The record-setting sale of Beeple NFT, a non-fungible token representing a digital artwork, at Christie’s for $69.3 million brought into limelight the explosive growth of asset tokenization using blockchain. Real estate tokens, digital artwork, capital markets fundraising, sports moments and crypto-collectibles are just some of the thriving use cases. These assets are represented as a digital token on the blockchain, providing undisputed ownership and provenance, reducing transaction costs and enabling transaction automation through smart contracts.
What is tokenization?
It is the process of creating a digital twin of a physical asset. The digital twin is known as a token; it maintains ownership, rights, behaviors and other properties of the asset. This novel concept makes the process simpler to trade the assets since selling or buying involves just trading the token on a global exchange similar to stock exchanges. In a nutshell, tokens bridge real-world assets to the digital world.
The benefits of tokenization are numerous. Primary benefits include:
- Fractional ownership: Tokens are divisible and allow us to fractionalize assets and own and perform actions over only a portion of an asset. Investors can invest and trade in small percentages of tokenized assets. For example, you can buy only a 0.1% share of a tokenized large real estate development or a Picasso art, getting a piece of action which was hitherto limited to large institutional investors. This dramatically removes the barriers for small investors to enter the market.
- Increased liquidity: Real estate, as an example, is considered an illiquid asset as it cannot be sold quickly. Tokenizing assets increases liquidity as the tokens can be traded on an exchange. Improved liquidity helps manage better prices and enables shorter-term investments in assets considered to be long-term acquisitions.
- Faster settlement with lower transaction costs: Costs are significantly reduced by doing away with a central third party to manage transactions. Simple payment and clearance can be automated within the blockchain network, providing near real-time transactions and avoiding days-long waiting.
- Improved transparency: Since every transaction is immutably recorded, the blockchain provides tamper-proof and trustworthy ownership history. The platform can selectively disclose information about the previous owners, financial history, and partnership status, giving investors relevant information to make sound investment decisions and creating a fraud barrier.
Successful examples of tokenization
- Tokenization of real estate assets enables fractional ownership of an asset. Blockchain allows a safe and frictionless registry and transfer of the cryptographic tokens, improving the liquidity and transparency of assets, removing intermediaries and reducing high transaction fees. In 2018, Elevated Returns completed a successful tokenization real estate deal, offering St. Regis Resort in Aspen, Colorado, worth $18 million on the Ethereum blockchain.
- Tokenization of sports moments allows fans to collect, trade and own some of the greatest sports moments. The NBA’s Top Shot project tokenizes highlight clips from games and enables players to bid their highlights against each other.
- Tokenization of art allows the ownership of an artwork to be split into smaller Non-Fungible Tokens recorded on a blockchain network. This allows easy transfer of ownership and democratizes the art market. In 2018, a multi-million dollar Andy Warhol painting was tokenized and sold on blockchain entirely using the smart contract.
- Tokenization of brand digital artifacts enables users to own rare digital artifacts through the blockchain network. The Pepsi Mic Drop genesis NFT, Pepsi’s tribute to its birth year, contained 1,893 genesis tokens using nearly 50 unique attributes across six categories, including microphones, stages and accessories.
Utility, security, fungible, non-fungible? Confused about the nomenclature associated with tokens? You are not alone. There is a lack of consistency in the names of token representation in the blockchain and crypto community. The industry has broadly divided the tokens into the following categories:
- Utility tokens have value but generally not considered to be cryptocurrency. Companies issue them to raise funds for the platform’s development and for users to buy in the hope of discounted access to a product. Most utility tokens are subject to minimal regulations. The most common utility tokens are those built upon the ERC-20 Ethereum standard, which was first used to develop smart contract functionality and inspired the proliferation of Initial Coin Offerings (ICOs).
- Security tokens were born when the market identified a more secure investment alternative than ICOs, which have been subject to numerous fraudulent schemes. As the name suggests, the security token is used to tokenize digital securities, primarily built using ERC-1400 standards, and are sold on security token exchanges. Security Token Offerings (STO) are regulated in most countries and preferred to ICO.
Both utility tokens and security tokens can be either fungible or non-fungible.
Fungible tokens have the same interchangeable value as one another. Any quantity of token has the same value as another equal quantity. A $1 bill is the same as another $1 bill regardless of the series number. The same applies to cryptocurrency.
Non-fungible tokens represent a unique asset and are not interchangeable with other same-type tokens as they typically have different properties and values. A house is a good example. Each house is unique and not interchangeable with another.
To ensure interoperability, InterWork Alliance (IWA), now part of the Global Blockchain Business Council (GBBC), is developing the Token Taxonomy Framework (TTF) for tokens. TTF brings in the common language to bridge the gap between all stakeholders, including developers, business executives, custodians, legal, and regulators, allowing them to work together to create new business models, processes and networks based on tokens.
Tokenization ecosystem key players include:
- Token issuers provide the necessary blockchain platform and support services to asset owners for launching their tokens.
- Regulatory compliance companies provide various compliance services as per each country’s requirements, including identify verification (KYC), anti-money laundering, and whitelist/blacklist investor information.
- Regulators such as the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) provide regulations for tokenizing digital securities.
- Trading exchanges provide regulated secondary trading of token securities services.
- User account providers are broker-dealers. They provide end-user wallets to hold their securities and facilitate trading securities.
- Legal firms provide the legal structure and regulatory compliance for token issuance deals.
- Custodians are third-party providers who hold physical assets representing securities on behalf of investors. They are safe-keepers of physical assets and minimize the risk of theft or loss.
- Collateralized loan/interest providers provide loans/interest against securities. They deploy smart contracts to distribute dividends or interest automatically.
Though tokens can be subject to regulatory hurdles and require a shift in mindset to operate, tokenization is accelerating. Blockchain-based tokenization as the representation of a physical object has already gained momentum in the markets. The ecosystem is strengthening with scalable and secure platforms, and new forms of tokens are being created from physical assets to intellectual properties.
The private stablecoin initiatives are driving central banks worldwide to look at the implementation of central bank digital currency for their currencies. The benefits of tokenization, especially fractional ownership, transparency, increased liquidity, and improved security, create new opportunities to improve the value transfer systems.
(Gigo Joseph is the vice-president of blockchain services at Chainyard.)