The Tokenization of Assets, What It Means for the Future of the Financial Services Industry

Published: 2021-06-17 08:37:51
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In the summer, a multi-million pound iconic work of art by Andy Warhol was sold with Maecenas, using blockchain to auction the piece and allowing multiple investors to own the piece.
Earlier in the summer, a multi-million pound iconic work of art by Andy Warhol was put up for auction for tokensThe tokenization of assets has the possibility to radically disrupt the financial services industry, creating a new and largely decentralized dynamic of interactions between actors. Before we explore this idea, let us first explore what tokenization is,d and why it has been gaining traction quickly.
Whilst tokens in the context of finance might be an unfamiliar term for some, many will have undoubtedly heard of Initial Coin Offerings (ICOs), which are a way of producing tokens. ICOs, which took off in 2017 and have continued to grow in popularity, are a form of crowdfunding that uses the blockchain to raise money from investors who typically invest their money in the form of a cryptocurrency (such as bitcoin or ethereum), and in return they receive tokens that hold a special value. ICOs can issue several different types of tokens, but here we will look at what are known as ‘security tokens’. This mechanism which produces security tokens can be known as a security token offering (STO) to distinguish it from an ICO that creates other token types. Security tokens can resemble traditional securities, except that the securities are represented digitally. This means that security tokens could represent a share in a company, ownership of a piece of real estate, or participation in an investment fund.
Creators of security tokens use smart contracts to link to assets’ rights to digital tokens on the blockchain. Therefore, when we refer to the tokenization of assets, it is this process of converting an asset’s rights into a digital token on the blockchain – similar in many ways to the traditional process of securitization, with a modern twist. These tokens can then be traded on a secondary market.
A world of tokenized assets could offer many advantages over the current situation today. One of the principal advantages of the tokenisation of assets is the reduction of friction in the process of creating, buying and selling securities. What this means is that tokenization has the possibility to increase liquidity. Whilst there are several factors that contribute to the greater liquidity of assets that are tokenized – regulations are an important factor that will be discussed below – there are a few key characteristics in particular of tokens that are relevant.
The first is the simple fact that by tokenizing assets – especially private securities or typically illiquid assets such as fine art – these tokens can be then be traded on a secondary market of the issuer’s choice. Added to this are the advantages of the smart contracts (software programs embedded in a blockchain that are used to verify or enforce predetermined contracts) that tokens rely on. Smart contracts can automate certain parts of the exchange process, reducing the need for intermediaries between buyers and sellers, and lowering costs whilst ensuring that the exchange will take place in a safe and predetermined manner. Indeed, the fact that the token-holder’s rights and other legal responsibilities are directly embedded in the token will add clarity and certainty to the process of buying and selling. Moreover, the immutable record of ownership inherent in the blockchain will add a layer of transparency, whereby it will be possible to prove the history of ownership.
Another positive inherent characteristic that tokens have is that they are divisible to an extremely high degree. This divisibility, combined with the reduction in costs and greater liquidity, could allow minimum investment amounts and periods to be practically eliminated, opening investments up to a broader base.
Tokenization can therefore be expected to benefit investors and thoseraising capital by making the financial services industry more accessible and fair, and cheaper, faster and easier, whilst also potentially unlocking trillions of Euros in currently illiquid assets, and vastly increasing the volumes of trade. Moreover, the fact that tokenization would decentralize the financial industry could also bring security benefits and added layers of protection from manipulation. For example, the lack of need for trust in a central authority reduces the likely of influence for political means, and the fact that the financial system will be more decentralised means that there is no single point of failure for the system, therefore adding stability.
Since the advantages of tokenization are most evident when applied to asset classes that are typically considered illiquid and can benefit from improved transparency, liquidity, efficiencies and lower minimum investments, there are two areas that have already seen activity in tokenization: real estate and fine art. If you wanted to invest in a building, or in fine art, your best option might be to invest in a fund that had this asset in its portfolio. Even though fine art and real estate funds make investing in the asset type more accessible and liquid, their minimum hold times and minimum investment amounts can be a barrier for many investors. Furthermore, the fund would typically be investing in a basket of similar assets, spreading your investment across a number of buildings or artworks you might have no interest in. With tokenization, you could, for example, invest €50 in your local university building or a piece of famous art by buying tokens that represent that specific asset, and then sell it to another interested investor at your will. This ability to choose freely where you invest, without the inconvenience of locking up significant portions of your money, will open up a new era of much greater personalization and customization in investment – an area that is increasingly relevant as investors now look beyond just returns and pay much closer attention to where their investments are made.
We can see actors already in this space bringing the token economy to life.
They are not alone, there are already a number of companies are helping build the infrastructure to support the growth of the token economy. Companies like Tokeny, a platform to issue and manage security tokens, and tZERO, an alternative trading system for the exchange of security tokens, are just two of many that are pushing forwards the concept of tokenization.
However, some obstacles need to be overcome if tokenization and the broader token economy is to take off. As with any new technology or solution, there are some questions that need addressing. How tokens will remain linked to the real asset that they represent is a point of concern. For example, imagine if you own token representing a small fraction of 100 gold bars in bank, and five bars are stolen. What happens to your token and the other token owners is crucially important, since the value of tokens becomes greatly undermined if they cannot be proven to be linked to real-world assets. Another point of consideration is the issue of governance. If ownership of an asset, such as building, is split between thousands of people there is little incentive for owners to bear the costs associated with that asset, such as maintenance and ensuring rent is collected. These are problems that can certainly be overcome, but they require thought and possibly intermediaries of some sort.
A big problem is a lack of international regulatory alignment. Security regulations are typically technology agnostics, meaning that security tokens, depending on their exact features, can fall under the full scope of relevant security regulations, which can vary significantly from jurisdiction to jurisdiction. This is true not just for the creation and initial sale of the tokens, but also for the trading on secondary markets. Consequently, many of the advantages of tokenization are undermined if instead of regulations prevent the international exchange of security tokens. What is needed are compliant methods of creating and exchanging tokens on an international scope. International regulatory alignment is an unlikely milestone in the near future, but easing compliance for tokenization within jurisdictions could be improved.
Some companies are already helping to solve the compliance issue. Harbor, for example, embeds compliance at the token level, checking if a trade is compliant, taking into account who the buyer and seller are, where the trade occurs and in what. If it is compliant, the trade can happen on any token exchange. More development in this area to facilitate easier creation and sale of tokens is needed to move forward.
Additionally, regulations specific to tokens would be welcome. Whilst it may seem counter intuitive to encourage regulation of a technology with decentralization and independence as some of its core characteristics, it is important to consider the risks of not providing a legal and safe framework in which the technology can thrive. A lack of scrutiny can allow scams and open the door to hacking – something particularly relevant for a relatively still nascent technology. Scams and hacks not only harm investors and the broader economy, but enough of them could discourage investors and cripple the token economy completely.
There has been a considerably uneven approach so far to regulating the token economy, but some governments have made significant progress. Both the US SEC and EU’s ESMA have made comments, albeit generic, in this area, meanwhile Malta has taken a more progressive approach and is planning to create a new marketplace for tokenized securities. Having more international regulatory alignment is very important for the safe development of the token economy. In the meantime, a set of common good practices and rules would be a good foundation.
Once some central questions about the functioning of the token economy can be answered, and there is progress on the regulatory front, we envisage tokenization proliferating vastly. This movement will involve actors from all levels (government, central banks, private companies and even local communities), and will depend on their communal effort to move tokenization forward. If these above-mentioned issues are addressed, as adoption increases and overhype – which undermines the true value of the token economy – dies down, we see the token economy taking off rapidly, with ripple effects throughout the financial services industry and broader economy.

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