Getting real – demystifying the legal and regulatory underpinnings of real-world asset tokenisation

As we explored in our first article, tokenisation of real-world assets (RWAs) offers enormous potential for traditional finance but when you try to implement this technology in today’s capital markets the challenge is more nuanced than it may initially seem. In this blog, we speak to a leading blockchain lawyer to explore the legal and regulatory underpinnings of RWA tokenisation and demystify the elements that are challenging market participants’ attempts to move forward.

Tokenisation – the next phase of dematerialisation

In recent years, financial instruments have gradually shifted from paper-based systems to electronic records and centralised databases. The next phase of modernising financial markets will go beyond record keeping and look at embedding the asset itself, including the terms and arrangements that give it effect, into the same instrument. Tokenisation is, using technology, the act of effectively bringing these two separate pieces together.

Hannah Glass, Special Counsel at the law firm Ashurst, explains: “Tokenisation, at its true potential, is about changing the form but not the function. It is more than a digital twin which takes an asset that exists in a paper form or as a PDF and creates another digital copy. It doesn’t change the legal rights and relationship. Instead, it embeds these rights and relationship into the token itself”.

The challenge of real estate tokenisation

Real estate is often touted as one of the Real-World Assets that should be ripe for tokenisation – and indeed real-estate tokenisation projects have already got off the ground. Property should seemingly be straightforward to tokenise because records remain paper-based, making it easier to justify a move to tokenisation than a market which is already electronic and has an established framework around it.

When Hannah outlines the process from a legal perspective, however, she underlines the challenges of tokenisation which go beyond simply implementing a new technology: “The difficulty around real estate lies in saying what does it actually mean to own a house? To be able to tokenise it, we need to work out what we are tokenising. It’s not the piece of paper. It’s the right that you have to that land, subject to all the other rights that other people also have to that land. The benefits of tokenisation are both the creation of the instrument and, importantly, the use of a different technological structure (a distributed ledger) to manage the instrument and these rights over its life cycle”.

Benefits of tokenisation over the asset lifecycle

To realise the true potential of tokenisation, institutions need to consider not just the instrument but also the means of settlement. Hannah outlines the process: “If we think about managing the instrument over its life cycle, this requires making payments to different people. It’s not just about what the parties have agreed to do but how can we get from A to B? The instrument may be tokenised but is the means of settling that instrument (the payment) also tokenised? That’s where it becomes exciting and challenging”.

Governments all over the world are extensively exploring Central Bank Digital Currencies (CBDCs) to potentially provide this means of settlement. International experiments such as Project mBridge’s work on cross-border payments and settlement are also significant, as are experiments from commercial banks looking at stablecoins and tokenised deposits as well as CBDCs.

Hannah comments: “Once you have a tokenised instrument as well as tokenised payment, you bring the two into the same ecosystem. Then you have delivery versus payment, which transforms the entire operation of the market because you completely change the risk framework around the instrument, and you can make payments in different ways”.

The emergence of different forms of tokenised money creates a variety of promises to pay with different risk profiles. This then raises fundamental questions around regulatory risk. Do financial institutions trust the Central Bank more than a private issuer which may not be regulated in the same way? Is one commercial bank’s money fungible with the money that sits in another commercial bank?  Is there a risk that suddenly a bank may not be able to access its clients’ money?

When you apply this thinking to an international bond transaction which may require billions of dollars’ worth of liquidity, regulated financial market participants need to be certain that they are using a trusted form of money. Hannah argues that “the whole conversation on Central Bank Digital Currency and tokenisation of deposits is fundamental to the success of tokenisation as the next phase of dematerialisation, because you need to have both working together”.

Moving ahead in an uncertain environment

A great deal of work is being done to transform traditional financial markets by changing both the form of financial instruments and transforming the form of money. “It takes time to do it properly but the financial institutions which lean into and work with those changes are those that are going to be well placed to take advantage of the benefits that will arise from tokenisation” says Hannah.

Despite the implementation challenges, tokenisation projects are advancing all the time and certain areas remain ripe for reform, in particular, the emerging market for carbon credits and carbon instruments where Hannah offers the prospect of optimism.

The carbon market has a complex structure with a whole raft of different projects which give rise to credits – and not all carbon credits are created equal. Tackling fraud and disinformation could be a key advantage for a tokenised market: “One of the ideas behind tokenisation is you can embed greater variability within the instrument itself. So that’s also another potential advantage of using a tokenised rather than a registry-based instrument. When you’re building the market from the beginning, potentially taking advantage of new technology, there is a huge opportunity there”.

In part 3 of this series, we speak to Rene Michau, Global Head of Digital Assets at Standard Chartered Bank about the practical challenges of making the transition to tokenised Real-World Assets from the perspective of regulated financial market participants.

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