Asset-Backed Tokenization: Everything You Wanted to Know

For a considerable amount of time in recent history, initial coin offerings, or ICOs as they are commonly abbreviated, have been the de facto standard for defining the confluence of a new technology like blockchain and the traditional world of investments. However, the inherent flaw with the ICOs was that they offered utility tokens.

What Are Utility Tokens?

Utility tokens, as the name defines, represent a certain utility that holds value only within the product or the project ecosystem. Although utility tokens were marred by scams, they have to be given the credit of unifying blockchain and investments.

Utility tokens and their success is purely built on speculation albeit a calculated one. The value of the utility tokens during the token sale or when traded on third-party exchanges is purely contingent upon this element of speculation rather than the tokenomics model.

What is this element of speculation that was eliminated? What if there was some tangible value to some tokens that represent an investment but at the same time, also hold value in the real world?

The answer lies in asset-backed tokens!

Asset-backed Tokens

As the name implies, these tokens are correlated with an external real-world asset with tangible value. They are offered to investors using a process called security token offering, commonly abbreviated as STO. Asset-backed tokens or security tokens represent the centroid of the vertices of traditional investment, security, and blockchain technology.

Relevance of Asset-backed Tokens

• Asset-backed tokens are quite similar to traditional stocks, right? Well… these security tokens can do a lot more than just what traditional stocks can.. Stocks are designed only to operate on company shares. However, security tokens can create cryptographic analogues of almost all traditional assets.
• This does not seem like a big deal… Until we introduce a factor called ‘liquidity!' Liquidity is the magnitude of ease with which an asset can be converted into cash. This quantity has a strong correlation with the trading volume, and it has a direct impact on the price of the asset.
• If an asset is difficult to sell – or in complicated lingo, difficult to exit a position via third-party exchange - it takes longer to find a buyer, and it translates into the lowering of the asset value. The reason for buyers not opting in to purchase highly illiquid assets like fine art and real estate is either because they do not have sufficient cash or even if they do, they have hesitation in putting all their eggs in a single basket.
• In effect, this highly illiquid yet valuable asset also stays confined to a few elite investors and it stops all nominal investors from competing in this lucrative market.
• Tokenization of these assets solves all these problems in a single shot. It ensures that the humongous as it with an exorbitant value is broken down into smaller pieces which represent an ownership that is tangible and fungible. Since the value of these tokens is quite likely to be in the vicinity of the affordable range for all investors, it also makes the entire market democratic. This solves the problem of liquidity when it comes to high value assets that were classically considered not at all liquid!

The Advantages of Asset Tokenization

As discussed in the lines about the first and foremost advantage brought about by tokenization is liquidity. In addition to that, what makes tokenization appealing is its round the clock trading capabilities. Tokenized asset markets are open 24 hours a day, seven days a week and 365 days a year. It also breaks all geographical barriers - a person in any corner of the world can trade tokenized assets in any other place. It also enhances price discovery and reduces price volatility.

Tokenization also eliminates the need for intermediaries who are required to validate the transaction and authenticate the people involved. These intermediaries also receive a portion of the investment for taking on counterparty risk. Since tokenization takes place on a blockchain, there is no need to establish trust – thanks to the smart contracts that can effectively and efficiently take care of validating the transaction.

Use Case Examples of Asset-backed Token:

Tokens are backed by real world assets and it is quite compatible to the gold standard that existed determining the value of paper currencies. Since one of the strongest driving factors for tokenization is enhanced liquidity, the first class of asset-backed tokens belongs to assets that are known for limitations in liquidity – derivatives, real estate, collectables, private equity, and the likes. These assets are easily worth trillions of dollars but they are stored without transactions as hedges against inflation.

A few examples can include:

Corporate debt or equity

Real estate investment trusts

Equity from commercial property and rental income

Intellectual property asset-backed tokens

Accounts payable and receivable

Smart Contracts - the Silver Bullet

What makes the entire ecosystem of security tokens and the using of blockchain technology for trading of assets is the presence of smart contracts. Smart contracts are self executive programs designed within the blockchain and programmed to execute upon certain conditions being met. This can be considered an extension of the 'if – then – else ' statements in programming, with an increased degree of complexity, accuracy, and dependability.

A lot of professional investors use the services of lawyers to perform due diligence on new investments. However, investors who do not have a lot of capital cannot afford to take such a risk. Security tokens have smart contracts built within them that can automate due diligence to a considerable extent. In addition to factors like liquidity and universal availability, this cost-saving is also one of the factors that contribute to the popularity of security tokens.

In addition, smart contracts can also have protocols with inbuilt dividend and profit share functions. This transforms the traditionally low liquid asset class into a passive generator for income.

Main Classes of Asset-backed Tokens

Most of these tokens can be classified into four categories:

1. Debt and equity tokenization
2. Commodity tokens
3. Hard assets tokens
4. Soft assets tokens

It is to be noted that in the last two classes, non-fungibility is a common factor that drives the need for tokenization.

Let us look at each class in some detail.

1. Debt and Equity Tokenization

Debts and equity are the de facto methods by which start-ups raise their funds. Traditionally, they have stuck to investment banks and traditional exchanges for launching their IPOs. This is perhaps the precursor for fractional ownership – stock certificates and mutual funds have been existing but these tokens offer a percentage digital ownership of a company debt or equity.

Trading debt and equity over the blockchain, and specifically over an STO is already here, and it represents a perfect use case for asset-backed tokens. It is expected that the price will decrease because of the destruction of asset value. However, it can easily be counterbalanced to buy the percent volume increase as it will create a new market value. This is expected to give a fillip to both incumbents and entrepreneurs because it is expected to enhance the value of the company assets and the market share. They would, however, need to act really fast during the emerging production and marketing industry shift.

Since the investors are required to hold the equity for at least one year, the equity would fall under the low liquidity category. Asset tokenization would only enhance liquidity for both private equity funds and hedge funds, and this will help them adapt to market fluctuations.

2. Commodity Tokens

It is possible that all traded commodities can be converted into security tokens – it includes but is not limited to oil, natural gas, sugar, wheat, and every other community that is traded on third-party exchanges. Even French commodities like renewable energy can be facilitated through a blockchain base exchange. This enables governments, utility companies and individuals to participate and transact together on a single platform.

One challenge when it comes to tokenize commodities is the physical verification it requires to establish the validity of the tokens. Traditionally, auditors had taken it upon themselves to verify the security and trustworthiness of custodial storage facilities. These auditors can take advantage of the blockchain technology by using manual verification methods and connect them with blockchain tracking.

When it comes to commodities, gold has to be dealt with differently. Each gold backed token represents a verified and audited gold bar, either in full or fraction. The auditing is done through the services of an 'Oracle ' provider who checks it for its weight, purity, and authenticity. This verification process, in addition to being cumbersome, is also costly. Therefore, it is important to address the cost associated with these Oracle providers before gold can completely be commoditised.

For this gold, however, there is a digital alternative - the bitcoin!

Bitcoin is often referred to as digital gold, and it has the potential to replace gold as a primary store of digital value using tokenized gold. Bitcoin presents a lot of advantages over physical gold – it is easily divisible and transferable. It is simple to take one percent of a bitcoin and send its equivalent in some form of Fiat currency to the crypto currency portfolio of an individual. In stark contrast, it is extremely difficult to take a gold bullion and fractionalise it. If a gold bar can be divided into tokens, it makes it extremely easy to sell or transfer a percentage of goals in a way that is similar to trading currency.

3. Hard Asset Tokens

As the name implies, hard assets represent tangible and physical items of monetary worth owned by individuals or organisations. The possibilities of tokenizing hard assets on the blockchain are almost infinite.

A few examples of hard assets worth tokenisation include real estate and collectables.

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Real estate tokenization has already happened through REITs. However, the issue of these tokens is quite restricted and it does not essentially solve the problem of liquidity. However, with real estate tokens, funding could become borderless and more profitable. Since these tokens are issued without many restrictions, it could also help in making real estate investment more democratic, opening the investment avenues in rented properties, senior care homes, and hotel chains, which were considered inaccessible for the lay investor so far.

Collectables have been far less accessible than real estate – it is the auction houses like Christies and Sotheby's that have a majority of control over the secondary art market. Although there are a lot of takers, they find it extremely difficult to sell expensive pieces of art – it is a situation where they have to choose one among the two evils. They should either compromise on selling the art or compromise on the pricing which might result in the value of the art getting diminished.

However, with asset-backed tokens, the artwork can be distributed via the blockchain, representing shares in the original work. The artwork could be put up in a museum and the returns could be distributed to all the shareholders. If any shareholder, or in this context, a token holder decides to sell their token, it is quite easy because the blockchain not only makes the process easier but since the value is low, it is extremely easy to find buyers. In short, asset tokens are all set to democratise the world of collectable art.

4. Soft Asset Tokens

Contrary to hard assets, soft assets are intangible but they do have a value which is difficult to quantify and evaluate. Examples would be intellectual properties. Copyright licences, trademarks, patents, and royalties have very low liquidity. They also do not have a secondary market place where they can be traded.

Today, there are a lot of practical difficulties in tokenizing these intellectual properties. However, once the code is correct, these intellectual property tokens are bound to enhance liquidity and increase the value of these IP assets, and they are sure to bring a lot of profit to media producers, innovators, and artists.

Conclusion

Any new technology is poised for a greater degree of acceptance only when it solves real-world problems in a way that is accessible even to the remotest of people. Blockchain and STOs might lack the regulatory certainty that is needed to make it mainstream. It is one of the reasons why China and Qatar have completely banned the sale of asset-backed tokens. Countries like Bermuda, Estonia, Lichtenstein, Switzerland and a lot of them allow the issue of security tokens but the regulatory framework is far from being defined and refined.

It will only be a matter of time before security tokens become mainstream methods of asset tokenization and make their way into almost every sphere of investment. Therefore, it might be a good idea for companies, investors, regulatory bodies, and almost every other entity important to be aware and prepared for this constructive paradigm-shift.