What Is Tokenization In Blockchain?
The Ultimate Guide On Tokenization In Blockchain
Today’s topic is What is tokenization in the blockchain. You may have heard of the term ‘token’ in discussions related to blockchain technology and cryptocurrency. Tokens have the power to transform the way that data is transferred whilst also offering innovative new avenues for investment. Let’s have a look at what tokenization is all about!
Tokenized digital assets are transforming the way we exchange information and value.
What are Tokens?
These are the entities that represent sensitive assets or data points in another form (usually digital). To conceptualise this, we can look at an example of tokens in a physical form, such as casino chips. These chips are used to tokenize the actual money behind them — enabling ease of use when playing casino games.
The casino chip completely replaces the underlying asset and can only be used in a pre-determined situation — in this case, the casino itself. If you held £500 worth of casino chips, you could exchange them for £500 of legal tender — you couldn’t take them to buy groceries.
Over the years, the concept of physical tokens has been implemented into digital systems across various industries. One of the most popular ways to use this process is when making card payments, as an alternative to encryption. This works through users storing their card information as ‘tokens’, which are substitutes for the sensitive card information found on physical credit and debit cards.
These tokens act as a ‘stand in’ for card information and are commonly expressed as a random string of numbers. As this token links to the underlying credit or debit card, merchants don’t need sensitive card information to process payments — all they need is the token.
At the other end of the transaction, banks will receive the request from the merchant for the funds to pay for the goods or services requested by the payor. Banks also incorporate elements of tokenization into their service offering, as customers’ money is stored in a tokenized digital format. This format digitally represents the customer’s money, allowing for quick transfers to be made between parties.
This process eliminates the risk of sensitive card details being stolen or duplicated. However, using tokenization during payments processing is just one example of this process. When combined with blockchain technology, tokenization opens pathways to change how businesses operate in today’s world.
The combination of tokenization and blockchain technology
Much like when casinos issue chips as their own form of tokens, blockchains can also allow tokens to be issued and stored within the network. As the blockchain is a publicly distributed ledger, whenever a token is issued on the network, all blockchain users can see the token and monitor its movements — but they won’t see the exact asset that underlies.
The most popular example of a token being used on the blockchain is Bitcoin — as tokenization of currency. Each Bitcoin is a token that can be tracked throughout the network. So, if Person A sent Person B one Bitcoin, all other users on that network could see the transaction happen in real-time.
Security Tokens, Utility Tokens, and Cryptocurrencies
Generally speaking, a token is a representation of a particular asset or utility. Within the context of blockchain technology, tokenization is the process of converting something of value into a digital token that’s usable on a blockchain application. Assets tokenized on the blockchain come in two forms. They can represent tangible assets like gold, real estate, and art, or intangible assets like voting rights, ownership rights, or content licensing. Practically anything can be tokenized if it is considered an asset that can be owned and has value to someone, and can be incorporated into a larger asset market.
The concept of tokenization precedes blockchain technology. The financial services industry has implemented some form of tokenization to protect clients’ confidential information since the 1970s. This process has typically involved the conversion of sensitive information such as credit card numbers, social security numbers, and other personally identifiable information into a string of alphanumeric characters, which are then processed through a cryptographic function to create a unique token.
To some extent, this method bears some resemblance to the tokenization process enabled by blockchain technology. However, while past tokenization mechanisms were primarily designed to protect sensitive data, blockchain-enabled tokenization allows for more secure yet flexible tokenization of assets that have significantly broadened the potential applications of digital tokens across a wide array of industries.
What is Asset Tokenization?
Asset tokenization is taking a real-world asset and tokenizing it onto a blockchain network.
Imagine you owned a house — the records of your ownership of that house would be in the form of various physical documents, such as title deeds. The process of transferring home ownership if you sold that house is a logistical headache, with all of the documents and paperwork handled by various parties during the sale process, there’s a higher risk of human error.
Instead, you could represent your house as a ‘token’ on a blockchain network — with all existing required data attached to the token itself. The process of transferring ownership would be far easier and more seamless as there would be no need for an intermediary to facilitate the transaction. What’s more, as the transfer of ownership would be publicly available information to all users on that specific blockchain, the whole process would be transparent and easy to refer to in the future.
The Benefits of Tokenization
Crypto tokens provide several user benefits that can be generalized into three main categories:
More Liquidity: Once tokenized, assets can be made available to a much larger audience, which increases market liquidity and removes the “liquidity premium” associated with investments that are traditionally more difficult or time-consuming to sell, like fine art or real estate. Tokenized assets can be designed to be freely exchangeable online and allow investors to acquire fractional ownership of a token’s underlying asset. As a result, crypto tokens can both contribute to the liquidity of existing markets and provide a broader range of investment opportunities to more investors.
Faster, Cheaper Transactions: Crypto tokens allow investors to bypass market intermediaries and other middlemen who are typically involved in the traditional asset management process. This effectively reduces the transaction costs and processing time of each exchange, allowing for a more streamlined, cost-efficient method of transferring value. Additionally, since crypto tokens exist on the blockchain, they can be traded and sold 24/7 around the globe.
Transparency and Provability: Because crypto tokens live on the blockchain, users can easily trace their provenance and transaction history in a way that is cryptographically verifiable. Transactions can be automatically recorded on the blockchain, and the immutability and transparency enabled by blockchain technology help guarantee the authenticity of each token’s stated history. These qualities enable crypto tokens to achieve a level of reliability that most other digital assets cannot match.
Crypto tokens enable both information and value to be transferred, stored, and verified in a way that is both efficient and secure. And while asset tokenization has massive implications within the financial services sector, this technology is equally valuable for smaller investors and other individuals who can benefit from more market access and more effective ways to leverage their existing assets.
Challenges to Tokenization
Blockchain projects that use crypto tokens can encounter regulatory hurdles as governments around the world scramble to react to the unprecedented nature of this new technology. These tokens can often involve characteristics common in financial securities but are often not subject to the same regulations as traditional securities. This presents a challenge to both government authorities and blockchain projects trying to balance innovation and compliance.
While an increasing number of countries have implemented crypto regulations in order to encourage growth, other nations are taking a stricter approach in order to front-run potential issues down the road. For example, in the U.S. the Securities and Exchange Commission is considering officially classifying certain tokens as securities, which would subject those projects to a heightened level of external scrutiny.
Another central concern for regulators is how security tokens will remain tethered to their underlying assets. If thousands of anonymous investors collectively own a tokenized hotel, how will they determine who is responsible for the hotel’s maintenance and operations? Or what happens if the gold reserves underpinning an asset-backed token go missing? In other words, while tokenizing digital assets allows for decentralized, trustless value transfers, physical asset tokenization will likely still require some degree of centralization and third-party involvement.
As a result, a more mature regulatory environment will likely be necessary in order to achieve the mass adoption of crypto tokens across a broader range of industries; courts need defined rules to arbitrate cases in which the blockchain environment and traditional world overlap. Many investors want specified protections and the ability to seek recourse in situations that cannot yet be fully codified in smart contracts.
What Does Crypto Tokenization Look Like?
There are four main categories of crypto tokens, although the delineations can blur depending on the specificities of a particular token or the platform with which it is tokenized.
Security tokens: Security tokens embody a particular investment, such as a share in a company, voting right in a company or other centralized organization, or some tangible or digital thing of value. In addition to serving as a digital representation of an underlying asset or utility, security tokens can be programmed with an inexhaustible array of unique characteristics and ownership rights. As such, these tokens constitute an entirely new type of digital asset.
Tokenized securities: It’s important to note that security tokens are not the same as “tokenized securities.” While the two terms are often conflated, a tokenized security serves as a straightforward digital stand-in for its underlying security and is typically designed to be easily exchanged, aggregated, or used. In other words, tokenized securities mainly exist to broaden the market accessibility or liquidity of the security being tokenized, without the addition of unique programmed or cryptographic characteristics such as those found in security tokens.
Utility tokens: Utility tokens represent access to a given product or service, usually on a specific blockchain network. Utility tokens may be used to power a blockchain network’s consensus mechanism, furnish the operations of a decentralized market, pay transaction fees, or grant holders the right to submit and vote on new developments within a decentralized autonomous organization (DAO) or another decentralized network. While security tokens are primarily used to establish ownership rights, utility tokens are more focused on practical use. Many of the crypto tokens launched via an Initial Coin Offering (ICO) on the Ethereum platform are intended to function as utility tokens.
Currency tokens: Currency tokens are designed to be traded and spent. Some are based on underlying assets — as is the case with asset-backed stablecoins such as MakerDAO’s DAI and Gemini’s GUSD. However, many others are not based on any underlying assets. Instead, their value is directly linked to their distribution mechanism and underlying blockchain network.
It’s important to note that just because a crypto token is designed for a specific purpose doesn’t mean that users will only use the token for that intended purpose. For instance, while utility tokens are not explicitly designed to be speculative investments, many people buy these tokens in hopes that their value will increase as demand for the company’s products or services grows.
In addition to the above classifications, tokens can also be designed to be either fungible or non-fungible, depending on their intended use. Fungible tokens are identical and can seamlessly replace one another. On the other hand, non-fungible tokens (NFTs) are unique and provably scarce, meaning their histories can be traced down to the individual level. Examples of NFTs include Ethereum’s Cryptokitties and the digital art and collectibles available for purchase on NFT marketplaces such as Nifty Gateway, OpenSea, and NBA Top Shot. As such, fungible tokens are typically used in environments where individual traceability is not a concern (such as in providing market liquidity), whereas NFTs are used in instances where uniqueness and provable scarcity is valued (such as in digital art and collectables).
Can I transfer my Tokens?
Tokens can be transferred to different wallets (or other parties) using blockchain technology. When you purchase a token on a blockchain-based platform, such as Ethereum, it will be transferred to your wallet. Specific tokens will be developed on certain platforms, meaning that they cannot be transferred onto another platform.
An example of this would be if you purchased a non-fungible token (NFT) created on the Ethereum network. This NFT could be easily sent to other people on the network, requiring only the receiver’s wallet address. However, transferring an Ethereum-based NFT to another network would not be possible, as it will have been built using entirely different technology.
Can Tokens exist on private blockchains?
Finally, tokens can (and do) exist on private blockchains. They work in the same way as they do on public blockchains, with the critical difference being that private tokens are not recognised within the context of public blockchains and vice versa. Public and private blockchains tend not to be connected, meaning tokens can only be issued and transferred on one blockchain type.
The Future of Crypto Tokenization
Tokenization — from asset tokenization to real estate tokenization — is radically transforming the way we interact with assets of value. Blockchain technology enables any asset or service to be represented and stored on a blockchain, thereby democratizing access to assets while providing an unprecedented level of online transparency and security. However, with the rules governing the sale, distribution, and management of crypto tokens continuing to vary from country to country, it will take a large-scale, multilateral effort to build the global, borderless value transfer systems that crypto tokens may one day enable. As more and more people and governments around the world come to terms with the incredible power and utility of blockchain, the tokenized future is very quickly becoming a reality.
