After completing this reading, you should be able to:

• Explain the process of tokenization and describe the fundamental features of tokenized assets and digital ledgers.
• Describe frictions and inefficiencies that can arise during different phases of an asset’s lifecycle and explain how the different features of tokenization can both increase and mitigate risks related to these frictions.
• Explain how the use of tokenization and digital ledgers can impact financial market externalities, including those related to the transmission of shocks across the financial system, investments in market infrastructure, and network and knowledge effects.
• Explain how the proliferation of distributed ledger technologies can impact retail investors and brokerage firms.
• Compare different models and methods that are currently available to achieve sharedness, programmability, and trust on a ledger, and describe the conditions under which trust can fail in such models.

1. Introduction

Recent advances in digital technologies are transforming financial markets through innovations such as high-frequency trading, mobile banking and payments, and crypto-asset issuance and trading. Tokenization represents one of the most significant recent financial innovations. The Boston Consulting Group estimates that asset tokenization could reach $16 trillion, or approximately 10 percent of global GDP, by 2030.

This reading provides a conceptual framework rooted in economic first principles to examine how tokenization may affect market inefficiencies. These inefficiencies are categorized into two broad groups: (1) frictions, which include information asymmetries, search problems, transaction costs, and counterparty risks analyzed throughout an asset’s lifecycle; and (2) externalities, internalities, and market power, which affect multiple stages of the asset lifecycle simultaneously.

2. The Process of Tokenization and Fundamental Features

2.1 Definition of a Digital Token

A digital token is defined as an asset or a representation of an asset on a digital ledger that possesses three fundamental features: sharedness, trust, and programmability. These features exist on a continuum rather than as binary characteristics.

Tokenization refers to the creation of assets or representations of assets on a shared, programmable, and trusted digital ledger. This definition is technology-neutral, focusing on functional features rather than any specific technological implementation such as distributed ledger technology (DLT).

2.2 The Three Fundamental Features of Token Ledgers

Sharedness

Sharedness refers to the capacity of transacting parties to possess, acquire, and transfer assets on the ledger. For tokens to be transferred, the ledger must be shared, meaning transacting parties can own assets recorded on the ledger and instruct it to update ownership. Asset ownership rights are embedded and transferable. A ledger’s degree of sharedness increases as more users join through onboarding or through merging with previously separate ledgers.

Trust

Trust depends on the accuracy of asset ownership records and the predictability of transaction orders. Trust is a necessary condition for agents to transact willingly on the ledger. Trust encompasses two dimensions:

• Trust in ownership: A token cannot be transferred without its owner’s consent, and once transferred with consent, the recipient’s ownership is lasting and cannot be suddenly reversed.
• Trust in orders: Instructions on the ledger will be predictably executed, and confirmation will be accurate, truthful, and final.

Programmability

Programmability means the ledger stores code-based instructions (smart contracts) that can create assets or financial applications. Key aspects include:

• Smart contracts can create transferable financial instruments such as bonds that pay coupons, or can be used to escrow and exchange assets.
• Immutable logic can be automatically enforced every time an asset is transferred, enabling strict compliance with regulations.
• Composability allows applications to be combined and reused across different transactions and protocols.
• Atomicity enables multiple transaction steps to execute as a single inseparable transaction—all steps complete successfully or none do.

2.3 Forms of Token Creation

Tokenization can take place in three distinct forms:

1. Native tokens: Digital tokens created through issuance directly on a shared, programmable, and trusted ledger. These tokens exist solely on the ledger.
2. Non-native tokens: Digital tokens created as virtual representations of existing assets held by a custodian. The unit of account is the off-ledger asset backing them.
3. Migration: The process by which a non-native token and the off-ledger asset it represents are replaced by a native token on the ledger.

EXAM TIP: Native vs. Non-Native Token Distinction

• The key distinction is whether the off-ledger backing asset serves as the token’s unit of account.
• If a token representing gold is backed by actual gold held off-ledger, it is non-native.
• If a stablecoin is denominated in USD but backed by government bonds (not USD itself), it is classified as native because bonds are not the currency itself.

3. Models to Achieve Sharedness, Programmability, and Trust

3.1 Models for Achieving Sharedness

Three main models exist to obtain sharedness on a ledger:

1. Single ledger model: Involves issuing native assets on a ledger where all potential transacting parties (or their intermediaries) have accounts.
2. Common ledger model: Creates representations of assets (initially on separate ledgers) on a ledger accessible to all parties by placing assets in escrow and issuing escrow certificates.
3. Compatible ledgers model: Involves standardizing technology across ledgers so they can run the same programs and offer coordinated transfers, making ledgers interoperable.

3.2 Models for Achieving Trust

Three categories of models exist to achieve trust through consensus on ledger state and programming functions:

3.3 Conditions Under Which Trust Can Fail

Permissionless DLT Trust Failures:

• Consensus mechanism attacks: Under proof-of-work, successful attack requires controlling >50% of computational power.
• Front-running and sandwich attacks: Users exploit pending transactions by manipulating fee levels to position transactions strategically in the validation queue.
• Oracle vulnerabilities: Applications (oracles) transmitting external information to smart contracts present vulnerabilities accounting for significant cyberattacks.

Permissioned DLT and Single-Operator Trust Failures:

• Network authorities can modify ledger records at their discretion, potentially manipulating trading or prices.
• Centralized ledgers face greater risks as no consensus among authorities is needed to alter the ledger.

4. Frictions Throughout the Asset Lifecycle

$$ \begin{array}{l|l|l} \textbf{Model} & \textbf{Mechanism} & \textbf{Source of Trust} \\ \hline {{\textbf{Single-Operator}\\ \textbf{Systems}}} & {{\text{Centralized: single entity}\\ \text{keeps records, executes,}\\ \text{and confirms transactions}}} & {{\text{Credibility of operator,}\\ \text{supervision, legal recourse}}} \\ \hline {{\textbf{Permissionless}\\ \textbf{DLT}}} & {{\text{Decentralized network of}\\ \text{nodes verify/validate;}\\ \text{incentivized through}\\ \text{rewards}}} & {{\text{Decentralization}\\ \text{(e.g., Bitcoin, Ethereum)}}} \\ \hline \textbf{Permissioned DLT} & {{\text{Hybrid: validators}\\ \text{onboarded by central}\\ \text{authority}}} & {{\text{Central authority oversight}\\ \text{with distributed validation}}} \end{array} $$

4.1 Asset Issuance

Current structure: Asset issuance requires creating records of bonds and shareholders, typically performed by registrars. Investment banks conduct due diligence and underwrite issuances, acting as a “credibility bridge” between new issuers and investors.

Tokenization’s impact: Shared and programmable ledgers can reduce issuance transaction costs:

• On a shared ledger, no separate record of asset owners is needed because every asset is linked to the purchasing owner’s account, eliminating registrar services.
• For native tokens, custodian services may not be required, generating additional cost savings.
• Smart contracts can automate auction execution for new share distribution.
• Data can be wrapped into token assets (e.g., bond terms, ESG data), improving transparency.

4.2 Asset Trading

Simultaneous settlement: Shared and programmable ledgers enable overcoming counterparty risk on immediate trades through simultaneous settlement without relying on financial intermediaries. Smart contracts ensure that both funds and assets are locked before an automated exchange—if the conditions are not met, the assets revert to their original owners. This represents delivery versus payment execution.

Limitation for derivatives: Sharedness and programmability cannot mitigate counterparty risk between contract initiation and future transaction execution. Two approaches exist: (1) employ an intermediary (CCP), or (2) lock all assets for the contract’s duration, which could reduce incentives to trade derivatives due to collateral lock-in costs.

Instantaneous settlement: A shared ledger can enable instantaneous settlement, reducing frictions to transaction speed. Current CCH clearing can take several business days. Faster settlement improves capital allocation and liquidity management.

Reduced search frictions: In OTC markets, a shared digital ledger with direct investor access could facilitate counterparty matching, reducing reliance on broker-dealers and lowering trading costs (e.g., bid-ask spreads).

4.3 Asset Servicing and Redemption

Collection and distribution of dividends and interest payments can be automated using shared, programmable ledgers. On a shared ledger, every asset links to the owner’s account, eliminating separate recordkeeping. Smart contracts can embed asset servicing directly into tokenized assets, specifying payments and conditions.

EMPIRICAL EVIDENCE: Quantifying Tokenization’s Impact

• Allen & Wittwer (2023): Up to 27% increase in welfare gains from centralized OTC bond markets
• Leung et al. (2023): Tokenized bonds show 0.22pp lower underwriting fees, 0.78pp lower yield spreads, 0.035pp lower bid-ask spreads
• Liu, Shim & Zheng (2023): Blockchain-based ABS yields an average 25 basis points lower than traditional ABS

5. Externalities, Internalities, and Market Power

Beyond frictions, financial markets are affected by externalities (when agents do not consider how their actions affect others), internalities (when participants are not fully informed or rational), and market power (the ability to influence prices or transaction terms).

5.1 Shock Transmission Externalities

High leverage, low funding liquidity, and interconnectedness amplify shock transmission among financial intermediaries. Tokenization may increase shock transmission through several channels:

Increased leverage incentives: Reduced debt issuance costs could make leverage more appealing. Programmability may also facilitate rehypothecation through automated smart contracts. This illustrates how mitigating one inefficiency (transaction costs) could amplify another (externalities).

Funding liquidity effects: If shared ledgers reduce the costs of investing in financial assets other than bank deposits, retail depositors may shift funds, increasing institutions’ reliance on wholesale funding, which is more likely to dry up during shocks.

Increased interconnectedness: Cheaper and faster access to wider markets can lead to greater financial system interdependencies. Programmability facilitates complex assets with returns dependent on multiple underlying assets. A run on one instrument can precipitate broader crises.

Increased trading speed: Widely shared ledgers can accelerate trading, amplifying the velocity of shock transmission. Programmability enables automated trading, potentially exacerbating flash-crash risks.

5.2 Market Infrastructure Investment Externalities

Counteracting operational risk requires significant investment. If private ledger operators bear only part of the total costs from operational risk events, they may underinvest in security. Tokenization may raise costs of operational risk events through increased interconnectedness and concentration risk (a widely shared ledger becomes a single point of failure for cyberattacks).

5.3 Network Externalities

A network externality occurs when the value of an action depends on how many other agents take the same action.

Positive effects: Increased sharedness improves market liquidity. Higher liquidity reduces bid-ask spreads, potentially creating a virtuous cycle. Asset fractionalization enabled by tokenization enhances retail investor access to diversification.

Negative effects: A proliferation of noninteroperable ledgers could decrease market liquidity by segmenting participants. This represents a decrease in sharedness rather than an increase.

5.4 Knowledge Externalities

More shared, programmable ledgers provide a common infrastructure for developers, easing innovation paths. A larger shared user base strengthens private companies’ incentives to invest in innovation. When more investors share a programmable ledger, a broader set of contingent actions can be executed, expanding the range of contractual outcomes.

5.5 Retail Investor Internalities

Internalities arise when retail investors do not fully comprehend asset risks. Tokenization’s impact on retail investors:

• Direct trading access: If retail investors are allowed direct trading on tokenized ledgers, internality costs could increase.
• Complex product creation: Increased programmability makes constructing complex products easier, especially problematic with derivatives.
• Permissionless DLT challenges: Regulatory enforcement is particularly difficult on permissionless distributed ledgers due to decentralized governance.

5.6 Market Power Inefficiencies

Potential to Reduce Market Power:

• Reduced switching costs: On a shared ledger, every broker could immediately verify others’ records, enabling direct asset transfers and increasing competitive pressure on brokerage fees.
• Direct trading option: Even if most trades continue through brokers, the outside option of direct trading can reduce fees.

Potential to Increase Market Power:

• If a ledger is privately owned, owners could extract monopoly rents from the more shared and dominant it becomes.
• Network effects, setup costs, and returns to scale can function as barriers preventing other ledgers from challenging a dominant position.

6. Summary: Tokenization’s Effects on Market Inefficiencies

$$ \begin{array}{l|l}  \textbf{Friction Type} & \textbf{Definition and Examples} \\ \hline {{\textbf{Asymmetric}\\ \textbf{information}}} & {{\text{One party has more transaction-relevant information}\\ \text{(e.g., IPO issuer knows more about company prospects)}}} \\ \hline \textbf{Search frictions} & {{\text{Impediments to matching between transaction parties,}\\ \text{potentially resulting in unrealized trades}}} \\ \hline \textbf{Transaction costs} & {{\text{Direct costs of trade and opportunity cost of time}\\ \text{involved in financial market activity}}} \\ \hline \textbf{Counterparty risk} & {{\text{Risk that one party does not deliver on contracted}\\ \text{obligations (immediate trades or derivatives)}}} \end{array} $$

7. Key Exam Considerations

Common Exam Pitfalls

• Conflating tokenization with DLT. Tokenization is defined by features (sharedness, programmability, trust), not specific technology.
• Assuming tokenization eliminates all counterparty risk. It addresses immediate trade risk but cannot eliminate derivatives counterparty risk without CCPs or costly collateral lock-in.
• Overlooking the dual nature of tokenization effects. Most inefficiencies can be mitigated or exacerbated depending on the implementation.
• Confusing simultaneous settlement (both legs settle at same time) with instantaneous settlement (settlement occurs immediately after trade agreement).
• Failing to recognize that ledger fragmentation represents a decrease in sharedness, not an increase.

Key Concepts to Remember

• The three fundamental features of token ledgers are sharedness, trust, and programmability—all exist on a continuum.
• Native tokens exist solely on the ledger; non-native tokens represent assets external to the ledger.
• Trust models: Single-operator (centralized), Permissionless DLT (decentralized), Permissioned DLT (hybrid).
• Market frictions occur throughout the asset lifecycle: issuance, exchange, servicing, and redemption.
•  Atomicity enables multiple transaction steps to execute as a single inseparable transaction.
• Mitigating one inefficiency can amplify another (e.g., lower transaction costs may increase leverage-related externalities).

Question

A risk analyst at a large multinational bank is conducting a training session for junior staff on the fundamental features of digital assets. The analyst explains that for a digital ledger to effectively support tokenization, it must possess three specific characteristics that function on a continuum rather than as binary features.

Which of the following combinations correctly identifies these three fundamental features?

1. Sharedness, Scalability, and Trust
2. Sharedness, Programmability, and Trust
3. Decentralization, Programmability, and Anonymity
4. Decentralization, Scalability, and Anonymity

Correct Answer: B

According to the IMF, the three fundamental features of digital token ledgers are Sharedness, Programmability, and Trust. Sharedness refers to the capacity of transacting parties to possess and transfer assets; Programmability means the ledger can execute code-based instructions (smart contracts); and Trust is the confidence in the accuracy of ownership and predictability of transaction execution.

Things to Remember:

Tokenization is the creation of assets or representations of assets on a shared, trusted, and programmable digital ledger.

These features are continuous, meaning a ledger can be more or less shared/programmable than another.

Distributed Ledger Technology (DLT) is a common implementation but is not part of the definition of a token; tokens can exist on centralized systems.