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Blockchain technology has garnered a lot of attention in recent years and opened up new ways of transacting. One transformative application of blockchain technology is that of asset tokenization – an emerging field in the crypto space and a potential future investment opportunity for institutional investors, such as family offices and investment firms.
What is Asset Tokenization?
Tokenization is a solution whereby the ownership of an asset is divided into digital tokens – It is a process by which an issuer creates digital tokens on the blockchain which represent virtual or real-world assets. These tokens can be described as a piece of software with a unique asset reference on the blockchain and legal rights attached; they can be viewed as digital “shares” of the underlying assets.
When used on real-world assets, tokenization essentially creates a bridge between the real-world assets and the digital world. Additionally, the utilization of distributed ledger technology guarantees that no single authority can change or erase your ownership of a token. In theory, ownership rights to basically any asset can be tokenized and stored on the blockchain, from real estate and art to precious metals and various kinds of financial securities.
Use Cases for Asset Tokenization
The use cases for asset tokenization are vast – in theory, everything from physical objects, such as real estate and art, to financial products, such as equities, to payment options and intangible assets, such as trademarks and intellectual property rights, could be tokenized. In practice however, the current most common use cases are precious metals, capital market instruments, real estate and precious collectibles.
Tokenization can be especially useful in the precious metals market, mainly because of the limitations presented by how hard it is to transport and store metals such as gold, silver or platinum, especially in larger quantities.
Tokenization allows for the transgression of traditional limits of the precious metals market. It allows investors to gain exposure to a precious metal such as gold in a unit that is agnostic of bar and brand. Since the token is a digital certificate of legal ownership, it can be processed or transferred instantly, but it can also be used to withdraw actual, physical gold at one of the numerous global locations, whenever the owner decides so.
Existing examples of precious metal tokenization include AURUSGold (AWG) and PAXOS Gold (PAXG). AURUS Gold is a gold-backed stablecoin on the Ethereum blockchain. Each AWG token is 1:1 collateralized by, and redeemable for 1 gram of 99.99% LBMA-accredited gold, stored in fully audited and insured vaults. Similarly, PAXOS Gold is a token backed by one fine troy ounce of a 400 oz London Good Delivery gold bar, stored in Brink’s vaults. By owning PAXG, you own the underlying physical gold, which is held in custody by Paxos Trust Company – a for-profit company based in New York.
Capital Market Instruments
This is the most direct use case for digital asset tokenization as it adds diversity to the traditional fund raising process via equity and debt instruments. Typically, these take the form of a Security Token Offering (STO), where each token represents a share of the underlying financial instrument.
One example of tokenized equity is the Tesla Tokenized Stock (TSLA), which is a tokenized representation of the Tesla stock that can be traded 24 hours a day, seven days a week.
Tokenization in real estate is the process of creating fractional ownership on a real estate asset with the help of blockchain-based tokens. Tokenization adds a new avenue to invest in real estate, on top of the existing approach via REITs, and allows participation in both capital appreciation as well as rental income distribution.
One of the first tokenization real estate deals was completed in 2018 by a company called Elevated Returns -a New York-based asset management firm. The offering was made on the St. Regis Resort in Aspen, Colorado, worth $18 million on the Ethereum blockchain.
More recent examples of successful real estate tokenization include Red Swan and Polymath’s partnership to tokenize over $2 billion in real estate in May 2021, as well as US-based real estate company RealT’s partnership with Mt. Pelerin to help tokenize its properties.
Dimitri Vardakas, Group Managing Director at DeFi Consulting Group, explains: “The immediate promises of tokenized real estate are related to fractional ownership of a discrete real estate property as well as increased liquidity. There are several key points to consider when investing in real estate on a digital ledger framework . These considerations range from governance and property management, distribution of cash flows generated by the property, ensuring the safe custody of the digital assets, legal rights and protections provided to the compliance around selling or transferring tokens.
With the expected growth of tokenized real estate, investors will get easier access to the global property market and the blockchain technology will most likely be a strong instigator of future innovation in the real estate market.”
This category includes artwork, fine wine, luxury cars etc. – collectible items that are usually out of reach to the average investor. Tokenization allows the fractionalization of these items, therefore making them available to a wider audience.
A notable example includes the tokenization of Picasso’s Fillette au béret painting in July 2021. This was done by Swiss-based digital asset bank Sygnum and Artemundi – an art investment pioneer. The tokenization of Picasso’s $4 million artwork enabled lower purchase barriers and opened up the market to a broader range of investors. Tokens of the painting were made available for subscription to professional and institutional investors exclusively through Sygnum and token holders have their ownership rights fully recognized under Swiss law.
Advantages of Asset Tokenization
- Accessibility: fractional ownership
As high-value objects, such as real estate, can get fractionalized through tokenization, accessibility to those assets increases. Ultimately, tokenization lowers the barrier of entry to investment, allowing investors to buy fractional amounts of the asset, thus lowering the minimum investment amount.
As accessibility increases and tokens can be traded in the secondary market – either peer to peer, over-the-counter (OTC) or through exchanges – liquidity can also increase. This is an especially important aspect for traditionally illiquid markets and non-fractionable assets, such as real estate and private placements.
- Transparency and Security
As tokens run on blockchains, transparency and security increases as well. Blockchains are decentralized digital ledgers shared with and verified by all its users. Thus, data on blockchains is extremely difficult to tamper with. With tokenization, investors have full transparency into the past transactions of a property, as well as an undeniable proof of ownership. Taking precious metals as an example, tokenization adds an extra layer of security as the physical product is still securely stored in vaults, and, on top of that, its certificate of ownership is secured with state-of-the-art cryptographic algorithms.
The blockchain technology underlying tokenized assets allows for more streamlined and efficient processes, partly because tokenization can omit the middleman usually required in many transactions. Many transactions can be automated, cutting down settlement time to minutes or seconds instead of hours or days and, in many cases, reducing costs. Trading can be done 24/7 and the real-time transactions can reduce counterparty risks, as well as trade breaks.
The ERC-1400 Security Token Standard
Security tokens are designed to represent complete or fractional ownership of an asset, as is the case when tokenizing an asset. In comparison to utility tokens – which have no limitations on who can send or receive the tokens – security tokens are subject to many restrictions based on identity, jurisdiction and asset category. Having a stake in a company, real estate, or intellectual property can all be represented by security tokens.
Originally, each security token created was supported by a new and unique smart contract on the Ethereum blockchain. However, there was a lack of consistency in how these smart contracts were engineered, leading to difficulties when it came to process stakeholders such as custodians or exchanges, as these stakeholders would have to complete both business and technical due diligence on assets. Challenges like this increased operational requirements unnecessary when issuing, trading, or managing Security Tokens, thus giving rise to a need for standardization across the industry. For the Security Token market to reach its full potential, issuers, investors, KYC/AML providers, wallets, exchanges, regulators, and developers need to be working within an agreed-upon framework. The ERC-1400 security token standard aims to achieve just that.
Essentially, the ERC1400 standard programmably enforces regulation for Security Tokens by applying jurisdictional laws from across the globe. This ultimately aids with:
- Increased Transparency – being able to reverse, force and check the status of transfers adds to the transparency of the token journey.
- Streamlined Due Diligence – standardization results in stakeholders (such as custodians or exchanges) no longer being responsible for carrying out due diligence processes prior to onboarding the asset.
- Expanded Range of Supported Assets – the standard offers support for a wide range of current as well as new financial assets.
- Improved User Experience – Investors can easily understand why trades fail and what’s needed to remain compliant.
However, while there are many significant benefits to the tokenization of assets, the industry is still in its infancy and has a few noteworthy challenges to overcome. For one, regulation around this field needs to become clearer and more robust, so as to reinforce the provenance, value, custody and linkage of the physical asset to the digital token. It is also critical to protect the ownership rights of the digital token owner. Furthermore, the infrastructure around tokenized assets needs to become more mature and reliable, and governance issues need to be addressed.
Use Case: Challenges in Real Estate Tokenization
Using the case of real estate tokenization, we can illustrate a few of these main challenges.
- Regulatory Uncertainty – There is still a significant lack of regulatory clarity when it comes to cryptocurrencies and tokens, with no clear frameworks or standards to adhere to. This makes operating in the tokenization space difficult.
- Legal Compliance – In order for companies to stay legally compliant, there is a need for standardized regulation across jurisdictions and regions. The ERC-1400 Security Token Standard is a technological step in the right direction when it comes to providing a standard framework for stakeholders to work within.
- Governance – While tokenization is often referred to as a democratization process, this poses questions around the governance of the underlying asset. In the case of real estate tokenization, several questions can emerge surrounding the issue of governance. Some examples, among many others, are:
- Where is the legal contract and how and by whom is it being enforced?
- If the building is rented out, how is the money divided among the investors?
- What happens if the building is damaged or burns down, etc?
These challenges will need to be addressed in order to achieve the widespread adoption of tokenized real estate and tokenized assets in general.
As institutional inflows in the crypto space are continuously increasing, the tokenization market represents a growing niche that may be worth paying attention to as an institutional investor.