Applications and Use Cases

Asset Tokenization: From Physical to Digital, Part 1

July 20, 2023

Due to the global digitization process, the asset ownership securitization process is also evolving. Rather than a physical document, a digital token digitally represents certain conditions under certain circumstances.

In the blockchain segment, the term “tokenization” refers to the digital securitization of assets. Numerous tokenization projects, many of which are still in their infancy, are currently driving industries across a wide range of industries, where regulated asset tokenization can open investments to a large pool of new investors previously excluded from markets.

Tokenization in simple terms

Firstly, a token is nothing more than a digitized form of an asset. With its creation, it receives a certain function or a certain value. Tokens now exist in a wide variety of uses and appearances. Cryptocurrencies like Bitcoin, whose course is constantly changing, are also a special form of token, as are NFTs (Non-Fungible Tokens), which have recently stirred up the art market in particular. Tokenization describes the process of digitally representing rights to an asset in the form of a fungible token (usually security token) or non-fungible token (NFT). This article focuses on security tokens.

Creating a "digital twin" in the form of a security token is done by documenting the token's parameters in a smart contract, a code that runs automatically when certain conditions in a blockchain transaction are met. These conditions can be derived from the properties of the underlying financial instrument and processed accordingly. Thus, a security token is a digitally securitized asset that exists on a blockchain and is regulated under applicable securities regulations. Unlike conventional securities, a security token is not kept in a securities account, but in a wallet. A wallet is a software application or physical medium that allows users to securely store, manage and transfer digital assets.

Simply put, the tokenization process creates multiple tokens of a larger object or financial instrument. A digital securitization process takes place (usually in the form of a so-called smart contract) that regulates the ownership of certain values, goods, physical objects or rights. For example, it has now become more common for musicians to tokenize their albums. This means that each token holder owns part of the rights or receives a certain percentage of sales for this album.

Basically, this principle can also be compared to that of a conventional share, where each shareholder also acquires a share of the company, including voting rights, etc. An asset can be anything that has monetary value for at least two parties (i.e., whose value can be expressed in cash and can be exchanged for another asset of the same). An asset can be a specific good, a physical item, or a legal right in itself.

Tokenization is the conversion of an object or property into a token stored on a blockchain. It sounds more complicated than it really is: tokenization moves value from a physical or digital object to a token that resides on the blockchain. With the token you are entitled to a part of the object or property. Tokens can be seen as a digital proof of ownership that can represent (part of) an object's value. These tokens exist on a blockchain and can be traded on a cryptocurrency exchange.

Digital tokens can be issued for physical or digital objects. It really doesn't matter what kind of object it is as long as it's owned by you. For example, it could be your house, your car, your stock portfolio, or your bank account balance. Companies can do this too, such as shares issued as tokens.

So-called security token offerings are performed to issue new tokens. In a first step, the properties of the financial instrument and the issue are defined by the issuer together with the issuing office and normally created in their off-chain systems, which, for example, serves as a starting point for inventory management.

Then, a technical tokenization solution (also known as a tokenization mechanism) is used to transfer instrument properties and issuance conditions to a smart contract using decentralized applications as parameters. The subsequent upload and execution of the smart contract will “deploy” it to the blockchain. This makes the smart contract available to all network participants, and the conditions and functions contained therein can be used.

Deployment takes place through a consensus mechanism that prevents forgery and ensures trust in the authenticity of the tokens and the rights associated with them. Upon successful deployment, a token is created that digitally represents the rights to the tokenized asset and therefore makes it tradable. The token is then delivered to a wallet at a cryptocurrency custodian. In addition, there is an inventory comparison with the off-chain systems and, if necessary, a database update.

The value proposition of tokenization

Tokenization of asset classes offers the prospect of boosting efficiency in capital markets, shortening value chains and improving cost and access for investors. The performance opportunities associated with tokenization can be summarized in four points:

Security: Tokenization offers a high level of security as a blockchain records all transactions transparently and tamper-proof. Property can, therefore, be tracked quickly and securely. For financial institutions, blockchain serves to mitigate the risk of fraud.

Efficiency: With the help of digitization and process automation, efficiencies and potential potential costs can be increased. This is primarily achieved by reducing manual process steps and solutions to scale the DLT infrastructure. Furthermore, financial institutions can save fees incurred by involving other intermediaries in the context of asset issuances or servicing, as smart contracts automate these processes.

Compliance: Financial service providers must comply with regulatory requirements, particularly in the area of anti-money laundering, which includes continuous monitoring of deals and transactions. Transactions with security tokens are characterized by the fact that they are transparently documented and tamper-proof on the blockchain network at all times. If financial service providers synchronize their earlier processes with the blockchain, the aforementioned tasks could be automated in the future.

Liquidity: Tokenization creates new areas of business for financial institutions, offering illiquid assets such as infrastructure or private equity investments to a wider range of customers. This is possible because security tokens can divide ownership of assets into smaller fractions than was previously possible. It also makes asset classes that require a high level of capital investment accessible to private investors and easier to trade, which also promotes the development of a liquid secondary market.

Which assets are suitable for tokenization?

Security tokens can represent liquid and illiquid assets. Liquid assets like stocks, bonds and some mutual funds are being converted into security tokens to attract savvy cryptocurrency investors. As liquid assets are already traded on established secondary markets, tokenization does not create new investment opportunities in the retail sector. Therefore, the long-term benefits of tokenizing liquid assets come from cost savings and efficiencies in processes such as inventory reconciliations, share buybacks and voting rights distribution.

On the other hand, the tokenization of illiquid assets offers greater potential to attract retail investors, as it allows broader access to investments previously reserved mainly for institutional investors or high net worth individuals. This includes private equity investments, real estate and infrastructure projects, art and collectibles. Through shared ownership, financial service providers can allow their customers to own part of an asset. This allows fractions of assets to be traded, allowing investors to buy and sell small portions at any time.

Part 2 of this series will discuss the benefits and challenges, as well as opporutnities created by tokenization.

Edited by Erik Linask

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