S&P explores how tokenization is disrupting financial industry

Tokenization offers several benefits including the fractioning of assets

  
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The COVID-19 pandemic has boosted investor interest in tokenization, according to S&P Global Ratings.

In a recent report titled "The Future Of Banking: Building A Token Collection," the ratings agency explored the potential use cases for tokenization and its effects on the financial industry.

Tokenization is the process of creating one or several digital representations of a physical or non-physical asset (including financial assets) and managing it on distributed ledgers, the report said.

As governments encouraged the public to stay at home to limit the spread of the virus, banks opted for digital channels, highlighting the benefits of digitalizing the financial services industry.

Tokenization allows the exchange of assets in an efficient manner, higher transaction security and increasing transparency of ownership.

"In our view, tokenization offers several benefits including the fractioning of assets, which enhances their liquidity and opens the door for investors or borrowers that may have been excluded from existing options," Mohamed Damak, credit analyst at S&P said.

“In addition, we believe the technology could allow new players to enter the market, further challenging incumbent banks' and asset managers' revenue,” Damak said.

Due to the new digital normal of high-speed transformation, banks are now expected to pursue new products or collaborations much faster than before the pandemic.

Tokenization challenges

The industry faces many hurdles before tokenization could become a usable route for fund raising.

S&P stated the below five points that need to be crossed for success:

- A regulatory and legal framework that recognizes the rights of token holders

- The right technology: distributed ledger technology still faces challenges like network stability, scalability, settlement finality, interoperability, and immunity to cyber risks. These challenges reduce the attractiveness of tokens to end users according to S&P.

- Anti-money laundering and counter financing of terrorism risks could emerge if anonymous dealing is allowed

- A central entity needs enough credibility to act as custodian for the assets

- If ownership of assets is divided among several token holders, potential restructuring might be considered more complex

The report noted that tokenization is expected to have a limited effect on financial institutions’ profitability in the next couple of years. The largest impacts will be in SME/corporate banking, asset management and clearing/settlement business.

“Whether tokenization will replace some financial products remains to be seen, but it may have positive effects on specific business lines, such as capital raising exercises, SME financing, and liquefaction of illiquid assets,” Damak said.

(Reporting by Gerard Aoun, editing by Seban Scaria)

(gerard.aoun@refinitiv.com)

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