Tokenization of Assets and Can it Drive Security Tokens to Main Street Acceptance?

The tokenization of assets refers to the process of issuing a blockchain token (specifically, a security token) that digitally represents a real tradable assets-in many ways similar to the traditional process of securitization, with a modest twist. These security tokens are created through a security token offering. An STO can be used to create a digital representation-a security token- of an asset, meaning that a security token could represent a share in a company, ownership of a piece of real estate, or participation in an investment fund. These security tokens can then be traded on a secondary market.

Numbers from Global Wealth Report show that total global wealth has now reached $280 trillion, it is 27 percent higher than a decade ago and much of this wealth is relatively illiquid. One of low liquidity asset’s, such as real estate value alone was estimated at $217 trillion where commercial property accounts to roughly $54 trillion (25%) a market that is slightly less than all globally traded equities and securitized debt instruments put together. The implication for this is that if we assume that commercial estate market has a 10% liquidity premium, then asset tokenization of commercial real estate alone can target a $5.4 trillion liquidity premium market, which is almost 10x bigger than the market cap of all cryptocurrencies put together. The potential asset backed token market size is so big and comprises of different assets (think oil, gold, fiat currencies, diamonds, art, intellectual property, real estate, shares of companies, etc.).

ICOs promise investors immediate liquidity. Normally in the current financial system, it can take 10 years for equity to become liquid in case of an exit. But a token has a price immediately upon its sale. Consequently, institutional investor interest in the cryptocurrency market has been on the rise especially the venture capital sector which has taken note of the revolutionary impact of ICOs on particularly the financial industry and this has seen stakeholders start investing in ICOs. Firms like Sequoia, Union Square Ventures and Andreessen Horowitz, are investing directly in ICOs and cryptocurrency hedge funds.

Let’s now have a detailed look at some of the advantages of tokenization.

Liquidity is not binary, it is a continuum, and low liquidity or illiquidity means that the assets are expensive to trade- Aswath Damodaran. Tokenization of assets-especially private securities or typically illiquid assets such as oil, gold, fiat currencies, diamonds, fine art, etc.- these tokens can then be traded on a secondary market of the issuer’s choice which increases the liquidity of these assets thanks to access to a larger pool of traders. This will be good news to both investors who consequently have more freedom and sellers because the tokens benefit from the “liquidity premium,” thereby capturing greater value from the underlying asset.

• Venture capital funds- this asset class is known to be very illiquid. Normally, investors have long investment horizons and must wait 5 to 10 years before earning a return. That’s why platforms like Blockchain Capital (BCAP), EQUI, and Spice VC want to reinvent the sector and as a result, lower the barrier to entry for investors and provide them opportunities to purchase pieces of investment portfolios and sell them faster.

The current system to trade commodities suffers from a number of problems, which adds cost: a lack of trust that requires middlemen who often charge high fees; requirements of USD/EUR settlement in emerging markets; paper-based record-keeping in emerging markets, which increases the chances of errors and fraud; and the lack of affordable access to supply chain financing for commodity producers. All this could be solved through tokenization.

The transaction of tokens is completed with smart contracts (software algorithms integrated into a blockchain which permit trusted transactions and agreements to be carried out among disparate, anonymous parties without the need for a central authority, legal system, or external enforcement mechanism) and as a result, certain parts of the exchange process are automated. This reduces the administrative burden involved in buying and selling, with fewer intermediaries needed, leading to not only faster deal execution, but also lower transaction fees.

Asset tokenization can enable new economic models around asset ownership such as fractional ownership (where investors can own a certain percentage of a certain asset) and hence this could open up investment in assets to a much wider audience thanks to reduced minimum investment amounts and periods. Tokens are highly divisible, meaning investors can purchase tokens that represent incredibly small percentages of the underlying assets. If each order is cheaper and easier to process, it will allow for a significant reduction of minimum investment amounts. In addition, the higher liquidity of security tokens could also reduce minimum investment periods since investors can exchange their tokens on the secondary markets, which are theoretically global and 24/7 (subject to regulatory limits).

• Tokenization through fractional ownership also allows diversification of risk arising out of asset ownership, that is, one wholly owned asset can be damaged and lose its value, while fractional ownership allows diversification of risk through owning a part of several assets.

In October this year, a luxury Manhattan condo development offered tokenized shares on the Ethereum Blockchain worth $30 million. Users can buy fractions of properties, earn income on those properties, then, as with traditional real estate investments, sell their fractions at higher prices depending on the appreciated values of the underlying property.

Tokenization enables newer models of raising capital, by allowing projects that are under development to issue shares in form of tokens to finance project development. Additionally, it enhances the utilization of network effect for certain products to increase their popularity in the market, by providing direct financial incentive to fractional owners.

Tokenization means that the token-holder’s rights and legal responsibilities can be embedded directly onto a security token, along with an immutable record of ownership. These capabilities promise to add transparency to transactions, allowing anyone to know whom they are dealing with, what their rights are, and who has previously owned this token. That’s why blockchain start-ups such as CEDEX want to see if individual investors can securely and easily trade gold, silver, and diamonds based on transparency.

Sellers could list their diamonds on the CEDEX platform and subsequently deliver them to a custodian, who would release them to the buyer once the transaction is complete. The CEDEX platform core aim is to provide investors with something that has long eluded the diamond industry-transparency.

• As we journey toward 2019, there is no arguing that tokenization offers the potential for a more efficient and fair financial world by greatly reducing the friction involved in the creation, buying, and selling of securities. It represents a remarkable power shift from large, centralized entities to the individual. This new concept through cryptology can replace third-party intermediaries as the keeper of trust, with blockchain participants running complex algorithms to certify the integrity of the ledger of transactions.