Tokenizing Real Assets and Loans
Tokenization refers to the process of converting rights into an asset through a digital token in the blockchain. There’s an increasing interest by financial technologists and intermediaries all over the world in determining how to convert real-world assets into blockchain to take advantage of Bitcoin while maintaining the assets’ characteristics.
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. The best solution would be to switch into the digital system and take advantage of Bitcoin by linking it into an asset.
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 as tokenizing assets.
But what’s the reason why someone would prefer a digital token representing physical assets and how can this be made possible?
For 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. In this article, we’ll 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
There are many assets that the lawyers would consider “intangible.” 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
Lawyers also make a distinction between fungible assets and those that are not. 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.
Ownership Transfer vs. Limited Rights Transfer
There are several different types of transfer of assets and different varieties of asset rights. In some cases, only limited rights linked to an asset are transferred, such as the lease to use land for a limited period of time instead of a full transfer of land ownership. Thousands of years of property ownership has resulted in a wide variety of ownership types and control including holding property on behalf of another person, a practice known as “bailment.” The details will depend upon the jurisdiction, the type of law, whether it’s civil law or common law, assets, as well as the rights that are meant to be transferred.
Some of the intangible assets can be given to millions of people all at once, like for example music rights. For instance, if a customer purchases a song from iTunes, they won’t gain the ownership of the song. They are merely buying the right to listen to that music under certain conditions.
Blockchain projects are usually divided among those that involve tokenizing partial rights, such as music licensing, as well as those that involve tokenizing the full ownership. An example is a real estate.
Token Consistency
In digital systems like Bitcoin, consistency is always present. Transactions need to follow the rules of the software, and there are no exceptions to this. However, in the real world, there are exceptions. For instance, gold bars may get stolen, real estate properties burned, or diamonds not delivered. Furthermore, humans don’t abide by the rules. Therefore, the biggest challenge for a system that requires tokenizing real-world assets is to ensure that the digital token will remain linked to the real-world asset.
Imagine a particular token representing a fractional interest in a set of gold bars kept in a vault. If if the gold bars will be taken out of the vault, how will this affect the digital token? Who can make sure that the token value remains linked to the gold bars that are kept in the vault? Who’s going to take the risk?
If the person who buys the token cannot be certain that the token is linked properly to the real-world asset, then the value of the token is going to fall, or it may become zero.
Legal Models
Licensing
Licensing music relies heavily on trust and paperwork. After making music, the musicians hope that the sales of their music will be calculated properly and will be reported back to them. Since digital streaming and downloads eliminate the need for physical sales of media that contain songs, the music will have better chances for tokenization. If music ownership is represented on the Blockchain technology, people who are involved in creating the music will have to set their shares electronically.
The goal is to require unlocking and payment every time someone listens to their music, and the payment will have to be distributed to the appropriate holders. Then the holders could possibly transfer their interest in music. For instance, the drummer would like to convert his ownership to the down payment of a house, etc., or to someone else who will then get the payment stream.
More accurate reporting could benefit everyone. However, there are certain changes that the tokenization may trigger. The tokenization of the ownership of music allows new business models like investing in music created by the public. If, for instance, a new band could sell 20% of their song to fans, what will this do to the production of music? How can this affect the intermediaries?
One good example of the tokenization of music ownership or licensing is the SingularDTV.
Trading Systems
For instance, a group of companies that want to trade oil with one another. They would normally exchange paperwork to maintain their own lists of trades. If they are able to move the transaction to a Blockchain-based system to trade their oil, it’s possible for them to minimize paperwork while maintaining a more robust record-keeping potentially.
There have been plenty of consortiums sprouting up that have aimed to replace the traditional paper trading systems with the Blockchain trading system. Generally, they don’t want to tokenize real-world assets directly. Instead, they are aiming to use the Blockchain system for the trading of real-world assets. This is basically a combination of the traditional paper record and the new Blockchain approach. The tokens will only have value in the context of a contractual system that involves past and future participants.
One example of this tokenization is the oil-trading project of Natixis, IBM, and Trafigura. There are also tokenization schemes that would require minimal use of property implemented for by digital locks.
Redemption
Just think of an art print made by a famous artist consisting of 1,000 prints. These art prints can be tokenized by getting ownership that’s held by a company with a standing offer to the public to redeem tokens for a single printing of art or if the redeemed tokens happen to be less than a particular threshold, which is usually a fraction of the art prints’ assessed value.
Delivering the prints physically can be made to a certain location or shipped to a certain address. By doing think, buyers are able to obtain a token that’s easy to transfer, and it will be possible for third-party markets to transact in a fraction of the art prints. This can be a good source of financing for the artists making the print an easy way for the broader public to be able to take part in the art industry.
The model above relies mainly on the company that’s holding the art to continue offering token redemptions. An obvious risk for the token holders is when the company doesn’t adhere to its commitment to exchange the tokens for real-world goods in its possession. Another possible issue is on how the company that’s holding the artwork will be compensated on the cost of storage.
A good example of this is Tether, although take note that the terms of service have indicated that redemption won’t be guaranteed.
Vaults and Smart Contracts
Think of a vault of gold owned by a company that we will call the Goldowner Inc. while Vault Inc. owns the vault. Vault Inc. has a good reputation, and they have third-party auditors who can verify the amount of gold kept in the vault.
Goldowner Inc. can provide a digital token to the public, which represents ownership of the gold. A smart contract made with Vault Inc. will maintain a public off-chain registry that will relate fractional interest of the gold using the tokens. For every token that’s sold, Goldowner Inc. will transfer the ownership to Vault Inc. who will hold the gold in behalf of the token owners. Vault Inc. will guarantee the redemption of the gold to anyone who can prove his or her ownership using a digital signature.
Goldowner can benefit from the fact that Vault Inc. is a trusted company and they have third-party auditors. The owners of the token will merely rely on the representation of Vault Inc. and not with Goldowner Inc., although it’s Goldowner that issues the token.
It’s clear to see that there are lots of risks involved in the example above and none of the risks would exist if the gold were a digital item that could be transferred electronically. Furthermore, gold requires physical storage, which will also cost you more money.
So why is there a need to tokenize gold?
One advantage to this is that the buyers of the tokens will know that they are the only ones who have received the token unlike with a paper certificate where they have no way of knowing that another certificate has been issued to other people.
There are already gold tokenization startups like Orebits and Vaultoro. Several related projects are underway, which are looking to use the digital tokens to track physical items through supply chains, while the token will be used for provenance instead of value.
