What is tokenization of assets and why is it important?

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Introduction

The spread of blockchain and Distributed Ledger Technology (DLT) applications and their use in financial markets facilitate the exchange of assets without the need for a central authority or intermediary.
The issuance of crypto-tokens is the best known application of DLT, at first in relation to tokens issued in Initial Coin Offerings (ICOs), initiatives aimed at financing start-ups.
However, the use of DLT-based tokens is also growing in other areas, and the tokenization of assets or the issue of Security Tokens (STO) have become one of the most important use cases of DLT in the financial markets. Such assets include securities, but also commodities and other non-financial assets such as real estate.

The theme of asset tokenization is handled by the publication OECD (2020), The Tokenisation of Assets and Potential Implications for Financial Markets. Blockchain Policy Series.

Tokenization

The tokenization of an asset is the creation of digital tokens on the blockchain representing that asset. The potential for asset tokenization is theoretically unlimited, as any real asset could be tokenized and stored on the blockchain. However, the tokenization of real assets involves much more than simply tracking data on DLTs, and the execution of a transaction on DLTs could have real-world legal effects, such as the transfer of ownership.
Asset tokenisation has potential cross-cutting implications for financial market practices and participants, market infrastructures and regulators.
Increased use of asset tokenization could have widespread potential benefits in terms of cost efficiency, speed, greater transparency and more inclusive participation of retail investors in markets. Although the use of tokenisation is currently limited, its potential is significant.

Tokenization of real assets that exist off-chain

Tokenisation of physical assets is the process of digitally representing an existing real asset on a DLT.
Thus, asset tokenization involves the representation on the DLT of pre-existing real assets by linking or embedding the economic value in digital tokens created on the blockchain.
The tokens issued exist on a ledger and also carry with them the rights on the assets they represent, acting as a store of value. The assets for which the tokens are issued continue to exist in the real world and, in the case of physical assets, these would typically need to be placed in custody to ensure that the tokens are constantly backed by these assets. Custody of assets therefore plays an increasingly important role in tokenization transactions.
Communication between the “off-chain” (traditional financial market infrastructures) and “on-chain” environments will be crucial for assets that continue to exist off-chain.
In theory, any asset can be tokenized and the rights on that asset be represented on a DLT.
Real assets for which there are pilot projects are real estate, commodities, such as gold, works of art or collectibles. Intangible assets, such as intellectual property, could also be tokenized, creating new types of assets and innovative digital markets.

Tokenization of native blockchain assets

There are important distinctions between tokenized assets that exist off the DLT and tokens that are native to the blockchain. Native tokens are born directly on the blockchain and live exclusively on the DLT. Payment tokens are examples of native tokens.
Tokens issued in ICOs are another example of native tokens: generated within the blockchain, they are not backed by an off-chain security or other asset. This has important implications for market structure and governance.

Challenges of tokenization

The adoption of asset tokenization of assets on a large scale requires to address a number of challenges related to the underlying technology: from scalability to interoperability, exposure to cyber risks, hacking risks and 51% attacks, as well as the business risks and costs associated with migrating to a DLT-based environment.
There are also governance issues related to the difficulty of identifying a single owner or node responsible for the entire network.
In addition, a potentially unclear regulatory and legal status for some tokenized assets is a risk for market participants, and should be addressed through clarity and interpretation of existing laws and regulations by financial regulators and supervisors.
Then there are questions about data protection and privacy, but also about data storage and the regulations applicable to data use, sharing and retention. This is particularly pertinent in jurisdictions with privacy regimes such as GDPR in Europe, which require very strict consent management processes, effective data rights management systems.

The legal status of blockchain, tokens, and smart contracts has yet to be defined in many jurisdictions, while countries such as Switzerland, Liechtenstein, and Germany have recently taken steps to implement a clear and favorable legal framework, opening the market to companies and promoting the growth of the new blockchain industry.

Benefits of tokenization: disintermediation

The application of DLT in asset tokenization can offer a number of benefits related to disintermediation:
– efficiency gains through the transfer of value without the need for trusted centralised intermediaries and/or through the efficient automation of processes, resulting in faster and potentially cheaper transactions
– the use of smart contracts can reduce the cost of issuing and administering securities, further reducing transaction costs, increasing execution speed and simplifying transactions.
– the use of smart contracts can facilitate corporate activities (e.g. coupon or dividend payments, voting) and collateral management (e.g. exchange of ownership interests).
– the automation introduced in the issuance, distribution and management of securities can reduce costs during the whole life of the securities, benefiting both issuers and investors.
– the distributed nature of the network with no single ‘point of failure’, the immutability of the blockchain and the application of cryptography can increase the resilience and security of the infrastructure.

A greater trasparency

In addition to the efficiency gains due to the disintermediation potential of DLT, asset tokenization can bring benefits such as increased transparency regarding transactional data, issuer information and asset characteristics through better record keeping and information sharing.
Financial markets can benefit from data integrity, immutability and security as well as the automated verifiability available in many blockchain-based systems.
Greater transparency can also be achieved in terms of compliance and interactions with regulators: as regulatory restrictions programmed into smart contracts are automatically enforced, the regulator can be automatically notified when restrictions are changed or deactivated. Regulators can also have near real-time information on specific on-chain events of interest to them.
The quality of the data that is fed into the blockchain is critical to the robustness of the recording and sharing of information.

Speed and wider participation

A wider use of asset tokenization may also benefit investors who would then have the opportunity to hold fractional ownership of an asset. Investors, particularly retail investors, may gain access to types of products that would otherwise be beyond their capacity, and may participate in capital markets with low investment or smaller portfolio sizes.
An indirect benefit of asset tokenization for market participants relates to potentially faster clearing and settlement due to the almost immediate transfer of ownership on the blockchain and the continuous reconciliation of the blockchain being updated at each transaction.

Conclusion

The application of DLT-enabled use cases is meaningful when there is:

– a sound business rationale for the application of DLTs, for example, the use of DLT solves a real business problem? Are there gaps in trust or security, is there enough space for disintermediation, are there measurable efficiency gains to be leveraged? How does the DLT-based use case compare to the traditional use case?

– a technical feasibility assessment demonstrating that the application of DLTs provides significant benefits over the technology currently in use, and also that the main technical challenges are overcome.

– an economic rationale for the transition to DLTs, i.e. a proven and measurable economic justification for the application of DLTs (for example measurable efficiencies and cost reductions to compare to the investment required to transition to a blockchain environment).

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