What Is Tokenization? Trading ETFs on a Blockchain

The blockchain technology allows for global, 24/7 trading.

Tokenization is the rendering of financial assets as electronic copies that can be transferred to a cryptocurrency network. 

The process, which is supposed to increase the speed and security of investment transactions, has drawn growing interest among traditional financial services firms over the past year, including one-time skeptics of the digital asset industry. 

Most recently, BlackRock, Inc., the world’s largest asset manager whose CEO Larry Fink once called cryptocurrency “an index of money laundering,” announced the creation of its BlackRock USD Institutional Liquidity Fund (BUIDL), which will "tokenize" physical assets, with those tokens recorded on the Ethereum blockchain.  

BlackRock’s new product may foreshadow a larger shift in how major companies issue and trade ETFs. Because of its size—more than $10 trillion in assets under management—BlackRock’s carries enormous influence over the financial services industry. Its application for a spot bitcoin ETF last year served as a turning point for those products' approval.

Learn how tokenization works and how it may impact the exchange-traded fund industry in the future.

What Is Tokenization of Real-World Assets?

Tokenization, also called the tokenization of real-world assets (RWA), is the process of converting ownership of physical or traditional financial assets into digital tokens on a blockchain. Assets like investment securities, real estate or artwork can be divided into smaller, more affordable tokens, making them accessible to a wider range of investors on a secure, transparent online ledger. 

What Assets Can Be Tokenized?

A wide range of real-world assets can be tokenized, including: 

• Financial instruments: Stocks, bonds, ETFs and even loans can be tokenized, potentially creating a more efficient, accessible financial system.  
• Real estate: Brick-and-mortar buildings, from commercial properties to residential units, can be divided into digital tokens, enabling fractional ownership and easier investment. 
• Commodities: Ownership of physical commodities like gold, oil, or diamonds can be represented by tokens, potentially streamlining trading and reducing storage costs. 
• Art and collectibles: Valuable paintings, sculptures, or rare coins can be tokenized, potentially increasing liquidity and facilitating ownership transfers. 

What Are the Benefits of RWA Tokenization?

• Fractional ownership: Assets like real estate or artwork can be divided into smaller, more affordable tokens, making them accessible to a wider range of investors. 
• Increased liquidity: Tokenization can make it easier to buy, sell, and trade real-world assets, potentially increasing their liquidity. 
• Transparency and security: Blockchain technology offers a secure, transparent way to track ownership and transaction history, potentially reducing fraud and increasing trust in transactions. 
• Reduced costs: Tokenization can potentially streamline processes and reduce administrative costs associated with traditional asset ownership. 

How Would a Tokenized ETF Work?

A tokenized ETF, also known as a security token ETF, would combine the structure of an exchange-traded fund with the benefits of blockchain technology. Here's how a tokenized ETF would work: 

Traditional ETF vs. Tokenized ETF

• Traditional ETF: A traditional ETF holds a basket of underlying assets like stocks, bonds, or commodities. Through the creation and redemption process, these assets are held by a custodian, and ownership is represented by ETF shares traded on a stock exchange. 
• Tokenized ETF: A tokenized ETF would tokenize the underlying assets of the ETF. These tokenized representations would reside on a blockchain, a secure and transparent digital ledger. Investors would hold digital tokens representing ownership in the ETF, instead of traditional ETF shares. 

Benefits of Tokenized ETFs

• Fractional ownership: Like traditional ETFs, tokenized ETFs would enable fractional ownership of the underlying assets, making them more accessible to a wider range of investors. 
• 24/7 trading: Blockchain technology allows for global, 24/7 trading, unlike traditional ETFs which are restricted by exchange hours. 
• Faster settlement: Transactions involving tokenized ETF shares could be settled faster and more efficiently due to the inherent nature of blockchain technology, which limits the need for a third party. 
• Reduced costs: Tokenization could potentially reduce administrative costs associated with traditional ETF structures. 
• Transparency and security: Blockchain technology can offer increased transparency regarding the underlying assets of the ETF and potentially enhance security by creating a tamper-proof record of ownership. 

Challenges of Tokenization

• Regulation: The regulatory landscape surrounding tokenized assets is still evolving, creating some uncertainty for investors. 
• Valuation: Determining the appropriate value of tokenized assets requires careful consideration and may not always be straightforward. 
• Liquidity risk: While tokenization can improve liquidity for some assets, it doesn't guarantee a readily available market for all tokenized assets. 
• Technical complexity: Understanding and navigating the technical aspects of blockchain technology can be challenging for some investors. 

Is Tokenization the Future of Trading ETFs?

Tokenized ETFs hold promise for increasing efficiency, accessibility, and transparency in the ETF market. However, regulatory hurdles, technological complexities, and investor education must be addressed before they become mainstream. 

Nitin Gaur, Global Head of Digital Asset & Technology Design at State Street, added his perspective on the tokenization of ETFs in a statement: 

“The speed and efficiency of trading on the blockchain… could create applications for tokenization in already liquid listed shares or units. In particular, ETFs stand to benefit… creating a new way for new participants to issue, hold, trade and service assets. The benefits of blockchain technology will allow for immediate settlement [and] seamless flow between asset classes via ETFs.” 

Bottom Line on the Tokenization of ETFs

Integrating traditional financial systems with blockchain technology presents technical challenges. For example, while tokenization can improve efficiency, increased liquidity for some tokenized ETFs could create a misalignment between an ETF’s shares and the underlying assets they represent.  

Tokenization of real-world assets represents a significant innovation with the potential to revolutionize the way we own and trade assets. However, investing in any new financial product carries inherent risks. Investors should conduct thorough research to understand those before considering an investment.