From Ledger Insights

Yesterday the BIS and Committee on Payments and Market Infrastructures (CPMI) delivered a report to the G20 on tokenization. That paper was both upbeat yet sober, balancing the opportunities, risks and steps that central banks need to take. A separate G20 report published today from the Financial Stability Board (FSB) is far more skeptical on the topic. Currently, there’s little risk because it views the adoption of tokenization as “very low” but growing. It also published a report on crypto-asset policy implementation.

At a more granular level, the risk is limited because most tokenization projects use permissioned blockchains and only use programmability in a limited way. Hence, the transactions are still relatively simple rather than composable. While the sector bemoans the current fragmentation which limits the tokenization benefits, from the FSB perspective, this reduces risk because it limits growth.

The FSB seems unconvinced about the benefits of tokenization, arguing that other current technologies can achieve similar results. It questions the appetite for tokenization adoption and outlines numerous hurdles in its path. Plus, it spends significant time delving into the potential risks.

From a financial stability perspective, those risks increase if the scale of tokenization grows, which will probably happen if the industry addresses the DLT interoperability and there’s greater regulatory clarity. While traditional finance (TradFi) transactions currently are relatively simple (compared to the composability used in DeFi), if TradFi tokenization projects become more complex or opaque, that could increase risks. Finally, if regulators fail to ensure risks related to tokenization are mitigated, this could create financial stability risks.

What are the tokenization risks that need addressing?

First off, the FSB is concerned about liquidity and maturity mismatches with tokenization. Some of the assets being tokenized may have different timelines for convertibility into cash compared to the tokens themselves. This could trigger redemption run risks. The fractionalization benefits touted by tokenization projects “could also raise maturity and liquidity transformation issues similar to those encountered with collective investment schemes.”

Regarding liquidity, while the FSB recognized the benefits of delivery versus payment or atomic settlement, this increases the need for cash, because there’s less netting of payments. While sometimes institutions can borrow funds, the higher liquidity increases the risk that funding might not always be available when needed. This could lead to liquidity stress events. Plus, given the automation enabled by DLT, the spread of such events would be faster.