Tokenization: What it is and how to think about it

Tokenization involves representing traditional assets as tokens on a digital platform. This financial innovation has the potential to reshape money and markets, but a common approach for comparing system designs and weighing efficiency gains against risks has yet to be defined. We offer such an approach to improve understanding of this expanding technology and guide policy discussions.

Tokenization has received a lot of attention in recent years as a technology that could revolutionize financial markets and payments. It promises fast settlement, low risk for counterparties and minimal barriers to competition.

Yet tokenization is often misunderstood.

It is intrinsically complex, and there is no universally recognized framework for assessing the benefits, risks and policy implications of various system designs. In this article, we present just such a framework—one that is clear, simple and structured.

What tokenization is

At its core, a tokenized system is a record-keeping system where assets and their ownership records are represented on a single digital ledger, allowing for instant and transparent transactions. Tokenization is the process of converting these assets into tokens on a ledger.

Imagine an individual, business or bank that owns an asset—a piece of art, a building, or a government bond or bank deposit—with the asset’s ownership recorded on a traditional ledger. The first step in creating a tokenized asset is to verify the asset’s authenticity and legal status, which is typically done by independent third parties. Then an issuer creates a legal structure to hold the asset in custody and ensure that any digital shares represent a valid legal claim to the asset.

The next step is the actual tokenization process, where the legal rights are coded onto a digital ledger like a blockchain in the form of a token (Figure 1). This code specifies the asset’s owner(s) and additional details such as how the asset is divided into shares or how the asset can eventually be sold or redeemed. Other assets are added to the system the same way.

Issuers use smart contracts built into a token’s code to handle any of the functions described above. A smart contract is an automated program that carries out a transaction after certain conditions are met, so parties don’t have to manually fill out paperwork or reconcile their records. Smart contracts can also be used for more complex financial transactions involving several tokenized assets or multiple conditions.

Figure 1: A tokenized system involves traditional assets being converted into tokens on a digital ledger

Designing a tokenized system involves making several choices:

• what types of assets can be represented on a ledger
• how transactions and contractual conditions are encoded and executed
• who can access, transact on and govern the ledger

Together, these choices determine how the tokenized system operates. And this, in turn, shapes both the potential efficiency gains and the risks relative to traditional systems.

The three core features of tokenized systems

Our analytical framework offers a lens through which one can assess a tokenized system. At the heart of the framework are three key design features of tokenized systems: programmability, integration and the openness of ledgers.

The configuration of these features depends on the goals of a specific system. Different combinations support different use cases and policy objectives and involve distinct trade‑offs between efficiency and risk.

The trade-offs of the various features are summarized in Table 1 and elaborated on below.

Programmability

Programmability is the extent to which transactions, rules and contractual conditions can be executed automatically—without human intervention—on the digital ledger.

For example, a bank needing liquidity could exchange a tokenized bond for cash as part of a repurchase agreement. At the bond’s maturity date, the smart contract automatically returns the bond to the bank after the bank repays the cash plus interest to the lender.

Automating the execution and settlement of a transaction through a tokenized system can reduce delays, operational costs and the need for manual reconciliation.

But this increased efficiency comes with risks. Rigid code or relying on external data could lead to errors or unintended outcomes. As well, automated rules may be difficult to modify quickly, especially during stress events.

Integration

Integration captures the extent to which multiple assets, or assets and cash, can settle on the same ledger or across different ledgers that can communicate with each other. More integrated designs can allow different assets to move and settle together, while less integrated designs require complex coordination across separate systems.

A good example of an integrated tokenized system is Project Agorá, an international initiative led in part by the Bank for International Settlements involving several central banks, including the Bank of Canada.

This type of platform, if implemented, would allow commercial and central banks to exchange wholesale funds on a globally and highly integrated programmable digital ledger. This would streamline existing cross-border payment systems. Instead of having different banks working in different time zones on different settlement platforms—leading to high costs for users and long processing times—payments could happen instantly, at any time and at a very low cost.

These are the main benefits of integrated systems: they reduce settlement frictions, speed up transactions and lower counterparty and settlement risks.

But more integration is not always better. Systems that concentrate activity on a single integrated ledger could create bottlenecks or single points of failure. Interconnected ledgers can also increase complexity and allow shocks to spread more rapidly during stress events.

Openness

Openness describes who can access a ledger, validate transactions and participate in governance. Some ledgers—like the Project Agorá prototype—are tightly controlled, with access restricted to a defined set of trusted participants. Other ledgers, such as public blockchains, allow broader participation (Figure 2).

A notable feature of public blockchains is that any user or service provider can interact with tokenized assets without needing approval from a central operator. This means a developer can build smart contracts and deploy them directly on the blockchain to create services such as crypto-trading platforms and lending applications. This openness can promote competition and innovation by enabling a broader range of participants to develop and offer new services.

However, systems with broad participation can complicate oversight and risk management. Monitoring and compliance are more difficult in these systems, and stress can spread quickly when confidence weakens.

Figure 2: A clear, structured framework can help assess tokenized systems

Qualitative evaluation of various payment and banking systems

Source: Bank of Canada

Why this framework matters for markets and policy-makers

Tokenization could transform market structures and the way money and financial assets are issued, transferred and settled. So far, adoption is still in its early stages. However, if the expansion of tokenization is not appropriately managed and understood, it could undermine the functioning of financial, monetary and payment systems that are integral to the mandates of central banks around the world. This is why the Bank of Canada, alongside other central banks and regulatory authorities are studying and experimenting with tokenized systems to better understand and assess the trade-offs between different use cases.

Our framework can inform broad assessments of the implications of tokenized assets for the financial system and assist in the design of tokenized systems. It could also help industry, central banks and the public better understand both the benefits and risks of tokenization.

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