Tokenization saves cost.
Does tokenization really save cost?
Under what conditions does tokenization make sense?
Most readers are likely to be familiar with the first of the three lines from above. Indeed it is the most frequently used marketing narrative in the entire tokenization history.
However a builder in the space or an Insiders Club member may find line 2 and 3 to be more representative or reflective of the reality on the ground.
Given my GTM advisory interactions of the late, I feel there is a dire need to clarify the most frequently uttered line in the space so more people understand the reality of the market.
Let’s work through these questions in turn.
Tokenization Saves Cost
First let’s complete the above sentence. Most of the time you will hear the following, “tokenization saves cost by disintermediating the multiple intermediaries involved”.
There is nothing technically wrong with that line except it is not what is happening in reality. While blockchain does have the technological capabilities necessary to make much of the manual data recording, transaction settlement and reconciliation processes redundant, these technological capabilities face a reality hurdle rooted in the decade-old, if not century-old, legal, regulatory and organisational practices and systems.
Just because accounting software has the technological capability to help a business do its bookkeeping, it doesn’t mean the software would get mass adoption by selling its technological capabilities to a 15th century audience.
At that time, the cost of educating business owners, court officials and installing computers across the continent would be a lot higher than the cost of headaches and slow bookkeeping.
In other words, just because tokenization can disintermediate intermediaries, it doesn’t mean the intermediaries will be made useless suddenly. There are many structural moats built up around these businesses. And that brings us to line 2.
Does tokenization really save cost?
The part of the conversation that is often omitted from the discussion is that currently the only legally recognized book of records on securities is one that is held in a CSD (central securities depository) and digital assets’ blockchain records are NOT legally recognized as source of truth.
This means ALL digital asset securities transactions must use the existing value chain and follow the existing securities practices. In short disintermiedation isn’t on the cards.
Below is a graphic taken from KPMG, showing the typical tokenization process. Notice the names in the red box (added by yours truly).
These are familiar names to people working in asset management or fund management. They are the usual cast of auxiliary service providers involved in securities transactions.
In a typical tokenization structure, the SPV set up to purchase assets needs to have its own custody, fund admin, collateral agent in addition to its own legal and back-office support.
These are in theory the redundant intermediaries tokenization is supposed to displace from the value chain. But of course, if you try to run a SPV without them, you probably won’t be able to convince any serious capital allocators who expect these solutions providers as table stakes. Also if you try to run a SPV without any of these 3rd party intermediaries, you will probably end up in jail.
So this is where the disintermediation leading to cost saving narrative falls apart. Not only are there no disintermediation, there are two sets of operational and admin costs. One associated with the underlying assets the tokenization SPV is purchasing and another with the running of the SPV itself.
And that brings us to the most important question of all. Under what condition does tokenization save cost?
Under what conditions does tokenization make sense?
The obvious answer is when there are no longer 2 sets of bookkeeping required or when onchain data can become a legally recognized source of truth.
In order to get there, we first need legislation passed in the Congress or Parliaments, regulations to be updated and businesses change their entire technology stack. While this would certainly eliminate a % of the cost structure, it is a pretty tall order (big cost) to get there in the immediate future.
And even if we do get there, there is a limit on the ceiling of that cost savings. For example, in traditional equity index ETFs the cost is say anything between 5bps to 30bps depending on the investor. The most you can save is that entire 5bps to 30bps. While not trivial, it is hardly a game changer.
So how about we switch it around. Instead of focusing on cost reduction, we figure out how to get more out of the same asset when it’s tokenized.
Take tokenized US TBills or MMF for example. In traditional markets, investors bear a low cost and hold them mostly for cash management or yield collection. It is hardly exciting to reduce 2bps fee to 1bps. Though this will often be marketed as a 50% fee reduction.
By contrast, in tokenized markets, the assets become much more useful. Tokenized MMF and TBills have far more utilities in a more accessible fashion to investors. Tokenized MMF can be leveraged for collateral management in a variety of derivatives markets, including intraday repo and perpetual swaps.
Sure no one likes to pay 50bps vs 10bps in fees, but if by paying 50bps in fees it unlocks a 8% opportunity, the value prop of tokenization suddenly is a lot more attractive.
So what does this all mean?
It means tokenization does NOT automatically lead to cost savings. In fact, it often leads to HIGHER cost structure for investors.
While the power of the technology can accommodate elimination of various manual processes and the intermediaries who carry them out, the current legal, regulatory and organizational structure make the cost of such elimination unappealing.
Instead, a much more attractive value prop is to leverage blockchain’s composability and interoperability to unlock more opportunities which are likely to far outweigh the extra costs involved.
While the precise setup required for each asset to reach this stage is different for different asset classes and geographies, the business case for such value unlock is often universally compelling. And I am encouraged to see more and more interesting use cases emerging.
Want to learn what these use cases are? Consider becoming an Insider Club subscriber or book one the limited GTM advisory calls today.
Disclaimer: This content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.