BIS report reveals potential risks of tokenization

The Bank for International Settlements (BIS) recently released a report titled (Tokenisation in the context of money and other assets: concepts and implications for central banks), which explores in depth how tokenization is reshaping the financial landscape and has a profound impact on the global economy. The role of central banks has an impact. The report highlights that tokenization can bring significant benefits, such as lower transaction costs and increased transaction speed, and these advantages have attracted strong interest from institutional investors.

However, BIS also warns that these advantages come with inherent risks and challenges. The report points out that risks involved in tokenization include governance and legal structure issues, as well as credit, liquidity, custody and operational risks. These challenges may differ from those faced by traditional market infrastructure and require a comprehensive assessment by the central bank.

Agustín Carstens, general manager of BIS, said: “While tokenization can improve the security and efficiency of financial systems, it also introduces economic, legal and technical challenges that need to be solved.”

Source: BIS Good benefits may come with high risks

The impact of tokenization on central bank functions

The report highlights the potential impact that tokenization arrangements could have on the conduct of monetary policy, particularly in terms of structural changes in regulated markets and shifts in demand for central bank money versus other forms of money. This evolving landscape could impact how central banks operate in the future. BIS calls on central banks to assess the trade-offs between different settlement asset types in token arrangements (Token Arrangements), and to identify, monitor and evaluate tokenized arrangements that may need to be subject to sound regulation, supervision and supervision.

Source: BIS tokenization is completely different from the “token arrangement” mechanism of traditional finance

In addition, the report points out that tokenization may trigger legal risks arising from uncertainty or unexpected circumstances in the application of the law. For example, in the United States, repo transactions are automatically suspended in the event of insolvency, but this advantage may not apply to tokenized versions of repo transactions.

Fabio Panetta, Chairman of the Committee on Payments and Market Infrastructures (CPMI), added: “The known risks of the existing system still apply, but due to the impact of token arrangements on market structure, these risks may Appear in different ways.”

What are Token Arrangements?

Traditional finance involves all financial activities managed by centralized institutions such as governments, financial institutions and banks, including the lending of funds, asset management, stock and bond market transactions, currency issuance and management, etc. These activities are often regulated by strict legal and regulatory frameworks and rely on third-party institutions to ensure the legality and security of transactions. The core features of traditional finance are centralization, legal currency support and a strong regulatory system.

For example:

In the traditional financial system, when you need to borrow funds, you usually go to a bank to apply for a loan. The bank will evaluate your credit status and then decide whether to approve the loan. The entire process is subject to bank regulations and national laws, and there will be corresponding interest and handling fees. This is in sharp contrast to decentralized finance (DeFi) where no intermediary is required and transactions are automatically executed by smart contracts.

Financial institutions test the waters of tokenization and urgently need regulatory guidance

Faced with the opportunities and challenges brought by tokenization, more and more global financial institutions have begun to explore tokenized deposits to improve settlement efficiency and realize the possibility of programmable payments. In September, UK Finance published the results of an experimental phase of the Regulated Liability Network (RLN), a scheme investigating the potential of tokenized deposits and programmability. During this phase, five applications ranging from house purchases to tokenized bond settlements were tested.

The trial explores key issues around tokenization, including the benefits, associated costs and potential revenue opportunities. The project identified significant advantages and explored multiple revenue models. However, the report found that to be commercially successful, it will be critical to develop broader applications than initial trials, such as approaches that diversify transaction types. Banks participating in the trial include Barclays, Citi UK, HSBC UK, Lloyds Banking Group, Mastercard, NatWest, Nationwide Building Society, Santander UK, Standard Chartered, Virgin Money and Visa.

BIS stressed that central banks need to provide strict regulation and supervision of this emerging tokenization phenomenon to ensure that financial stability is not threatened. Augustin Carstens noted: “Effective governance and risk management are crucial to realizing the benefits of token arrangements.” He emphasized that central banks must strike a balance between promoting innovation and maintaining financial stability.

Source: BIS BIS Innovation Center’s collection of projects involving tokenization

Experts call for stronger regulation to ensure financial stability

As tokenization rises globally, central banks are facing unprecedented challenges and opportunities. The BIS report makes clear that while tokenization has the potential to make the financial system more efficient, it can also pose risks to financial stability. The report recommends that central banks should actively participate in the development process of tokenization and develop appropriate regulatory frameworks to ensure market transparency and security.

Chairman of the Payments and Market Infrastructure Committee Fabio. "Effective governance and risk management will be key to realizing the benefits of token arrangements," Panetta stressed. He warned that if tokenization is not properly regulated, it could have a potential negative impact on the global financial system.

All in all, the latest BIS report is a wake-up call for central banks around the world, highlighting the double-edged sword effect of tokenization. In an era of rapid development of financial technology, how to maintain financial stability while promoting innovation will become a major issue facing central banks and regulatory agencies in various countries.