In this article, I will describe what it means to tokenize an asset on a Blockchain and how it relates to physical assets and other financial instruments. Imagine the scenario is that you want to invest in real estate, but your budget is $10,000. You want to get on the property ladder and build equity and increase your investment gradually. Over the first few years, you want to invest your $10,000 in monthly sums as your budget allows.
Obviously, with the traditional real estate market, this approach is impossible, and you would naturally save in another way and then hope to enter the property market in a few years time once you have saved a lump sum. Put another way, how are you supposed to buy two- or three-square feet in an apartment monthly?
Let us flip the scenario. Imagine that you have some property — say a condo. You need cash quickly. The condo is valued at $200,000 but you just need $10,000. How do you raise cash against your investment, re-mortgaging is an option but it is costly and takes time?
Enter stage left – Digital Tokenization. Tokenization is a method that converts rights to an asset into a digital token. Suppose you convert your condo, worth $200,000 into tokens. Tokenization can transform this apartment into 200,000 tokens (the number is totally arbitrary; we could make it as easily 10 million tokens). Each token represents a share of the underlying asset. Finally, you issue the token on some sort of a platform supporting smart contracts, so that these tokens can be freely bought and sold on different exchanges.
When you buy one token, you actually buy a share of the ownership in the asset. Buy ½ of the available tokens and you own 50% of the asset. Buy all the tokens and you are 100% owner of the asset. Obviously, you are not becoming a legal owner of the property. However, because Blockchain is a public ledger that is immutable, it ensures that once you buy tokens, nobody can “erase” your ownership even if it is not registered in a government-run land registry service… It should be obvious now why Blockchain enables this type of services.
Thus, we took an asset, tokenized it and created its digital representation that lives on Blockchain. Blockchain guarantees that the ownership information is immutable. If only life were so simple, in reality, some problems need to be solved before we can successfully tokenize real-world assets on Blockchain.
One big issue problem is that no country has a solid regulation for tokenization. For example, what happens if a company that handles the tokenized asset sells the property? Token owners just own tokens. They have no legal rights on the property, and they are not protected by the law. Therefore, a robust legal framework is needed to accommodate these new business models and the whole digital asset and tokenization space.
Tokenization of other assets works is the same principle. If there is a Monet painting valued at $10 million, it can be tokenized as well. The same applies to gold, jewelry and diamonds basically anything of a monetary value that would warrant fractional ownership. Company stocks is a more complicated space, as in most jurisdictions it is prohibited to sell fractional parts of company shares. Again, to make this fractional ownership of stocks real legal and regulatory changes are necessary to successfully implement tokenization.
Property is one thing but imagine we tokenize Securities…
Company stocks is a more complicated space, as in most jurisdictions it is prohibited to sell fractional parts of company shares. Again, to make this fractional ownership of stocks real legal and regulatory changes are necessary to successfully implement tokenization.
First of all, lets clarify naming. Security Tokens are smart contracts that function as financial instruments: they may suggest the same rights that come with ownership, for example, as a stock certificate or a bond may do. Certain players point out that the term “security token” is really only useful in the context of US securities law, which may not apply to all these instruments. The term, “Investment Token,” may be a better term or you could use, “financial token.” These are financial instruments that may suggest various forms of ownership, including direct, indirect and shared ownership. “Investment” is likely to be apt in most cases, but it may not always be the best term to use.
So, why bother with financial tokens? The existing set-up for investing in securities and trading them seems to work pretty well. There are two primary reasons:
Investors who buy shares in a startup often expect to wait up to 10 years to exchange those shares for cash or publicly traded stock. Tokenization could support a much more liquid and efficient secondary market.
Simply put, tokens hold out the promise of supporting many owners for a single asset, where before it was practical only to have one. Think people owning parts of shares and what this would do for small investors.
Mechanisms exist today to accomplish some of these forms of fractionalization, but none are efficient enough to be widely used. In my opinion, tokenization will make wealth available to a broader set of investors by reducing the need for large investments and increasing liquidity.
There are other advantages, but none more compelling than liquidity and fractionalization. For example, tokenization could reduce the time and costs associated with clearance, settlement, reporting and compliance. The bottom line is this model will simply be more efficient way to do what a large portion of the world is already doing.
Finally, one of the biggest barriers facing Tokenization across all use cases is security. If the Tokens are stolen by hackers along with it goes cold hard money and asset ownership. In a world where ledgers are immutable (not able to be changed or altered) and by their very nature open to the business network, security is a real concern. How do you secure the Tokens is the ball game? Without confidence in this space, the whole value chain falls down. Think of it this way, you are keeping cash under your bed and you have no way to secure your doors and windows and you live in a bad part of town, do you want to put cash under your bed? I will come back to this topic in later blogs.