The Future of Custody in a Tokenized World

Introduction

The tokenization of digital assets is changing how value is managed and traded, introducing new levels of efficiency, transparency, and inclusivity in global financial markets. The future of tokenization has recently become a central topic in both traditional and decentralized finance discussions, often surpassing the broader interest in digital assets. While cryptocurrencies have shown their durability, with an expected market capitalization of $4.5 trillion by 2028, the growth of tokenized assets is projected to significantly outpace the crypto market.[1] This statement is in line with BlackRock’s CEO Larry Fink where he accentuated the fact that tokenization will be the next generation of markets.[2]

Moreover, most asset classes are typically introduced by institutions and later adopted by retail users, this pattern has influenced the development of custodial services. Custody services, once primarily needed for cryptocurrencies, have evolved to become essential for a broader range of tokenized assets, including Non-Fungible Tokens (“NFT”) and tokenized securities. Custodians now must also adapt to accommodate the new ways these assets are being used, such as for staking, restaking, lending, and borrowing.

Current Landscape of Tokenized Assets[3]

1- Real Estate

1.1- Blockchain and Real Estate

A. Smart contracts on the blockchain make buying and selling property more efficient. They reduce the need for intermediaries and cut down on transaction times, speeding up the process.

· Blockchain uses smart contracts, which are self-executing contracts with the terms of the agreement directly written into code. These contracts automatically enforce the terms of a property transaction once certain conditions are met.

B. Blockchain technology keeps property ownership records clear and unchangeable. This reduces the chances of fraud and disputes by providing a reliable, permanent record of ownership.

· Blockchain’s decentralized and immutable ledger records property ownership in a way that cannot be altered or tampered with. Once a property title is recorded on the blockchain, it’s secure and permanent, ensuring clear and undisputed ownership records.

C. Blockchain can automate tasks like rental agreements, maintenance requests, and payments. This makes property management more efficient and lessens the administrative workload.

· Smart contracts can also be used in property management to automate routine tasks. For example, a rental agreement can be coded into a smart contract that automatically collects rent payments

D. Tokenization, or turning property into digital tokens, allows for fractional ownership. This means smaller investors can buy a share of a high-value property, which increases market liquidity and opens up investment opportunities.

1.2- Real Estate Tokenization

a) Blockchain allows real estate to be split into smaller, tradable tokens. This means you don’t need a large amount of money to invest in expensive properties, as you can buy smaller shares.

b) Unlike traditional real estate investments, which can be hard to sell quickly, tokenized properties can be traded more easily on secondary markets. This makes it easier to convert your investment into cash.

c) Blockchain’s secure and transparent ledger records all transactions. This reduces fraud risks and ensures accurate property records, giving investors’ confidence in the integrity of ownership and transactions.

d) Smart contracts automate and simplify property transfers, legal documents, and payments. This cuts administrative costs and speeds up transactions, making deals more efficient.

e) Tokenization allows people from anywhere in the world to invest in real estate. With just an internet connection and the ability to buy tokens, investors can access global real estate markets and diversify their portfolios.

1.3- Case Studies

i. RealT provides fractional ownership in real estate properties through security tokens, offering democratized investment opportunities. Investors can purchase tokens that represent a share in a property and receive rental income proportional to their holdings. RealT’s platform facilitates an easy and efficient way for investors to engage in real estate investments and earn passive income.

ii. The St. Regis Aspen Resort in Colorado was tokenized, enabling investors to purchase shares in this luxury hotel through digital tokens. Utilizing the Ethereum (“ETH”) blockchain, ERC-20 tokens were issued to represent fractional ownership of the resort. These tokens can be bought, sold, and traded on secondary markets, offering liquidity and accessibility that traditional real estate investments typically do not provide.

2- Decentralized Finance (“DeFi”)

2.1- Blockchain in DeFi

Blockchain technology serves as the essential infrastructure for DeFi, enabling peer-to-peer transactions, minimizing the need for intermediaries, and providing transparency and security. It supports decentralized applications (“dApps”) and smart contracts, which automate and secure various financial processes.

2.2- Tokenization in DeFi

Tokenized assets can be traded and utilized within DeFi ecosystems, making traditionally illiquid assets divisible, accessible, and transferable. Tokenization in DeFi democratizes access to investment opportunities, broadening participation in asset ownership. The use cases of tokenization of DeFi instruments are:

· Fractional ownership which allows broader access to high-value assets, such as real estate and art, by enabling investors to purchase fractional shares.

· Blockchain technology facilitates real-time settlement, allowing transactions to be settled almost instantaneously, which significantly enhances efficiency. Additionally, it enables cost-effective and efficient cross-border payments, reducing barriers in global trade.

· Real-world assets, such as property and commodities, can be used as collateral within DeFi protocols, thereby expanding financial opportunities.

2.3- Legal Regulation Surrounding DeFi

The European regulatory landscape, particularly through the Markets in Crypto-Assets Regulation (“MiCA”) regulation, harmonizes the regulatory framework across the EU, making it easier for companies to operate within the crypto market. However, depending on the type of asset, tokens may fall under different regulatory regimes, which can influence their classification and the obligations of issuers. This poses regulatory challenges, as the classification of tokens under various regimes, such as Markets in Financial Instruments Directive (“MiFID”) and MiCA, significantly affects the legal obligations and the potential for broader adoption.

Challenges for Adoption

The lack of industry standards for tokenized securities has been a challenge since the rise of the ETH blockchain and the widespread use of smart contracts starting in 2015. Although creating tokens became easier, there was no guarantee that these tokens could be universally used or exchanged across the blockchain. To address this, the ERC-20 standard was introduced on the ETH blockchain, enabling developers to create tokens compatible with other products and services. While ERC-20 has become the dominant standard for ETH based tokens, it falls short in addressing the complexities of ensuring interoperability when tokenization involves regulated financial instruments.

In response to the lack of industry standards for tokenized securities, Tokeny has been working on developing the ERC-3643 standard (“Standard”),[4] which is designed to ensure compliance for financial institutions and third parties. This framework provides a mechanism for enforcing control and compliance, allowing issuers or their agents to retain ownership of the tokens while using public blockchains to represent financial instruments legitimately. As the Standard gains wider adoption and new asset classes emerge, market fragmentation may decrease.

Legal and Regulatory Framework

Legal and regulatory uncertainty is often cited as a significant obstacle in industry discussions. However, in the UK, this uncertainty is diminishing. The Financial Conduct Authority (“FCA”) and the Bank of England have recently announced the establishment of a Digital Securities Sandbox, and the legal framework for tokenized assets has been clarified.

The UK Law Commission (“Commision”) has proposed a draft bill that would introduce a new "third category" of personal property under English law, specifically designed to accommodate certain digital assets, including tokenized assets on a blockchain. Currently, English law recognizes two main categories of personal property:[5]

1- "things in possession" (tangible objects)

2- "things in action" (legal rights or claims).

However, the Commission identified that some digital assets, such as crypto-tokens, possess unique characteristics that do not fit neatly into these existing categories.

The proposed legislation would establish this new category to legally recognize digital assets that can exist independently of legal enforceability and are rivalrous, meaning their use by one person precludes equivalent use by others at the same time. This would provide legal recognition and protection for property rights in tokenized assets. Notably, the draft bill does not define exactly what falls into this new category, leaving its interpretation and development to the courts through case law.

Hence, under English law, tokenized assets on a blockchain would be recognized as property, much like any other assets. Legally, these assets do not differ from their traditional counterparts. While their real-world characteristics might vary, this variation is not dependent on whether they are on-chain or off-chain. The distinction between bonds, equities, or other securities is not substantive; it lies solely in their representation, whether digital or physical.

Conversely, the situation in the United States under the SEC's SAB 121 ruling,[6] custodians in the U.S. are still required to recognize all types of digital assets as liabilities on their balance sheets. This regulatory approach complicates operations for custodians and other operators in the digital asset market.

The regulatory landscape in the EU has become more defined with the introduction of the MiCA Regulation, which is currently in its initial implementation phase. MiCA specifically addresses both crypto assets and the service providers that offer new types of services, which previously did not exist in their current form for these assets.

Despite various national and regulatory advancements, as well as new regulations addressing specific digital asset questions and use cases, there are still gaps in the overall regulatory framework. For instance, Exchange-Traded Products (“ETP”s) typically involve both primary and secondary markets. In certain jurisdictions, trading on the secondary market requires the ETP to be recorded in a central register. However, for tokenized assets to be tradable on the secondary market, existing regulations need to be updated, as blockchain technology eliminates the need for a centralized register.

[1] https://zodia-custody.com/wp-content/uploads/2024/08/The-Future-of-Custody-in-a-Tokenised-World-Final.pdf

[2]https://www.forbes.com/sites/davidbirch/2023/03/01/larry-fink-says-tokens-are-the-next-generation-for-markets/

[3] As Derin Partners we acknowledge that there are many different tokenized assets and aren’t limited to two. However, Zodia’s report accentuates two tokenized assets among many which are real estate and DEFI. Therefore, in this report we have analyzed only these two.

[4] https://tokeny.com/luxembourg-the-epicenter-of-the-tokenization-era/

[5] https://lawcom.gov.uk/project/digital-assets/

[6] https://www.sec.gov/regulation/staff-interpretations/accounting-bulletins/old/staff-accounting-bulletin-121