Can tokenization of illiquid assets be the biggest value unlock for cryptocurrencies?

The Challenge

A quick review of Coinmarketmap would reveal that the majority of the top 100 cryptocurrencies traded today are network enablers, commonly known as utility tokens. Prime examples include Ethereum (ETH), FileCoin (FIL) Stellar (XLM) and Cardano (ADA). These utility tokens fuel the usage, demand, adoption and stability of the platforms to which they power. Once developed to scale, these platforms demonstrate the potential to disrupt and transform age-old business problems and industries.

While this may sound prospective, the reality is that tectonic shifts are underway and early signs of disruption is visible across industries. For example, creators of New York-based ShelterZoom, an Ethereum-powered platform that is built to be Real Estate Standards Organisation (RESO) data dictionary-compliant, is already disrupting the real estate industry. Through Ethereum smart contract technology, ShelterZoom is significantly refining and streamlining the making of real estate offers (through its “Offer Now” and “Rent Now” services) and reducing mountains of paperwork and commissions costs in the process.

However, when floated in open market exchanges, the value of these tokens (read acquisition price) fluctuate widely based on trading demand and market sentiments, at times rising 10x or 100x its originally intended utility value. While the meteoric price hike of these tokens has drawn mass interest to its underlying technologies (mostly due to speculative purposes), this very price rise and associated volatility of cryptocurrencies hamper liquidity, harm platform economics and importantly, inhibit the growth of these networks in the longer run. Case in point is Ethereum which at its peak (Jan 14, 2018) saw its unit value (Ether) spike at around $1,400. At around the same time, Vitalik Buterin, co-creator of Ethereum, raised concerns of the highly volatile prices of Ether, addressing the need for Ether’s market price to be steady and sufficiently low and negligible for it to serve as an effective “fuel” to power its network.

Herein lies the conundrum — appreciation of token value brings money, attention and interest into the cryptocurrency market (everyone wants to make money). It also attracts large institutional enterprises and other bodies which give the cryptocurrency economy legitimacy and market participation, yet the depreciation of token value to reflect its lowerst possible unit (or utility value) is required for these platforms to succeed and be sustainable.

If “platform utility” is not the best element to drive value of these crypto tokens, then what else can be a good solve?

Idea already being explored: tokenization of liquid assets

Between the four largest banks in the US — State Street, BNY Mellon, Citi and JP Morgan, they oversee $15+ trillion worth of assets (stocks, bonds and other liquid assets). While transaction fees of trading such assets is very low (subzero percentages), profits for these financial behemoths come from sheer volume of assets. Several blockchain startups have eyed this space and have started exploring ways and means to tokenize these assets into tradable securities (read: crypto tokens backed by liquid assets — which give them stable values). Additional value available for taking is to cut out the middlemen for such trades (such as custodian banks described above) which can significantly lower asset exchange fees — a use case which is being actively explored by Polymath, a blockchain startup that is trying to help migrate trillions of dollars of financial securities into blockchain, by building a marketplace and platform that helps people issue security tokens and implement governance mechanisms to help these new tokens meet regulations.

Another example which comes to mind is Jibrel Network, which through its decentralized protocol allows for assets such as currencies, bonds, equities, commodities and other financial instruments to be placed on the blockchain. It has created tokens that represent the value of real world assets. These tokens called as Crypto Depository Receipts (CryDRs) are backed by Jibrel Network Token (JNT). CryDRs can be used for remittances, global payments, trading, and hedging or automated and decentralized financial instruments such as bonds, commodities, debt instruments, and securities. Additionally, CryDRs have regulation embedded, ensuring all token transfers on the Jibrel Network are fully KYC /AML compliant.

While tokenized assets sound promising (assuming they overcome regulatory hurdles in due time and are able to become mainstream) the challenge remians in that they still do not unlock “new value”. Instead, they “mimic” value in the traditional market within the new blockchain-enabled world while surfacing some price-value benefits when compared to situation before.

Idea worth exploring: Tokenization of traditional illiquid assets

A potential value pool often overlooked is the tokenization of traditional illiquid assets.

Currently the global infrastructure market alone is valued at $3 trillion plus. Infra assets are by its very nature, illiquid (viz. they are very immobile, command very high valuations and hence have limited participants who hold the power to buy/sell such large assets at short notice).

If we were to hypothetically assume that a large pension fund owned “a highway” and wanted to urgently liquidate or sell such an asset quickly, they might have to digest a loss of good 20–30% of the asset’s fair value. This 20–30% loss is what would be marked as “illiquidity discount”. This discount, as commented by Prof Steve McKeon (University of Oregon) on CNBC Power Lunch program recently, represents huge value and therein lies the promise. Tokenization of such hypothetical “highways” — an illiquid asset and creating a market in which to trade these tokens, has the potential to reduce the illiquidity discount substantially by reducing frictions to trade.

Drawing parallels to the overall infrastructure market, if we were to assume a liquidity premium of between 10–30% when such assets are tokenized, fractionalized and freely traded, the premium alone can represent a market opportunity of 2x the entire cryptocurrencies market (as at April 2018).

Another case in point is tokenization of fine art (value of total art market is assumed to be as large as $650 billion, of which over $590 billion is illiquid and not monetized). A Credit Suisse paper on tokenization of illiquid assets and the blockchain, points to the fact that:

  1. Sub-dividing artworks into smaller units of value via tokenization broadens investor classes in the market, which expanding the market and increasing the artwork’s overall value. This lowers the barrier of entry for smaller investors for whom the initial investment requirements may be prohibitive.
  2. Smaller units of value allows investors access to a greater diversity of styles, periods, or artists. This diversification better insulates against market trends and fashion that ownership of a single work of equivalent value allows.

Of course, one does not presume that all traditional assets will be tokenized. However, if tokenization of these traditionally illiquid assets is executed successfully across different sectors — from real property to fine art, gems, horses, yachts, aircrafts — this will provide markets with much desired liquidity, fuel growth of the blockchain ecosystem and more importantly, provide a much-needed anchor point for cryptocurrency prices. Importantly, this will also have a cross-over effect on utility tokens that power the network to which these assets reside.

Challenges impeding value unlock?

There are however two key challenges that impede value unlock:

  1. Market makers need to be credible — In order to create the necessary market depth to allow liquid trading of these traditional assets, market makers need to be credible, fostering trust through the platform in which they operate and across asset classes in which they tokenize.
  2. Platforms need to be “inclusive in nature” — In order to facilitate frictionless global trading across jurisdictions, market makers need to be inclusive in nature, with roles of government, regulatory and other legal bodies clearly defined along with market participants. While there will be regulatory hurdles to address, these issues are not in the author’s view impasses too hard to pass!

Concluding thoughts

I had an interesting conversation on this very topic at a recent blockchain event, which I chaired with several distinguished panel members and a room of 200+ audience. While discussions focused primarily on the future of decentralization, it also converged on the future of cryptocurrencies, what determines its fair value and what would it take for cryptocurrencies to act akin to traditional securities.

While half of the audience members believed that current technology is not yet mature enough for mass adoption, others also believed that tokenization of traditional illiquid assets can potentially have an impact on the asset’s liquidity.

I personally am of the opinion that tokenization of traditional illiquid assets will bring across the biggest value unlock for cryptocurrencies in the years to come. Not only will it bring in new value, but it will break down traditional barriers — making asset purchase more affordable and accessible to all.

What do you think?

Bonnie Yiu is Founder of Consulere.io, a blockchain, IoT & AI consulting company. Prior to that Bonnie was an Associate at international law firms in Sydney and Silicon Valley, specializing in Financial Services and Venture Capital laws.