How Does Tokenization Work?

In 2009, the world witnessed the revolutionary inception of Bitcoin; the first cryptocurrency that leveraged the distributed ledger technology to offer a decentralized digital landscape. Since the inception of Bitcoin, thousands of other digital currencies and assets that leverages on distributed ledger technology have come into existence, including the foundation initiated by Bitcoin.

What is a Token?

A token is a digital footprint or representation of a tradable asset on top of a blockchain. Tokenization stands for the process of converting a real-world asset into a digital asset which gets stored on a blockchain. Tokens can represent any of a diverse set of assets; physical, crypto or otherwise, including real estate, artifacts, intellectual property, and company shares. The practical upshot of this is that $256 trillion worth of real-world assets are an untapped pool with the potential to be tokenized.

One could question why tokenization is even necessary for an ecosystem that has been thriving for decades. It is the illiquidity of these assets together with the high cost of operation and time-consuming processes that result in the need for tokenization. A majority of the processes are time-consuming and require burdensome paperwork. While conventional securitization enables one or more assets to be traded with minimized risk, it does not address the above issues.

In an attempt to redress these inefficiencies, tokenization leverages distributed ledger technology and smart contracts. These innovations allow tokenization to introduce a layer of programmability, eliminating the need for intermediaries, and consequently reducing operational cost and speeding up processes. Tokenization also addresses indivisibility of assets and in turn, illiquidity; it paves the way for fractional ownership which significantly reduces the barrier to entry, thereby inviting a new class of investors to own a part of an asset.

Tokenization can be leveraged by any industry or asset category today, and as of July 2019 1400 tokens exist, with a total market cap of $18,022,123,037. The merits of tokenization can be better understood through the process that it follows.

Process of Tokenization

Tokenization enables the masses to hold assets or to invest in assets in which they otherwise would not have been able, and the investment in a previously inaccessible class of assets is facilitated by the option of fractional ownership. For example, real estate. Take a shopping mall, an asset which on average, requires an investment higher than $20M. Traditionally, a shopping mall could not be owned by investors with smaller investment sizes but by utilizing tokenization, these same investors can do precisely that and own a share in the shopping mall.

Tokenomics defines the volume of tokens that represent a particular asset, and is a critical step in the process of tokenization. If 200,000 tokens are issued for this shopping mall, it would mean that each token represents a 0.0005% share of the mall, meaning that supply of a token defines the share of ownership that is transferred. In this case, buying 100,000 tokens would translate into 50% ownership of the shopping mall. If the mall costs $20 million, a token supply of 200,000 would mean that each token represents $100 worth of the mall, meaning that an individual with a $2,000 investment budget could also invest in a shopping mall worth $20 million by purchasing 20 tokens. The possibility of investing $100 in a property that is worth $20 million has the potential to unravel liquidity premium worth millions of dollars. Consequently, tokenization can boost the volume of global trade considerably, given that private fundraising in the U.S. alone amounts to $2.4 trillion.

Next, these tokens are transformed into programmable assets with the use of smart contracts: algorithmic software contracts which automate the validation of various terms and conditions. These contracts also insert business logic in the automation process. While smart contracts significantly reduce the need for manual settlements, the immutable structure of blockchain ensures that the transactions are tamper-proof and cannot be manipulated by any party. Using smart contracts also facilitates self-regulatory compliance checks corresponding to the KYC and AML requirements that are an integral part of digital identification. In addition to increasing the settlement speed, tokenization also simplifies the processes of ownership transfer, distribution, and security.

Overall, the process of tokenization overcomes the challenges presented by conventional asset ownership and distribution structures. It allows a new category of assets to be traded such as that of carbon offsets and at the same time, allows a new class of investors to trade in assets that otherwise would have been over and above their capability. Other than introducing new opportunities, tokenization also solves such existing inefficiencies as slow speed, high cost, manipulation, and intermediation. These advancements have all led to the application of tokenization across a diverse pool of industries and assets.

Applications of Tokenization

According to a prediction by the World Economic Forum, 10% of the global GDP will eventually be held in the form of crypto assets, amounting to $10 trillion, with fractional ownership and magnitude of liquidity driving this rate of conversion. This multitude of new possibilities is acting as a catalyst for tokenization to penetrate even the most conservative asset classes. The application of tokens across real estate, financial instruments, and commodities has already begun and calls for far deeper examination.

Real Estate

Real estate is characterized as an asset class that does not offer easy liquidity to its existing investors. Furthermore, investors with a modest investment budget are currently not able to leverage real estate assets, such as resorts and shopping malls. The traditional real estate industry is burdened with cumbersome paperwork, slow speed, and lack of organized markets, but it stands a good chance of being disrupted by tokenization, as the application of smart contracts and blockchain offers fractional ownership, ease of transfer, and higher liquidity premiums.

Example: In October 2018, Elevate Returns closed $18 million on Aspen Digital, a real estate project that leverages tokenization to offer interested investors a smaller ownership stake the St. Regis Aspen Resort: a luxury resort with 179 rooms, 29,000 square feet of outdoor and indoor conference venues, and four onsite food outlets. A small stake in this magnificent resort can be owned by investors who otherwise could not have been able to benefit from the project.

Financial Instruments

Financial instruments are assets or bundles of assets that can be created, traded, and modified, such as stocks, bonds, futures, and derivatives. The financial landscape is predominantly represented by large centralized trust agents that facilitate the process of their creation and trade. With the introduction of tokenization, the process of disintermediation can grow rapidly, resulting in lessened administrative burden, faster execution, and lower transaction cost. Creation of tokens also integrates a layer of transparency and security by making use of the immutable distributed ledger technology.

With tokenization, a retail-fueled demand for uncapped primary markets has emerged and gained traction. The real-time automated cash flow is what backs the paradigm shift in the financial ecosystem. For example, in September 2018, one of Austria’s largest banks issued government bonds worth $1.3 billion on the Ethereum public network.

Commodities

The commodity market includes goods or products that are mined or grown, including precious metals, coffee beans, gold, and energy. The commodity sector is plagued with deep-rooted centralized structures that control the supply, pricing mechanisms, and transaction volumes, all existing on inefficient market infrastructure. Tokenization ushers in an independent and centralized market structure, which is significantly more transparent, as well as more efficient, accessible, and liquid.

By eliminating the need for a “trusted” third party, blockchain and smart contracts drive robustness, cost reduction, and a more secure environment. Digix is an example of a project that tokenizes gold. DGX tokens are backed by gold in a ratio of 1:1 where each token is equivalent to 1gram of 99.99% gold, so purchasing one DGX token translates into buying actual gold from London Bullion Market Association-certified refiners, and helps to radically disrupt the traditional gold market by making it transparent and efficient.

Conclusion

Security tokens are technologically superior with the merits of a more transparent, secure, and efficient ecosystem for assets to be created and traded. They are emerging as a bridge between the current centralized structures and the utopian version that dismantles intermediation and establishes effective value chains. The mass adoption of tokenization lies in the provision of fractional ownership and augmented liquidity. Additionally, it offers ownership of a wide range of assets that were inaccessible to investors before. At the same time, it allows a new class of investors to hold and own a diverse pool of assets. Several stakeholders engaged in the security value chain believe that tokenization can transform ownership and safekeeping of assets with a single point of truth.

* The information above does not constitute any form of financial or investment advice and should not be relied upon. Investing in Digital Assets carries risk. For more information please see our risk warning.

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