This article first appeared in The Edge Malaysia Weekly, July 15, 2024 – July 21, 2024
How significant is the rise of tokenization for capital markets?
Governments, private institutions and financial organizations are busy collaborating on various projects that leverage on digital representations of assets, rights, or items of value through a smart contract on blockchain technology. We focus today on asset tokenization, which digitally converts real assets or rights that can be traded safely on public or private markets.
Simplistically, asset tokenization represents physical, or financial, assets or any rights associated to these assets in the form of a digital token on a blockchain. Blockchain technology enables a market for assets that could not be traded easily, by fractionalizing these “lumpy” assets into digital parts that can then be traded, creating a wider base of investors who could partake in smaller investment sums. What was only possible for institutional investors in the past can now be made available to a wider array of investors in a cost efficient, transparent and safe manner. Furthermore, certain actions can occur automatically without human intervention, e.g. corporate actions can take place when certain triggers are met, since a smart contract can be embedded into the token. In short, asset tokenization can potentially change the funding and operational model for various industries, particularly the capital market.
Asset tokenization presents a novel method to support real economy actors to optimize their assets, both financial and non-financial, in a different manner. What may have been previously non-bankable real-world asset may find its way into the financial eco-system. For example, an approach was taken by Japanese real estate firm Kenedix where they issued a digital security backed by a hotel in Sapporo City that uses the MUFG’s Progmat blockchain platform. This digital security comes with a utility token that can only be exchanged for souvenirs on-site at the hotel thereby encouraging owners of these tokens to visit and use the hotel. In a similar vein, in the case of Malaysia, can land which is not fully operationalized or “monetized” by their owners be unlocked via tokenization?
The land can be tokenized, registered on a blockchain, and access or user rights can be given or “sold” to other economic actors to utilize the land without changing the underlying ownership rights. Another example with potentially broad application is from the Technology Innovation Institute (TII), an arm of Abu Dhabi’s Advanced Technology Research Council (ATRC). Recently they announced they are tokenizing its carbon trading platform to support the trading of carbon tokens associated with green projects. Similarly, Malaysia, being an oil producer and emerging as a significant regional data center could perhaps think of novel ways to unlock the value of these assets to finance its path towards a carbon free future via tokenization. In the past, syndicated loans or raising capital via the equity or bond markets is the usual financing route. However, with the advent of blockchain technology, can these assets, or revenue streams from these assets, be digitally represented as a token, registered on a blockchain, whether private or public, fund green projects listed on the stock exchange or a digital exchange, thereby helping Malaysia offset the carbon emissions generated by these industries?
Malaysia is not unfamiliar to tokenization
In October 2023, via Labuan International Business and Financial Centre, Malaysia listed its first digital sukuk led by Fusang Exchange. The structure basically wraps the underlying sukuk into a digital format enabling investors another pathway to accessing shariah-compliant high-quality liquid assets.
Aside from strides made by private players and governments in capitalizing on technology such as blockchain, there remains legal matters that requires attention. Specifically, appropriate regulatory treatment should be formulated for this asset class to take its rightful place in the financial system.
Blockchain projects that fall outside the remit of existing securities law and projects that use crypto tokens can encounter significant regulatory hurdles as governments scramble to react to the seamless cross border capability of blockchain technology. The regulatory framework differs country to country and safe to say, some level of harmonization of rules and practices including type of assets eligible to be tokenized would go a long way towards developing digital tokens into a safe asset class.
Our neighbor Thailand, for example, has taken significant steps to regulate digital assets and support the growth of tokenization. The Emergency Decree on Digital Asset Businesses, introduced in 2018, provides a regulatory framework for offering digital tokens and operating digital asset businesses in the country. Singapore is working towards the legal and regulatory treatment for tokenized investment funds related to Project Guardian pilots that are close to commercialization. Japan has implemented clear guidelines indicating how digital tokens are to be regulated under an amendment to the Act on Settlement of Funds (Act No. 59 of 2009, the Settlement Act) and the Financial Instruments and Exchange Act (Act No. 25 of 1948, the FIEA) in 2019; where security tokens are deemed as “interests in a collective investment scheme that are represented by tokens” (denshi kiroku iten kenri). There are clear lines to adopt when promoting security tokens and the type of assets being distributed.
Ultimately, for asset tokenization to take its rightful place in capital markets, clarity and guidance from regulators are sorely needed and clear taxonomy is crucial for legal purposes. Providing guidelines for token classification and determining implications under property law, contract law, licensing requirements, and tax law is essential. Market participants need to understand how their projects will be regulated to avoid potential enforcement actions. Regulation by enforcement is not the most proactive or productive way forward to harness new technology.
With the many projects being formulated on a public blockchain, these global or multi-jurisdictional crypto projects are coming to the fore. The establishment of international standards in areas such as AML/CFT laws, accounting, and taxation is necessary to promote consistency and facilitate cross-border transactions. Malaysia can play a role to promote a safe space for tokenized projects to create more liquidity and product variety for its capital market.
Tokenization is gaining traction because there is recognition that the adoption of blockchain technology can support more efficient capital formation and collateral solutions, not to mention the operational efficiencies that can ensue.
In conclusion, tokenization can potentially bring significant benefits to augment traditional funding models. It opens up new opportunities for the securitization of non-bankable real-world assets. Real estate, environmental sustainability, and agriculture are just a few of the industries that can potentially stand to gain from tokenization as legal and regulatory frameworks improve.
