Financial Stability Board Report on Tokenization Risks

The Financial Stability Board (FSB) released a report Wednesday stating that the risks posed to the global financial system by institutional finance's exploration of tokenization are minimal, primarily due to the technology's limited adoption thus far.

In its report, the FSB, created in 2009 by the G20 in response to the global financial crisis, noted that initiatives like BlackRock’s BUIDL fund are still in their early stages, which helps to mitigate potential threats to the financial system for now.

>The limited publicly available data on tokenization suggest that its adoption is very low but appears to be growing, and the use of tokenization in the financial sector does not currently pose a material risk to financial stability, mostly due to its small scale,

the FSB report stated.

Despite suggesting that the technology currently presents a low risk due to its inability to scale, the report identified several financial stability vulnerabilities associated with DLT-based tokenization:

Key Concerns

1. Liquidity Mismatches: The timelines for converting tokenized assets into cash may differ from the assets themselves, leading to redemption run risks that threaten financial stability.
2. Leverage Issues: The composable nature of smart contracts allows users to borrow tokens and use them as collateral for additional loans, which can be risky.
3. Asset Quality: The complexity and opaqueness of tokenization projects may lead to increased risks during market stress.
4. Interconnectedness and Operational Fragility: As projects grow more complex, associated risks are likely to increase.

The report warns that these risks could escalate significantly if the tokenization of assets scales and if the industry resolves interoperability issues and receives clearer regulatory guidance.

>Tokenization could have implications for financial stability if increased complexity and opacity lead to unpredictable outcomes during stress, and if vulnerabilities are not adequately addressed through oversight, regulation, supervision, and enforcement,

the report said.

Leverage as a Risk

Leverage was noted as a significant risk, particularly with the nature of smart contracts. Users can borrow tokens from lending protocols and use them for additional loans, common in decentralized finance (DeFi).

The FSB expressed skepticism about the advantages of tokenization compared to existing technologies that might achieve similar outcomes without associated risks. Various barriers to widespread adoption include unclear investor demand, lack of interoperability among DLT platforms, and differing legal and regulatory frameworks across jurisdictions.

The report emphasizes the need for effective oversight and regulatory measures to address vulnerabilities in the adoption of tokenization.

The FSB findings were echoed by the latest annual Future of Finance report from SIX, showing that 46% of asset managers expect to trade tokenized real-world assets using DLT in the next three years. Michele Curtoni, head of strategy at SIX Digital Exchange, stated:

>Tokenization continues to represent a transformative opportunity for capital markets. However, as the FSB points out, unexpected risks need to be planned for as tokenization scales up. Promoting liquidity and velocity of tokenization with institutional-grade systems is crucial for achieving real scalability. Innovation cannot come at the expense of financial stability.