How to Build an Institutional-Grade Digital Asset Exchange

Technology innovation has enabled the growth of digital asset classes. The tokenization of traditional and crypto trading was just the beginning. Everything is tradeable and tokenized now: Carbon credits, real estate, art, wine, music, collectibles, e-sports, influencers, and more.  

Even after the regulatory freeze on crypto securities, especially in 2022, we are still experiencing more financial institutions tokenizing bonds, as well as regulated entities distributing stock tokens or using the blockchain for pre-IPO liquidity.

Not to be mistaken with cryptocurrency assets, digital assets (or tokens) can represent a variety of ‘things’ such as ownership in a company, access to a particular service, or even a physical asset such as gold. The main difference between these two types of assets is their primary use case. Cryptocurrencies are mainly used as a means of exchange, whereas digital assets or tokens can represent a wide variety of things beyond just currency. Additionally, cryptocurrencies are often decentralized, while digital assets or tokens can be decentralized or centralized depending on the specific blockchain network they are built on.

HSBC predicted that digital assets could reach 24 trillion USD by 2027, up from $2T in 2021, according to Finoa. JP Morgan has a plan to tokenize trillions of dollars of assets to develop new mechanisms in financial services such as trading, borrowing, and lending.

Equity, funds, debt, and real estate can all benefit from tokenization. Mid-cap companies, investment banks, asset managers, funds, and stock exchanges from around the globe are already starting to shift towards blockchain-based financial assets.

"I believe the next generation for markets, the next generation for securities, will be tokenization of securities," BlackRock's Larry Fink, who's previously expressed skepticism over crypto, told New York Times. 

Bringing the Costs Down

Roland Berger’s study projects that tokenized equity could reduce €4.6 billion in trading costs by 2030. "I actually believe this technology is going to be very important," Fink said. "Think about instantaneous settlement [of] bonds and stocks, no middlemen, we’re going to bring down fees even more dramatically. Think about it. It changes the whole ecosystem." 

Take Real Estate as another example. It allows easy and cost-effective transacting by selling the assets quickly - bringing liquidity to the illiquid market. 

Can exchanges rely on tokenized markets as a sustainable, institutional-grade addition to their business roadmaps?

Security Tokens Listing by Exchanges - The LuxSE Story

Last year, Luxembourg Stock Exchange admitted security tokens listing, further confirming the expanding interest in tokenization. “The Luxembourg Stock Exchange (the "LuxSE") announced on 31 January 2022 that it will admit security tokens on its Securities Official List (SOL), which is a dedicated section of the LuxSE's official list. Security tokens are to be understood as financial instruments that are issued and exist on a distributed ledger, allowing for a fully digital issuance process (the "DLT Financial Instruments").” (Ashurst, 2022). 

Many traditional exchanges are now offering tokenized assets alongside their traditional offerings. Some examples of traditional exchanges that offer tokenized assets include:

1. SIX Swiss Exchange: This exchange offers tokenized shares of various companies, such as Nestle and Novartis, through its platform called SIX Digital Exchange (SDX). 

2. Deutsche Börse: The German exchange has launched a blockchain-based platform called "DLT" which allows companies to issue and trade securities in a tokenized form. 

3. Binance: While Binance is a cryptocurrency exchange, it has also launched a separate platform called Binance DEX which offers trading of tokenized versions of various assets, including stocks and commodities. 

4. London Stock Exchange: LSEG has recently announced its partnership with Nivaura, which is a platform that uses blockchain technology to enable the issuance and trading of tokenized securities. 

5. NASDAQ: The NASDAQ stock exchange has been exploring the use of blockchain technology to offer tokenized assets and has been testing its own platform, the Nasdaq Linq.

It is evident that tokenization is a new technology that exchanges and key players in the financial services market embrace with care. Some exchange-traded funds (ETFs), (like iShares Gold Trust and United States Oil Fund) have also been tokenized. They are subject to the same stringent requirements as stocks and are regulated by the US Securities and Exchange Commission (SEC).

How to Build Institutional-Grade Tokenized-Asset Exchanges

At Exberry, we collaborate with exchanges in various stages of their digital asset journey. Taking a page out of their playbook, here are the steps I believe every exchange must follow to successfully launch an institutional-grade digital asset exchange. 

Research the Regulatory Environment:

The first step in building an institutional-grade tokenized-asset exchange is to research the regulatory environment. Understanding the applicable laws and regulations in the country of registration is key. Given that asset tokenization is relatively new, guidelines from regulators are needed to run the business within the regulatory frameworks.

The global legal system has not yet passed sufficient regulations to support tokenization; therefore, tokens may or may not be legally supported. The legality of a token depends on the underlying asset and the regulations prevalent in each jurisdiction. 

Choose a jurisdiction and obtain the necessary licenses: 

As already highlighted in the previous point, regulatory aspects are key to building an institutional-grade tokenized-asset exchange. Therefore, choosing a supportive legal jurisdiction can make or break the business. 

Liechtenstein for example passed its Token and Trusted Technology Service Provider Act in 2019, becoming the first jurisdiction to offer comprehensive measures to regulate the token economy. The law provides standards regarding civil law issues for the protection of clients and their assets. It also supervises asset tokenization service providers and has provisions to combat money laundering and the financing of terrorism. The law also provides measures that clarify the position of digital securities.

Many countries have joined the race for clear rules and standards since then. On June 20th, 2022, the European Parliament and the Council Presidency reached a provisional agreement on MiCA (Markets in Crypto Assets) proposal. MiCA focuses on maintaining financial stability and protecting investors while promoting more widespread transformation in the crypto asset sector. It covers stablecoins, trading venues, and crypto asset wallets.

In June 2022, the US introduced Lummis-Gillibrand Crypto Bill. It is an important step in terms of the regulatory framework for stablecoins, Bitcoin, and other digital assets. The SEC has made it clear that tokenized stocks require the same underlying rules as normal equity shares and that exchanges that trade in tokenized securities must be registered with the SEC. 

Choose the right technology: 

Choosing the right technology is a critical next point. Blockchain and DLT are the core of tokenized technology. According to Blockdata, the benefits of using blockchain include: 

• Broader investor bases

• No borders

• Lower costs

• Fewer intermediaries

• Enhanced liquidity for traders

• Transparency regarding the asset’s lifecycle

• Time to market

The technology must be asset agnostic, opening new markets, rather than using legacy technology. The cross-chain interoperability of tokenized assets is essential to make sure assets are not locked in one single blockchain and, hence, offer improvements in asset liquidity.

According to Blockdata: The easiest way to tokenize digital assets is by using an existing service, rather than coding and creating your own solution.

Various providers can help with the process. The chart below compares the top 10 asset tokenization companies. However, there are many more providers in the industry with varying expertise and from different jurisdictions.

Develop a Business Plan: 

Developing a business plan is essential for any exchange, not just an institutional-grade tokenized-asset exchange. It should include the exchange’s mission, vision, target market, customer persona, competitive landscape, and financial projections.

Market sizing is also important and some of it has been highlighted in the second paragraph of this article. The competitive landscape is included just above and, based on this, Unique Selling Points (USPs) should be drawn, along with competitive advantages. 

Another useful tool to use is SWOT (Strengths, Weaknesses, Opportunities, and Threats). The first two are related to the internal company environment, while the latter two are related to external factors. 

What is more, building a strong brand as well as a detailed GTM (Go to Market) is key to launching a successful institutional-grade tokenized-asset exchange. Partnerships with financial institutions, custodians, and tech providers should also be a part of the GTM. Further, establishing risk management protocols are necessary. To be sure, I recommend a phased approach, i.e. start with a limited user base and gradually expand. 

Technology is a break-or-make component of your business plan. Make it as lean and sensible as you can, incorporating innovative solutions like the cloud which can reduce the cost of ownership substantially.

What Will Tokenized-Asset Exchanges Look Like in 2029?

Although hard to predict anything in such a rapidly changing environment, it is very likely that the number of institutional-grade digital asset exchanges will increase. The pioneers have a heads-up and the first-mover advantage that may lead to the economics of scale and, further, mergers and acquisitions. Barriers to entry for new companies will result from global regulations, infrastructure, and governance issues. These challenges must be addressed to attain a wide adoption of tokenized digital assets.

Asset tokenization offers numerous benefits that are too appealing for exchanges to ignore. Those benefits include:

• Quicker settlement

• Higher liquidity

• Improved risk management

• Lower costs

According to CFC St. Moritz: “Throughout the next decade, we expect digital assets to play a key role in both public and private markets and integrate most of the traditional financial markets, led by developments of central bank digital currencies (CBDC) and stablecoins as well as large-scale implementations of tokenization initiatives.”

Additional trends to watch closely for the future are:

• Greater asset class diversity (as more assets get tokenized).

• More regulatory clarity. With demand, comes facilitation. I predict that entities will supply regulatory frameworks.

• Greater interoperability: Tokenized asset exchanges will become more interoperable with wallets, custodians, and other exchanges.

• Increased emphasis on security and cybersecurity measures (advanced encryption techniques, multi-factor authentication, and continuous monitoring and surveillance)

• Increased usage of cloud infrastructure and software-as-a-service (SaaS) solutions will enable tokenized asset exchanges to scale more efficiently and cost-effectively, while also providing greater flexibility in managing data and applications. This will enable exchanges to offer more advanced features and functionality to their users, such as real-time market data, advanced analytics, and trading algorithms.