Global Digital Assets

Beyond Crypto: Tokenization

Authored By
Analyst Name Alkesh Shah
Analyst Email alkesh.shah@bofa.com
Analyst Designation Crypto&Digital Assets Strategy
Analyst Region BofAS
Analyst Phone +1 646 855 1556
Analyst Name Andrew Moss
Analyst Email andrew.moss@bofa.com
Analyst Designation Crypto&Digital Assets Strategy
Analyst Region BofAS
Analyst Phone +1 646 743 2178
Report Details
Primer 29 June 2023 Cryptocurrency & Digital Assets United States

Global Digital Assets

Beyond Crypto: Tokenization

Authored By
Analyst Name Alkesh Shah
Analyst Email alkesh.shah@bofa.com
Analyst Designation Crypto&Digital Assets Strategy
Analyst Region BofAS
Analyst Phone +1 646 855 1556
Analyst Name Andrew Moss
Analyst Email andrew.moss@bofa.com
Analyst Designation Crypto&Digital Assets Strategy
Analyst Region BofAS
Analyst Phone +1 646 743 2178
Report Details
Primer 29 June 2023 Cryptocurrency & Digital Assets United States
Glossary
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BofA Securities does and seeks to do business with issuers covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

 

Key takeaways
  • Traditional asset tokenization may reach $16tn+, transforming infrastructure and markets over the next 5-15 yrs
  • Tokenization enables efficiencies (faster, cheaper, simpler) and catalyzes a new generation of SaaS companies
  • DLT/BCT is more than just crypto trading; institutional and corporate use cases are in production

Global Digital Assets

DLT/BCT = Distributed Ledger Technology/Blockchain Technology
EIB = European Investment Bank
FI = Financial Institution
LC = Letter of Credit
Memecoins = tokens with no utility or intrinsic value that are used primarily for speculative trading
NFT = Non-Fungible Token
Repo = Repurchase Agreement
SaaS = Software-as-a-Service
TradFi = Traditional Finance
DMV = Department of motor vehicles

*Tokenization refers to the process of creating digital representations of traditional financial and non-financial assets that can be exchanged and tracked on distributed ledgers or blockchains.

**Network participants of public permissionless blockchains like Bitcoin and Ethereum are decentralized, which limits scalability and potential use cases. Network participants of private permissioned and customizable distributed ledgers are centralized consortiums of FIs or corporates, which expands scalability. Scalability and customization for regulatory requirements expands potential use cases well beyond speculative token trading.

 

Global Digital Assets

Tokenization - an infrastructure evolution

We are on the verge of an infrastructure evolution that may reshape how value is transferred, settled and stored across every industry. Tokenization is just one DLT/BCT application, but this one application may  transform financial and non-financial infrastructure and public and private financial markets over the next 5-15 years.* Disruptive innovations like the radio, television and email took 30 years to reach mainstream adoption. We expect a far shorter road for digital assets.

Efficiencies and reduced cost for every industry

FIs are increasingly leveraging DLT/BCT, smart contracts and tokenization to enable 24/7 real-time or customizable settlement; reduce credit risk; lower settlement, financing and operational costs; increase liquidity for previously illiquid assets; and allocate capital more efficiently. Corporates are leveraging the same technology to generate incremental revenues, automate manual processes, optimize supply chains, increase customer loyalty, offset contributions to climate change and combat counterfeiting. We expect DLT/BCT implementation to accelerate among FIs and corporates as the opportunity cost of uncaptured efficiencies increases.

TradFi and corporate adoption accelerates rapidly

FI and corporate tokenization use cases are diverse and expanding.  Citi issued a tokenized LC to decrease processing time to 3 hours from 5-10 days.  The EIB issued a tokenized 100mn bond with T+0 settlement. KKR and Hamilton Lane tokenized private equity funds to reduce minimum investments to $10k-$100k from $5mn. Broadridge's DLT platform settles $1.4tn a month of tokenized repos. Nike generated $93mn+ in secondary NFT sales by tokenizing royalty streams. Pharma companies are tokenizing supply chains to combat drug counterfeiting that results in a million deaths a year. The California DMV tokenized vehicle titles to reduce issuance to minutes from weeks.

Tokenized traditional assets aren't "crypto"

 Blockchains are a type of distributed ledger that allow open access to network data (public) and the network (permissionless). Memecoins receive outsized attention, but blockchains require tokens to reward network participants for processing transactions and to secure the network by ensuring participants have "skin in the game." In contrast,  distributed ledgers facilitate regulated FI and corporate use cases by restricting access to network data (private) and the network (permissioned). Distributed ledgers do not require tokens to reward network participants for processing transactions or to secure the network because participants already have "skin in the game" - their reputations.**

Welcome to the token economy

In the not-too-distant future, you may open an iPhone app to check the market value of portfolio holdings, which include tokenized dollars, Apple (AAPL) stock, corporate bonds, interest in a private equity fund, carbon credits, royalty rights to Rihanna and Diplo songs, interest in a diversified blue-chip art fund and tokens that power blockchain operating systems. You may sell 47.62765% of your private equity interest at 5:15pm to 20 different buyers through a liquid secondary market. We expect tokenized assets to become so ubiquitous that "token portfolios" will simply be referred to as "portfolios."

 

Global Digital Assets

  Executive Summary and Key Conclusions

 Tokenization - the transformation of global markets

 Tokenization refers to the process of creating digital programmable representations of traditional financial and non-financial assets that can be exchanged and tracked on distributed ledgers or blockchains. We expect the tokenization of traditional assets to transform financial and non-financial infrastructure and public and private financial markets over the next 5-15 years. As we wrote in our Primer (see our 10/4 report), we are only in the first innings of a major change in infrastructure and applications that may reshape how value is transferred, settled and stored.

Our view is that the tokenization of traditional assets and issuance of assets in tokenized form have the potential to increase efficiencies and reduce costs across an asset's lifecycle, improve the efficient allocation of capital, optimize global supply chains, catalyze a new generation of software-as-a-service (SaaS) companies and ultimately drive mainstream adoption. Disruptive innovations like the radio, television and email took 30 years to reach mainstream adoption, but we expect a far shorter road for digital assets.

"I actually believe this technology is going to be very importantI believe the next generation for markets, the next generation for securities, will be tokenization of securities."

-Larry Fink, BlackRock chairman & CEO, Nov 30, 2022

 

 DLT and tokenized traditional assets aren't "crypto"

 Although some blockchains support the exchange and transfer of tokenized traditional assets, our view is that decentralization and lack of customization, data privacy and permissioned access to the network limit current financial institution and corporate use cases that require expanded scalability and regulatory compliance.

Blockchains are public, permissionless and require tokens

Blockchains are a type of distributed ledger that remove the need for some intermediaries, support trustless transactions, record network activity and token ownership data transparently (public) and allow open access to join the network (permissionless). Blockchains record ownership of the 26k+ tokens that exist within the digital asset ecosystem, but we expect 99% of those in existence today to essentially disappear over the next 10 years. Memecoins like Shiba Inu (SHIB) and Pepe (PEPE) receive outsized attention, despite having no utility or intrinsic value, but other tokens are different. Public permissionless blockchains like Bitcoin, Ethereum (see our 4/6 report) and third-generation blockchains (see our 3/21 report) are decentralized and require tokens to reward network participants for processing transactions, but also to secure the network by requiring participants to have "skin in the game" that disincentivizes malicious behavior.

Distributed ledger customization expands FI and corporate use cases

In contrast, distributed ledgers provide customizable infrastructure for financial institution and corporate use cases that ensure regulatory compliance by restricting access to network activity and token ownership data (private) and preventing unknown entities from joining the network (permissioned). Distributed ledgers still remove the need for some intermediaries, but also the need for tokens to reward network participants and secure the network. Network participants, which may be a consortium of financial institutions or corporates, are centralized and don't require tokens to align incentives because they already have "skin in the game" - their reputations.

Disruption potential should not be ignored

 Just as there was an explosion of simple to complex websites in the 1990s that altered how we shop and interact, in the coming years, we could see the tokenization and decentralization of many aspects of the economy.   Distributed ledgers and blockchains provide back-end infrastructure, but some investors may underappreciate how this disruptive technology is powering an infrastructure evolution that may touch every industry. We believe the lack of user-friendly front-end interfaces and a disproportionate focus on bitcoin, memecoins, regulatory headwinds and illicit activity are overshadowing the rapid development of real-world use cases that are in active production today.

"I was initially a crypto skeptic, butI think crypto is here to stay and with proper oversight and regulation, it has the potential to greatly benefit society and grow the global economy."

-Bill Ackman, Pershing Square Capital Management founder & CEO, Nov 20, 2022

 

We expect the tokenization of assets and funds within markets that are the least efficient and most intermediated to be tokenized first, and assets and funds within markets where the reverse is true to be tokenized last. Consultants expect the value of tokenized assets to reach 10% of global GDP ($16.1tn) by 2030.1 However, our view is that forecasting the value of tokenized assets over the next 10 years may signal tokenization's disruption potential, but ultimately distracts from the largest transformation of infrastructure and markets in over 50 years, efficiencies that DLT/BCT enables and new products and applications that become economically viable.

"The unified ledger thus opens the way for entirely new types of economic arrangements that are impossible today due to incentive and informational frictions. The eventual transformation of the financial system will be limited only by the imagination and ingenuity of developers that build on the system, much as the ecosystem of smartphone apps has far exceeded the expectations of the platform builders themselves."

-BIS, Blueprint for the future monetary systems, Jun 20, 2023

 

    Efficiencies and reduced costs drive accelerating adoption

  Institutional investors and banks are increasingly leveraging DLT/BCT, smart (self-executing) contracts, tokenization and fractionalization to enable customizable settlement times; reduce credit risk; lower settlement, financing and operational costs; increase liquidity for previously illiquid assets; and more efficiently reallocate funds previously held as collateral to yield-bearing assets or rebalance portfolios with illiquid assets. DLT/BCT may also facilitate increased retail accessibility to alternative assets, as well as the creation of improved financial assets and applications, some of which were not economically viable previously (Exhibit 1).

See Appendix I: The Tokenization Process for a deep dive

  Exhibit 1:  Tokenized assets and funds enable efficiencies that may drive digital asset adoption to accelerate

The tokenization process facilitates the use of traditional assets within the digital asset ecosystem

Exhibit 1: For an accessible version Merrill clients call 800-637-7455; Merrill Edge Self-Directed clients call 877-653-4732

Source: BofA Global Research

Smart contracts are self-executing contracts. L1, L2, L3 = Layer 1, Layer 2, Layer 3.

Note that the tokenization process shown above is simplified.

BofA GLOBAL RESEARCH

Our view is that corporate DLT/BCT and tokenization use cases are potentially more diverse and expansive than financial institution use cases. In fact, over half of Fortune 100 companies have launched projects leveraging DLT/BCT since the beginning of 2020.2 Corporates across every industry are increasingly leveraging the same underlying technology as financial institutions to generate incremental revenues, lower costs by automating manual processes, optimize supply chains, broaden potential customer pools, increase customer loyalty, offset contributions to climate change, combat counterfeiting and appeal to Enviromental, Social and Governance (ESG)-focused customers and investors. Many companies with the greatest risk of disruption, or that fear a loss of market share, are proactively exploring how to enter the digital asset ecosystem and leverage its many use cases.

Welcome to the token economy

 Tokenization is just one of many DLT/BCT applications, but we expect this one application to lead to new and more efficient primary and secondary markets for financial and non-financial products. In the not-too-distant future, institutional and retail investors may open an iPhone app to check the real-time market value of their portfolio holdings, which include tokenized dollars, Apple (AAPL) stock, corporate bonds and interests in a private equity fund and commercial building that's located on a different continent. Portfolio holdings may also include carbon credits, rights to royalties generated from Rihanna and Diplo songs, interest in a diversified blue-chip art fund, bitcoin (BTC) and other tokens that provide holders with a call on cash flows and power smart contract-enabled blockchain operating systems.

Ownership of these (tokenized) assets will be immutably recorded on one of the 5-15 distributed ledgers or blockchains that survive consolidation, some of which are public (full data transparency for transactions since inception) and permissionless (anyone can join the network) and some of which are private and permissioned. Within the same app, you may fractionalize and sell 47.62765% of your interest in a private equity fund at 5:15pm EST to 20 different institutional or retail buyers (with whom you've never interacted) in a liquid secondary market with 24/7 real-time settlement and smart contracts performing anti-money laundering/know your client (AML/KYC) requirements. It's difficult to overstate how transformative DLT/BCT, tokenization and the thousands of decentralized apps that have yet to be created could be.

"I could see a day in the not-too-distant future when a client's portfolio is not 10% to 15% alternatives, but 50%."

-Marc Rowan, Apollo CEO, May 5, 2022

 

The more things change, the more they stay the same

  The digitization of financial assets began in 1971 when Nasdaq introduced infrastructure enabling the world's first electronic stock exchange, but it wasn't until 2001 that US stock markets fully transitioned to decimalization of asset prices, which drove smaller order sizes and heightened liquidity.3 However, 27% of settlement systems today still leverage legacy infrastructure that is over 20 years old.4 Today's financial systems continue to be built on centralized (company-owned) and fragmented infrastructure that requires third-party intermediaries, which limits efficiencies, interoperability, innovation and functionality; increases time to settlement and costs; and prevents the efficient allocation of capital (Exhibit 2).

  Exhibit 2:  Today's financial systems are built on centralized, fragmented and non-interoperable infrastructure

Traditional financial infrastructure

Exhibit 2: For an accessible version Merrill clients call 800-637-7455; Merrill Edge Self-Directed clients call 877-653-4732

Source: BofA Global Research

BofA GLOBAL RESEARCH

 Why now for tokenization? Pilots reach maturity

 Despite last year's digital asset market correction (see our 12/2 report), financial institution, central bank and corporate interest remained, and industry development accelerated for private permissioned distributed ledgers and blockchains. Our view is that customizable distributed ledgers, blockchain subnetworks (subnets) and smart contracts have reached maturity and production after years of development.

In contrast to public permissionless blockchains, private permissioned distributed ledgers and blockchain subnets integrate separate systems into one and enable the efficiencies provided by distributed (shared) ledgers, but with enhanced functionality and reduced regulatory and reputational risk. We expect DLT/BCT implementation to accelerate as the opportunity costs of uncaptured efficiencies and reduced costs increase.

The next evolution of software has only just begun

Bitcoin's blockchain launched 14 years ago, Ethereum's launched eight years ago and the first decentralized applications launched seven years ago, but many of the newest blockchains and applications are less than three years old and remain early in their development roadmaps. However, distributed ledgers and blockchain subnets intended for institutional and corporate use cases are even more nascent than the newest blockchains and require time to mature, despite numerous use cases already executed and ongoing.

"The end goal is to deliver financial services to customers faster, cheaper and with better outcomes than exist today. Over time we expect all financial assets to eventually move onto the blockchain infrastructure."

-Jonathan Steinberg, WisdomTree CEO, Jul 2022

 

  Blurred lines - tokenized assets vs blockchain-native

 Tokens will likely become so ubiquitous that "tokenized assets" and "token portfolios" will simply be referred to as "assets" and "portfolios" over the longer term. Our view is that there is limited reason to distinguish between tokens that represent ownership of Treasuries and physical gold, tokens representing ownership of a corporate bond issued in tokenized form and tokens powering blockchain operating systems and decentralized storage protocols. We expect the lines to blur between tokenized pre-existing traditional assets, assets issued in tokenized form and blockchain-native assets (Exhibit 3).

  Exhibit 3:  We expect the lines to blur between token types over time as tokenized issuances become the norm

A breakdown of token types and how we define them

For an accessible version Merrill clients call 800-637-7455; Merrill Edge Self-Directed clients call 877-653-4732

Token Types

Token Type Definitions

Tokenized pre-existing

traditional assets

The tokenization of pre-existing traditional assets refers to the process of transforming an asset that was originally issued off-chain through a primary or secondary offering and recorded in book entry form on a traditional ledger, such as a central securities depository, into a token. The token represents digital ownership of the off-chain asset, embeds the rights of the asset and can be traded or pledged as collateral on a DLT/BCT-powered secondary market or within a DLT/BCT-powered application. The pre-existing traditional asset, which is held by a custodian within a special purpose vehicle, continues to exist off-chain in the "real world" but also exists within the digital asset ecosystem with ownership changes recorded on a distributed ledger or blockchain.

Tokenized traditional assets

Tokenized traditional assets refer to traditional assets that were originally issued on-chain in tokenized form through a primary offering, also known as a security token offering (STO), with token ownership recorded on a distributed ledger or blockchain. The token represents ownership of an asset that exists exclusively within the digital asset ecosystem and can be traded or pledged as collateral on a DLT/BCT-powered secondary market or within an DLT/BCT-powered application. At no point was token ownership recorded on a traditional ledger.

Blockchain-native assets

Blockchain-native assets, such as Bitcoin (BTC), Ethereum (ETH), Solana (SOL), Avalanche (AVAX), Uniswap (UNI) and Shiba Inu (SHIB), refer to tokens that were originally issued on-chain in tokenized form through an initial coin offering (ICO) or as a reward to network participants in exchange for securing the network and processing transactions. Token ownership is recorded on a distributed ledger or blockchain. The token exists exclusively within the digital asset ecosystem and can be traded or pledged as collateral on a DLT/BCT-powered secondary market or within a DLT/BCT-powered application. At no point was token ownership recorded on a traditional ledger.

Source: BofA Global Research

BofA GLOBAL RESEARCH

 

 Beneficiaries & Ecosystem Synergies

  TradFi is leveraging the technology to fill a void

A digital asset company which collapsed last year likely slowed institutional crypto trading as institutional investors reevaluated counterparty risk and assured themselves that custody, exchange and broker-dealers were separate entities or siloed. However, the collapses created a void that is currently being filled by trusted and experienced TradFi firms, as well as regulatory-focused digital asset companies, offering institutional-grade distributed ledgers, trading platforms and products. Although we appreciate the "decentralized-everything" ethos at the heart of the digital asset ecosystem, digital asset trading platforms like Coinbase and FTX were never decentralized and decentralized exchanges like Uniswap (see our 6/13 report) are unlikely to provide the privacy and regulatory rigor required for institutional use cases.

"Crypto is here to stay. What's happened [with recent SEC lawsuits] is clearly a setback. But right now I actually think it's a huge opportunity for the incumbent financial firms to actually take the lead."

-Dawn Fitzpatrick, Soros Fund Management CEO, Jun 7, 2023

 

 Private sector expertise needed to implement DLT/BCT

  Commercial, investment and central banks; institutional investors; corporates; and governments are leveraging the private sector to build new financial and non-financial systems and integrate the underlying technology into their processes. We expect private sector beneficiaries to include both traditional and digital asset companies. However, the largest and stickiest revenue opportunities are likely to exist for infrastructure providers that offer customizable distributed ledger platforms and blockchain subnets, mature and audited smart contracts, cybersecurity (see our 1/26 report), digital asset custody/wallets (see our 12/21 report), oracle networks (see our 2/16 report), management systems and cloud storage.

Infrastructure providers offering distributed ledger and blockchain platforms are likely to adopt SaaS revenue models, in our view, potentially forming a new generation of SaaS companies. Many of the digital asset companies listed below are developing distributed ledgers to support tokenized currencies, but these same ledgers are also likely to support tokenized assets more broadly.

 Traditional and digital asset companies both included

Tokenized currencies (CBDCs) produce beneficiaries

We expect DLT/BCT and tokenization beneficiaries to include traditional and digital asset companies, the majority of which are currently private. For example, the New York Innovation Center (NYIC), a unit of the Federal Reserve Bank of New York, launched a wholesale CBDC pilot (see our 11/17 report) to research and develop CBDCs (see our 1/17 report) and partnered with Amazon Web Services (AWS), BNY Mellon, Citi, Deloitte, HSBC, PNC Bank, Sullivan & Cromwell LLP, SWIFT, TD Bank, Truist, U.S. Bank and Wells Fargo. The People's Bank of China partnered with Alibaba, JD.com and Tencent, among others, to research, develop and distribute its CBDC.

Central banks and governments are also leveraging the distributed ledger platforms offered by digital asset companies. The NYIC partnered with SETL; Bank of Canada partnered with R3; Monetary Authority of Singapore partnered with ConsenSys; Norges Bank partnered with Nahmii; Royal Monetary Authority of Bhutan partnered with Ripple; Bank of Jamaica and Central Bank of the Philippines partnered with eCurrency Mint; Central Bank of Nigeria and Eastern Caribbean Central Bank (ECCB) partnered with Bitt; and Bank of the Lao and National Bank of Cambodia partnered with Soramitsu.

Tokenized traditional and alternative assets produce beneficiaries

Banks like Goldman Sachs, HSBC, JP Morgan and Société Générale are building in-house digital asset trading platforms through partnerships with distributed ledger and blockchain platforms like Digital Asset's Canton Network, Ethereum, Linux Foundation's Hyperledger and Tezos. Banks and asset managers, such as Citi, Cumberland, Franklin Templeton, Société Générale, T. Rowe, UBS, Wellington and WisdomTree are also leveraging external platforms like ADDX; Avalanche (see our 12/10 report); Broadridge's Distributed Ledger Repo (DLR) (see our 2/14 report), powered by VMWare Blockchain and Digital Asset's Daml smart contracts; Contour Network, powered by R3 Corda's distributed ledger; Figure Technologies' Provenance Blockchain; Ethereum; HQLAx, also powered by R3 Corda's distributed ledger; Polygon; and Stellar.

Private equity firms like KKR, Hamilton Lane, Partners Group and Apollo are tokenizing, or planning to tokenize, portions of funds by partnering with distributed ledger and blockchain platforms like ADDX, Avalanche, Figure Technologies' Provenance Blockchain and Digital Fund Services, Polygon and Securitize.

Decentralized applications for tokenized assets produce beneficiaries

Digital asset companies like Gauntlet (see our 2/8 report) and Skolem (see our 2/10 report) are catalyzing the institutionalization of decentralized Web3 applications (see our 5/4 report) by leveraging data transparency to provide financial modeling and simulation platforms that offer similar services to an investment bank's risk desk, as well as execution services and analytics. Over the longer term, we expect the development of decentralized applications, specifically decentralized finance (DeFi) applications, with real-world functionality to increase the efficiency of traditional products and services.

 Ecosystem synergies make accelerated development likely

Accelerating ecosystem adoption to drive development and growth

We expect the digital asset ecosystem's adoption and development to accelerate, despite last year's risk asset correction and the digital asset ecosystem's self-inflicted wounds related to FTX's high-profile bankruptcy (see our 12/2 report). Next-generation blockchains (see our 3/21 report) that have emerged since the Ethereum blockchain launched 8 years ago (see our 4/6 report) have implemented innovative and differentiated approaches to improving the trade-off between scalability, decentralization and security.

 A nascent industry requires time to mature

Distributed ledgers and blockchains are not competing in a zero-sum game. Technological advancement at one of the ecosystem's three layers (distributed ledgers/blockchains, scaling solutions/oracle networks, applications) produces synergies that benefit the digital asset ecosystem as a whole by enabling the creation and development of new decentralized applications that were not possible on the Bitcoin or Ethereum blockchains due to lower scalability. Despite rapid growth and development, we remind readers that this is a nascent industry that needs time to mature.

Decentralized oracles, identity, storage, analytics, insurance are all needed

Adoption and usage of tokenized assets are likely to drive development throughout the ecosystem as developers build applications and ancillary services to support what we expect to be significant growth in tokenized asset market values and trading volumes over the next 5 to 10 years. New and more efficient financial products will require an expanding quantity of real-world data provided by decentralized oracle networks (see our 2/16 report), compliance with Ant Money Laundering (AML) / Know your Customer (KYC) requirements and undercollateralized lending will require decentralized identity NFTs and advanced analytics (see our 1/26), increased usage of distributed ledgers and blockchains will require decentralized storage protocols to house exponential data growth and customer acquisition strategies will require decentralized insurance protocols to mitigate security risks.

Our view is that digital asset adoption by banks, financial institutions and corporates is likely to drive ecosystem synergies, leading to the accelerated development of decentralized Web3 applications that may gradually capture market share across most industries (see our 7/21 report) over time (Exhibit 4).

See Appendix II: Decentralized Web3 Apps for a deep dive

  Exhibit 4:  Web2 to Web3 - the transition from internet renters to owners

Web1 through Web3 from the perspective of content generation, governance, trust, ownership and profit

For an accessible version Merrill clients call 800-637-7455; Merrill Edge Self-Directed clients call 877-653-4732

 

Web1

Web2

Web3

 

1990 - 2004

2004 - Present

Present - ???

Content Creation

Platform Operators Create

Platform Users Create

Platform Users Create

Governance / Control

Platform Operators Govern

Platform Operators Govern

Platform Users Govern

Trust

Non-Verifiable

Non-Verifiable

Verifiable

Ownership

Platform Operators Own

Platform Operators Own

Platform Users Own

Profit

Platform Operators Profit

Platform Operators Profit

Platform Users Profit

Source: BofA Global Research

BofA GLOBAL RESEARCH

 

 Challenges & Risks to Adoption

We summarize the key challenges and risks that could slow the adoption of DLT/BCT and tokenized assets. We categorize primary risks as regulatory and legal - the risk that regulatory and legal frameworks inhibit broad adoption of tokenized assets - and secondary risks as security, lack of global coordination and inadequate liquidity.

  Exhibit 5:  Key risks that could slow the adoption of tokenized assets

Risks for DLT/BCT and tokenized assets - regulatory, legal, security, global coordination and liquidity

For an accessible version Merrill clients call 800-637-7455; Merrill Edge Self-Directed clients call 877-653-4732

Risk

Overview

Regulatory

Lack of comprehensive regulatory frameworks coordinated globally

We view the lack of comprehensive and coordinated regulatory frameworks globally as the largest near-term headwind to mainstream digital asset adoption. Jurisdictions with comprehensive regulatory frameworks may incentivize digital asset companies to relocate, but these companies will still need to navigate complexities driven by regional differences and inconsistences in digital asset regulations. For example, a token regulated in the EU under the newly implemented Markets in Crypto Assets (MiCA) regulatory framework may not be regulatory compliant in the US.

Complexity may prevent accelerating adoption

Regulatory complexity could produce headwinds for the tokenization of traditional assets. Different asset classes are subject to different regulatory requirements regionally and globally, but how tokens are classified (security or commodity) remains unclear. Bank and institutional focus on compliance may slow DLT/BCT integration and the expansion of tokenization to additional asset classes that are relatively more efficient unless the benefits provided by DLT/BCT significantly outweigh regulatory risks. However, we expect the lack of clarity regarding token classification to be less of an adoption headwind for tokenized traditional assets, given that regulatory classification and requirements are already established.

Compliance with existing regulation

Distributed ledgers and blockchains must balance data storage auditability with privacy and the right to be forgotten included in the EU's General Data Protection Regulation (GDPR). Our view is that many institutional-focused distributed ledger and blockchain platforms, like Canton Network and Avalanche, enable customization and compliance with GDPR, but regulatory compliance raises questions for public permissionless blockchains.

Legal

Legal frameworks around asset ownership and consumer protections create ambiguity

Legal questions related to asset ownership remain unresolved and untested in the courts. For example, if an investor sells a token representing an interest in a commercial building, does ownership transfer when the transaction is recorded on a distributed ledger or blockchain or when the transaction is recorded on the traditional books and records? If ownership transfer occurs due to a smart contract hack or simple human error, does the original owner have a claim to the asset or any recourse?

Legal implications for smart contracts remain unclear

Smart contracts may enable the transfer of asset ownership without legal permission. If an investor pledges a tokenized interest in a commercial building as collateral for a loan through a DeFi application and the value of that interest declines below the threshold and triggers a liquidation, does the smart contract have legal permission to sell the interest in the commercial building?

Decentralization provides benefits but leaves no one accountable

Decentralized oracle networks enable smart contracts to verifiably and securely access real-world data like market prices and the weather. If an oracle providing pricing data malfunctioned or if the market price input into a smart contract is manipulated, are the affected parties entitled to damages? The price of DAI, a decentralized stablecoin, may have been manipulated on Coinbase Pro in Dec'20, causing the token's price to rise above the market price, which triggered ~$88mn of liquidations when DAI's potentially manipulated price was input into Compound smart contracts. These issues are likely to play out in the courts, but the unclear legal status of smart contracts raises concerns around enforceability, as well as consumer and investor protections.

Security

One major hack away from adoption and development deceleration

Hacks, theft and illicit activity more broadly represent less than 1% of digital asset transactions, but we expect that a significant hack resulting from an exploited software bug in a smart contract would pressure financial institutions and corporates to reconsider DLT/BCT implementation risks. Smart contracts are software and software can include bugs, leading to vulnerabilities. Bug bounties, audits and insurance may mitigate the risk of theft, but an exploited vulnerability in a private permissioned distributed ledger optimized for institutional use would be a major blow to the industry's credibility.

Global

Coordination

Benefits unlikely to be fully captured without global coordination

Lack of global coordination related to common standards could lead to tokenized assets and platforms that are not interoperable with each other. Risks that could arise from a lack of global coordination include the potential inability to realize efficiencies and decreased costs related to settlement, liquidity, credit/liquidity risk, financing costs and cross-border payments/transfers. Distributed ledgers that are interoperable with some platforms but not others, or which prevent entry to some financial institutions but not others, could inhibit new market entrants and economic competition, increase banking system concentration, and solidify trading partners between countries, while excluding emerging economies from the global financial system.

Liquidity

Benefits unlikely to be fully captured without liquidity

We expect the tokenization of traditional assets to drive the formation of secondary markets for previously illiquid assets like interests in private equity funds or commercial buildings, royalty streams, carbon credits and blue-chip art. Our view is that tokenization for the sake of tokenization is a waste of resources and the formation of a secondary market without adequate liquidity provides limited benefit as efficiencies and cost benefits are unlikely to be captured. Similarly, corporates may issue tokenized bonds with T+0 settlement, but without adequate liquidity, investors are likely worse off than if they had purchased the bond through a traditional issuance. Concerns around liquidity are likely to decrease as adoption accelerates, but we expect even moderate liquidity for previously illiquid assets to provide benefits. However, we note the potential risk of bifurcated liquidity across on-chain and off-chain markets or across two on-chain markets for the same asset if interoperability is not prioritized.

Source: BofA Global Research

BofA GLOBAL RESEARCH

 

 Drivers of Adoption

 Digitization and the infrastructure evolution

The digitization of financial assets originated when Nasdaq introduced infrastructure in 1971 that enabled the world's first electronic stock exchange, which facilitated the future decimalization of asset prices, smaller order sizes and heightened liquidity. Similarly, we expect the underlying DLT/BCT infrastructure to facilitate the disruptive transformation of tokenized (digital) assets by enabling efficiencies and decreased costs.

We provide the catalysts driving financial institutions, central banks and corporates to incorporate DLT/BCT-powered infrastructure and tokenized assets below.

 Operational efficiencies and lower costs

DLT/BCT-powered infrastructure results in efficiencies and lower costs

 Distributed ledgers and blockchains provide decentralized infrastructure that removes fragmentation and the need for intermediaries to process and execute transactions, which increases efficiencies, interoperability, innovation and functionality; facilitates 24/7 real-time settlement and cost reductions; and enables the efficient allocation of capital (Exhibit 6).

Potential to transform markets at a rapid rate

 We expect DLT/BCT-powered infrastructure to reduce the time to settlement and cost by removing the need for intermediaries and enabling the automation of administrative and operational processes through the implementation of smart contracts. For example, cross-border payments and transfers can take 7 days to settle, involve 5 or more intermediaries and cost 10x more than domestic payments. Cross-border payments cost corporates $120bn in transaction fees in 2020 and are heavily reliant on manual processes. Over one-third of payment data was validated manually in 2020.5, 6, 7 But tokenized demand deposits and currencies remove the need for intermediaries, which eliminates the reliance on manual processes, enabling real time settlement and lowered costs. Potential disintermediation may also allow banks to unlock $4tn of funds held in accounts at correspondent banks, which could be reallocated to yield-bearing assets.8

Liquidity, accessibility and improved capital allocation

Efficiencies and cost reductions that enable lower minimum investments, broader investor pools and heighted secondary market liquidity may also facilitate increased institutional and retail exposure to alternative investments, as well as enable institutional investors to reallocate funds previously pledged as collateral to investments in yield-bearing assets and private equity firms to reallocate capital invested in illiquid assets to investments that may provide higher expected risk-adjusted returns.

Efficiencies decrease manual processes and corporate expenses

Corporates may also incorporate DLT/BCT, smart contracts and tokenization to automate manual processes related to supply chain management and to decrease the time required to trace the provenance of goods. In the future, DLT/BCT may also enable the automation of corporate actions, such as coupon and dividend payments and voting, enabling reduced operational costs. Payments may be linked to the delivery or GPS location of tokenized goods, restocking of inventory automatically using Internet of Things (IoT) devices and events that trigger insurance payouts. Indirect taxes like sales tax may be sent directly to governments at the point of sale.

 New and improved products and applications have emerged

DLT/BCT-powered infrastructure may also enable the creation of new and more efficient products and applications that were too expensive or impractical to create on today's financial systems. DLT/BCT transforms the below into economically viable products and applications:

  • financial products and applications for low-income individuals;
  • retail investor exposure to alternative assets like private equity, commercial real estate and blue-chip art;
  • government tracking of consumer behavior and central bank tracking of inflation in real time while preserving privacy;
  • corporates purchasing carbon credits in a liquid secondary market to offset contributions to climate change;
  • intra-day settlement for repurchase agreements (repos) and new products like perpetual futures and prediction market (binary future) contracts;
  • a way for artists to create royalty streams (see our 3/18 report) from the resale of their work;
  • the ability for subsistence farmers to obtain parametric insurance to protect their crops (see our 2/16 report) from extreme weather events in developing countries without ever meeting with an insurance agent;
  • manufacturers of luxury goods and pharmaceuticals issuing NFTs alongside an article of clothing, timepiece or drug shipment that acts as a certificate of authenticity to combat counterfeiting;
  • or food retailers tokenizing supply chains to increase the traceability of goods and to identify the origin of a food-borne illness if an outbreak occurs.

  Exhibit 6:  Financial systems that leverage distributed ledger technology are decentralized and interoperable, promote innovation and expand functionality

Financial infrastructure built with distributed ledger technology

Exhibit 6: For an accessible version Merrill clients call 800-637-7455; Merrill Edge Self-Directed clients call 877-653-4732

Source: BofA Global Research

BofA GLOBAL RESEARCH

 Private permissioned distributed ledgers & blockchains

Highly decentralized, public and permissionless blockchains have trade-offs

Distributed ledgers and blockchains may optimize the trade-offs between scalability, decentralization and security, known as the blockchain trilemma, for different end users and use cases (Exhibit 7). We view decentralized, public and permissionless blockchains that enable trustless transactions and reduced reliance on intermediaries like Ethereum (see our 4/6 report), Cardano, TRON, Solana (see our 1/11 report), Polygon (see our 2/28 report) and Avalanche (see our 12/10 report) as critical for the digital asset ecosystem's development and growth. However, decentralized, public permissionless blockchains, including third-generation blockchains (see our 3/21 report), provide data transparency and reduce security risks at the expense of data privacy and scalability, which inhibits institutional and corporate adoption and use cases that require data privacy and high scalability.

See Appendix III: Blockchain Trilemma Components for a deep dive

  Exhibit 7:  TradFi and corporate use cases will likely prioritize scalability and security over decentralization

Blockchain Trilemma - trade-offs between scalability, decentralization and security

Exhibit 7: For an accessible version Merrill clients call 800-637-7455; Merrill Edge Self-Directed clients call 877-653-4732

Source: BofA Global Research

BofA GLOBAL RESEARCH

Financial institution and corporate use cases require privacy

Decentralization isn't the end-all-be-all. Our view is that decentralization is beneficial, but scalability and security are likely more important than decentralization for TradFi and corporate use cases, which may not require truly trustless transactions or the level of decentralization that public blockchains rely on to securely function. Instead, TradFi and corporate adoption of DLT/BCT-powered use cases rely on private permissioned and customizable distributed ledgers and blockchains that are appropriately regulated and can facilitate AML/KYC compliance procedures, token transfer restrictions and order flow/data privacy. We expect distributed ledgers and blockchains that enable the creation of private permissioned and customizable distributed ledgers and blockchain subnets to provide an institutional and corporate on-ramp to the digital asset ecosystem.

"[The Canton Network] has the privacy of a private blockchain on a public networkThus, the Canton Network fills a major gap in the public ledger space: it has smart contracts on a single virtual ledger, similar to Ethereum, Solana, Tezos, and many more, and it has built-in privacy with selective transparency, similar to the bitcoin lightning network and Zcash."

-Canton Network: A Network of Networks for Smart Contract Applications, May 2023

 

 Real-time (or customizable) settlement

DLT/BCT, smart contracts, tokenization and fractionalization are all required

As speculative trading of memecoins with limited to no intrinsic value fades, we expect focus to shift to the technological benefits that DLT/BCT, smart contracts, tokenization and fractionalization facilitate by enabling traditional assets to be traded on distributed ledgers and blockchains with 24/7 real-time settlement.

Tokenization and smart contracts enable atomic (simultaneous) settlement for tokenized assets by automating much of the clearing and settlement process, including financial institutions' payment messages, which provide routing information and payer/payee identification, compliance with AML/KYC requirements and the crediting and debiting of customer accounts. We expect real-time settlement to drive lower credit risk; decreased financing, settlement and operational costs; capital allocation efficiencies and retail accessibility.

Customizable Settlement > Real-Time Settlement

Decreasing time to settlement or enabling real-time settlement by transitioning to a real-time gross settlement (RTGS) process from a deferred net settlement (DNS) process provides counterparties with benefits like decreased credit risk, but at the cost of increased liquidity risk. Although we view 24/7 real-time settlement as a significant technological accomplishment, we expect financial institutions to prefer customizable settlement times that optimize the tradeoff between credit and liquidity risk. We also note that settlement costs are rising ~14% each year and 5-10% of trades fail each day, driven largely by human error and the seven non-interoperable systems for which the average trade is routed, indicating the significant implications that a distributed (shared) ledger enabling real-time, or customizable, settlement provides.9

"…a unified ledger allows sequences of financial transactions to be automated and seamlessly integrated. This reduces the need for manual interventions and reconciliations that arise from the traditional separation of messaging, clearing and settlement, thereby eliminating delays and uncertainty. The ledger also support simultaneous and instantaneous settlement, reducing settlement times and credit risks."

-BIS, Blueprint for the future monetary systems, Jun 20, 2023

 

 Fractionalization

Transforming Illiquid assets drives efficient secondary markets

Electronic trading and decimalization have driven lower average order sizes over the last five decades, resulting in heightened liquidity. We expect tokenization, which enables fractionalization up to 18 decimal places, to transform illiquid assets into liquid ones, increase retail and institutional exposure to alternative investments like private equity, real estate, and blue-chip art and carbon credits, as well as drive the formation of more efficient and liquid primary and secondary markets. Fractionalization may also enable banks and investors to reallocate capital and rebalance portfolios more quickly.

New functionality - transfer of illiquid (physical) asset ownership and value

The market value of tokenized gold surpassed $1bn in mid-Mar, but prior to the emergence of tokenized gold, investors seeking exposure to gold's price could purchase ETFs and futures and those seeking exposure to physical gold could purchase it through dealers. However, these investment vehicles come with drawbacks related to cost, settlement and liquidity. In contrast, tokenized gold provides exposure to physical gold, 24/7 real-time settlement, no management fees and no storage or insurance costs, while fractionalization enables the transfer of physical gold ownership and value that was not previously possible (Exhibit 8).

   Exhibit 8:  Tokenization enables fractionalization and real-time settlement

Alkesh sells a specific gold bar to Andrew who can gift 50% to both Caroline and Joshua

Exhibit 8: For an accessible version Merrill clients call 800-637-7455; Merrill Edge Self-Directed clients call 877-653-4732

Source: BofA Global Research

BofA GLOBAL RESEARCH

 Accessibility

Lowering the barriers to entry for retail investment in alternatives

High barriers to entry create headwinds to investment in alternative assets, which are out of reach to all but the wealthiest retail investors. For example, retail investors seeking exposure to gold's price or physical gold can buy a share of a gold ETF or a physical gold bar, but not for less than ~$180 a share or $1,900+ for a gold bar.

Private equity exposure for retail investors, even wealthy ones, has even higher barriers to entry and inhibits exposure to the 99%+ of companies globally and in the US that are private, which results in client concentration risk for private equity funds, secondary market illiquidity and the inefficient allocation of capital (Exhibit 9). However, we expect tokenization and fractionalization to drive lower minimum investments and increased retail exposure to alternative investments like physical gold and private equity, which benefit both limited partners (LPs) and general partners (GPs).

  Exhibit 9:  There were ~329mn companies globally in 2019, but only 43k were publicly listed

Number of companies globally and in the US vs number of listed companies globally and in the US

Exhibit 9: For an accessible version Merrill clients call 800-637-7455; Merrill Edge Self-Directed clients call 877-653-4732

Source: World Bank, Statista, Eurostat, OECD, Statistisches Bundesamt, US Census Bureau

BofA GLOBAL RESEARCH

Accessible to all - new financial assets and products to emerge

Tokenization, fractionalization and heightened secondary market liquidity may also increase exposure by retail investors, as well as institutional investors, to previously illiquid or inefficiently priced alternative assets like commercial real estate, blue-chip art, carbon credits and royalty streams. Tokenization of these assets lowers the barriers to entry, enhancing liquidity and enabling the efficient reallocation of capital if an investor wishes to diversify or exit an investment. It can take years to fully exit investments in private funds. Tokenization may also enable offshore individuals and companies to access previously unavailable markets and products.

The centralized, fragmented and non-interoperable financial systems of today also create high barriers to entry for companies planning to build financial applications. However, interoperable applications can be built on top of distributed ledgers and blockchains, enabling the development of applications that would be too expensive or impractical to create on today's financial systems.

Smart contracts and tokenization also enable the creation of innovative products, some of which were not previously available in traditional or digital asset markets, like perpetual futures and prediction market (binary future) contracts.

   Transparency

Reduced information asymmetries and more efficient price discovery

Blockchain transactions are immutably recorded and transparent to those with the proper data science and quant tools, which enables the analysis of millions of transactions between millions of addresses and across dozens of blockchains. We expect data transparency to drive reduced information asymmetries and, combined with heightened liquidity, to lead to more efficient price discovery, particularly for previously illiquid assets.

Enabling deeper analysis of tokenized assets in real time

Data transparency allows for deeper analysis of tokenized and blockchain-native assets in real time. We expect fundamental analysts to cover the tokens powering tokens blockchains and applications as they would equities over the longer term, but models will likely transition from updating forecasts and price objectives on a periodic, or quarterly, basis to integrating real-time data feeds as adoption, development, usage and resulting cash flows become transparent (Exhibit 10).

  Exhibit 10:  Transparency provided by DLT/BCT enables near real-time tracking of usage and resulting cash flows from transaction (tx) fees

Transaction fees generated by smart contract-enabled blockchains from 2021-2023 ytd

For an accessible version Merrill clients call 800-637-7455; Merrill Edge Self-Directed clients call 877-653-4732

 Blockchain

Token

Mkt Value*

Tx Fees (2021)

Tx Fees (2022)

Tx Fees (2023)**

% Change Y/Y

Mkt Value/Tx Fee

Ethereum

ETH

$220,152,475,347

$9,924,548,484

$4,276,613,973

$2,683,246,031

-37%

82

BNB

BNB

$38,506,222,392

$908,963,474

$414,581,740

$224,594,835

-46%

171

Cardano

ADA

$9,440,263,488

$8,060,363

$8,331,528

$3,030,433

-64%

3,115

Solana

SOL

$6,629,964,494

$28,251,985

$26,195,222

$14,233,581

-46%

466

TRON

TRX

$6,344,034,885

$294,571,175

$333,838,444

$876,915,603

163%

7

Polygon

MATIC

$5,853,866,015

$10,420,455

$26,103,956

$48,003,968

84%

122

Polkadot

DOT

$5,811,422,371

$2,134,470

$726,614

$413,545

-43%

14,053

Avalanche

AVAX

$4,168,895,368

$41,184,384

$94,636,135

$12,848,033

-86%

324

Cosmos

ATOM

$2,568,252,834

$600,060

$915,408

$632,642

-31%

4,060

Stellar

XLM

$2,227,352,676

$231,650

$60,613

$137,274

126%

16,226

NEAR Protocol

NEAR

$1,195,841,165

$710,602

$3,297,417

$456,661

-86%

2,619

Source: BofA Global Research, Token Terminal

*Market values and transaction fees as of 6/20/23. **2023 transaction fees are annualized.

BofA GLOBAL RESEARCH

 Data transparency benefits law enforcement, governments and central banks

The transparency provided by blockchains may also provide law enforcement agencies with the ability to effectively track stolen tokens and illicit fund flows years after the crime occurred (see our 1/26 report). The transparency provided by distributed ledgers may also provide governments and central banks with the ability to track consumer behavior and inflation in real time, instead of using lagged data, as well as enable corporates to tokenize their supply chains, producing efficiencies and decreased costs.

Holistic analysis for structured finance products

Securitization enables the transformation of illiquid, long-duration, assets into liquid assets, but includes drawbacks. Lack of transparency into the securitized asset's underlying collateral reduces an investor's ability to analyze the creditworthiness of borrowers. Analysis of the thousands of mortgages that are packaged into mortgage-backed securities (MBSs) or thousands of auto loans packaged into asset-backed securities (ABSs) would be time-consuming and unlikely to enable a holistic analysis of mortgage owners' creditworthiness.

Data transparency may have mitigated the GFC of '07/'08

 Our view is that risks related to the Global Financial Crisis (GFC) of '07/'08 may have been mitigated if the individual mortgages used as collateral for MBSs had been tokenized and analyzed. Data transparency enabled by tokenization provides insight into the creditworthiness of MBSs at the individual mortgage level, which may have prevented the lowering of lending standards and the ability for credit rating agencies to issue investment-grade ratings for MBSs filled with subprime mortgages. Tokenized MBSs may have also made it more difficult for mortgage originators to pass along the credit risk to investment banks and institutional investors, both of which could have more effectively evaluated the creditworthiness of a MBS's underlying collateral.

Transparency provides valuable insight for home buyers

What if you tokenized your house? The data transparency provided by distributed ledgers and blockchains could provide not just ownership of the property to potential buyers, but also include an immutable record of sales history or even the last time the roof was replaced, what materials were used and which contractor installed it. Incremental and accurate data may provide valuable info for buyers and tokenization may reduce or remove legal costs associated with transferring a deed. Tokenization combined with fractionalization may also enable a homeowner to sell a property more easily by enabling multiple buyers, unknown to each other, to purchase an interest in the property.

We do not expect hundreds of thousands of individual mortgages or homes to be tokenized in the near term, but use the examples above to illustrate how tokenization enables data transparency and deeper analysis of assets, specifically structured products.

Supply chain fragmentation drives inefficiencies

Supply chains globally rely on a complex web of centralized and fragmented systems. Flows of information, inventory and finances from banks, suppliers and retailers are delayed, prone to tampering and often stored within separate systems that are not interoperable, which limits efficiencies, interoperability, innovation and functionality. Intermediaries exist throughout the supply chain, increasing costs, particularly for cross-border trade (Exhibit 11).

  Exhibit 11:   Supply chains rely on non-interoperable systems that inhibit transparency, efficiencies and optimization

 The current state of supply chains - participants maintain fragmented infrastructure that leads to data silos