by Albert Ho
How does tokenization work, anyway?
Not everything will be tokenized, but that which can be will be.
2017 saw the hype of utility tokens and ICOs. 2018 marks the hyped start of asset tokenization and the launch of securities tokens/platforms. This trend is notably huge in the U.S, given how A16z and GGV Capital invested in the likes of tokenization platforms like TrustToken, Harbor, and Polymath.
In Asia, the trend is starting to pick up too. For instance, Rate3 Network was funded by various notable Asian VCs that include Matrix Partners China and Fenbushi Capital.
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, I want to give a comprehensive introduction to tokenization through using real estate as a primary example. Here’s what we’ll discuss:
- What exactly is Tokenization? (Is it not just securitization?)
- What are the real benefits of tokenization? (Why do we even bother?)
- What are some of the tougher issues to think about? (How do we ask the right questions?)
- What are the challenges for tokenization? (What’s stopping adoption?)
- How will the tokenized future be? (What are some elements?)
Let’s get started!
What is Tokenization?
Isn’t Tokenization just securitization?
For structured finance professionals, tokenization might seem like securitization. In summary, securitization consists of a few steps:
- 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
- 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.
- After issuing the securities, the SPV sells the securities to investors, whilst transferring the proceeds to the originator afterwards.
Securitization has various 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.
Clearly, tokenization =/= 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.
What are the real benefits of Tokenization then?
Numerous research pieces have talked about various benefits of tokenization, but these various benefits can be categorized into three core principles: 1) liquidity, 2) programmability and 3) immutable proof of ownership.
Key Principle 1: Liquidity
World Economic Forum predicts that over the next ten years, 10% of the world’s GDP will be stored in crypto assets, amounting to $10 trillion. This is primarily due to increased fractional ownership, and unlocking of liquidity premiums.
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.
Key Principle 2: 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.
Key Principle 3: 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.
Let’s dive 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:
- 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.
- Claim rights: Claims to only certain specific uses (and claims) of the asset
- Ownership rights: Equity ownership and control of the asset
- 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:
- 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
- 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.
- 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.
Contracts and smart contracts are incomplete:
- Contracts are only enforceable when events and actions can be verified by a third party
This is the long-standing problem of “oracles” in tokenization. There are some events that can be captured in code, but near impossible for any arbiter to determine if they really happened.
For instance, I issued out real estate tokens to holders so they can receive a portion of the rental income. However, it is possible that I do not document down all the rental agreements so token holders do not know what the real amount of rental income is. If this cannot be enforced effectively, there is no rational reason for parties to abide by the smart contract.
2. It is near impossible to write a contract that contains all possible conditions and events, hence achieving “completeness”
The problem with contracts is not what is in them, it is what is not in them. It is very costly and operationally challenging to write down every condition and event. Furthermore, events and conditions change in real life — and contracts have to adapt to these real-life changes.
Given the limitations of smart contracts as inherently incomplete, certain asset types should not be tokenized.
What should not be tokenized?
- When the blockchain cannot fully capture the change of ownership of assets
There are some assets in markets where I can sell the physical asset outside of the protocol directly, despite it being tokenized. For instance, I can tokenize real estate and transfer the token (with ownership rights) to you, but it is possible I can also legally sell the same real estate to another.
There are also other cases when I can trade tokens, but have no guarantees that I can verify the authenticity of the underlying asset. In the case of real estate, it is easier to verify, but other examples include gold bars. If it takes a lot of costs and resources to verify the authenticity, tokenization might not be a viable solution.
2. When the use of prices impede the protocol from achieving its objectives
There are some situations in which we don’t want prices to determine who gets what. Sometimes, prices do not capture external societal benefits and costs, and might not be the most equitable way to allocate resources. Examples include social goods, for instance.
3. Sometimes, we just do not want to tokenize some ‘assets’ and rights
For instance, rights to birth certificates or educational records should not be tokenized since they represent a unique right. We do not, and should not tokenize these ‘assets’.
Clearly, there are some asset classes that should not be tokenized, given real-life limitations.
How do you really tokenize?
We have walked through the what and why of tokenization, now let’s talk a little about the how of tokenization.
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, I suggest this:
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.”
Clearly, there are many challenges associated with tokenization.
1. Lack of tokenization standards and legal infrastructure
Tokenization is not simply the creation of a token — any Solidity developer can do it. Instead, it’s about the design of the whole system, including understanding the various rights and issues we’ve talked about previously.
How do tokenization standards cater for these issues:
- Incentives (claim rights, ownership rights, governance)
- Privileges of users and system admins (who operate the token contracts)
- Life-cycle management of an asset (issuance, payouts, withdrawal)
- Security management
- Integration of KYC/AML requirements across different jurisdictions
- Integration with exchanges
- Interoperability between different public chains
In the case of cross-chain interoperability, we do see different chains with different nascent characteristics. For instance, Ethereum has scalability issues but provides for more complex Turing-complete smart contracts. How about other public blockchain networks like Stellar or IOST or Zilliqa?
How can tokenized assets (in the form of tokens) be interoperable across these different chains?
2. Digital identity that’s globally and legally-recognized
From a regulatory point of view, it is a regulatory nightmare for assets to be issued and transferred across citizens of different legal jurisdictions.
Suppose I am an EU resident looking to tokenize my real estate and the token only imbues claim rights. How do I transfer this token to U.S persons, whilst taking into account their identity, KYC/AML issues, U.S regulations, taxes and all the other issues?
How can I reasonably and easily deal with a verified, attested U.S person in a legally-compliant way for both our national jurisdictions?
3. Tokenization does not mean instant liquidity
Liquidity is the biggest challenge in the security token space and it does not happen organically. History has given us various examples of financial markets and instruments that have not yet achieved significant levels of liquidity. Helping to create liquidity through allowing institutional investors or accredited retail investors — through custodian solutions will be key. Of course, the underlying asset must be useful.
How do we introduce long-term, sustainable solutions for large institutional investors — the market makers — to create and maintain liquidity?
What does a tokenized future look like?
I’m generally bullish on a tokenized future: a fairer, more equitable world with lower barrier to entry and capital requirements for individuals or businesses.
Through capturing value in tokenized assets, we can re-create all the sophistication of the existing financial and operational world we live in, with far less operational costs and complexities. When combining tokenization with reasonably complex business logic enabled by smart contracts, we can represent complex business interactions faithfully and more efficiently.
There will be interoperability, through standardization
ERC 20 for token standards, as an example
If the ecosystem for global assets becomes interoperable, it means we can hold ownership claims to a commercial building, early-stage equity, corporate bonds, a T-bill, a single-family residence, and a decentralized network on the same platform.
Different assets can reference each other contractually and interact in an automated way. It means an increased liquidity for all (tokenized) asset classes.
ERC 725 for Identity, as another
Fabian Vogelstellar — creator of the ERC 20 standard — is leading the front for a unique decentralized identity for “humans, groups, objects and machines”. Quoting directly from the ERC 725 Github itself, “ This identity can hold keys to sign actions (transactions, documents, logins, access, etc), and claims, which are attested from third parties (issuers) and self-attested (#ERC735), as well as a proxy function to act directly on the blockchain”.
You can read more here about ERC 725 here:
Managing Identity with a UI for ERC 725
At Origin, we’re building a platform for decentralized, peer-to-peer marketplaces. You can imagine a future Airbnb-like…medium.comRate3 Cross-Chain Identity Protocol — Identity and Claims (ERC 725, ERC735)
At Rate3, we initially wanted to build a blockchain-based settlement and clearance network for businesses. We…medium.com
The future of tokenization is not here (yet), but it will be sooner than we know
We are optimistic and bullish for the future of tokenization and tokenized securities. There are many elements of the envisioned tokenized future that we observe today:
- Governments are increasingly partnering with private companies to create infrastructural solutions
One such example is the collaboration between NASDAQ, Monetary Authority of Singapore (Singapore’s Central Bank) and Singapore Exchange (Singapore’s main stock exchange) to develop Delivery versus Payment capabilities for settlement of tokenized assets across different blockchain platforms to improve operational efficiency and reduce settlement risks.
MAS and SGX partner Anquan Deloitte and Nasdaq to harness blockchain technology
Singapore, 24 August 2018… The Monetary Authority of Singapore (MAS) and Singapore Exchange (SGX) today announced a…www.mas.gov.sg
2. Projects have recognized the need for compliance, and are creating solutions that target automated compliance and AML/KYC
We have touched about the need to meld real-world legal requirements into the blockchain space. There are various projects that have been doing these globally:
- Harbor: A compliance platform and protocol to ensure tokenized securities comply with existing securities laws at issuance and on every trade, everywhere across the globe.
- Rate3 Network: A protocol that handles asset-tokenization and identity management across both Ethereum and Stellar blockchains.
- Polymath: A security token platform on which regulatory-compliant tokens can be built
I do notice more blockchain projects building tokenization solutions targeted at different asset classes, different ways of modeling structured finance through issuing both debt and equity tokens, for instance. More importantly, these solutions know that working directly with regulatory authorities, collaborating with central banks and other projects will help to improve the overall ecosystem.
Ensuring the legally-compliant design of the whole system is key.
3. “Paths of least resistance” will help everyone relate existing real examples to upcoming tokenization projects
Real estate have always been quoted as an example for tokenization projects. This is due to the structure of real estate investment trusts (REITs), that one could relate more easily to tokenized structures.
Tokenized real estate is not REITs, but there are various principles we can use to help us understand, relate and think better: property rights, economics for REITs for instance.
Not everything will be tokenized, but those that can be will be.
Disclosure: I work at Rate3 Network, a dual-protocol that handles asset-tokenization and identity management across both Ethereum and Stellar blockchains.