August 2023, Federal Reserve Board, Washington, Dc.Published the article "Tokenization: Overview and Financial Stability Implications", which examines the history of tokenization and its pros and cons for financial stability. In this article, the authors detail tokenization, an emerging and fast-growing financial innovation in the crypto asset market, and the possible benefits and potential impact on financial stability. Tokenization refers to the process of converting non-crypto assets (i.e., "reference assets") into digital forms (i.e., "crypto tokens"). As discussed in the article, tokenization establishes the link between the digital asset system and the traditional financial system. If the size of the tokenized asset is large enough, the crypto token may pass the volatility of the crypto asset market to the market of the reference asset corresponding to the crypto token. The Institute of Financial Technology of Chinese Min University (WeChat ID: ruc fintech) compiled the core part of the research.
*｜finance and economics discussion series, federal reserve board, washington, d.c.
Authors Francesca Carapella, Grace Chuan, Jacob Gerszten, Chelsea Hunter, Nathan Swem
Compiled by Xu Qing'an.
Features of the token
Crypto tokenization consists of five important characteristics: it is supported by the blockchain, there is a corresponding reference asset, there is a valuation mechanism for the reference asset, there is a way to store and keep the reference asset, and it can be exchanged for crypto tokens to redeem the reference asset.
Crypto tokens can be divided into four types depending on whether the crypto token is issued on a permissioned or permissionless blockchain, and whether the reference asset is on-chain or off-chain. Crypto tokens issued on permissioned blockchains are typically controlled by a central authority that grants access to specific users in a separate system. For instance, in January 2023, the European Investment Bank (EIB) issued a crypto token tied to bonds on HSBC Orion, HSBC's bond tokenization platform. During the same period, Ondo Finance issued a crypto token called OUSG on Ethereum.
Figure 1 As for the position of the reference asset in the blockchainOff-chain reference assets can be both physical (e.g., real estate and commodities) and non-physical (e.g., intellectual property, **, and bonds)., but off-chain assets must exist outside the blockchain. In addition, crypto tokens for off-chain assets usually involve an off-chain third party (such as a bank) who is responsible for assessing the value of the reference asset and keeping the reference asset. Cryptocurrencies corresponding to on-chain assets can be used to hold and value the assets through smart contracts.
Similar to stablecoins, crypto tokens allow their holders to redeem reference assets from token issuers, and this mechanism for exchanging crypto tokens is known as "redemption mechanisms". The existence of redemption mechanisms creates secondary markets for cryptocurrencies, such as centralized cryptocurrency exchanges and decentralized finance (DeFi) exchanges. Some crypto tokens that correspond to on-chain liabilities or equity do not contain a redemption mechanism, but as compensation, they provide token holders with other rights such as ownership, income rights, etc.
The size and case of the crypto token market.
Using news reports and public databases, the authors estimate that as of March 2023, the market size of crypto tokens for permissionless blockchains is about 21$500 million. It is worth noting that since June 2022, the entire decentralized financial systemTotal Value Locked (TVL).Largely unchanged, but TVL related to real-world assets has grown since July 2021.
Figure 2 TVL of assets under the decentralized finance chain
Note: Real-world assets lending refers to special decentralized finance lending protocols that use tokenized reference real-world assets as collateral for loans. real-world assets refers to protocols that involve the tokenization and trading of off-chain assets.
With the development of crypto tokens, the form of its reference assets has gradually been enriched, including agricultural products, real estate and finance.
Among the types of reference assets in Figure 3, real estate assets are different, the market liquidity is weak, their value assessment is difficult, and the legal and tax processes involved are relatively complex, making the ownership and transaction process more cumbersome. Take, for example, Real Token IncRealt, Inc. (abbreviated as Realt) is an issuer of tokenized real estate projects that aggregates a collection of homes and tokenizes the legal rights and interests of those residences. Each residence is owned by a legally separate limited liability company from Realt. It's not the residences themselves that are tokenized, but the equity of these independent LLCs. That is, each dwelling corresponds to a separate limited liability company, and the shares of this independent limited liability company can be divided into smaller shares, thus achieving joint ownership. As of September 2022, Realt has completed the tokenization of 970 real estate units worth more than $52 million.
In addition to real estate assets, reference assets include financial assets such as bonds, bonds and exchange-traded funds (ETFs). In this case, while the crypto token represents a financial asset with market pricing, the ** of the crypto token and its corresponding financial asset are not necessarily the same. Some of the reasons include: tokenization** enables round-the-clock trading, while ** is limited by opening hours; In decentralized finance applications (DApps), the programmability and composability of crypto tokens may affect the liquidity of the token. 
Figure 4 Meta and Tokenization.
Note: Bittrex FB refers to the tokenization of Meta listed on the cryptocurrency exchange Bittrex**.
The possible benefits of crypto tokens.
Crypto tokens enable investors to access markets that would otherwise be inaccessible or have higher costs. By converting ** or ** into virtual tokens, investors will not only be able to access the "traditional" investment market, but will also be able to trade these tokens more conveniently on the secondary market (as mentioned earlier). Real estate tokenization may allow investment in a small portion of the underlying assets, where investors can purchase a share of a particular commercial building or residential investment; This is different from real estate investment trusts (REITs), where the investor owns a share of the real estate portfolio.
The programmability of crypto tokens, as well as the ability to utilize smart contracts, makes it possible for people to embed additional functionality in crypto tokens; These features may also benefit the market for their reference assets. For example, liquidity s**ing mechanisms can be introduced into the settlement process of crypto tokens. This could lower the barrier to entry for the investor base, leading to a more competitive and liquid market, and making the market** more in line with the actual value of crypto tokens.
Crypto tokens may also be used as collateral to facilitate lending. Prior to the introduction of crypto tokens, the cost of borrowing and lending with grain could be particularly high; After the introduction of the crypto token, the token can be used as collateral in the secondary market to complete the lending due to the higher asset liquidity, divisibility and transferability of the crypto token representing the grain than the grain.
Transactions of crypto tokens may be settled faster than their counterparts in real-world reference assets as well as in financial reference assets. In terms of representing other assets, the closest financial instrument to crypto tokens is ETFs. The academic literature on ETFs has documented a strong positive correlation between the liquidity of an ETF and its foundation, and found that additional trading activity in ETFs improves the information efficiency of the underlying ETFs. As a result, crypto tokens have the potential to facilitate market liquidity and a higher level of market equilibrium.
The impact of crypto tokens on financial stability.
The overall value of the crypto token market is at the multi-billion dollar level, which is small compared to the cryptoasset market and the traditional financial system, so it does not yet pose a significant financial stability issue. However, if crypto tokens continue to grow in volume and size, it could make the crypto asset market more vulnerable and potentially transmit instability to the traditional financial system.
In order to ensure long-term financial stability, the redemption mechanism of crypto tokens needs to be focused on. For example, if large enough, a fire-sale of crypto tokens could have a ripple effect in traditional financial markets, as price dislocations in the crypto token market provide market participants with an incentive to buy tokens, redeem them, and reference assets. This instability transmission mechanism may have a greater impact on illiquid asset tokens, such as real estate.
In addition, crypto token issuers may also face outflows. This is because any uncertainty about the tokens' collateralization levels behind the tokens, in particular due to insufficient disclosure and inaccurate information from the issuer, may increase the incentive for investors to redeem the reference asset, triggering a rapid sell-off of the reference asset.
The institutional mismatch between the crypto token market and the traditional financial market can also lead to financial instability. For example, a mismatch in trading hours may have an undesirable impact on investors or institutions in an emergency. Over the weekend, the sell-off of real estate tokens can quickly reduce the market value of institutions holding tokens, as well as token issuers, hurting their borrowing power and thus their ability to repay their debts. The token sell-off will be particularly severe if affected institutions can only receive infusions during the opening hours of traditional financial markets.
As the size and reach of crypto tokens grows, traditional financial institutions may become more exposed to the crypto asset market by directly holding the reference asset or by using the token as collateral. As mentioned above, Santander is already using grain tokens as collateral to provide loans to farmers; Ondo Finance is also launching an initiative to tokenize various money market instruments, such as the Money Market Funds (MMF) in the United States. In addition, while Ondo Finance's initiative is similar to JPMorgan's first use of tokenized money market** (MMF) shares as collateral for buyback and lending transactions, the impact of this initiative on traditional financial markets is likely to be much broader. Because Ondo Finance's tokens are deployed on the public blockchain Ethereum, rather than on an agency's permissioned chain, this means that Ondo Finance has no control over how users and DeFi protocols use these tokens. As of May 2023, according to DeFi Llama, Ondo Finance's ETF tokens account for 32% of the market capitalization of assets issued by decentralized protocols related to off-chain assets, making them the largest project in this category.
Finally, similar to the role of indentization during the global financial crisis, tokenization may disguise higher-risk or illiquid reference assets as safe and easily tradable assets and encourage higher leverage. An abrupt reversal of market winds could trigger a systemic financial collapse event.
Summary
This report aims to provide background information on digital tokens and discuss their potential benefits and implications for financial stability. Currently, tokenization is relatively small, both in terms of overall size and in terms of the size of the market size of the token's reference asset. However, many projects involving various reference asset classes are in development, suggesting that tokenization could become a larger part of the digital asset ecosystem. Among the range of benefits of crypto tokens, lowering the barrier to entry and improving liquidity in otherwise inaccessible markets stand out the most. The financial stability risk of crypto tokens is mainly related to the link they create between the digital asset system and the traditional financial system, such as the possibility of capital outflows from token issuers, or the transmission of market shocks from one financial system to another by crypto tokens.
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endEdited by Xue Jingyi.
Editor-in-charge: Xu Hecong.