The hype for tokenization in secondary markets has reached a boiling point. Last year, Moody's called the concept — which describes converting ownership of assets into blockchain-stored tokens — a "revolutionary process" for alternative assets markets. Deloitte added that it could "reshape private asset funds."
So why hasn’t it boiled over?
Market observers have been trumpeting tokenization since as early as 2017, but that still hasn't translated to widespread adoption. Institutional and retail investors alike are excited at the potential impact of tokenization on secondary markets. However, before it goes from “great idea” to “game-changer”, there are serious regulatory and technological hurdles to overcome.
We’ll break down what’s holding the concept back, but first, let’s look at what tokenization of the secondary markets might actually look like.
Blockchain technology offers a transparent and timely way to store cryptocurrency and other digital ownership tokens. The blockchain is decentralized, which basically means transactions on it don’t need middlemen. As such, it can streamline current processes, reduce costs, and increase liquidity.
A widely-known example of “digital ownership tokens” would be NFTs, which surged to popularity in 2021 as a blockchain-based certificate of ownership and proof of provenance in the digital art market. However, the tokenization use case extends far beyond cartoon ape JPEGs.
Investment banks like BlackRock, Goldman Sachs, and HSBC are already tokenizing funds and bonds. Tokenization uses smart contracts, or programmable code on the blockchain, to automatically update ownership records when they are bought and sold. That means the potential for instantaneous settlements and reduced complexity in the secondary markets.
McKinsey estimates the total market cap of tokenized assets could reach $2 trillion by 2030 — and that doesn't include crypto, stablecoins, or CBDCs. As tokenization grows, ownership of all kinds of assets could move to the blockchain.
These could include public secondary assets like mutual funds, ETFs, and securities, as well as private secondaries, such as pre-IPO stock. In fact, McKinsey sees $1 billion potential in private secondary markets, and another $1 billion in alternative assets.
Market revolutions usually don't happen overnight, and indeed, there are several key hurdles in the way of widespread tokenization.
One of the biggest: regulation and compliance. Regulations vary by jurisdiction, and emerging tokenization projects need to meet strict securities, tax, and property laws. Tokens would also need to comply with regulations in each jurisdiction they are created, bought, and sold.
On top of that, blockchain technology is still relatively untested, not to mention broad. In other words, there’s not just a blockchain, but a number of blockchains that run smart contracts, each with different security protocols, transaction speeds, and fees. Few institutional actors have fully explored the ins and outs of each, and interoperability — the way the blockchains talk to each other — is still evolving. So it’s not necessarily a question of “when” to start, but rather, “where”.
Another issue is pricing. Tokenization offers a way to trade non-traditional assets, but how do you determine their value?
Fortunately, this particular problem is well on its way to being solved. Augment* enables better price discovery for private assets by connecting buyers and sellers of shares in pre-IPO companies. Augment's private secondary marketplace lets qualified investors track historical prices of private companies, providing a solid basis for valuations and deal-making.
Finally, we reach what McKinsey calls the "cold start problem". It's a Catch-22 when innovating new products: you need significant liquidity and demand for investors and institutions to see value in tokenization. But that liquidity won't materialize until people take the plunge and fully embrace the new technology.
The evolution of new technologies is never straightforward. For example, today we think of railroads as a bedrock of American infrastructure, but it took decades to lay the tracks and perfect the technology.
Tokenization has huge potential, particularly in private secondary markets, but the foundations are still wobbly. Clearer regulation, improved interoperability, and higher investor demand are all necessary before tokenization can fully take off.
*Securities transactions are executed on Augment Capital, LLC's ATS and offered through Augment Capital, LLC (member FINRA/SIPC).
Important Disclosures: Investing in private securities involves substantial risk, including the potential loss of principal. Private securities are typically illiquid, have limited pricing transparency, and often require longer holding periods. These investments are available exclusively to qualified accredited investors and offer no guarantee of returns. Additionally, past performance of private securities does not indicate or predict future results.