Applications and Use Cases

Asset Tokenization: From Physical to Digital, Part 2

July 20, 2023

(If you missed Part 1 of this series, you may read it here.)

Topics such as digital means of payment and blockchain are gaining more and more relevance, which will revolutionize the areas of finance, industry 4.0, mobility and logistics. The blockchain area is developing very dynamically and companies must deal with it intensively.

 Simply put, a blockchain is a distributed, decentralized database. Copies of these databases are stored on multiple servers. A single update on one server leads to a simultaneous update of data on all others. Transactions on blockchain-based platforms cannot be changed later and are partially transparent. "Tokens" can now be linked to this, primarily as digital images of valuables, money or securities. Transactions are transmitted and updated in near real-time, and all processes are automated and standardized through Smart Contracts. Values are recorded in an immutable data structure and managed by an algorithm based on cryptographic mechanisms. In this way, various points of friction in the current economy can be tackled preventively.

Benefits of tokenization

Tokenization offers significant advantages over the conventional approach of securitization through financial intermediaries such as banks, insurance companies and the judiciary. Your involvement can be reduced due to digital securitization and forwarding (disintermediation), which leads to a significant increase in efficiency when trading digital assets. Trading hours are also significantly extended, as trading can generally be carried out 24/7 via the blockchain. In addition, the costs of these transactions are significantly reduced.

Another advantage is the low susceptibility to mistakes, as human error can be almost completely avoided. Tokenization reduces obstacles for investors to participate in financial markets.

As these new tokens are splittable, investors can also participate in unique asset classes for which their capital was previously insufficient. For example, it is possible to buy 0.01% of a valuable artwork via blockchain. In recent years, asset classes such as real estate, art and rare vehicles have shown impressive returns, making them promising alternatives to traditional asset classes such as stocks and bonds.

Disintermediation in digital asset trading also results in significant advantages for issuers: the previously high fees for issuing share certificates, which would be incurred due to the necessary cooperation with investment banks and other institutions, can be avoided. Therefore, it will be possible to issue stocks or bonds as easily as, for example, taking out a loan from the house bank. Tokenization therefore also makes it easier for small and medium-sized businesses or start-ups to get the financial resources they need.

The way an object's ownership is determined and stored on the blockchain can dramatically change the way we manage our properties. Since everything takes place on a blockchain, this means that there is no bank, notary or paperwork involved in buying a token (and therefore investing in the house). The removal of investment intermediaries, such as tokens, is another step towards these two goals. Tokenization eliminates the need for any intermediary and allows for online transactions in a secure and decentralized system. It makes it possible for everyone to make (small) investments and therefore reduces power differences in the financial world, no matter how much money you have to make certain investments anymore.

There are more advantages to tokenizing on blockchains: tokens on a blockchain have no geographic barriers. An investor in Asia can invest in a skyscraper in Europe without having to leave his country. And all with the security, speed and convenience of blockchain. In addition, the risk of investing is much lower because you can spread your portfolios. Since it is possible to buy only part of an object, it is easy to invest in many different objects to spread the risk.

What business models does tokenization enable?

Financial institutions have numerous opportunities to position themselves as intermediaries or infrastructure providers in the tokenization value chain. Possible business models can be divided into pre-trade, trade and post-trade business models based on their role in the value chain, as per the examples below:

Pre-Trade: To prepare a token issuance, issuing institutions structure the issuance or investment conditions together with issuers, prepare contractual documents and securities prospectuses, and support distribution to investors.

Trading: In order for investors and issuers to be able to trade in tokens, trading venues are needed where tokens can be listed. These are multilateral trading venues that allow buyers and sellers to coordinate transactions. The so-called DLT pilot regime includes regulatory requirements for market infrastructures that allow trading of tokenized assets.

Post-trade: Crypto custodians play a key role in the token value chain as they are technically and legally capable of holding tokens in wallets for investors.

New horizons in the universe of investments

Smart contracts are small executable programs that can automate cash flows, such as credit, leasing or fiduciary processes. These efficient programs can digitally enforce compliance with a contract and allow peer-to-peer verified transactions to be performed without any intermediary media. The result is automation, reliability, security, speed, economy and precision. They also help to transfer cash, securities and other valuables in a transparent and conflict-free manner.

The approach of the idea can be compared with the blockchain objective, as the forgoing of the human component in contract execution should minimize risks and reduce transaction costs. In addition, trust must be strengthened, as human contractual partners no longer need to trust each other, they only need to trust the software in the correct functioning of the program logic.

Digitizing assets via tokenization is an exciting trend. Crowdfunding models that use blockchain or other distributed ledger technology to create a digital instrument in the form of tokens and transmit it to investors must legally decide what it should be: title, participation right, co-ownership, replica derived from cash flows of an indivisible actions. Another application area with great growth potential is the tokenization of rights. The digital mapping of property rights to an asset is a good example of this. These rights can be represented in the form of a unique token and can be sold in their entirety or in fragments.

The usual high transaction costs can be reduced here by transactions taking place in real time and without counterparty risk at minimal costs through the delivery versus payment mechanism of the blockchain. It is understandable and cannot be changed unilaterally, another decisive advantage in markets, which are often characterized by a lack of transparency and opaque cost structures.

The challenges of tokenization

There are still some hurdles before properties can be tokenized on a blockchain. The biggest problem is that there is still not a single country that has solid regulations on cryptocurrencies. Imagine if the owner who sold the house tokens suddenly sells the house? Token owners only have their tokens. They have no legal right to the house and are evicted because they are not protected by law. This is why changes in government regulations that protect these new investment methods must be introduced first.

The same applies to tokenizing shares, for which you must first allow shares to be sold in fractions. Another problem is more of an ethical nature. Ownership tokenization brings back another form of centralization. The idea of blockchain and smart contracts is to provide a platform "on trust." This is possible with digital products, but not with physical goods. Someone can always get away with Picasso's symbolic painting, for example. Therefore, we will have to accept some form of centralization in tokenizing physical properties.

So, it may be some time before we see tokenization of properties in our daily lives. Government regulations offer good hope. There are also countries that have ready-made laws that adapt to new blockchain market models. Investments in objects are so large that it won't be long before tokenization on blockchains emerges.

Trust in digital assets requires legal certainty. The regulatory framework for tokenizing traditional assets is a constant work in progress. Innovative players are already going one step further, offering customers a new generation of digital assets. In addition to targeted information about opportunities and risks, a legally secure framework and adequate infrastructure are crucial. For example, claims and ownership of digital tokens must be direct and unrestricted to the underlying asset. There is still a regulatory gray area in this regard.

Accompanying customers with targeted learning offerings to empower them to safely trade digital assets is an indispensable tool for customer retention. It will be at least as important to give customers the freedom to move their assets and related services across platforms. This means that financial institutions must ensure the integrity of assets during transmission between individual services and between different blockchains. Above all, this includes partnerships, because in tomorrow's open financial world, no single institution will be able to serve investors' needs alone.

Edited by Erik Linask

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