Digital-asset exchanges are in a race to generate liquidity. Liquidity, the ability to turn an asset into cash without moving the price, is the measure of a trading venue’s success.
For the crypto world, this means trading volumes in Bitcoin and other digital assets. For those exchanges looking to serve licensed financial institutions, liquidity is tied to tokenization – the expression of traditional securities as smart contracts trading on blockchain rails.
In the tokenization space, creating liquidity involves creating entire market ecosystems and security lifecycles practically from scratch. The underlying securities exist in their traditional environments. Tokenization is an exercise in attracting the varied layers of buyers and sellers that make a market. Why should investors want a tokenized stock or bond if they can already get the underlying?
One way is to make those underlying instruments more liquid. Blockchain is a tool to digitize securities (or other things). It also allows near-instant settlement, which is not just fast but means investors don’t need to put capital aside to pre-fund trades. The prospect of tokenization is taking place as the United States is planning to move its securities settlement time from T+2 (two days after the trade is agreed) to T+1.
Even so, there’s a big difference between settling trades the next day versus right away. The advent of digital-asset exchanges will mean traders and investors could handle the same instrument – a company’s stock or bond – across venues with different settlement times.
While that might create arbitrage opportunities, tokenization will still require something more compelling, at least to get started: creating liquidity where little exists in the traditional setting.
The team at Fusang Exchange, a digital-asset exchange licensed by Labuan, the offshore financial center of Malaysia, thinks it has identified a market segment that can be augmented this way: sukuk, or Islamic fixed-income instruments.
Fusang Exchange has recently tokenized and listed a digital sukuk representing the corresponding underlying sukuk issued by the International Islamic Liquidity Management Corporation (IILM).
Fusang chairman Henry Chong (pictured) says sukuk are a means to generating proprietary liquidity on the exchange, and a steppingstone to tokenizing other types of securities.
“I see a lot of tokenization projects at banks,” he said, “but those assets can’t move among them, and investors can’t transfer those assets among the various silos of financial institutions. They can on our exchange.”
Fusang is using tokenized sukuk as a wedge to become a global venue for all kinds of securities tokens – if it can generate the liquidity that sukuks otherwise lack.
The problem is a longstanding one: IILM was set up by the central banks of several Islamic countries in 2010 to address it, by creating and issuing dollar-denominated sharia-compliant financial instruments. More than a decade later, while the international sukuk market has more than doubled in size, it remains bereft of a secondary market.
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The global market reached $915 billion as of 2022, according to Fitch, more than double its size from 10 years ago. Issuers include supranationals, banks, and sovereigns from Malaysia and Saudi Arabia (the two biggest issuers of sukuk), but in the past three years other markets have become more active or issued sukuk for the first time. A new driver of sukuk issuance is the ‘green sukuk’, with Malaysia and Indonesia’s governments issuing the sukuks designed to finance green projects.
Sukuk arose to provide fixed-income instruments in lieu of bonds, which are based on lending and therefore are forbidden under sharia law, which regards interest as usury. Sukuk represents ownership shares in an underlying asset or commercial interest, and therefore is comparable to an asset-backed instrument.
However, despite this growth, sukuk have not been able to pay the role that US Treasuries do in the global bond market: serve as the highly liquid, investment-grade financial asset that commercial banks can trade to manage their short-term funding needs. IILM was founded to enable this, but Islamic finance still lacks something like the convenient and safe short-term Treasury bills.
No secondary market
The reasons for this are both on the issuer side and the investor’s.
In terms of supply, the market is fragmented. Because sharia standards vary by country, a sukuk issued by (say) Malaysia may not be recognized by Islamic advisors in the Gulf states. Sovereign issuances are too few to create a dollar-based benchmark yield curve.
On the demand side, there isn’t a secondary market. Most investors are Islamic commercial banks, and they hold these instruments to maturity. This is a chicken-and-egg problem, as one reason for the buy-and-hold ethos is inadequate supply: if you sell a sukuk instrument, you may not find a replacement for the portfolio. Bond investors will often rebalance their portfolios to manage changes in duration (after a few years, a five-year bond will now have only two or three years till maturity).
There’s also an innate challenge for sukuk, because they are structured products with complex cashflows beneath, so they are harder to value than a vanilla bond, especially in times of crisis. This structural issue can be partially offset within Islamic finance by the issuance of a special type of sukuk called a Salam, which is designed to enable the investor to get quick access to the cash of the underlying asset; but this usually requires some kind of pre-funding arrangement, which ties up capital. The bottom line is that any security backed by tangible assets rather than by debt is going to be a challenge for short-term liquidity.
This detour into Islamic finance is important because it raises the question of what tokenization solves.
Kelvin Ung, president of Fusang, argues that digitizing and distributing tokenized sukuk can generate the Islamic equivalent to US Treasuries. “Their yields are the lowest risk within emerging markets,” he said.
This digitization process is meant to create new standards among sukuk and reduce the friction and complexity of the existing market. Fusang hopes to position itself as a neutral marketplace, with proper governance measures such as requiring third-party custody.
Fusang is tokenizing sukuk by issuing Fusang Depository Receipts: it holds the original sukuk in custody and issues receipts in tranches as smart contracts. These FDRs operate on the same principle as American Depository Receipts, which are issued on US stock exchanges by banks in the US holding a foreign stock in trust. American investors can then access the ADR to receive the same economic benefits as directly holding the local stock, while trading and accounting for it as they would any other US security.
Similarly, holders of FDRs own the economic rights to the underlying sukuk, which they buy and sell on Fusang Exchange; these tokens follow the ERC-20 standard, meaning they can trade on public Ethereum. Because it’s in token form, the market trades round the clock and offers atomic settlement, so investors don’t need to wait one or two days to receive cash or the underlying.
Jumpstart secondary trading
This divergence is key to Fusang’s understanding of how it generates new liquidity on its exchange. “Instant settlement means investors will arbitrage trades on our exchange versus other national exchanges, which creates new liquidity,” Chong said.
In the case of sukuk, the idea is to generate any trading at all. Almost all sukuk are held to maturity by local state pension funds or Islamic banks. IILM is a major player in the dollar-denominated market, responsible for close to 25 percent of all issuance, but its bonds rarely trade, except in a rarified interbank market. Fusang is betting that simply digitizing its bonds and enabling instant settlement, it will jumpstart a secondary market.
It is starting with international sukuk listed in Labuan, where such instruments are considered high quality and liquid assets for banks and brokers. The first investors in its tokenization project are Labuan-based Malaysian banks and brokers. Fusang’s next step will be to onboard other financial institutions – many international banks have branches there – and then tackle onshore Malaysian institutions operating in the local, ringgit-based Islamic market.
At the same time it intends to broaden its investor base into the Middle East and Europe, arguing that once it has proven tokenization can solve access and liquidity issues for Islamic instruments, it can do the same for orthodox stocks and bonds.
Ung believes the initial sukuk tokenization can quickly scale into a bigger business. Fusang is working with several Islamic banks in the Middle East with their own broker networks that together could pull in millions of individual investors, helping turn sukuk trading from an interbank instrument into a retail market for anyone trading on Ethereum.
The limits of digital
Fusang hopes digitizing sukuk will mitigate the challenges of fragmentation and a lack of a secondary market. What tokenization can’t do is change the underlying nature of sukuk, which remain based on underlying transactional cashflows rather than debt. To whatever extent this is the reason why sukuk don’t offer T-bill-like short-term liquidity, it won’t change just by putting them in digital form. Nor will it change the mind of a sharia scholar who believes (say) that Malaysia’s version of sukuk isn’t strict enough.
The question then is: who are the investors who will be attracted by the settlement-arbitrage opportunity? They are probably not going to be the status-quo buy side, at least not right away. They will be traders from outside. They will compare tokenized sukuk to tokenized T-Bills – and they will also compare it to what’s going on in the crypto markets, particularly once they are able to access ETFs or other tracker products.
Attracting outside investors is a healthy thing because it brings new vectors of liquidity to the market. But are these going to be committed to the sukuk ecosystem, or just hot money? How will this sit with some sharia scholars?
These questions aren’t to disparage Fusang’s project, just to highlight the challenges that all the digital-asset exchanges now face. Tokenization of registered securities to distribute among licensed financial institutions is the name of the game. If Fusang’s found a niche that draws new liquidity and can generate a self-perpetuating market, it will be a win for the industry at large.