Tokenization, and the issuing of related security tokens, can represent regulated financial instruments (such as equities, bonds, loans, and funds), tangible assets (such as real estate, artworks, precious metals) or intellectual property (such as copyright to works of authorship). The tokenization of these assets allows for the issuing of a blockchain token, specifically a security token, that digitally represents a real tradeable asset, and is similar to the process of tokenization used in data security.
The related process of tokenization for data, which is where the tokenization of assets as a concept emerges, is a similar process of using tokens to represent something else. In the case of data security, the tokens represent sensitive data by replacing the data with a token. The information the token represents is stored safely in a centralized server known as a token vault, and the token vault is the only place where the original information can be mapped back to the corresponding token.
These tokens are often used in place of encryption; unlike encrypted data, tokenized data is undecipherable and irreversible. The distinction is important, as encryption uses a mathematical relationship to the data that can be deciphered, whereas only a token vault can trace a token back to the original data. Tokens are increasingly used to secure many types of sensitive or personally identifiable data. They are being used more often as the backend systems of many organizations rely on Social Security numbers, passport numbers, and driver's license numbers as unique identifiers to access information for billing, order status, and customer service.
Tokenization used for data security has been used since the 1970s, when it was used to separate sensitive information from other information stored in databases. Other early forms of tokenization included subway tokens and casino tokens, which serve as representations or substitutes for money, offering the same concept used in digital tokenization. More recently, in 2001, TrustCommerce was credited with creating the concept of tokenization to protect payment card data. Since then, tokenization for data security has been expanded to use cases including patient records, software programs, security, login credentials, and governance.
The tokenization of assets is similar to the process used for data security, where a token is used to represent a real and tradeable asset. The tokens created to represent these assets are referred to as either security tokens, fungible tokens, or non-fungible tokens. And the choice of which token to use depends on the asset and how it is intended to be traded. Once an asset is tokenized and digitalized, it can be broken down into smaller parts that can take the form of tokens, which offers a representation of a proportional part of the digitized assets and associated ownership rights.
Early examples of tokenized items include bottles of wine, pills or jewelry. IBM, in partnership with Pacific International Lines, ran a pilot program in 2019 to track a 28-ton shipment of mandarin oranges from China to Singapore on the IBM blockchain platform. Similarly, as tokenization of assets grows, the value of blockchain grows, with the blockchain market expected to grow to more than USD$176 billion by 2025, and grow beyond USD$3.1 trillion by 2030.
Security tokens digitally represent a real tradeable asset and are created through a type of initial coin offering, referred to as a security token offering (STO) to distinguish it from other types of ICOs, which can produce different tokens. An STO can represent a share in a company, ownership of a piece of real estate, or participation in an investment fund. These tokens can be traded both on-chain and off-chain (traditional financial market infrastructures), and the communication between off-chain and on-chain environments are crucial for assets that continue to exist off-chain.
The security token combines distributed ledger technology with new features dependent on the design of the token. Specifically, these tokens are programmable. And, as such, security tokens can be considered financial securities and must be issued, transacted, and processed in accordance with the relevant federal securities laws in the jurisdictions where they are permitted to be issued and sold. The programmability of these tokens refers to the possibility for them to be programmed for the enforcement of ownership and trading restrictions. And they represent securities that are issued conventionally and brought to the secondary on-chain market in digital form, where the security token operates as a store of value.
These are tokens used for "fungible" goods, which are goods that are interchangeable because they are identical to each other for practical purposes. Commodities, common shares, and dollar bills are examples of fungible goods. Fungible tokens offer a more frictionless way of exchanging assets. Tokenized fungible goods have already seen adoption, notably with gold, where there is more than $142 million worth of gold represented through digital "gold tokens".
Non-fungible tokens (NFTs) are the opposite of fungible tokens and represent real-world assets and items that are by definition unique, irreplaceable, and non-interchangeable. Attributes represented by NFTs can vary by unique serial numbers or dynamic information such as location, size, or consistency of the product itself. Tokenizing the ownership of an asset traditionally held by one entity enables the ability to partially own the unique asset. This can improve the liquidity of assets and allow more investors to take part in the markets. Early physical items represented by NFTs have included bottles of wine, jewelry, and pharmaceuticals, and as part of a standardized supply chain for real-time tracking from manufacturer to producer to consumer.
As well, tokenization allows for real-time tracking of the products and enables the producer to identify possible fraudulent use. The use of nontransferable NFTs for identity management has been considered, especially for occupation-specific credentials such as medical licenses, law degrees, and certifications unique to an individual.
While the decentralized and emerging nature of tokenized assets necessitates that there is no specific approach to tokenize an asset, there is a general framework that defines the process of tokenizing an asset. The first step is the selection of an asset and an analysis of the asset in order to establish the correct price, which is used to develop the token's value. For assets that do not have an implicit or established market value, the valuation should be done by an auditing or accounting firm, with the understanding that the more credibility the chosen firm has, the stronger the valuation. For assets with an established value, this is an unnecessary process.
Once the valuation is done, a smart contract is created and the price and number of tokens correspond with the price and valuation of the asset. The rights and ownership of the asset is also defined in the issuance of the token. This process is also referred to as tokenomics. During this process, the eventual supply and demand can be tipped, with too much supply diluting demand and the value of the token and restricting supply, stifling liquidity. As well, during this period comes an understanding of whether the token will give equity or profit sharing.
In the case of tokens that offer equity in an asset, as the asset gains value, so does the token; this is a model similar to a traditional security held in a publicly traded company, where the perceived value of the company influences the value of the share held in the company.
In a profit-sharing or cash flow token, the token offers a value pegged to a percentage of the value of an asset. For example, in the case of real estate such as an apartment building, a token could represent 0.5 percent of the profits generated by the rent of the apartments, and the token holder receives the value from the profits generated from assets as opposed to rise in the value itself.
These tokens are then shared on a blockchain, or the decentralized public ledger, where people can transact the tokens. The smart contracts act as executable applications residing in the shared ledger, which execute their programmed instructions when triggered by a transaction. Ethereum is one such example and one of the largest public blockchains developed the concept of smart contracts.
The Ethereum blockchain has more than 300,000 smart contracts associated with different tokens. With a proliferation of smart contracts comes a need for compatibility between tokens; this has resulted in the creation of several standards. These standards allow developers to build applications that apply to all tokens adhering to the same standard for full compatibility. Ethereum standards are typically ERC-20 and ERC-721 (respectively fungible and non-fungible tokens). A token standard consists of predefined functions or attributes for the specificities of each asset and standards are chosen based on the characteristics of the asset. The most popular standards include the aforementioned ERC-20 and ERC-721, as well as ERC-1400.
ERC-20 covers fungible tokens, such that it works for a transfer of value between users and allows for the authorization of someone to spend value on one's behalf.
ERC-721 covers non-fungible tokens, such that it works for transfer of ownership of assets, authorizes an operator to transfer an asset on one's behalf, and authorizes transfer of all assets on one's behalf.
ERC-1400 covers security tokens, such that it allows the transfer of ownership of a security token between users, yet still requires a certificate; allows for the same security token to be split between several partitions; authorizes a transfer of a security token on one's behalf; manages the documentation associated with the security token; and allows a controller to force the transfer or redemption of an asset.
With the ability to tokenize physical and illiquid assets comes the ability to tokenize exotic assets, such as artwork, sports teams, and racehorses. Other, otherwise traditional assets, such as bonds, real estate, and venture capital funds, can be and have been tokenized. As can commodities and almost every other asset class.
Assets open to tokenization
The tokenization of commodities offers a new market opportunity across the sourcing of commodities and the trading lifecycle. Converting the physical assets into tradeable digital assets can improve liquidity and lesser barriers to entry in asset classes led by institutional investors.
Where tokenization can permit fractional ownership of innovation of a resulting technology. This can create new models of ownership and participatory income streams from licensing.
Tokenization can reduce the costs and foster greater market participation in the loan process, due in part to process automation and simplified workflows. The duplication of information among counter-parties, excessive manual processes, data re-entry, and lengthy settlement times creates cost and delay in loan markets.
Illiquid assets, including artwork, wine, ownership interests in private companies, partnership shares, and more, can be tokenized to offer provenance, lending, and price discovery through the blockchain's transparency.
Private equity shares
Information about shareholders and shares of small-to-medium size companies is recorded on papers or spreadsheets, with each party managing records in individual databases and creating data silos, with is prone to errors. Tokenization of equity shares allows companies to interact with shareholders and provide information on a single shared and immutable ledger, offering shareholders ownership transparency and authenticity to run trades on the secondary market. As well, it offers new avenues of investment for small-to-medium size companies not necessarily capable otherwise.
Companies offering tokenization services
With the increase in tokenization of assets comes a growing expectation of a new tokenized economy, or token economy. This token economy is expected to offer a more efficient and fair financial world by reducing the friction involved in the creation, buying, and selling of securities. As well, the four main advantages of a token economy include greater liquidity, faster and cheaper transactions, more transparency, and more accessibility.
For liquidity, tokenizing assets, especially private securities or illiquid assets such as fine arts, can be traded on a secondary market of the issuer's choice, benefiting investors by offering more choice and benefitting sellers because the token can benefit from the increased liquidity and capture greater value for the underlying asset.
On-chain settlement via security tokens enables disintermediation, removing the need for middlemen, where value transfers can be processed without centralized intermediaries but rather through a process automation using smart contracts. This automation can lead to reduced costs in the issuance and servicing of securities, reducing the costs throughout the security's lifetime and reducing fees for issuers and investors.
As well, automation of value transfers through a decentralized ledger also allows transactions to happen more rapidly. As trust is decentralized, counterparty risk is reduced and the reduced friction, in terms of time, could lower operational risk. And the process of wallet-to-wallet exchanges could further improve the efficiency and speed of settlements. A tokenized economy can also allow for the converting of a single asset into another asset and eliminate the entire process of exchanging cash between settlements.
A tokenized economy can offer greater transparency through the use of the distributed ledger, which increases the recording and sharing of information. The ledger also works to strengthen the data integrity through its immutability and improve the safeties of the securities. This is especially useful as a single point of failure is removed once a decentralized ledger is verified by global nodes. There are further implications for the possibility of automatic auditability, and could lead to registrars and transfer agents being redundant, as corporate or shareholder registries are replaced by the decentralized ledger. This can also offer the automation of regulatory enforcement, as it can be programmed into smart contracts, which would notify regulators in the case of a restrictions violation.
While current investments lack exposure to a global investor base with political and economic boundaries complicating trading equities across markets, the tokenization of funds could enable retail investors to access asset classes and risk otherwise beyond their capacity. This could increase the flow of private financing from capital owners to small- and medium-sized enterprises. As well, it improves the ability for a retail trader to diversify an asset portfolio, through investments into previously unavailable funds and through fractal ownership of previously illiquid assets.
Fractal ownership and decentralized access offers more inclusiveness for smaller investors, which benefits the investor and those seeking access to financing. Further, this can help sellers looking for a place to sell an investment, especially those considered illiquid. And participation in the markets can be increased and a wider range of investors can participate. Fractioning assets also introduces the notion of shared ownership, where multiple people can buy an asset and use it.
The advantages of the token economy, and tokenization overall, is that it opens up new possibilities for investments and could permit a minimum investment in a piece of art or a piece of real estate a person may otherwise not have a chance to invest in or purchase outright. And, after purchasing, these tokens could also be sold at the holder's discretion. This offers greater possibilities for where investors can place their money, with greater personalization and customization in investment, especially as investors look beyond returns and instead look closer to where they are investing. Tokenization could unlock trillions of dollars in illiquid assets and increase the volume of trades accordingly.
In another scenario, an owner of a building needing to increase liquidity could tokenize the asset and sell the number of tokens necessary to raise the funds, rather than sell the real estate for full value on a traditional market and lose the asset altogether.
In the development of a broader tokenized economy, there are some challenges that need to be overcome before a wider adoption can exist. This includes challenges around regulatory alignment, especially as blockchain platforms are de facto decentralized. And security regulations will vary significantly, depending on the jurisdiction. There will be governance and compliance challenges faced by a necessarily decentralized and global trading system, which can be called into question as regulations and governance work to standardize the market. This already occurs when trading certain tokenized assets that fall into jurisdictional regulatory requirements.
The challenges faced by a tokenized economy by regulatory environment include the responsibility placed on the buyers and sellers of assets, which is increased in the decentralized system, given the removal of intermediaries. However, it is unlikely that financial authorities are interested in removing those authorities, which would require a new framework in order to ensure the token market is compliant with existing or new regulatory and supervisory frameworks.
These regulations can undermine many of the advantages offered by tokenization, many of which would only be maintained through agreed upon international regulatory alignment, an unlikely milestone. However, regulations developed for tokenization, and offering clear guidance specific to tokens and tokenization, could ease uncertainties and concerns around tokenization. This can be especially important to discourage scams or hacking in the nascent token economy, which could damage the confidence of current and potential investors.
Regulations have been uneven and jurisdictional, but traditional market structure has made moves to adapt to and accept the token economy. Both the United States' SEC and the European Union's ESMA have made comments on the token economy, pointing to the regulatory bodies considering how to accommodate the token economy. While Malta and Switzerland have made more progressive plans for the new marketplaces for tokenized securities and have worked to develop the clear regulatory framework considered necessary for a safe development of the token economy.
In the case where a regulatory framework exists, even if that regulatory framework is disparate and based on jurisdiction, can be managed through compliance embedded at the token level, through the smart contracts and the programming of the token. And there are companies already working on this during the issuance of tokens. This programming can take into account who the buyer and seller are, where the trade occurs, and if the trade is compliant on the token exchange. This could be the area which, if developed properly, could ease regulatory challenges faced in the creation and sale of tokens.
Fractal ownership, an exciting feature of the tokenization of assets, can complicate the token economy and require regulatory standards and theoretic approaches to enforce governance. For example, in real estate, a company owning a commercial property is incentivized to maintain the property and has a simple enough organization to see maintenance done in a regular manner. But, if the ownership is split among thousands of people, there is little incentive for owners to maintain the property or, depending on the tokenization schema, ensure rent is collected. This is especially as these responsibilities to the property have costs associated with them. These challenges do not have an easy answer from the point of view of governance.
In part a problem of understanding and acceptance, the relatively early phase of blockchain technology has seen both challenges to its overall acceptance from institutional investors and retail investors. As well, with the rise of the technology, there have been large fees as the infrastructure is developed. And with the slow adoption of the technology, the liquidity on the decentralized exchanges is poor, although with a rise of interest and willingness to trade on the tokenized economy could see a rise in the liquidity and a reduction in related fees.
Digital and secondary exchanges for tokens and digital assets
Considered the tokenization of currency, central banks have begun to explore the use of alternative currency types with the emergence of distributed ledger technology and blockchain. This would meet the decline in the use of banknotes in advanced countries, but also offer a technological way for developing countries and the previously unbanked to take part in currencies and holding currencies in a more secured manner. The Central Bank Digital Currencies (CBDC), as proposed by central bank projects, would be a new form of money issued digitally by the central bank.
Money, as a form of promise to pay, serves as a store of value; as the token economy works on representation, a tokenization of currency makes similar sense. While physical money offers a level of privacy not enjoyed by digital deposits, a digital currency could be used to offer similar levels of privacy for those concerned. CBDC could be account of token based, issued centrally or de-centrally, and have been split into two different categories based on proposed purposes: wholesale CBDC and retail CBDC.
Wholesale CBDCs are intended to be suitable for financial institutions holding reserve deposits in a central bank. The wholesale CBDC can improve efficiency of payments and security settlement, and resolve concerns of liquidity and counterparty credit. This could ensure replacement or support for reserves in the central bank through a restricted-access token, which would serve as a bearer asset in wholesale central bank digital currencies; this would allow a sender to transfer value to a receiver without intermediaries.
The retail CBDC would be a digital currency intended for use by the general public. The retail CBDC would be based on distributed ledger technology, and intended to carry the features of availability, anonymity, and traceability while also offering the possibility for an interest rate application. These CBDCs are used among central banks in emerging economies where they have garnered a lot of interest. The primary reason for this popularity is for capitalizing on opportunities for growth in financial technology, as the retail CBDC can promote financial inclusion and a shift to a cashless society, helping to reduce the costs of cash printing and management.
The key factors, which could be considered the underlying principles, of retail CBDCs include the following:
- Retail CBDCs are suitable for the liability side of a Central Bank's balance sheet.
- They present a new variant of central bank money, subject to central bank functions of issuing, management and controlling, and can focus on a country's monetary policy.
- Distribution would be associated with one-to-one parity at par with the relevant fiat currency, with support for seamless and flexible conversion against cash and commercial bank money.
- The retail CBDCs could be developed on open infrastructures to allow businesses to create services and products over it.
- Retail CBDCs would not require users to have a bank account for accessing or obtaining the digital currency, and the associated transaction cost could also be lowered.
- These retail CBDCs must be accepted as a legal tender and a mode of payment, and be able to serve as a safe store of value for citizens, governments, and enterprises.
Both retail and wholesale CBDCs would offer efficiency for payment and settlement systems, but retail CBDCs have garnered more interest as most central banks do not want to create conflict between central bank and private sector money. However, retail CBDC can also present various risks to financial stability and monetary policy.
Whereas wholesale CBDCs allow users to monitor them during payment or settlement in real time, and would allow for support for linking with many different currency, payment, and settlement platforms. For example, wholesale CBDCs could allow users to link securities or forex platforms directly with cash platforms. They could also improve the speed of transactions and eliminating the risks of settlement, while fostering simpler cross-border payment systems by reducing the number of intermediaries.
CBDC project examples
Bank of Canada
Project Jasper - a collaborative research initiative between public and private sectors to understand how distributed ledger technology could change wholesale payment systems.
Banque de France, European Central Bank (ECB)
Open to projects and experiments with the ECB and other central banks in the Eurosystem, in particular with regard to wholesale CBDC.
Central Bank Group
The Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Sveriges Riksbank, and the Swiss National Bank, with cooperation from the Bank for International Settlements, have created a group to share experience as they assess potential cases for CBDCs in home jurisdictions.
Central Bank of Brazil
Project Salt - exploring distributed ledger technology for interbank payments contingency and resiliency of system as well as a decentralized information exchange platform.
Central Bank of Iceland
Rafkrona - exploring CBDCs for home economy
Companies in this industry
10 Business Cases for Tokenization of Assets - micobo GmbH - Medium
August 31, 2020
area2invest | Tokenized Assets and Securities - What are the Advantages of Tokenization?
Max J. Heinzle
November 3, 2020
Asset Tokenization - Brickken
Asset Tokenization - Real Assets on the Blockchain
November 20, 2019
Asset Tokenization on the Blockchain - A Complete Guide | 101 Blockchains
February 22, 2021