BlockchainCTN GuidesNewsTokenization 101 – Part 1 – A Deep Dive

http://cryptotechnews.co/wp-content/uploads/2019/04/how-does-tokenisation-work-1280x960.jpg

Conceptually, tokenization might seem easy: Issue an ERC-20 token (or any other blockchain tokens), imbue legal rights and ownership rights in the tokens, and you can trade them easily. However, this warrants a much deeper look: how do you distinguish claim rights and ownership rights? What are the differences in tokenization between different asset classes? What is impeding tokenization from adoption?

Thinking comprehensively about tokenization requires an understanding of blockchains and smart contracts, legal, finance, and economics. There has already been in-depth research on each of these components.

In this piece we deep dive into introduction to tokenization through using real estate as a primary example. Enjoy!

 

What is Tokenization?

Is Tokenization the same as securitization?

For structured finance professionals, tokenization might seem like securitization. In summary, securitization consists of a few steps:

  1. Originator (owner of the assets) collects the assets in a pool and transfers the pool to a legal entity (usually a special purpose vehicle). Through this legal structure, assets are not exposed to counter-party risks or risk of bankruptcy of the originator bank
  2. The SPV structures the assets within the pool into several tranches, according to different risk levels and characteristics usually. Securities are issued, and backed by the cash flows generated by the underlying assets.
  3. After issuing the securities, the SPV sells the securities to investors, whilst transferring the proceeds to the originator afterwards.
Securitization has some flaws.

The classic securitization process is extremely costly and takes up a lot of time. The entire process might cost up to millions of dollars and takes up to a year. The securitization process requires agreements with various parties under conditions of asymmetric information, as well as a heterogeneous structure of asset data.

Furthermore, there might be a lack of full transparency in the various stages of securitization, all of which hinder auditing and rating of the underlying assets. In the sub-prime mortgage crisis, there is no transparency on the credit pool nor the audit process that lead to defaults on the bonds issued.

Tokenization is different from securitization

Tokenization , in its simplest definition ,  refers to converting an asset into a digital token on the blockchain system. The biggest difference between tokenization and securitization, is how programmability is introduced into the tokenized asset. This way, business logic can be introduced, reducing the need for manual settlements. Smart contracts can have functions for automatic transactions, formulas for calculating asset prices and other specific features.

 

So, what are the real benefits of Tokenization?

Numerous research pieces have talked about various benefits of tokenization, but these various benefits can be categorized into three core principles: liquidity, programmability and immutable proof of ownership.

Liquidity

Assuming no legal and regulatory barriers, tokenization allows for increased fractional ownership. Most tokens can be broken into 18 decimals, as compared to fiat which can be broken down to $0.01 only. Fractional ownership lowers the barriers of entry for new investors. For instance, instead of paying $1 million for a new apartment, I can pay $50,000 for a tokenized fraction of the real estate. For investors, fractional ownership and lower barriers help them to increase portfolio diversification and construct a “truer” market portfolio.

The increase in liquidity helps unlock value for markets through liquidity premiums. When illiquid assets become more liquid, a liquidity premium of approximately ~20–30% is unlocked. One example is real estate: Even a fractional improvement in the sales price of such investments could result in trillions of dollars of new value for issuers and resellers.

Programmability built into tokens

Programmability refers to the ability to introduce certain business logic into smart contracts, allowing for automated events to occur. Tokenization can also lead to easier management of investors and their rights. Secondary transactions can be easily tracked by collaborating with third-party exchanges, allowing investors to receive distributions and exercise their other rights (e.g., voting) through the blockchain.

Programmability is especially useful in increasing the speed of settlements. In traditional finance, settlements refer to the process of documentation of the transfer of asset ownership before the ownership of assets actually changes hands. Compliance can be programmed into the tokens, if all participants have a digital identity that has gone through the relevant compliance/KYC/AML checks.

Immutable proof of ownership

Blockchains are immutable and keep a public trace of every transfer, and owner. This digital trace of transactions not only proves the history of ownership but also helps to ensure less fraud. The immutable structure makes it impossible for a token-holder to “double-sell” a token — accepting a transfer for the same token to two different sources. This helps assure investors that no one can falsify transactions after the transaction has happened.

 

Diving deeper into tokenization

Tokenization is the process of digitally storing the property rights to a thing of value (asset) on a blockchain or distributed ledger, so that ownership can be transferred via the blockchain’s protocol. What are the other challenges?

Issue #1: What are the requirements for tokenization to take place?

There are 3 fundamental requirements:

  1. The rights to an asset can be stored digitally on a blockchain. Let’s go back to the real estate example. If I want to tokenize my house, I must be able to record my ownership of my house on a token itself. This means that to regulatory authorities, holding a token represents an ownership right or claim right on the house itself. (We will go into these rights in a bit.)
  2. These rights can be legally transferred via blockchains.Whilst I can document my rights to my house in a legally-recognized way, I should be able to transfer these rights to anyone I want and that person will have legal ownership of my house, assuming my tokens are imbued with ownership rights.
  3. Tokens can be easily exchanged for value, giving the assets “value”. Lastly, like any security, I must be able to exchange my real estate token for value easily — so I can subscribe value to the asset.
Issue #2: What are the other legal issues to consider?

Apart from the 3 requirements, what is more crucial to take note is the exact asset you are tokenizing: Does the token represent a claim on the asset or does the token represent actual ownership of the asset itself? Investors and token issuers must think carefully about what exactly a token represents.

The truth is: it depends on what you want to tokenize. Tokenization is flexible. Using real estate as an example again, what can be tokenized could be direct ownership in the real estate (being a partial equity owner), right to rental income, or even the right to use an asset (renting the apartment).

Hence, a token could represent ownership of the underlying real asset, an interest in a debt secured by the asset, an equity interest in a legal entity that owns that asset, or a right to the cash flow from the asset.

There are 3 basic categories of rights to understand.

The rights bestowed by tokenized securities (or security token) can be very complex to understand. However, tokenized securities can include claims to the assets (and usually the resulting cash flows), direct ownership rights, governance rights or a combination of all.

  1. Claim rights: Claims to only certain specific uses (and claims) of the asset
  2. Ownership rights: Equity ownership and control of the asset
  3. Governance: System by which a group of people can come to unified decisions

Let’s illustrate this with real estate again, with a few examples on the token holders’ rights:

  1. Claim rights, but no ownership rights: Token holders are entitled to cash flows from ongoing leases, but they have no ‘equity’ and ‘ownership’ of the underlying real estate
  2. Claim rights, AND ownership rights: Token holders are the ‘owners’ of the underlying real estate with claims to the cash flows. They can make decisions directly: how much to charge for rent, investments made to maintain the real estate, hiring staff and given the proceeds from the sale of the real estate.
  3. Only ownership rights: This example is rarely the case, but it means that token holders are now the ‘equity owners’ of the real estate.
What are the challenges that arise from these different rights?

It is possible that there is a separation of claim rights and ownership rights, and this creates misaligned incentives between both parties.

What if… the tokens have ownership rights for token holders? How do 1,000 token holders make decisions collectively for the best of the assets? Is there a need for delegated voting or decision making?

What if… the tokens only imbue claim rights for token holders? The token issuers (owners) can reduce profits and cash flows to the token holders, by re-investing the profits. This will be to the detriment of token holders who originally look towards the future cash flow.

The smart contract geek might ask: can’t one automate all these logic in smart contracts?

No, smart contracts cannot solve all these issues.

How do you really tokenize?

There are a few categories of assets that have been tokenized:

  • Fiat currencies – The tokenization of fiat currencies gave rise to stablecoins. Tether is the first example, creating USDT. However, there are inherent challenges with Tether. For a good, updated summary on stablecoins, read more here.
  • Gold – An example of a gold tokenization project is Digix. Each DGX token is 1:1 gold-backed, and 1 token represent 1 gram of 99.99% gold from London Bullion Market Association-certified refiners, with gold stored in The Safehouse vault. Purchasing 1 DGX token is equivalent to purchasing actual gold itself.
  • Real Estate – My primary interest lies in real estate, given the analogy between REITs and tokenized real estate. A few interesting examples are how a Manhattan real estate property was most recently tokenized, or how a portion of the St. Regis Aspen is tokenized. In the case of St. Regis Aspen, each Aspen token represents an indirect ownership interest in a common stock of the St. Regis Aspen REIT. According to Elevated Returns, the “REIT provides tax efficient structure while the blockchain provides peer-to-peer investing and cross-border transaction made simpler for investors.”

 

We hope this piece helped you understand a little more about the process of tokenisation. Next we delve into the challenges and how a tokenized future looks like in Tokenization 101, Part 2.

 

Source: freeCodeCamp.org, How does tokenization work, anyway?

Aisha Hillary-Morgan

Aisha Hillary-Morgan

Leave a Reply

Your email address will not be published. Required fields are marked *