What is asset tokenization and how will it revolutionize and disrupt financial markets

Introduction

Asset tokenization is the process by which an issuer creates digital tokens on a distributed ledger or blockchain, which represent either digital or physical assets. Asset tokenization is an area of explosive growth for the blockchain industry. Since Bitcoin’s earliest days, attempts have been made to use bitcoins as “tokens” to represent assets. Early on, this was done by leveraging a bitcoin’s metadata field to attach meaning to a bitcoin transaction (thereby creating a “colored coin1 ”) and recognize the ownership of that coin as the ownership of some other asset. The bitcoin blockchain could then track ownership of a represented asset and enable secure and direct transfer of ownership. Since then, there has been a veritable Cambrian Explosion of protocols and blockchains that have been purpose-built for the representation and transfer of many types of assets.

Today, blockchain’s application to securities issuance and trading is well underway, and the benefits of its application to many types of securities is becoming better understood. Here are some questions people usually have about this technology, how will tokenization impact securities that have reference to real, physical assets? How can blockchain address, if at all, unique challenges that come with investing in those asset classes?

Tokenizing financing assets: equity and debt

When it comes to financial assets, tokenization of securities (equity and/or debt) is seen by the market as the sector with the most imminent potential for growth. This is mainly driven by the recent hype around tokens issued in, mostly unregulated, ICOs and the currently trending ‘Security Token Offerings’ or STOs, which has been marketed as a more “regulatory-compliant” successor of ICOs aiming to raise capital, as well as ‘Security Tokens’ representing existing securities in secondary DLT markets. Both the above designations are self-defined by market participants and the designation of an issuance as regulatory compliant will only depend on the particular issuance on a case-by-case basis.

STOs are securities offerings consisting of the issuance of DLT-based tokens that aim to comply with the securities regulatory framework at the jurisdiction of issuance and at the jurisdictions where the offering is marketed to investors. Regulations applying to the offering and throughout the security lifecycle are digitally represented on the blockchain through programmable enforcement of ownership and trading restrictions, for instance (‘programmable securities’). STOs are self-defined as there is no formally agreed classification for such token offerings. Security Tokens, also self-defined, are tokenized versions of securities that are already issued by conventional methods (existing share certificates) which aim to bring these assets onto the secondary on-chain market in digital form. Whether the issuance will be regulatory compliant does not depend on the designation/use of a particular ‘label’ but will be determined on a case-by-case basis.

The electronification of financial markets and the use of automation for the issuance and trading of financial instruments is not new; securities have existed in electronic-only format for a long time in what is described as “dematerialised” form. Tokenized securities could be seen as a form of cryptography-enabled dematerialised securities that are based and recorded on a decentralised ledgers powered by DLTs, instead of electronic book-entries in securities registries of central securities depositories. The decentralization of tokenized securities, coupled with the ability to automatically transact and settle without trusted intermediaries, may be where most of the disruptive potential of tokenisation lies. Tokenized securities eliminate the need for the use of intermediaries or proxies in the distribution of dividends or votes, giving investors full control of the equity they own.

Benefits of tokenization

The application of DLTs in asset tokenisation may deliver efficiency gains through the transfer of value without the need for trusted centralized intermediaries and/or through the efficient automation of processes, resulting in faster, potentially cheaper and frictionless transactions driven by disintermediation and automation. The use of smart contracts may reduce the cost of issuing and administering securities, further reducing the cost of transactions, increasing speed of execution and streamlining transactions. Smart contracts may facilitate corporate actions (e.g. coupon or dividend payments, voting), escrow arrangements (e.g. release of funds) and collateral management (e.g. exchange of ownership interest). Custody chains typically involved in traditional securities holdings may be shortened and their transparency increased, avoiding potential liquidity problems for market participants in case of operational issues or financial distress of sub-custodians.

Automation introduced in the issuance, distribution, management of securities but also around securities servicing and corporate actions may reduce costs throughout the securities transaction lifetime, benefiting issuers and investors alike. The distributed nature of the network with no single ‘point of failure’, the immutability of the ledger and the application of cryptography may add to the resilience and safety of the infrastructure. This of course depends on the applicable consensus mechanism and the governance model of each DLT which may give rise to other vulnerabilities (e.g. risks of forks).

In addition to the efficiency gains driven by its disintermediation potential, asset tokenisation may bring

Increased transparency may also be achieved in terms of regulatory compliance and interactions with regulators: as programmed regulatory restrictions are automatically enforced, the regulator may be automatically notified through smart contracts when restrictions are modified or turned-off. Regulators may also have quasi-real-time information about specific on-chain events of interest to them.

It should be highlighted, however, that the quality of the data that is inputted into the blockchain is critical for the robustness of information recording and sharing. DLTs do not resolve the ‘garbage in, garbage out’ conundrum and poor quality of data inputs (e.g. malicious or erroneous ‘oracles’ feeding external data into the network) will result in a transparent, immutable, time-stamped repository of unsound or flawed outputs. In a tokenized world, it could be argued that there will be a need for regulated entities attesting to the accuracy of data before these are inputted into the blockchain.

Tokenization of assets could allow for direct access of investors in primary and secondary markets. ICOs were a prime example of tokens issued directly to investors on platforms/issuing venues facilitated by technology companies and without any middleman function in the traditional sense. Secondary trading, however, continues to occur mostly at centralized exchanges, and pure decentralized exchanges are yet to dominate tokenized trading.

The benefits from the wider use of asset tokenisation may be enjoyed by investors who would have the possibility to hold fractional ownership of assets (or interest in funds). Tokenization of assets may allow for the slicing up of assets, dividing ownership into smaller claims than typically observed in stocks and bonds, in a way similar to structured products and securitisation. Investors, particularly retail, may therefore gain access to asset classes and risks that may have been otherwise beyond their capacity (e.g. participation in private equity funds) and participate in capital markets with lower minimum tickets or portfolio sizes.

Investors would thus potentially be able to better design or diversify their investment portfolio in certain asset classes with larger ticket sizes in their conventional form (e.g. real estate, gain exposure to a specific neighborhood or diversify holdings internationally) or with new digital assets (e.g. intellectual property).

Fractional ownership may allow for more inclusive access of small and retail investors to somehow restricted asset classes, while enabling global pools of capital to reach parts of the financial markets previously reserved to large investors. Private placements of equity or debt of small and medium-sized companies (SMEs) are examples of security transactions that are traditionally restricted to large institutional investors and funds.

Increase in the participation of retail investors in previously restricted asset classes in a tokenized world would not mean that participation of retail investors in high-risk products should be completely unrestricted. Limitations to their participation and relevant thresholds to protect their interests can apply, as with the example of accreditation of investors under Regulation D in the United States or through the application of suitability requirements. Compliance of tokenized assets with the relevant (pre-existing) applicable regulatory framework will allow for such safeguards to be in place, therefore clarity around the applicable regulatory framework is of paramount importance for the issuers and participants in tokenized markets.

Conclusion

There is a lot more to cover in the process of asset tokenization. Clear benefits exist from applying blockchain to securities trading; but with respect to securities that derive underlying value from real, physical assets, the tokenization of those physical assets for the purpose of standardized, transparent and tamper-proof record keeping has the potential, we think, to drive significant value for investors. This will, for example, accelerate due diligence processes and prevent significant price dislocations due to lack of transparency to the value drivers of the underlying physical asset (such as occupancy rates and maintenance history). In short, it’s not just about tokenizing the securities, but also tokenizing the physical assets — we believe powerful benefits can be realized by tokenizing both and connecting the two.

--

--

Get the Medium app

A button that says 'Download on the App Store', and if clicked it will lead you to the iOS App store
A button that says 'Get it on, Google Play', and if clicked it will lead you to the Google Play store
DigiEx by Shondy Sainthea

I'm Shondy Sainthea and I welcome anyone to come learn with me about Blockchain,Digital assets and technology.(educational purposes only)