The 2023 total volume of futures and options contracts traded in the global listed derivatives market surpassed 137 billion. That means approximately 34 billion contracts were traded per quarter, 11 billion per month, 2 billion per week, 376 million per day, 16 million per hour, 261,000 per minute, and 4,300 per second. Constant trading is the nature of financial markets, but there have been signs that the current structure may be unable to keep up with the rapidly increasing level of trading volume in these markets. Tokenization could be just the thing to increase trading efficiency and reliability.
Tokenization has become quite the buzz word, especially in derivatives markets and clearinghouses. The tokenization of assets refers to the process of issuing a digital token that represents ownership in a real asset. The token is issued on a distributed ledger and the transfer of ownership is recorded on that ledger, similar to how bitcoin transactions are recorded on the bitcoin blockchain.
Tokenization was introduced in 2017 as an alternative tool to track ownership and automate the transfer of securities, leading to more liquidity, transparency and accessibility. For derivatives markets specifically, this could pave the way for greater efficiency, particularly in certain post-trade processes. For example, the industry currently relies on a complex web of interconnected systems to move collateral to meet margin calls from clearinghouses. Tokenization could allow cash and securities to be transferred instantaneously on a 24/7 basis, eliminating the risks that can arise over weekends and holidays.
There are many benefits to incorporating tokenization in global futures and options trading. According to a 2023 McKinsey & Company report, it would make around-the-clock operations, data availability and trading a reality. The top benefits include faster transaction processing and delivery, decreased operational and infrastructure costs, and greater accessibility and transparency on a massive scale. “Industry experts have forecasted up to $5 trillion in tokenized digital-securities trade volume by 2030,” according to the report.
However, before the industry gets to that point, extensive research must be conducted and tested. Generally, getting tokenization on its feet means deciding how to tokenize each asset, creating a neutral secure storage facility for the physical component of the asset if applicable, setting up a digital wallet and ongoing maintenance. Addressing user dependency on centralized systems, lack of technological infrastructure to support and developing a strong trust with potential users stand to be the largest obstacles.
Tokenization trailblazers
So, who were the trailblazers in this technology? In 2019, three leading European exchanges explored potential applications in securities markets exchanges by buying equity stakes in start-ups with expertise in tokenization and digital asset development.
Deutsche Börse Group was the first to jump into tokenization. In August 2018 the German market infrastructure company acquired shares of HQLAx, a company based in London that was founded by Olly Benkert, a former managing director at Goldman Sachs, and Guido Stroemer, a former managing director at UBS. In contrast to the traditional settlement process, banks using the HQLAx platform did not move securities from one custody account to another. Instead, tokens were transferred via the blockchain while the securities remained in place. At the time, HQLAx predicted this would help improve the mobility of collateral across the fragmented securities settlement landscape in Europe. Deutsche Börse Group and HQLAx were just the first to research and test this new way of conducting transactions and collateral management within Europe.
The London Stock Exchange Group focused on securities issuance. In February 2019, LSEG was the lead investor in a $20 million funding round for Nivaura, a company based in London that was founded in 2016. According to Nivaura, its platform will make the process for issuing financial instruments much more efficient and less expensive than the current approach. Nivaura estimated it could reduce the amount of time required to bring financial instruments into the market by up to 80%. For LSEG, the investment offered potential strategic benefits. Reducing the cost of the issuance process made it easier to bring more financial products to market and led to more listings, and turnover on LSEG's markets. It also gave LSEG a window into the tokenization process and a head-start on applying this innovation to other asset classes.
Euronext joined the push soon after and announced a €5 million investment in a startup called Tokeny Solutions. The Luxembourg-based company was founded in 2017 as a provider of end-to-end solutions that issue, manage, and transfer tokenized securities. One of its platform's key features is integrating compliance obligations into the tokenization process so that participants can comply with securities laws.
Since 2019, many companies have joined this critical discussion. In May 2022, JP Morgan launched its Tokenized Collateral Network (TCN) using money market funds (MMFs) as collateral, a system that can be used for transactions in derivatives trading. The goal was to increase utility and mobility of financial assets using blockchain technology. The network was launched under Onyx Digital Assets, an asset tokenization platform that enables financial institutions, asset managers and fintechs to unlock untapped utility for their financial assets. Onyx was the first global bank to offer a blockchain-based platform for wholesale payments transactions, researching how to enhance the global movement of information and assets.
Following the launch, JP Morgan’s managing director and head of blockchain launch and Onyx division Tyrone Lobban announced that the first asset class available on TCN was MMFs and that the platform was “live and open for business!” JP Morgan also confirmed that the first transaction using tokenized MMFs as collateral had successfully taken place.
Fast forward to December 2023, Lobban and his team published a brief on “How Tokenization Can Fuel a $400 Billion Opportunity in Distributing Alternatives Investments to Individuals.” The brief highlighted how tokenization can “streamline, automate, and simplify most stages of alternative investments and enhance liquidity and collateralization.” This would expand the types of portfolios used in the alternatives industry, increasing investments and opportunity for additional revenue. This is just one example of how tokenization is making trading in different industries more accessible and how this tool has the power to enhance underutilized resources.
Leading institutions and high-profile industry leaders are voicing their intentions to invest in tokenization. BlackRock’s CEO Larry Fink has even announced his plans to incorporate tokenized collateral. During a January CNBC interview after the launch of bitcoin ETFs in the US, Fink said, "We believe this is just the beginning. ETFs are step one in the technological revolution in the financial markets...Step two is going to be the tokenization of every financial asset."
The promise
At FIA's Expo conference in Chicago in October, a diverse panel of experts discussed the technology outlook and the path to widespread adoption of tokenized collateral. Although the industry is a long way from a widespread embrace of this technology, panelists agreed market participants are still making steady progress and strategic investments in the future of this technology.
There are still many hurdles to adoption of tokenized collateral. Commissioner Caroline Pham of the Commodity Futures Trading Commission said she was "not so optimistic" about the pace of adoption in the US – not necessarily because of the promise of tokenization, but rather the "lack of legal certainty" in the space. "If we're leading with an enforcement-first approach over operational and technical issues, it's not a good regulatory environment" to foster innovation and investment, Pham said.
Helen Gordon, global head of clearing product development and strategy at JP Morgan, noted that her organization is working on proof of concepts including its work with Onyx. But she acknowledged that "proving you can move a low value tokenized asset in the real world is one thing, industrializing it is completely different."
Despite the challenges, tokenization holds a lot of promise for derivatives industry and markets. FIA Expo panelists made it clear that tokenization of collateral is seen by experts as a real solution to some of the inefficiencies in settlement processes and margining in derivatives markets.
Kelly Mathieson, chief business development officer at software technology company Digital Asset, kicked off the panel by defining tokens as assets that "incorporate the workflow data or the lifecycle" of the asset as well. That makes tokenized assets not just more liquid, but also more transparent. "You can embed on that definition of that asset the eligibility criteria," Mathieson said. "The asset, digitally, can begin to let you know if it’s a suitable or transferable form of collateral."
Mark Wendland, chief operating officer and partner at DRW Holdings, said his firm is exploring ways to use tokenized assets in Treasury repo markets to increase the return on its capital. But the end game for the industry is bigger than generating extra yield in this market, and rather, the "more efficient use of capital" across the board. "Tokenization has potential benefits from efficiency but also to credit risk management, operational risk management, settlement risk management, for the entire industry as a whole," he said.
While tokenization is still in the beginning stages, the introduction of this technology years ago sparked an important discussion on building a more valuable, accessible, and transparent transaction system for all. Greater global accessibility could drive enhanced risk management or reduce the risk of time lost between transactions in derivatives markets. Proof that companies are preparing for the possibility of tokenization becoming a critical part of the industry lies in the significant expansions of digital assets teams that continue to be seen across the globe.
