited and enlightened by the power of DLT, as John was saying, but the reality of financial services is it's set up in a way that what I call a progressive enhancement is more warranted than knocking your buildings down and building from scratch. This is just to echo John's point earlier, why it's in everybody's interest because there is a financial stability concern in this by building all the pipelines from scratch, but also there's a huge amount of cost to let rip up the existing systems which, in many, many aspects, are working very well. Therefore, innovation is to unlock incremental innovation or innovative power to speed up certain elements of the existing processes, which could be improved, but not to change all the pipelines. It's against that backdrop that we're seeing, for instance, there is demand in the primary side, but until there's a sufficient secondary market to catch up, the whole ecosystem hasn't quite fulfilled it's full circle feedback loop yet.

In many ways, regulation is very much telling the same story, because what we have seen in the UK and globally, is incremental thought leadership, as you call it, to essentially create this level playing field between banks and virtual assets or crypto-assets service providers. Especially, post-FTX, and a catapult of, I think, crypto scares, as we call it, it becomes ever-so evidently clear that financial services requires consistency across the board. From that perspective, the sentiment is clear, but the execution is very important. To answer the question about tokenised money, so I'm going to go reverse order. In the private money sense, this is probably where the regulation has the most financial stability concerns. We've seen, definitely, a double-down on understanding, analysing, processing, segmenting, and creating further taxonomy in something like the stablecoin, or a stablecoin like tokens. Ultimately, what the regulators want to understand is the systemic impacts of stablecoins. Therefore, they are quite often split into systemic stablecoins versus non-systemic stablecoins by the nature of the issuers and design feature itself, and also the assets that they are backed by. This automatically means ancillary services are caught in such regulatory framework as well. If we're thinking about from payment to settlement, from, essentially, the back-end mechanism to tracking and monitoring and reporting, all of that is essentially caught in this, I think, the fastest moving lane of the digital money or tokenised money, as you speak.

However, if you then move to tokenised deposit, I think Matt's also right in saying that globally different jurisdictions have different understandings as such. Naturally, a lot of us in the industry would like to encourage, our counterparts in central banks and regulators to see that a tokenised deposit is a digital format of a traditional asset, which I think is well-understood. But what the regulator is trying to understand is that a digital format of something, does that pose the same risk systemically, financially or non-financially to the financial system as of today? Which we totally understand why they need a bit more time to reach that conclusion. I think part of the private and public dialogues in this space is to help, based on the product that the firms are investing or developing is to help regulators and central bankers and public services to understand, as well as the customer or clients' angle as well, to understand what incremental value these unlock and what are the key design features that can create that reassurance on the digital chain as we call it, as a concept.

But then, moving back to the CBDC we talked about earlier, regulatory framework about CBDC is very interesting because it goes hand-in-hand with the regulatory investment and development of the product on its own. The reality is, it is probably likely that either retail of wholesale CBDC is accepted by central banks as just a digital format of the current legal tender. However, execution is very important and a lot of exploration and the nature of what and how to regulate such access comes within the public and private forums and such POCs and experimentations, so to speak. I would say we probably would not see a legislative framework so different from today's e-money, from that perspective, but what we will see is an understanding of what does either retail or host CBDCs truly unlocks and how does the access to, for instance, central banks' balance sheet look like in the regulated space? That will be a very interesting space to watch.

Laura: Definitely, you mention public, private discussions. Do you think they are working well, and if not, which party should improve that?

John: Well, I suppose the best example that was alluded to earlier is the Project Guardian in Singapore, where the industry has worked very effectively with the regulator. We've been really pleased recently to see that that's expanded and brought in a number of other international regulators, which will make sure that lessons and learned and will also hopefully mean that there'll be international alignment, consistency and avoid regulatory arbitrage between different jurisdictions, where firms need to make changing investment decisions on a periodic basis, depending on which jurisdiction, as different types of approaches. What we're trying to do at the Investment Association is also try and influence the debate around how regulation takes place, by making sure that the buy side's voice is heard when regulations are designed and also when the sell side produce their product. For example, corporate bonds, we would for instance, like to see a UK sovereign debt instrument issued on DLT, which might be a product of the digital security sandbox that we mentioned earlier, and having the buy-side voice at the table, with the issuers, with the regulators and the governments and the policy-makers, I think is a really important piece as we try to navigate what is a complex area.

Shearin: Following, what John said, I would say it's very encouraging and also very positive to see such strength in the collaboration between the public and private side. Further to Project Guardian and now Global Layer One, which is launched by MAS, I think, very recently. We're also part of-, well, part of, I think, is a very, very broad word, 'We will aspire to be part of,' is probably the right word, to be Project Agora, which was launched by BIS fairly recently. The reason we say, 'We aspire to,' because there's so much great hype about this, it's one of the biggest, most ambitious BIS innovation projects to-date. It involves a lot of central banks across all key jurisdictions, geographical locations, from EMEA, LATAM as well as APAC, both from both developing and developed economies, along with a great call for participation for the private sector, to be able to address and hopefully experiment and establish, at a minimum, ideally some protocols about how does that initiative look like in this blended world, when there will be a co-existence of private and public solutions. This is a great, exciting, time to be talking about their projects. I think, concurrently into that, Bank of England has always been very open on public and private initiatives. We've seen this, for instance, played out in the AI PPF in the past, so we were very hopeful with that, over time, Bank of England would also bring that across in their asset space as well. In many, many ways, the digital sandbox design itself actually enables this dialogue to happen more frequently, and the taskforce that we're part of have been very lucky to get a lot of face-time with Bank of England, to be able to understand, for instance, how to support in the international competitiveness, as well as innovative objectives, whilst not compromising the financial stability aspect to that.

In many ways, I would also say Europe is also catching up, because if we look at MiCA, like I said in the beginning, MiCA is one of the world's first framework that went live for digital assets in this space, it covers, obviously, a lot. Predominantly, one would argue, MiCA has a lot of focus on stablecoins, as well as the unbacked cryptos in that sense, but that doesn't mean this is the core focus. It's just that MiCA in many ways, opened up dialogue, generate this innovative collaboration between public and private sectors because, again, a lot of Level 2 texts will still be worked on that moment, which requires a lot of interpretative guidance from both sides, to converge on a good landing spot towards the end as when Level 2 is finally finalised. We see many, many good examples in this space about, essentially, both sides are very motivated to make it work, but naturally, proof is in the pudding? So yes, I think regulations create a fostering environment for traditional players/incumbents, as well as the challengers, to want to contemplate a play in this field. The reality is, I think, going back to a lot of the work John and IA have been doing, which is about the demand. The demand in the investment side is by institutional clients or institutional investors, and the retail side is about retail investors as well.

The demand is heavily linked with education, as well as a lot of other elements, so to speak, for instance, like, tax, returns, on the volatility etc. One can argue that a lot of the ingredients are there but how do we then cook it together to make it successful, requires expertise, culinary expertise from great chefs. A lot of what we're doing right now is to ensure that the ingredients are there by doing our day-job throughout but at the same time, we would like those catalysts to all come together to help drive that demand.

Laura: Thank you. Thank you, everyone, we're almost out of time. I've got one final question, very briefly, from each of you. Let's say, in the next 12 months or 24 months, what are the biggest near-future trends which the FS institutions should prepare for in this space?

Shearin: I think 2 to 24 months, is long and short. The reason I say it's long and short is, in the DLT space, right, a lot of products can emerge as contenders, and the same time, financial services, as a whole, as we talked about before, has a lot of plumbing that works quite well today. In the one-to two-year window, we'll probably see accelerated automation by the use of DLT, more than likely in the middle and back office than it is on the primary demands, simply because one would like to think that middle and back office efficiency needs to be achieved before a great connector is in place to connect the primary and secondary market. I would watch out for those in the middle and back office initiatives or related initiatives, which help accelerate essentially the connectivity between the buy-side and sell-side.

Laura: Thank you. What about you, John?

John: The technology is there. It's ready, we've spoken about it for many years, probably a decade or so, but it hasn't quite reached that tipping point yet, and I think there are probably two reasons for that and things to look out for in that time period. Firstly is the education piece, which you just mention there. I think, particularly within asset managers, there's still a job of work to be done to almost reassure actually senior leaders about the benefits and certainly mitigate some of the risks that could be apparent within the use of the DLT and tokenisation. There is still need for greater knowledge-sharing, experience and know-how amongst the industry. The second thing, which is slightly less certain, is around market conditions. I mentioned the fact that MMF tokenisation took off because of the higher than recent experience interest rates, we've seen market volatility over the summer. We've got geopolitical risks coming at us from all directions. I wonder if there could be a new suite of products that could cater for those type of scenarios that might, as of now, be unexpected, that could come into the market, where this technology could really help but otherwise, I think the certainty is that we will see the greater adoption of tokenisation within funds and by funds within the assets and the sandboxes that are set up to facilitate that. As we mentioned earlier, with the digital money piece really accelerating, once everything comes together, the future's really bright for tokenisation.

Laura: Matt, anything to add from the US?

Matt: I think I'd agree with everything they just said. I'd also highlight on Shearin’s point around productivity. I think you're going to see the convergence of things like AI and blockchain or DLT technology where they can work in harmony together to multiply the effect of the different technologies. And then I'd also add that over the next 12 to 24 months, you'll see a lot more collaboration across traditional finance and digital finance. I was going to say this earlier, but all the different global sandboxes and POCs or collaborations between the government and the industry have been great, but over the next 12 to 24 months, you'll see a sort of meeting in the middle of TradFi and DeFi. And when I say DeFi, I mean the larger digital finance rather than just DeFi as it's known today. I think you'll see a new DeFi emerge. But, again, I'm very optimistic for the next 12 to 24 months and echo what John was saying, I think tokenisation leads the way. I know some people are getting a little bit tired of hearing about tokenisation because we haven't seen the value unlock yet but I think that does happen over the next 12 to 24 months.

Laura: I was going to end, Matt, with a question about market cap. Do you want to estimate where it could be in 24 months?

Matt: I will take the safer route and just say higher than it is today, and I note that we're recording this the day after we saw a significant decrease in market cap, so I feel confident in saying that it'll be higher in the future than it is today.

Laura: Thank you, I'll take that. That's a wrap. So it will be exciting to see how the space develops over the next few years and beyond but thank you so much for coming and thank you, Matt, for joining us from the US, and thank you, the listeners, I hope this was interesting for you as well, and as always, please subscribe to our future episodes and rate and review the series, it really helps our listeners to find us. If you'd like to hear more from us on risk and regulation, please look out for our regular publications on our website, which we'll link into the show notes, and Tessa Norman will be back next month with our next episode. Thank you.