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Tokenize Stocks, Bonds, Funds, But Proceed With Care

Replacing a 700-year-old system of recording asset ownership with digital chips comes with its own set of risks.

(Bloomberg Opinion) -- Earlier this year, Singapore jailed three Chinese nationals for putting strong glue on their palms to steal casino chips from other gamblers. Substitute “chips” with digital tokens, and “glue” with deceptive computer code, and you could be talking about theft of bonds, equities, mutual funds or any other ownership interest that can have a parallel life on the blockchain. 

Turning financial securities into cryptographic representations that can be bought and sold in tiny fractions of what is possible today opens up a new avenue for the masses to accumulate wealth. Using blockchains to democratize finance is an idea that Asia, in particular, has fallen in love with.

Last week, the Singapore central bank announced five new pilots — in partnership with Ant Group Co., Franklin Templeton, JPMorgan Chase & Co. and other private-sector players — to explore different aspects of tokenization. Hong Kong’s Securities and Futures Commission issued a circular this month for those planning to bring tokenized digital assets to the market.

For both large institutions and financial hubs like Hong Kong and Singapore, it makes sense to build the shiny new rails on which much of tomorrow’s money may move. Transactions will be a lot faster, with fewer intermediaries and at a lower cost. Citigroup Inc. has estimated issuance of tokenized securities at between $4 trillion to $5 trillion by 2030. But enforceability of property rights in a public blockchain — a decentralized network where nobody knows or trusts anyone — may emerge as a thorny issue.

The conventional way of recording asset ownership goes back at least 700 years. In 1494, Luca Pacioli wrote his treatise on double-entry bookkeeping, a system that he claimed had by then been in vogue in Venice for a couple of centuries. The technique relies on crediting one account to reflect what is acquired, such as real estate, and debiting another account, like bank deposits, to show how the increase came about.

The newly created assets and liabilities of investors and issuers get translated into claims of their financial institutions on one another. If only a single currency is involved, the IOUs are settled with absolute finality on the balance sheet of the national monetary authority where these banks have accounts.

Digital tokens will shake up this entire edifice. Stablecoins, or crypto assets that target a fixed monetary value, have been described by US Securities and Exchange Commission Chair Gary Gensler as “the poker chip in the casino.” Tokenized securities will be somewhat  different. Their values will fluctuate based on demand and supply, and they will come with built-in software that directs the issuer to pay interest or dividends to investors.

But just like chips represent cash, tokens will stand in for securities, delinked from accounts. Value will shift from player to player, with distributed ledger technology, or DLT, keeping track of fund movement. But what is the legal finality of these transactions? If a dispute crops up, will blockchains be recognized by the courts as final books of records, an ownership ledger? One can’t be very sure.

Asset manager Schroders Plc and global funds network Calastone are running a pilot under the Monetary Authority of Singapore’s Project Guardian that will seek to “apply the security attributes inherent in DLT to evolve traditional forms of bookkeeping and demonstrate proof of ownership through tokens.”

Authorities won’t be in a hurry to trust a layer of technology as the final basis for ownership, not when a ransomware attack can force Industrial & Commercial Bank of China Ltd., the world’s largest bank, to settle trades with counterparties via messengers carrying USB sticks

Hong Kong’s circular is clear: The regulator would treat the token as only a wrapper around something that is valuable. The usual rules will apply. Intermediaries will conduct due diligence on issuers of tokenized securities and their technology vendors, make disclosures to the public, and take additional precautions before offering tokens on public networks that don’t have a central authority and where anyone can participate.

This is dangerous territory. According to one industry researcher, fraudsters deployed more than 200,000 scam tokens between September 2020 and November last year. Why are institutions so keen, then, to back an idea that takes them away from the time-tested system of recording property rights? Especially when it risks exposing them (and their clients) to new problems such as fraudulent computer code embedded in self-executing smart contracts? A possible answer: Satoshi Nakamoto.

The pseudonymous creator of Bitcoin may have failed in inventing a better form of money, but a payment system based on cryptographic proof, the technology he sketched out in his 2008 paper, is ready. The public sector, which is wary of cryptocurrencies, wants to be in control of this new architecture with central bank digital currencies, or CBDCs. That could potentially erode the importance of private-sector intermediaries, unless banks and asset managers take the lead and insert themselves into the equation.

The custodial institutions’ best bet is to hope that courts will be reluctant to come up with a “Law of The Horse.” That dictum was made famous by a US judge in the 1990s who wanted to stress the point that every innovation (cyberspace, back then) does not require a new set of rules. Tort laws are perfectly capable of taking care of people getting kicked by someone else’s horse; there are other legal codes to deal with prize money from racing or the standard of veterinarian care.

Ditto for tokens. When disputes arise — as they inevitably will — courts and regulators would throw away the cryptography, and go back to the underlying securities. Their ownership rights would be legally honored not much differently than was the custom 700 years ago in Venice. The same institutions that Nakamoto was going to make extinct with his push for decentralization of finance would remain in charge, albeit they would be using the new technology to spread the reach of their products.

Still, it’s one thing for institutions to exchange value among themselves in private digital networks supervised by a central authority, but intermediaries selling tokenized stocks, bonds or funds to the public in an open marketplace where anyone can participate anonymously? That could get messy. Even if you catch swindlers with chips glued to their hands, it may be hard to return stolen property to its rightful owners if it has changed hands at five other tables — or outside the casino, for that matter. Regulators need to temper their optimism, and make haste slowly.

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To contact the author of this story:
Andy Mukherjee at [email protected]

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