We’re thinking about tokenization all wrong

No more physical certificates, no more middlemen. Just a few clicks, and you’re a shareholder. This is the promise of tokenization, giving us new ways to transact, store and distribute wealth.

Bank of China International (BOCI) recently became the first Chinese financial institution to launch a tokenized security — issuing 200 million yuan in fully digital structured notes. This is a significant step in bridging traditional securities and crypto. And this, it appears, is a mere taste of what’s to come.

The tokenization market is poised to explode in the coming years. According to financial giants like Citi and research firms like Bernstein, the market could be worth up to $5 trillion by 2030.

But many institutions are still failing to grasp its full potential. Yes, you can digitize certain assets and put them on the blockchain. And yes, this may yield some boost in efficiency. But that’s not enough.

Tokenization should be more than just creating digital twins of real-world assets. It also needs to be more about capturing and standardizing all financial aspects of these assets — from their intrinsic value to their potential risks.

Current practices often neglect these dimensions, resulting in incomplete digital representations that fail to leverage the full potential of blockchain technology.

The pitfalls of current tokenization models

Current failures in tokenization are more a result of a lack of innovation than a lack of potential. Most platforms only digitize the underlying asset, but they neglect to include liabilities or cash flows associated with those assets.

In this context, cash flows describe the payment obligations of the parties: In other words, the expected inflows and outflows of money generated from the asset, like periodic payments from a bond or rents from a tokenized property. Liabilities, meanwhile, refer to any obligations or potential risks tied to the asset, such as debts or other obligations that could impact the asset’s value.

Despite their importance, these key aspects are often overlooked. As a result, you get an asset-backed token on a blockchain — but the terms and conditions are often attached as a PDF.

This requires human intervention to calculate cash flows, which is a major concern as it allows errors and discrepancies to creep in. A similar lack of transparency and verifiability around cash flows was one of the primary triggers of the 2008 banking crisis.

To avoid another such crisis, we must ensure liabilities and cash flows related to underlying assets are tokenized, machine-readable and machine-executable, not just the assets themselves.

Existing standards are critical to a tokenized future

The typical tokenized financial product today is essentially a digital representation of a document — a contract turned into a token. The true innovation, however, is in developing “Smart Financial Contracts,” which signifies an interplay between a well-established standardization framework and blockchain technology.

To start, implementing open banking standards which allow banks to share their data in a secure, standardized way would make it easier to track liabilities and cash flow across different institutions.

By applying these standards to Smart Financial Contracts, we can ensure that details of the tokenized financial asset and all financial obligations are machine-readable and executable.

Using such smart financial contracts will lead to higher information quality and transparency. Due to their machine-readable and executable nature, they can also lead to greater efficiency in price discovery, analysis, trading and securitization. As a result, company-wide risk management also becomes simpler and more effective.

Given that the entire system would be transparent and machine-auditable, systemic risk management becomes a realistic possibility. This makes it easy to stress test for different market scenarios, offering a clear view of potential vulnerabilities and helping us prevent future financial crises.

Smart financial contracts go beyond simply being technologically innovative. They are about designing a more secure, stable and efficient financial asset tokenization ecosystem where all stakeholders can transact with confidence.

With blockchain-based financial infrastructure, most of the management or transfer of these tokenized instruments can be done automatically on-chain. This reduces the need for human oversight and the risk of fraud or error.

The ACTUS (Algorithmic Contract Types Unified Standards) is a grouping of open standards to represent financial contracts. ACTUS is already helping standardize tokenization for smart financial contracts. Banks, regulators, accountants and tech firms can use the framework to analyze and report on financial stability and define terminology, algorithms and data models used to describe cash flow patterns.

Designed to represent a wide range of financial instruments, ACTUS improves regulatory reporting across all sectors and streamlines financial operations at the enterprise level. It serves as a foundation not only for traditional finance instruments, but also for the growth and adoption of DeFi by building new products based on a widely accepted financial structure. When built into blockchain-based smart contracts, ACTUS could enable a mutually beneficial relationship between distributed ledger technology (DLT) and tokenization.

The primary objective of ACTUS in standardizing tokenization is to provide an algorithmic representation of financial agreements, cash flows and the current and future states of risk factors (market risk, counterparty risk, and behavioral risk) that’s intelligent, machine-readable and machine-executable.

With a standardized language and taxonomy in place, smart financial contracts can be easily incorporated into existing banking and financial infrastructure. This taxonomy needs to define the terms, conditions and parameters of each financial smart contract type and cover a wide range of financial instruments; This can ensure consistency and interoperability in the tokenized ecosystem.

The promise of blockchain technology

Blockchain is undoubtedly a game-changer and the most disruptive innovation in finance since the advent of computers in the banks in the 1960s. But innovation in payments is not the same as innovation in finance, and that’s where the potential of this groundbreaking technology lies.

Blockchain could redefine finance, making it transparent, efficient and low-cost. Funds could be verified without custodians, and cash flows could be demonstrated without audits. The logic of the financial contract can be embedded in the token making pricing discovery far more efficient.

SME lending could also be streamlined if we conducted proper due diligence — shifting the focus from paperwork to knowing the borrower. With securitization, credit was made accessible to more businesses.

But tokenization must be standardized, with the cash flow logic embedded in a machine-readable and machine-executable way. Otherwise, we’re just replicating the old system. After all, blockchain isn’t just about making payments easier — it’s about transforming finance as a whole.