How COVID-19 and tokenization can transform the financial sector
By  Anthony Butler

Talking about COVID-19 and the “new normal” has become a cliché and, in some cases, has assumed an air of defeatism. While the world assesses the overwhelmingly economic impact of COVID-19, it is important to note that the pandemic has also acted as a catalyst for positive change, such as the shift towards digitization, cashless payments or ecommerce, which in the long run may benefit an integral part of the economy: Small and Medium-sized Enterprises (SMEs).

In the short run, however, SMEs face significant challenges; with many of these related to access to liquidity and cash flow. In this economic climate, it’s proving challenging for SMEs to access lending facilities. For this reason, we have seen multiple central banks in the Middle East take bold steps to inject liquidity into the sector and a range of government measures focused on supporting SMEs.

However, as we consider a post-COVID world and the particular challenges we are facing today, it is clear that it represents a significant opportunity to do things better: to reimagine and rewire capital markets to address some of the systemic challenges. How should we seek to create alternative mechanisms for SMEs to get access to capital and look at how advances in technology can make more effective and trustworthy financial systems?

“Tokenization” will play an important role. Taking advantage of distributed ledger technologies, such as blockchains, an asset can be tokenized; with ownership of each unit of that asset represented digitally on a single shared ledger that all participants in a market or financial system can view as a single source of truth. These tokens could be fungible or non-fungible; and, in the case of fungibles, could be a digital representation of a share in an physical asset, such as real estate, art work, or a share in a company; or could be a digital instrument created for general payment, such as Central Bank Digital Currencies.

Tokenization can provide a mechanism for people, firms, or even governments to get access to additional sources of liquidity as an alternative to traditional forms of bank lending. This could be through tokenization of shares in an enterprise or it could be by tokenization of accounts receivable and accounts payable obligations. Imagine, for example, a firm that provides services to a number of clients and has negotiated 60 or 90 day payment terms. Rather than wait for payment to arrive according to these terms, a firm could tokenize the receivables, have multiple financial institutions bid on providing working capital finance against it where they make immediate payment to the firm secured against the receivable. There are already some interesting startups exploring these concepts.

As regional governments will almost certainly accelerate their exploration of Public-Private Partnerships (PPPs) and alternative forms of fundraising, such as municipal bonds, there are a number of possible roles for tokenization to play in creating more efficient and effective fully digital securities and markets. For example, with social distancing having resulted in hotels and restaurants being closed, many municipalities are missing out on important sources of revenue from the various service charges and taxes. Tokenized general obligation bonds can be issued to raise funds that are then repaid by future tax revenues; tokenized revenue bonds can fund projects that generate revenues, such as roads in which tolls are collected for distribution.

In addition to opening up liquidity in traditionally illiquid asset classes, tokenization enables fractional ownership models; by making the units of ownership smaller, the cost of acquisition can be lowered. This has obvious benefits from a liquidity perspective but also in terms of accelerating national objectives around financial inclusion; with more people being able to afford to invest in asset classes that might previously have been outside of their reach for structural or economic reasons.

By digitizing these assets in this way, it becomes possible to improve the efficiency of the market and end to end processes – from issuance through to clearing and settlement. Looking at the structure of capital markets today, one will find there are a number of intermediaries that exist to create trust, remove friction, and address counter-party risks. By leveraging blockchain and other technologies, a tokenized securities market can avoid many of the risks that drive these inefficiencies and create markets that are more efficient and cost-effective.

Tokens also bring increased transparency to a market and a country’s financial system. All participants across the industry will have – via the immutable record stored on the distributed ledger – a view of the ownership of the assets, the history of these assets, and other attributes and aspects as relevant to ensuring a transparent marketplace.

In practice, a country or market that wanted to introduce a token-based approach to SME financing, municipal bonds, or the tokenization of any other asset class, could start relatively simply and quickly. The technology already exists and is being trialed by leading institutions and IBM is already working with its clients globally in this area.

SMEs, firms, or government agencies that want to raise capital by issuing tokens would work with a bank to create a digital representation of asset(s), such as the capital table for a firm; with the bank performing the role of ensuring that the asset that is to be represented by the token actually exists and all regulatory requirements are met.

Many of the regulatory rules associated with an asset could be programmed into the token itself. For example, preventing ownership to pass to people who don’t meet certain criteria will allow the financial sector to move to a compliant-by-design regulatory model.

Investors can view the issued tokens and purchase them. The broker or bank would fulfil the regulatory requirements around Know Your Customer (KYC) and as the network grows, more regional and international banks and brokers could join.

Once purchased, the title would move digitally to the buyer with no delayed settlement. Delivery of the token will be simultaneous to payment. This would represent a significant improvement over contemporary approaches both in terms of time and transaction cost.

As we think through what a post-COVID world looks like and how we can transform the challenges that we face into opportunities, governments and financial services organizations in the region should look at how the adoption of tokenization can support this recovery and enable a stronger, more innovative, and competitive system to emerge.

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