- Enter Tokenization – The Dawn of a New Era
- What Is An STO?
- Why Tokenize?
- What Can Be Tokenized?
- Where Are We Now?
- What Does the End Journey Look Like?
The Internet was ground-breaking, it allowed information to become digital and since its inception it has allowed many new types of businesses, sectors, and careers to flourish that were not previously possible. In the early days of the Internet, controlled alternatives were developed including a dial-up service from AOL (America Online), which was later abandoned when it became clear users much preferred a decentralized web.
This idea of a truly decentralized Internet then came to the fore – a web that was not controlled by any one party. A web that could transmit information from person to person with no intermediaries. The birth and growth of the Internet was a ground-breaking era and created boundless opportunities for the parts of the world that could access it.
The Internet, as revolutionary as it has now become has still had a hard time making monetary finance and the free movement of monetary assets truly digitalized without any central intermediaries. Bitcoin was invented in 2008 and came with a view to change all of this when its ledger launched in 2009. It made the decentralized transfer of monetary assets from one person to another possible and had solved the double-spend problem, which had plagued past attempts at decentralized financial systems.
Despite all this, the cryptocurrency has struggled to gain mainstream adoption as a payment method, as traditional third-party systems are more efficient. At this moment in time there is no need for the public to switch.
Even with the introduction of decentralized currencies the transfer of assets such as equities is run mostly through third parties with little in the way of direct free-moving transfers, but this could all be about to change.
The First Iteration of Tokenization – The ICO Era:
Back in 2017 there was a flurry of activity in the cryptocurrency space regarding digital tokens, but these tokens took a very different form to the tokenization in the context of this article. ICOs, or Initial Coin Offerings offered the potential use case of decentralized capital raise for projects and start-ups looking to raise money through the creation of new digital assets. STOs have the potential to not only create new digital assets, but also reinvent existing traditional assets into digital form.
ICOs were not well suited to replicate traditional assets due to a lack of equity rights and the failure to adhere to strict financial/securities laws and regulations. In an ICO, the participant was often gifted tokens, which did not represent equity, but yet still had the potential to trespass on existing financial laws and security regulations. This system did not often protect buyers with strict laws and rules relating to standard securities issuance.
Enter Tokenization – The Dawn of a New Era
What is tokenization? Tokenization can best be described as the creation of a blockchain recorded token that represents a real-world tradable asset. Many people will be familiar with the concept of securitization in the modern financial world; however, tokenization has the ability to take this creation of a digital financial instrument much further.
What Is An STO?
One area of interest, which falls under the vast scope of ‘tokenization’ are STOs or Security Token Offerings.
These types of offerings can also fall under name different titles such as DSOs (or digital security offerings), as the space is still maturing it is likely more names will be given to describe this rapidly evolving market. These offerings can help raise capital, but also set the terms for the ownership of digital assets. Tokenization even has the ability to replicate existing cap tables and transfer them onto the blockchain, whilst maintaining alignment with existing regulations.
The specific addition of the blockchain element to the creation of new financial instruments can bring with it many benefits such as trust, decentralization, cost-efficiency, disintermediation, and additional use-cases.
Just to highlight one of these areas in the latest quarterly report from the BIS (Bank Of International Settlements) it was stated:
“Tokenisation” is a new buzz word in finance. Incumbent financial institutions as well as new entrants are investing heavily in projects seeking to transform securities into digital tokens – digital representations of value that are not recorded in accounts. A key motivation is to lower the estimated USD 17-24 billion spent annually on trade processing (Broadridge (2015). Tokenisation could also transform how the underlying risks are managed”.
Tokenization makes it possible to take almost anything that exists in the financial world and make it truly digital and decentralized. This means making asset transfers decentralized, Intermediary-less, and enabling a truly ‘programmable money’.
Decentralized – The whole idea behind a blockchain is decentralization. Much like the Internet users of blockchains will likely prefer a more decentralized setup. Centralized blockchains may have certain use-cases, but they are limited and can often be replicated by incumbent suppliers. It wouldn’t make much sense to tokenize certain types of assets on a private blockchain due to the size and scale of such markets.
As Marco Schurtenberger technology officer at the Tezos Foundation states:
“…tokenized assets such as digital stocks or bonds cannot pass between private chains, meaning that to own a digital security tokenized on a private chain, one would have to be a member of the consortium governing the private chain – given the size and scale of private and public capital markets, it would be virtually impossible to bring all participants onto one private chain network, and value would be destroyed because of fragmentation rather than created.”
Intermediary-less – As tokenization will allow the ability for tokens to be transferred from seller to holder, so long as rules and regulations are met as deemed by the tokens contract.
Programmable money – As these digital tokens reside on smart contract platforms that can transform a digital asset into so much more and can even help to enforce regulations and compliance. For example, Equisafe released details on their NYX token standard developed for Tezos which includes 4 elements:
– 1 smart contract for digital identity management
– 1 smart contract to create a digital representation of the company issuing securities and related regulations
– 1 smart contract for materialization of securities registers (shares, funds, and bonds).
– 1 smart contract allowing the custody of the titles directly on the blockchain.
As Bilal El Alamy the CEO of Equisafe states: “On a legacy system, a transfer of shares would take at least a week, but with the blockchain, we are able to achieve it in a minute”. This ability to create and even combine smart contracts, whilst simultaneously having the ability to register records on a publicly verifiable ledger allows for multiple potential use-cases, some of which haven’t even been thought of yet. Such composability will give certain token standards the edge when it comes to particular use-cases.
Tokenization can have many benefits including those already touched upon, however certain asset classes have more to gain from tokenization than others. One such asset class that is ripe for tokenization is real estate. Presently, to invest in real estate you often need large amounts of money just to fund the initial capital. The process is also long and drawn out and ownership rights are inefficient to transfer often requiring many third-party intermediaries. The market is also quite illiquid due in some part to the reasons mentioned above.
Tokenization allows for just a fraction of a property to sell to potential investors; this allows for much greater liquidity. It also affords investors a much great choice and instead of just investing in one or two properties, they will soon be able to invest in hundreds if not thousands and trade these asset classes in an instant. With strict smart contract measures, these tokens could eventually be traded by retail markets, so long as regulations are adhered to. This should greatly increase liquidity in these markets as retail will be more inclined to buy fractions of big projects than large institutional investors.
There is also the ability to take advantage of existing blockchain architecture, for example Vertalo hopes to offer not only dividends from their token offerings, but also staking rewards. As Dave Hendricks of Vertalo states: “A real estate fund managed via a Tezos security token could simultaneously pay out a staking-based dividend next to an asset-secured dividend as is traditionally paid in investments like real estate investment trusts…” This could mean investors get rewarded twice for their investment, whilst saving on all the third-party costs that would be associated with a traditional sale of the asset.
This could mean that participants in STOs could get regular staking-based dividends every three days and then asset-based performance dividends in a more traditional timeframe. These staking rewards will be highly liquid and easily tradable on the open market and the staking rewards could provide immediate returns. There could be options of using the staking dividend to buy more of the tokenized asset so that your asset holdings grow over time. Of course, there is a lot of legal framework to be created and amended with respect to many of these potential ideas to see if they are in fact feasible and compliant with respect to the real world, but the potential is there.
Many of the pain points with the buying and selling of real estate property can also be mitigated. For example, if you have a smart contract that has all of the terms and conditions of the property already etched into the code of the contract it resides on then you would need less notary interventions from third-parties. These notary actions can often prove expensive and inefficient.
What Can Be Tokenized?
So, let’s address some areas in the key ‘real world’ markets and industries that can be tokenized. These include: Equities, derivatives, real estate, sports teams, insurance, pensions, electricity, commodities, businesses, art, music, content, data and more. Even people could theoretically be tokenized. Basically, almost anything that can be owned and even some things that can’t be owned can be theoretically tokenized.
The area of equities and derivatives has been a prime focus for discussion as it is more easily relatable. This is because the digitalization of this sector has already taken place on a large scale with the plethora of online trading desks and multi-functional trading app environments being used by the mainstream every day. Despite this advancement through digitalization, there is still one key element missing on the journey to making equity trading as seamless and as efficient as possible. Tokenization. Imagine 24/7 programmable tokenized assets trading in the biggest financial markets around the world.
It’s not only the retail market that is pushing for the tokenization of equities, many of the institutions that provide these services are keen to leverage blockchain technology in order to tokenize their offerings as there are some significant cost savings to be had by cutting out middlemen.
Indeed, if you can begin to comprehend that almost anything can become ‘tokenized’, then you in turn begin to understand the transformational set of events that could take place over the next few decades.
Corey Soreff, a member of the Tezos Commons Foundation states: “Stocks represent equity in a company, security tokens represent ownership in any type of asset”. These are big distinctions and because of this it opens the door to the many assets which have yet to have digitalized financial products enabled. At the very least it opens the door to have existing financial products related to these assets optimized, as ownership can be established via the blockchain and programmed to achieve faster innovation.
Where Are We Now?
STO’s have yet to take off in a big way. In fact, 24-hour trading volumes struggle to get above $20,000. This is put even more into context when you consider all cryptocurrencies combined have a daily volume above $176,000,000,000 as of today. A staggering 879999900% difference, but clearly there is room for exceptional growth should tokenization start to gain momentum.
Part of this initial lag has been down to technology, part down to markets (especially liquidity), part down to regulations/ compliance, and part down to security. Of course, there are other factors in play too.
Technology because ownership is a very different beast when compared to transactions. Solutions have been found and we expect to start seeing these solutions launch in Q2 of this year with the launch of some highly anticipated security token offerings, such as the Elevated Returns Thai Real Estate offering. In this initiative it is hoped $1 billion of real estate assets will be tokenized utilizing the Tezos blockchain.
Markets in the space have already been burned by the ICO era. This era created a level of hype that ultimately took ICOs into a bubble and this inevitably popped, leaving many investors without a shirt. People will be understandably cautious when it comes to investing in digital tokens of any kind from this point on.
The main factor however, is that the markets are presently only open to certain types of investors. Accredited investors can take part in the offering, but there is yet to be any real liquidity from the open retail markets. There are stringent timelines, as well as other rules as to when and how non-accredited investors can take part and to the average retail customer this is all a bit inconvenient and complex at this stage. As technology and regulations align, there is the potential to move on from this point, this is a process which is going to greatly pick up speed over the course of this year.
Regulations and compliance, because it’s been hard to create a form of tokenization that can allow flexibility to adhere to many different rules and regulations across the world, spanning many different continents. This requires a great deal of compossibility in the tokens architecture, so when issuers look to tokenize, they select which compliance structures they need to adhere to with respect to their offering.
One of the biggest challenges is how do you let the highly liquid retail open markets take part in the tokenization market. Of course, it is a lot more in-depth than this, but these obstacles are gradually being overcome. This is because virtually anything can be created with the use of smart contracts. Not only is technology advancing in this area, compliance and regulations also seem to be adapting to these markets.
In the first quarter of 2020 the Securities and Exchange Commission published a proposal, which could be of benefit to those looking to run security token offerings (STOs) in the future. In it was a proposal to raise caps on both Regulation A+ and Regulation CF (Crowdfunding). In the proposal it was put forward that regulation A funding caps could be raised from $50 million to $75 million. It was also proposed Regulation CF (crowdfunding) caps could be raised from just over $1 million to $5 million.
Of course, this is yet to be adopted, but if it was it would allow for greater flexibility to raise capital, especially from non-accredited investors, so long as raises are run compliantly in-line with necessary regulations.
Another potential obstacle for STOs in the compliance/regulations field is the Bit License in New York. New York is the epicenter of the financial world and is the major hub of stock markets around the globe. This at present means it’s hard for companies and businesses that operate in New York to deal with some cryptocurrencies they have not yet been given the authority to do so. First, companies such as exchanges must obtain a bit license and then have been the authority/clearing to list different types of assets.
This includes cryptocurrencies such as Tezos, which is expected to be one of the biggest underlying technologies for tokenization due in part to its formal verification and forkless upgrade abilities. This obstacle would also apply for any organization wanting to take part in the tokenization system for example the INX exchange platform, who are looking to enable regulated security token listings.
In December 2019 a breakthrough for the industry was made when the Department Of Financial Services in New York proposed 2 new measures:
“(1) a public list of coins that are permitted for the Virtual Currency Business Activities of DFS-regulated virtual currency businesses without DFS’s prior approval, and (2) a proposed model framework for the creation of company-specific coin-listing or -adoption policies that, if approved by DFS, will enable regulated virtual currency businesses to self-certify additional coins without DFS’s prior approval.”
If these proposals were enacted in the future, then it may make it easier for organizations and in particular exchanges to list new types of assets in New York. For example, at this moment in time it would be hard for a bit-licensed exchange such as Gemini operating within New York to list a coin such as Tezos, which has not yet had approval unlike coins such as ZCash. However, if these new proposed measures were adopted this may open the door for this to be possible, in-turn potentially enhancing the security token markets as the underlying technologies become more liquid and accessible to big institutions. It may also have an impact on not only the overriding infrastructure of tokenization, but also the tokens themselves.
Security is also a big factor in the lack of activity thus far. There have been some large-scale, well-known hacks in the cryptocurrency sector and some relate to tokens on blockchains. In May 2016 The DAO was conceptualized. The DAO stood for The Decentralized Autonomous Organization and this was one of the earliest forms of tokenization ever created on a blockchain. It was also one of the biggest fundraisers in history and at the time raising over $150 million from 11,000 investors. The DAO’s offering was delivered in the form of an ERC-20 token, however on June 17th 2016 the DAO was subjected to an attack exploiting vulnerabilities in the contract’s code. Around $50 million worth of Ether was drained from the contract. In July 2017 another exploit in a contract codebase resulted in the accidental loss of around $300 million in Ether.
When it comes to security tokens, some of the assets that are often best suited to tokenization, such as real estate are often very high in value. With this in mind, security is paramount and up until now the technology of certain blockchains has not proven itself to be reliable. As technology has progressed more security focussed options have been developed, such as formal verification which can help prove the properties of a smart contract’s code and therefore eliminate many errors. Formal verification is very useful at eliminating recursive bug type errors, which lead to the DAO hack.
There is no doubt there is still a long way to go but there has been great progress. For example, Microsoft has been working on Project Everest and is now well over halfway through its 5-year arc. Indeed in 2018, Tezos adopted the HACL* library providing verified cryptographic primitives to work from. Michelson a low-level, stacked-based, strongly-typed language well suited to formal verification, is having more tooling built around it such as high-level language compilers, so it will be easier to create formally verified smart contracts on Tezos. Michelson 2.0 is also being worked on, which hopes to generate even better functional programming abilities.
What Does the End Journey Look Like?
Let us take a purely hypothetical look at what might be possible when it comes to the future of tokenization.
- All global financial assets are tokenized. Across many different chains (which are interoperable) both private and public.
This would be quite some feat considering the following: “The addressable market for security tokenization is in excess of USD268 trillion, which is composed of the global stock of investable financial assets. This is the next iterative step in the pervasion of blockchain in finance, we see future development in addressing the USD595 trillion*** global derivatives market on blockchain.” – Zac Ceferrati, Dalma Capital.
- The Nasdaq trades tokenized blockchain-based assets on a large scale, delivering great speed and efficiency with 24-hour markets.
- Tokenized assets begin to enter our world without people knowing it. Social media apps let you transfer tokens instantly with the click of a button and the scope for exchange is unlimited. Want to trade an authentic antique book signed by a prestigious author for a car, over your most loved social media platform? Not a problem. The ramps and rails will be built so that tokenized assets can interact with social media platforms, webpages and email at the click of a button.
- There is a Uniswap like facility for trading all tokenized assets. In order to promote liquidity within the tokenized markets a bonding curve type concept could be created, which allows automatic digital asset exchange between all tokenized assets as they are connected to their underlying blockchain.
Ethereum Uniswap facilitates the automatic digital asset exchange between ETH and ERC20 tokens and consists of two smart contracts. The design was formulated to help provide liquidity between Ethereum and Ethereum tokens (ERC20). Rather than going through a traditional exchange that looks to match buyers and sellers, projects can now go through Uniswap which instead utilizes liquidity reserves to automatically swap Eth and ERC20 tokens. Sort of like an instant version of Etherdelta with instant liquidity and cheaper gas usage.
But what if you could create a Uniswap for legally compliant ownership tokens better suited to asset ownership, rather than transactions? Whereby, instant liquidity and exchange could take place between tokens and blockchains. Instead of swapping ERC-20 tokens they could be swapping ERC-1400 type tokens on Ethereum or FA2 and NYX standards on Tezos. Indeed, there are many other tokenization standards being developed including Reg D V-Token standard by Vertalo, which makes it easy for companies to easily transfer their existing regular cap tables to the blockchain.
In fact – Coase a trading card game on Tezos is adopting bonding curve smart contracts to provide instant liquidity for their trading cards. This leads onto the next potential outcome…
- The ability able to buy property with trading cards instantly. Yes, imagine a future, whereby you could buy a fraction of real estate with digital wealth you have accumulated playing online trading card games. You could even turn a digitized game of Monopoly into a real-life game of purchasing and leasing fractional real estate assets. Of course, this concept of trading anything easily doesn’t just apply to trading cards and real estate, but this is one fun option to consider.
- Many new use cases will emerge as a result of property tokenization. Imagine an online auction taking place, whereby participants in the auction put forward an amount of capital they are willing to invest and then at the end of the auction the property ownership is distributed in relation to the percentage of investment a said participant agreed to pay in relations to all other bids. Sort of like a first-price sealed-bid blind auction, but with a unique twist.
- Security token issuers will become big staking pools, whereby the cryptocurrency they collected in an initial sale allows them to make continue interest helping cash-flow and sustaining projects for longer time periods. For example, cryptocurrency collected for a long-term property development project, which takes years to complete can be staked. This could provide a safe-guard to any unexpected costs that may arise. One reason security token issuers may be tempted to stake with any cryptocurrency sent for funding would be to have a say in how the underlying technology is developed through Governance systems. This is because the underlying technology could have a big say in how their security tokens could perform and innovate. For example, a proposed innovation to the underlying blockchain, which focussed on privacy could have a large-scale impact on security tokens residing on that blockchain. If someone had over a billion dollars tied to an asset on a blockchain, it is likely they would want some kind of say in how the underlying technology which powers their asset is developed.
This is just the tip of the iceberg as to what is possible, and TokenCrunch look forward to analyzing and covering more potential use-cases in the future. Suffice to say the future looks very bright for the tokenized world and you would be wise to take heed of its great potential.
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