With the growing interest in blockchain and the increasing number of tokens being offered on exchanges, we thought we would take a deep dive into tokenization, what it means and how it works.
As we all know by now, there is an increasing interest by financial technologists and intermediaries all over the world trying to determine the best way to harness blockchain and take advantage of the efficiencies that can be created for consumers and businesses.
Below we break down tokenization and the tokenizing different types of assets. Next we’ll delve deeper into token transfer and legal models.
What is Tokenization?
Tokenization is the process of replacing and breaking sensitive data into unique identification algorithms that contain all the essential information about the data without compromising its security. It refers to the process of converting rights to an asset through a digital token in the blockchain.
Why Tokenize Real World Assets?
Our world is filled with different assets in the form of real estate, stocks, carbon credits, gold, oil, etc. Most of these assets are difficult to subdivide or physically transfer, allowing sellers and buyers to trade in paper representing these assets. However, paperwork, along with complex legal agreements, are a bit cumbersome and can be difficult to keep track of.
Commodity exchanges are already done with physical paper and have substituted electronic transactions as well as standardized agreements. However, the systems’ overhead is huge. Startups, as well as other financial companies all over the world, are now trying to come up with systems geared towards the next phase of this evolution and that’s what we call tokenizing assets.
But what’s the reason why someone would prefer a digital token representing physical assets and how can this be made possible?
Here is an example. Jane is a wholesaler of diamonds and owns $15 million worth of these gems. However, it can be difficult to transfer diamonds to buyers since they would require security and close-up inspection to ensure that these gems are authentic. Joe would like to invest thousands of dollars in Jane’s diamonds. However, he doesn’t want to go through the hassle of receiving them physically. Joe would simply want to own a small part of the many diamonds to diversify his diamond position because diamonds are available in different cuts and grades, and the demand will eventually change for each type.
On the other hand, it can be a hassle for Jane to take the time to look for Joe to sell her diamonds. She wants an easy process of subdividing her diamond stocks and sell fractional pieces of the diamond to several people. Furthermore, Joe would prefer to be able to trade his fractional ownership easily to other people instead of just dealing with Jane. The ability to make both Jane and Joe happy in this situation is what the Blockchain tokens can provide, by using it to represent real life assets.
There have been several methods that were proposed when it comes to taking real-world assets into the blockchain technology. The main goal is to achieve speed, security, and ease of transfer of the Bitcoins, along with the combined real-world assets. This is a new term for an old concept known as securitization, a process of turning a certain type of assets into security. In some cases, the tokenization is of the securitized assets.
Below we explore the different types of real-world assets that can be put into the Blockchain, along with some models that are piloted by various startup companies, financial intermediaries, as well as the government.
Intangible Assets
These assets exist mainly because of the operation of law even if there’s really no physical object involved. Some of the most common examples of intangible assets are carbon credits, patents, copyrights, brand names, etc. Since intangible assets don’t have a physical form, they can be easily combined with the blockchain-based systems.
One of the biggest challenges with intangible assets is in ensuring the blockchain’s model of asset transfer is in line with that of the real world’s legal model of transfer. There might be some jurisdictional differences that could make the transfer even more difficult. With that in mind, intangible assets are much easier to tokenize unlike the physical assets because there are only a few concerns regarding shipment and storage.
Fungible Assets
Fungible items refer to something that can be replaced by another similar item. Examples are gold, water, wheat, etc. Fungible assets are easier to convert into tokens since they can be broken down to smaller units, which is pretty similar to Bitcoin. The token can also represent a group of objects such as gold instead of a set of individual objects, such as a warehouse that’s filled with unique art pieces.
Assets that are not fungible need an abstraction layer before they can be tokenized. Examples are companies that group assets together and offer them a package. This method is usually used in securing mortgages, wherein a set of mortgages having unique characteristics are bundled to a group with almost the same characteristics.
Fungible assets are much easier to tokenize since the general set of tokens is usually linked to a general set of interchangeable asset components. Example of these is a 10 kg of gold.
Tokenization presents many possibilities when trading assets. Check out our next blog covering how to transfer tokens and the different legal models.
