Understand the systemic change from digitization to tokenization of financial services

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The financial industry has seen growing demand for exposure to digital – and crypto – assets across all asset classes. This has generated interest, demand and investment from institutional financial institutions ranging from digital asset custody to digital asset trading desks, regulatory and compliance frameworks, and audit and risk models.

It’s fair to say that digital assets have taken the financial services industry by storm. While traditional finance’s attention and investment in decentralized finance (DeFi) is hailed as a progressive move, there are tremendous challenges and hurdles that financial services providers and institutions must address in order to make digital asset adoption mainstream.

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For one, the industry is on a massive digitalization path to modernize aging financial systems that rely on a ledger-based transaction system. It must ensure that the path to digitalization runs smoothly, has minimal disruption and brings the financial system, which moves assets and payments, up to the speed of the digital age and keeps pace with digital commerce and the digital provision of services.

These efforts have resulted in innovations in application programming interfaces (APIs) to support new business models. In addition to taking the form of digital products and services, these strategic APIs also take the form of co-creation vehicles to add value to the consumer and financial services ecosystem. The industry has seen growth in API management across the lifecycle as a link to securing businesses and delivering services at the same time, shifting the IT focus from projects to strategic APIs.

More recently, the approach has included financial technology or fintech partnerships and / or modernizing the technology. It focused on the user experience and API, with little attention paid to the systemic elements of the financial services industry such as payment, treasury, risk models, fraud, regulation and compliance, to name a few. While the user experience approach has had some success, the shortcomings have surfaced with legacy design parts of tightly coupled designs. The use cases that manifest as financial application eventually catch up with the constraints of financial systems and the assets locked in the ledger that rely on the relay of batch processes to move assets.

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So how does a financial institution manage these two drastically different models at the same time as the industry evolves in a complex transformation with a disruptive turn? On the one hand, digitization efforts are focused on a ledger-based model that largely represents the existing infrastructure, while on the other hand, the disruptive twist promotes a token-based model that questions and negates current digitization efforts. How do financial institutions manage the delicate balance in which two worlds can coexist and provide a seamless, unique experience?

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Understand digitization and fintech-led disruption

The financial services industry is in a constant state of flux, including the recent radical changes. The industry has witnessed many previous breakthroughs, including the introduction of computers into banking systems, anytime banking with ATMs and the Internet, and mobile technology that have shifted the mindset to “anytime, anywhere”.

Today, the financial services industry is largely focused on massive digitization efforts with initiatives such as Open Banking, Payment Services Directive-2 (PSD 2), Strong Customer Authentication (SCA) and ISO 20022 for payment harmonization and modernization. Much of these digitization efforts are industry-led, and some are driven by a regulatory policy. They are efforts to stay competitive and meet customer demands for real-time instant movement of assets and digital fiat as settlement tools.

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The challenges facing the financial services industry are immense, including constant changes in the regulatory landscape, customer expectations from digital natives, the need for real-time, round-the-clock operations to meet customer requests, and exogenous factors of ecosystems, the creation of interesting technology -Engine battles for financial institutions. The outdated infrastructure, which represents both significant investments and past modernizations, is now hindering the speed and scope required to unlock the digital value of not just products and services but the entire financial institution itself.

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With the advent of every significant change, the financial services industry has been able to adapt and withstand the disruption. The movement led by Fintech is another big change underpinned by radically different business models led by new innovative technologies, business structures and the digitization of adjacent and consumer experiences in every segment of digital business and engagement. This change – paired with increasing regulation, compliance pressure and disruptions from the fintech ecosystem – is forcing the established financial services industry to rethink innovations and business models. This is to keep the systems competitive, innovative, and malleable for future disruptive changes that may occur – like DeFi, which is powered by tokenization.

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Understand the impact of asset tokenization

We have found that digitization is the first step in many enterprise and permissionless blockchain projects. Tokenization is the process of converting or claiming an asset and rights into a digital representation or token on a blockchain network. At this point it may be advisable to distinguish between a (crypto) asset or a currency and a tokenized asset.

A (crypto) asset or currency is a medium of exchange or a protocol-controlled exchange mechanism that often embodies the same properties as a real currency – such as durability, limited supply and recognition by a network – and at the same time is supported by a shared belief system, such as a fiat currency. A (crypto) asset or currency is also a by-product of trust systems or consensus to support the economic incentive model that rewards and powers a network’s trust system and makes it a network’s trust currency. A token, on the other hand, can be many things: a digital representation of a physical good that makes it a digital twin, or a layer two protocol that is based on the (crypto) asset or currency and represents a unit of value.

This distinction between a (crypto) asset or currency and a tokenized asset is important in order to understand the exchange vehicles, valuation models and fungibility in various value networks that emerge and pose challenges for interoperability. The challenges are not just technical, but also business challenges related to Equitable Swaps. The tokenization of assets can lead to the creation of a business model that encourages partial ownership or the ability to own an instance of a large asset. The promised tokenization of assets in blockchain-based business networks is not just digitization or a solution to the inefficiencies of time and trust; it also creates new business models and co-creations from synergies of network participants that did not exist before.

While the blockchain itself provides the technology constructs to facilitate sharing, ownership, and trust in the network, it is in digitizing elements of value where asset tokenization is essential. In essence, digitization is a kind of requirement for tokenization. In the financial services context, the digitization of existing services and token-controlled DeFi represent two parallel business flows that will converge as the industry wants to offer a unified user experience.

Tokenization implies that account management and claims to assets are controlled by cryptographic keys, as opposed to account management and asset management by a system operator called a bank. While tokenization is more than just account management and claims to an asset, it enables divisibility, fungibility, and disintermediate business functions like asset transfer. It is a fundamental building block and prerequisite for an “Internet of Value”.

opinion

The answer to the question How does a financial institution manage the delicate balance in which two worlds can coexist and provide a seamless and unique experience? is a complicated one. The operational structure, which encompasses the complexity of existing structures while also encompassing the exponential growth (and complexity) of a digital asset ecosystem, needs to be adequately considered. This represents both a monumental operational challenge and an enormous landscape of opportunities and a path for new business models.

It is widely known and accepted that blockchain technology lays the foundation for a trustworthy digital transaction network that, as a non-intermediary platform, encourages the growth of marketplaces and secondary markets due to new synergies and co-creation due to new digital interactions and value sharing mechanisms.

Open Banking has led the digitization effort with a number of open APIs. These APIs can be extended to tokenized asset structures and transform the entire business process of various DeFi market structures into consumable units in which different asset classes, marketplaces and DeFi support services can be combined into a unique experience that hides the transaction complexity.

This article does not provide investment advice or recommendations. Every step of investing and trading involves risk, and readers should conduct their own research in making their decision.

The views, thoughts, and opinions expressed herein are those of the author alone and do not necessarily reflect the views and opinions of Cointelegraph.

Nitin Gaur is the founder and director of IBM Digital Asset Labs, where he develops industry standards and use cases and works to bring blockchain to business. Previously, he was Chief Technology Officer of IBM World Wire and IBM Mobile Payments and Enterprise Mobile Solutions, and founded IBM Blockchain Labs, where he led efforts to establish blockchain practice for the company. Gaur is also an excellent IBM engineer and master IBM inventor with a rich patent portfolio. He also works as a research and portfolio manager for Portal Asset Management, a multi-manager fund specializing in digital assets and DeFi investment strategies.