Tokens and securities have a lot in common. Both are claims on assets. The developments of these instruments have also benefited from advances in computer technology operationalizing the concepts underlying the instruments.
However, there are differences. Tokenization extends the possibilities from securitization. Tokenization adds a new dimension – programmability. This enables the terms of a claim to be modified, under different circumstances, through a process that is programmed into the token, for example through a smart contract. Before discussing this, it is useful to look at the genesis of securitization as it provides insights into the future development of tokenization.
Securitization – a brief history
Most of us are familiar with stocks and bonds as securities. However, we don’t call the process securitization when stocks and bonds are issued. Rather, we usually reserve the term for the conversion of claims such as loans, or title deeds to a property, into marketable securities.
Securitization began in the 1970s when banks sold home loans or mortgages to non-bank institutions. This freed up the funds locked up in the loans, allowing the banks to make fresh home loans. Meanwhile, non-bank institutions formed pools of loans and issued securities backed by those loans. Such securities were bought by pension funds, mutual funds, and insurance companies. Mortgage payments received by the loan pools were passed on, after expenses, to the security holders. Such securities came to be known as mortgage pass-through securities.
Investors like pension funds and insurance companies are attracted to buying home loans because they have large amounts of funds from member contributions or premiums that they need to invest in long-term assets to meet future withdrawals. Mortgage securities meet the requirements as home loans are issued for terms as long as 25 to 30 years. There is one drawback, however.
Homeowners have the right to redeem or prepay their loans, and usually do so when interest rates fall, as they can refinance their loans at lower rates. When prepayment occurs, the maturity of the loan is reduced drastically. This presents a problem as the reason for investing in home loans is their long maturity.
An innovation that overcame the problem of uncertain maturity involved dividing the mortgage pool into different tranches or layers, arranged according to the order in which they would receive prepayments. Investors in the first tranche would essentially be holding a security that has the shortest maturity compared to the other tranches, as any prepayment would be paid to them first. Investors in tranches that are least affected by prepayments, would have much greater certainty that the securities they hold are essentially long-term. Securities structured in this manner are known as collateralized mortgage obligations.
It is likely that the concept of securitization predates the 1970s. However, operationalizing it means keeping track of the tens of thousands of non-homogenous mortgages, a task feasible only with the greater availability, and power, of computers beginning in the 1970s. Today, the securitization market has gone beyond mortgages to other assets like auto loans, credit card loans, and student loans. In the meantime, real estate such as shopping malls, and commercial and residential buildings have been securitized using REITs. Consequently, the securitization market has grown to about USD51 trillion.
What accounts for the size of this market? First, real estate loans are big-ticket items. Given the demand for housing and commercial space, the financing requirement of the real estate market is big. Banks are able to meet this financing need as they can sell the home loans they originate to the loan pools which, in turn, can easily sell securities to investment-hungry pension funds, mutual funds, and insurance companies.
The players in this market are mainly institutional as mortgage-backed securities are considered complex financial instruments that retail investors cannot purchase. A final note about this market is that it operates in a regulated environment that requires securities to be registered before they can be sold.
Like the securitization process, the tokenization process creates claims on assets. These claims are represented by digital tokens which reside on a blockchain or distributed ledger. Ownership of a claim is recorded on the distributed ledger, which provides security for proof of ownership since the record cannot be erased or changed. The digital nature of the token creates flexibility for this financial instrument, as one can own a fraction of the asset. Fractionalization makes the asset more liquid as the cost of ownership is more affordable with smaller bite sizes. Further, through non-fungible tokens (NFTs), tokenization makes possible claims on and the trading of unique one-of-a-kind intangible assets like a digital picture.
As the token is just a digital program, going beyond the token as a record of asset ownership becomes a possibility. For example, utility tokens are claims to services, as opposed to security tokens which are claims to assets.
Riding on blockchain technology, tokenization holds promise for new products and new ways of conducting economic activities. However, the tokenization market has not quite taken off. From a paltry US$2.3 billion in 2021, it is projected to grow to US$5.6 billion in 2025. Are there any lessons to be learned from the US$51 trillion securitization market?
The participation of institutions largely accounts for the size of the securitization market. Institutions, however, are less interested in the tokenization market as it is fractured due to the heterogeneous nature of the assets being tokenized and the lack of scale. Nevertheless, the growth of the market can be fostered by the standardization of procedures and terms of the underlying asset or services. Initially, third-party monitoring and audit may also be needed till more robust authentication procedures can be developed. In addition, an industry organization may be needed to spearhead various initiatives, as ad hoc arrangements by various players may not be adequate. Finally, with the maturation of the industry and with education, the barrier to retail investor participation would be overcome, bringing a new source of funds and adding dynamism to the industry.