Tokenized Assets: An Ally to Regulatory Compliance

In late October, global regulators formed a tokenized assets policy forum to explore the technology’s use cases. As part of this project, four financial regulators joined together: the UK Financial Conduct Authority (FCA), the Monetary Authority of Singapore (MAS), which also serves as Singapore’s central bank, the Financial Services Agency of Japan (FSA), and the Swiss Financial Market Supervisory Authority (FINMA).

The project aims to share knowledge and examine the benefits, regulatory challenges, and commercial use cases of tokenized assets and tokenized funds.

Leong Sing Chiong, deputy managing director of MAS, said that the “MAS partnership with FSA, FCA and FINMA shows a strong desire among policymakers to deepen our understanding of the opportunities and risks arising from digital asset innovation. Through this partnership, we hope to promote the development of common standards and regulatory frameworks that can better support cross border interoperability, as well as sustainable growth of the digital asset ecosystem.”

MAS is known for supporting innovation and the utilization of emerging technologies for financial markets. In 2016, it launched the FinTech Regulatory Sandbox framework to encourage and enable experimentation of technological innovation to deliver financial products and services. Major financial institutions such as JPMorgan and UBS have been experimenting with asset tokenization products with MAS.

In late 2022, The Federal Reserve Bank of New York’s Innovation Center (NYIC) and MAS announced Project Cedar Phase II x Ubin+, a joint experiment to investigate how wholesale central bank digital currencies could improve the efficiency of cross-border wholesale payments involving multiple currencies. Fed Governor Christopher J. Waller recently gave a speech explicitly focusing on tokenization and Artificial Intelligence (AI), and said that [these] “two areas of innovation may have the potential to deliver substantial benefits.”

Meanwhile, the European Commission’s whitepaper on distributed ledger technology (DLT) proposes regulatory measures to ensure compliance of DLT-based products and services with existing financial regulations.

These developments reflect the increasing recognition and adoption of tokenized assets within regulatory frameworks worldwide. It’s not surprising as the utilization of blockchain could produce significant cost reduction both in transactions and compliance.

A recent report by JPMorgan noted that “while we estimate that a multi-currency CBDC [Central Bank Digital Currency] could cut costs by 80%, …. deposit tokens could unlock similar benefits by reducing fees, settlement times, and counterparty risks, and by enabling more direct funds transfers.”

Specifically for compliance, studies from McKinsey, Infosys and Accentuate indicate that blockchain technology could cut compliance costs by up to 50%. But it’s not merely just about the benefits of cost reduction. The International Organization of Securities Commissions (IOSCO) acknowledges the potential of blockchain technology to enhance regulatory compliance in securities markets.

There is a misconception that tokenized assets are used to bypass regulations. Tokenized assets can actually assist regulation by making things more transparent, automating compliance, and keeping track of transactions. It can simplify regulatory processes and create a safer, more effective system for all stakeholders. Let’s see how tokenized assets can serve as a trusted ally to regulatory compliance.

Tokenized Assets Could Enable Successful Compliance

Blockchain’s immutability could provide real-time visibility into transactions and ownership records. This enables regulators to monitor activity, identify fraud, and ensure adherence to obligations:

Streamlined reporting: It reduces the time and cost associated with manual reporting. It enables companies to always be compliant with reporting requirements and ensures that investors have access to timely and accurate financial information.

Facilitates improved liquidity: Traditional securities might have limited liquidity due to lengthy settlement periods and complex trading processes. Blockchain enables faster settlements and automated trade execution, which can increase liquidity.

Improved investor protection: It improves investor protection by providing greater transparency, reducing information asymmetry, and enabling automated compliance measures. This helps mitigate fraudulent activities and ensures investors are better informed about the traded assets they hold.

Facilitate ownership and transfer restrictions: Blockchain provides the flexibility to set rules around who can hold the tokenized assets, how many investors can hold the tokenized assets, and how it can be transferred. This includes token-based criteria (i.e., buy or sell lockups tied to when a tokenized assets was issued) as well as identity-based criteria (i.e., residency or accreditation status).

Enhanced data integrity: Blockchain’s immutability prevents unauthorized alterations or tampering. This strengthens the accuracy and reliability of regulatory reporting, audits, and investigations.

Systematically automate enforcement: Blockchain automates enforcement of the issuer’s rules and restrictions via smart contracts. Before permitting a transfer to take place, the smart contract ensures all requirements are met and whether the buyer and seller have the right attestations tied to their identity. Since this functionality is built on-chain via smart contracts, even very complex compliance requirements can be automated efficiently and cost effectively.

Facilitate global regulatory harmonization: This can be achieved by establishing standardized compliance protocols and enabling interoperability between different regulatory frameworks. This can reduce regulatory fragmentation and costs, which would enhance cross-border investment opportunities.

Increased market efficiency: As a result of faster settlement times, enhanced liquidity and streamlined transferability is achieved. These benefits reduce transaction costs, mitigate counterparty risk, and create a more fluid trading environment.

Tokenized Assets Could Resolve Regulatory Compliance Issues/Challenges

Tokenized assets enhanced transparency, automated compliance mechanisms and auditable transaction records, may simplify compliance challenges:

Know your customer (KYC) and anti-money laundering (AML) compliance

One of the primary regulatory compliance challenges which financial institutions face is KYC and AML compliance. Issuers need to consider how they will fulfill KYC/AML obligations. Tokenized assets can enable seamless, transparent, and immutable tracking of transactions and the ownership of assets. This can make it easier for institutions to comply with KYC and AML regulations. KYC providers can attach attestations to the investor’s identity, which can be thought of as on-chain evidence verifying an attribute of a user’s identity (i.e., residency or accreditation) and facilitate automated compliance rules around ownership and transfer.

Cross-border transactions compliance

Cross-border transactions often struggle with a complex web of regulatory compliance challenges. Tokenized assets, being blockchain-based, can facilitate borderless transactions while complying with local regulations. This can help financial institutions to streamline their cross-border transactions.

Securities regulations compliance

Tokenized assets need to comply with securities regulations. However, the existing regulations often fail to consider the unique properties of blockchain-based traded assets. With tokenized assets, the compliance process can be simplified by automating regulatory checks and reporting, making it easier for financial institutions to comply with securities regulations.

Fractional ownership compliance

Tokenized securities enable fractional ownership, which addresses the challenge of limited access to financial markets due to high capital requirements and helps to promote financial inclusion.

To appeal to investors with lower capital capabilities to participate in financial markets, brokerage companies such as Fidelity, Charles Schwab or Robinhood offer fractional shares of ownership for stocks and ETFs. Investors could have ownership of a few dollars of securities such as Google or Amazon that they might be interested in, but cannot afford to buy a whole share.

But on the exchange itself, you can only buy one unit of a share. The exchange will not allow the trade of a fractional share. This creates complex legal and compliance issues, because legally the broker owns the share and would have to create a separate legal mechanism to provide fractional ownership for investors. Tokenized assets can solve this complexity by enabling direct fractional ownership to investors, even for less than $1. This can help foster financial inclusion.

Secondary market compliance

The secondary market for traditional securities grapples with regulatory compliance challenges, such as trade matching and settlement. Tokenized assets can provide a transparent and efficient trading platform with automated compliance checks, making it easier for financial institutions to comply with secondary market regulations.

In a recent interview with the Financial Times, Gary Gensler urged regulators to tame AI risks to financial stability, indicating that without swift intervention, due to the heavy reliance of AI financial models “on the same underlying base model or underlying data aggregator,” it would be “nearly unavoidable” that AI would trigger a financial crisis within a decade.

Gensler further said that shaping AI regulation would be a tough test for U.S. regulators, as potential risks cut across financial markets and stem from models crafted by tech companies that sit outside the remit of Wall Street watchdogs.

Tokenized assets can mitigate some of the risks Gensler is talking about, and might prevent a financial crisis, despite tech companies not complying with financial regulations. Tokenized assets provide full visibility to the tokenized asset characteristics, including ownership. This feature combined with transparency enabled by blockchain may allow financial regulators to observe market activity in real time and create threshold alerts and prompt trading halts.

In a digital age with growing distrust and concern about emerging technologies, tokenized assets can serve as a trusted ally to regulatory compliance, while mitigating the concerns and fostering financial inclusion.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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About the Author: Tony Ramos

Tony Ramos is a seasoned expert in business funding and real estate investment, with a remarkable journey spanning over 20 years. His expertise in flipping properties and implementing the buy-and-hold strategy has positioned him well in the real estate investment sector. Tony's profound understanding of financial strategies extends to teaching individuals and businesses how to become debt-free and leverage the power of LLCs for funding. For insights, mentorship, or collaboration opportunities, Tony can be reached at Connect with him to unlock the potential of smart financial strategies and embark on a path to financial success and freedom.

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