BIS report highlights risks in traditional finance's move toward tokenization

The Bank for International Settlements (BIS) released a report on Monday titled "Tokenization in the Context of Money and Other Assets: Concepts and Implications for Central Banks," exploring how tokenization could reshape the financial landscape and impact the role of central banks.

The report emphasized that tokenization can offer significant benefits, such as reducing transaction costs and increasing transaction speeds, which have garnered the interest of institutional investors. However, the international financial institution that ensures liquidity for global central banks warned that these advantages come with inherent risks and challenges.

Risks to governance and financial stability

The report identified several risks associated with tokenization, including potential governance and legal framework issues as well as credit, liquidity, custody and operational risks. These challenges could manifest differently than those faced by traditional market infrastructures, necessitating a thorough assessment by central banks.

"Central banks need to assess the trade-offs and the appropriate balance between different types of settlement assets in token arrangements, identifying, monitoring and assessing tokenisation arrangements that may need to be subject to sound regulation, supervision, and oversight," the report said.

The BIS report highlighted the potential impact of token arrangements on monetary policy implementation, particularly regarding changes in the structure of regulated markets and the demand for central banks versus other forms of money. This evolving landscape could influence how central banks operate in the future.

BIS General Manager Agustín Carstens noted that while tokenization can enhance the financial system's safety and efficiency, it also introduces economic, legal and technical challenges that must be addressed.

The report stated that legal risks from tokenization could arise from a law's unexpected or uncertain application.

"With respect to token arrangements, it could arise in cases where the application of existing laws to the concept of tokens is not clear or certain. For example, in the U.S., repo transactions receive an automatic stay from bankruptcy, an advantage that may not extend to tokenised versions of repo transactions," the report said.

Chair of the Committee on Payments and Market Infrastructures (CPMIA) Fabio Panetta added that effective governance and risk management will be crucial for realizing the benefits of token arrangements.

"The well known risks of existing systems apply, but these risks may materialise in different ways due to the effects of token arrangements on market structure," said Panetta.

Tokenization trialed by major financial institutions 

An increasing number of global financial institutions are exploring tokenized deposits to improve settlement efficiency and enable the possibility of programmable payments. In September, UK Finance released the results of the experimentation phase of the Regulated Liability Network ( RLN ), which investigates the potential for tokenized deposits and programmability. This phase tested five use cases, ranging from home purchases to tokenized bond settlements.

The trial looked at key questions for tokenization, including the benefits delivered, associated costs, and potential revenue opportunities. The project identified significant advantages and explored several revenue models. However, the report found that for commercial success, it is essential to develop a broader array of use cases beyond those initially trialed, such as ways to diversify transaction types.

The banks participating in the trial included Barclays, Citi UK, HSBC UK, Lloyds Banking Group, Mastercard, NatWest, Nationwide, Santander UK, Standard Chartered, Virgin Money and Visa.