How Tokenized Securities Fit into the Future of Digital Asset Custody

The U.S. Securities and Exchange Commission (SEC) is currently writing the next generation of crypto regulations. The rules aren’t finished, but qualified custodian requirements governing traditional finance will almost certainly apply to custodianship of tokenized securities. 

 Tokenization of securities refers to creating digital representations of real-world assets, such as stocks, on a blockchain.  

 As institutional interest in blockchain continues to grow, tokenization is emerging as a bridge between traditional and digital finance. It promises not only greater efficiency and transparency but also the potential to unlock liquidity in markets that have historically been slow, expensive, and difficult to access. 

 The practice is still in its infancy, but BlackRock CEO Larry Fink believes that every financial asset will be tokenized in the future, and Boston Consulting Group estimates the global market cap of tokenized securities will be at least $16 trillion by 2030.   

Key Takeaways

• Tokenized securities are gaining traction, but regulatory clarity on qualified custody remains a work in progress. 

• Tokenized securities promise operational benefits such as faster settlement, lower costs, and enhanced transparency of traditionally illiquid assets.

• May’s SEC tokenization roundtable was clear: Traditional securities in tokenized form are still securities, and forthcoming regulations will reflect that.

• Which types of custodians count as “qualified custodians,” as well as whether funds may engage in self-custody of digital assets, remain open questions. 

What Are Tokenized Securities?

 When imagining a “digitalized representation of a traditional asset,” some might picture a Bitcoin somehow corresponding to a piece of real estate. But that’s not quite how tokenization of assets works.  

 A tokenized security is a traditional financial asset that has been converted into digital tokens on a blockchain. That token represents ownership and carries the same legal rights and economic value as the original asset, but with the added benefit of being on the blockchain.  

Here are a couple real-world examples: 

• Singapore’s DBS bank issued a $11 million tokenized bond using a private blockchain. 

• Elevated Returns, a real estate management firm, tokenized and sold 18.9% of ownership in the St. Aspen Regis Resort using the Ethereum blockchain. 

Relevantly, the value of a tokenized security is based on its corresponding real-world asset; it has nothing to do with the value of any cryptocurrency. For instance, if a token was generated using the Ethereum blockchain, and the value of Ethereum drops, the token’s value wouldn’t be impacted. 

Why Tokenize a Security in the First Place?

Institutional investors have plenty of ways to package and sell securities, so why consider using tokenized securities?  

• Speed: Trades that normally take T+1 days to complete (one business day after the trade date) can settle near-instantly on the blockchain. 

• Cost: Blockchain trades require fewer intermediaries and less overhead than traditional finance, lowering costs. 

• Transparency: Every token transaction is recorded on the blockchain’s ledger, providing an immutable audit trail.  

How Tokenized Securities Work

Tokenized securities use blockchain technology and smart contracts to record ownership and enforce trading rules, enabling peer-to-peer transactions with compliance built in.  

Tokenization of securities can be complex. However, the core mechanics are more straightforward than they may initially seem: 

1. An asset is chosen for digitization.

2. A tokenized version of the asset is generated on a blockchain.

3. Tokens are distributed to investors.

4. Investors can trade tokens on specialized exchanges according to pre-written “smart contract” rules. 

Two key components deserve closer examination: smart contracts and the impact of blockchain technology on asset custody for tokenized securities. 

What Are Smart Contracts?

Smart contracts are customizable, self-executing pieces of code that dictate how tokens are transferred on the blockchain. They can be programmed to enforce regulatory restrictions, automate processes, and are responsible for some of the advantages that tokenized securities have over traditional financial instruments.  

For instance, a smart contract could be programmed to enforce know-your-customer laws by permitting trades only between whitelisted addresses. It could also cut administrative costs by automating dividend distributions, interest payments, or voting rights without manual intervention.  

These automations and rules span an asset’s lifecycle, from issuance to trading to settlement, reducing reliance on intermediaries and minimizing human error. 

How Is Asset Custody for Tokenized Securities Unique?

In traditional finance, custodians manage paper-based records or entries in centralized databases. But with tokenized assets, ownership is recorded directly on the blockchain, with access to assets controlled by private cryptographic keys. 

Since the holder of a private key effectively holds the asset, safeguarding that key is central to digital asset custody. 

The Challenge of Tokenized Securities

Despite its promise, tokenization of securities comes with unique regulatory and cybersecurity challenges. 

• SEC commissioner Hester Peirce writes that “traditional securities in tokenized form are still securities,” but how existing securities law applies in a tokenized context remains unclear. 

• Legal certainty is essential. The rights represented by tokens must be both legally binding and operationally enforceable across countries and jurisdictions. For tokenization to work, the underlying asset must always be accessible.

• Blockchain-based securities carry unique cybersecurity risks. Smart contracts can be helpful for automating compliance, but their rigidity could also be breached or exploited by bad actors. 

• Retail investors’ lack of familiarity with digital assets adds another layer of complexity. Until the education gap closes, skepticism of tokenized securities may persist. 

Considerations for Adopting Tokenized Securities

Tokenized securities represent a growing trend that forward-looking institutions can leverage for innovation and growth. However, adoption requires a thoughtful approach. Key considerations when integrating tokenized securities into offerings include:  

• The SEC is writing the next generation of digital asset regulations. It is essential to stay current with regulatory trends and prepare for compliance.

• Offering tokenized securities requires secure digital asset custody and token management solutions. Security protocols must be robust enough to meet these challenges.

• Integration with existing operational workflows is critical. Portfolio management systems must be able to track tokenized securities alongside traditional holdings or accommodate separate asset classes if required. 

BitGo is the leading qualified digital asset custodian, offering institutional-grade security for tokenized securities alongside compliance support, API integration, and high-touch customer support. 

Stay tuned to the BitGo blog for the latest digital asset news impacting institutional investors. 

FAQ

Here are some quick answers about digital asset custody and tokenized securities.  

What are tokenized securities?

Tokenized securities are traditional financial assets, like stocks, bonds, or notes, that are digitally represented on a blockchain. Each token reflects legal ownership and rights, combining the regulatory framework of traditional finance with the efficiency and programmability of distributed ledger technology. 

How do tokenized securities differ from traditional securities?

The key difference lies in infrastructure: Tokenized securities are recorded and transferred on blockchains using smart contracts, enabling real-time settlement, automated compliance, and greater transparency than traditional systems reliant on centralized intermediaries.  

What benefits do tokenized securities offer?

Tokenization enables faster settlement, lower costs due to fewer intermediaries, and enhanced transparency with blockchain ledgers. 

Are tokenized securities safe for investment?

Tokenized securities carry the same underlying risk as their traditional counterparts, but they also present additional cybersecurity issues. Institutional investors should ensure that proper compliance, cybersecurity countermeasures, and infrastructure are in place when conducting due diligence for a potential digital asset custody provider.