In the field of tokenization, European exchanges are thinking like venture capitalists. To get a better handle on this promising new technology, the exchanges are buying equity stakes in young companies with expertise in tokenization and helping them develop new products and services.
The tokenization of assets refers to the process of issuing a digital token that represents ownership in a real asset. The token is issued on a distributed ledger and the transfer of ownership is recorded on that ledger, similar to how bitcoin transactions are recorded on the bitcoin blockchain.
Although this technology is still at an early stage of development, the expectation is that tokenization will make it easier to track ownership and automate the transfer of securities, leading to more liquidity, transparency and accessibility. Technology analysts at consulting firm Deloitte commented in a recent report that tokenization has the potential to disrupt the financial industry by "greatly reducing the friction" involved in creating, trading, clearing and settling securities.
Deutsche Börse Group was the first to make a move. In August 2018 the German market infrastructure company acquired shares of HQLAx, a company based in London that was founded by Olly Benkert, a former managing director at Goldman Sachs, and Guido Stroemer, a former managing director at UBS.
HQLAx specializes in using distributed ledger technology to deliver liquidity management and collateral management solutions for institutional clients. Since its formation in 2016, the startup has been working with several banks to apply its technology in the securities lending industry.
In contrast to the traditional settlement process, banks using the HQLAx platform will not actually move securities from one custody account to another. Instead tokens will be transferred via the blockchain while the securities remain in place. According to HQLAx, this will help improve the mobility of collateral across the fragmented securities settlement landscape in Europe.
The decision to invest came after the two companies started working together on an application for the repo trading system operated by Eurex, the Deutsche Börse subsidiary. The Germany company bought an initial stake in HQLAx in August and then bought a second tranche in December to further strengthen the partnership.
Six banks have already confirmed that they have started their onboarding processes and will join the platform at launch date, which is expected by the end of 2019. HQLAx is also working to add custodians to its network. Clearstream, the custodial subsidiary of Deutsche Börse, is already on board, and in May, Stroemer announced that HQLAx will connect to Euroclear, another leading European securities custodian.
"This blockchain use case reveals the significance and potential of the technology," Jens Hachmeister, in charge of blockchain initiatives across Deutsche Börse, said in a January press release. "This creates higher liquidity, transparency and efficiency for financial markets in general and securities financing in particular. We look forward to applying DLT for further solutions along the whole value chain."
The London Stock Exchange Group is another example of a European exchange investing in tokenization. In February, LSEG was the lead investor in a $20 million funding round for Nivaura, a company based in London that was founded in 2016. In addition, Nikhil Rathi, the chief executive officer of the London Stock Exchange, will take a seat on its board of directors.
The above image, provided by back-office automation provider Nivaura, shows how blockchain registration and settlement could theoretically work in an industry marketplace. Logos for institutions are used for illustrative purposes only.
Nivaura is aiming to automate the entire life cycle for the issuance of financial instruments. The company's platform allows companies to issue bonds, equities, loans and derivatives as digital tokens and use distributed ledger technology to record each step of the process. That's only part of the solution, however. Nivaura also uses machine learning and natural language processing to automate the workflow involved in creating a financial instrument and bringing it to market. Nivaura got its start in an incubator operated by Allen and Overy, a leading international law firm, and one of its innovations is a "legal markup language" that automates the legal documentation required for the issuance of financial instruments.
According to Nivaura, its platform will make the process for issuing financial instruments much more efficient and less expensive than the current approach, which involves multiple steps, large numbers of documents, and many different participants. Nivaura estimates it can reduce the amount of time required to bring financial instruments into the market by up to 80%.
For LSEG, the investment offers potential strategic benefits in two ways. First, if Nivaura is successful in reducing the cost of the issuance process, that would make it easier to bring more financial products to market, which could lead to more listings and more turnover on LSEG's markets. Second, the investment gives LSEG a window into the tokenization process and a head start on applying this innovation to other asset classes. At the same time, if Nivaura successfully transitions from promising startup to profitable service provider, LSEG could recover the cost of its investment and maybe even make a return.
The investment builds on an existing relationship between the two companies. Nivaura has conducted several tests of its platform in the regulatory sandbox program of the U.K. Financial Conduct Authority. This program allows businesses to test innovative products and services with real customers in a controlled environment. LSEG participated in the most recent of these tests, which was designed to demonstrate that actual shares in a U.K. company could be tokenized and issued within existing custody and settlement systems. The shares were issued on Nivaura's platform and distributed to investors via LSE's Turquoise platform, a regulated trading venue for stocks.
During an earlier test in the FCA sandbox, Nivaura worked with Marex Solutions, a subsidiary of Marex Spectron, to issue a structured product to retail investors. The structured product, a principal protected note linked to the performance of the FTSE 100 stock index, was issued as a token on the Ethereum blockchain in parallel with a traditional issuance via Clearstream.
The third and most recent example came in July, when Euronext announced a €5 million investment in a startup called Tokeny Solutions. The Luxembourg-based company was founded in 2017 as a provider of end-to-end solutions that issue, manage, and transfer tokenized securities. One of the key features of its platform is that it integrates compliance obligations into the tokenization process so that participants can comply with securities laws.
In a press release, Euronext said the deal will allow it to "onboard a renowned team in the digital asset industry" and bring more private companies and investment firms into its client base. The deal also will give the Paris-based exchange a 23.5% stake in the company and representation in its governance.
The strategy behind the investment is to combine Tokeny Solutions’ expertise in token management with a separate project called Liquidshare that uses the Ethereum blockchain to settle trades. Liquidshare was established in 2017 as a joint venture backed by Euronext and several French financial services firms with the goal of improving access to capital markets for small and medium-sized companies. The Liquidshare platform moved into pilot phase at the end of 2018 and plans to go into production by the end of 2019.
Luc Falempin, chief executive officer of Tokeny, commented in a blog on Medium that the investment from Euronext will help Tokeny strengthen its tokenization platform by adding more talent and financing its expansion into new lines of business. He also commented that Euronext "shared our vision of a digital capital markets world" and predicted that the partnership will develop into "a central infrastructure in the upcoming tokenized financial world."