How to Prove the Value of Underlying Assets with Blockchain
Over the past five years we’ve seen a wide variety of digital assets grow, mature, and flourish on blockchain, the majority of them on Ethereum. Living on a blockchain is the key distinguishing factor between these kinds of digital assets, usually referred to as Tokens, and other (financial) assets. While some tokens are created purely for fun or for the sole purpose of raising capital for a startup project, a sizeable number of tokens come with some sort of promise of value backing. Because blockchain is still a new technology, and because blockchain startups aren’t always a great poster child for stable, safe investments, there is naturally a lot of confusion and mistrust around tokens, and what makes them valuable. So, in this article we are going to ask what this digital promise of real value is actually worth (pun intended).
One thing to note: the various types and classifications of tokens are always a matter for legal experts, and can even vary from jurisdiction to jurisdiction. This article is not about providing an overview of all these token types and their classifications; rather we want to discuss if it’s possible to trust that a token can in fact represent a physical asset and, if so, how to be sure of its value.
What can tokens represent?
By definition, a token is just a representation of some value, sort of a Platonic shadow that exists in another dimension. The term “Token” is often also used as unit of measure (one, two, three tokens), which is a bit confusing. Digital assets are another (more appropriate) name for the same thing. Digital assets/tokens can actually represent a wide variety of things. Some are simply about providing services on blockchain, and their value is very subjective. These are referred to as “utility tokens”, and in the ICO days, they were the main instrument for raising investment capital. Instead of granting a stake in a company or project, they represent a way to make a platform function by providing an intrinsic means of payment. The closest they come to having an actual stake in something is when they grant you some voting or consensus rights.
But tokens really become interesting when what they represent, or the promise anyway, is not just some arbitrary service but rather something the average person can actually grasp. Commodities such as gold, water, oil, minerals are perfect big picture examples. Resources and raw materials are ideal tokenization subjects, though as of now they still need an enterprising person to convince their owners to digitalize them.
Here is where tokenization starts to become truly interesting, and a bit complicated. You see, when you tokenize a commodity like gold, you’re also tokenizing its value. The resulting digital asset is worth the value of the thing it represents. Whenever we’re talking about cases where value (by itself or in something) is being tokenized, we are talking about “Asset Backed Tokens.” And all tokens that have a real asset backing them are simply digital claims to the real asset itself.
Accessing underlying assets
But holding the token is not the same as holding the real asset, of course. The only link from the token to the real asset is the promise that you can claim it in exchange for the token. Whether you know the asset issuer or not, you have no choice but to trust them. In their simplest form, these kinds of tokens are comparable to a warehouse receipt, although from a regulatory perspective they are anything but. For the holder, however, it is the closest possible analogy. Similar to a warehouse receipt, the holder should have the right to claim the real asset in exchange for the token, and in order to make good on such a guarantee, the issuer must actually have the real asset in store somewhere.
It is more than fair to be skeptical of the physical asset on the other end of your digital asset, and whether or not you can really claim it. Distrust in the value and even the existence of any backing is totally understandable given the many scams that have happened in the past with tokens. However, in today’s world this issue is everywhere, and you don’t even need to involve digital technology to have doubt in a backing. Think about national gold reserves. Germany, for example, famously has much of its gold stored in the USA. But there hasn’t been an audit in half a century, so the germans just have to trust that their gold is still there, safe and sound in Fort Knox. This sounds very much like a token, just not on blockchain. Whether the issuer (in this case the US government) can be trusted remains to be seen. When you really think about it, this sort of blind-trust has become normal in much of the global financial system. The vast majority financial titles have never even had any backing in the first place.
Real world, real problems
If this sort of behavior is normal in other settings, why is it suddenly such a big turn-off when blockchain is involved? People tend to believe that the token world somehow works differently from the real world, and that it needs different solutions. In fact, the closer the digital solution is to an already existing one in the real world the better. Blockchain technology is a very young, almost nascent technology. Using it for applications that have proven to work in the real world can only help it mature.
So, let us see what the real world has to offer when it comes to proving whether backing exists for a certain financial title or not. The traditional way is to ask a credible third party to do an audit, and auditing is just as important when we’re talking about tokens as it is in any other real world scenario. This is the next best thing to having the token holders visit the asset and do an audit of it themselves. The most important thing is that the auditor is trusted by everyone, because the whole audit is only as credible as the auditor. This is true in both the real and digital worlds.
Who guards the guards?
However there is now a fundamental difference. Audits are normally documented in the form of a piece of paper or report, physically signed by the auditor and involved parties. This is then distributed simply by download or physical mail (remember that?). When everything is checks out, the issuer is trustworthy, and there is nothing fishy, this method is absolutely fine. But in case there is no backing, its value is less than claimed, or if there is some other problem, then the audit might be tainted too. It could be forged, or have legal issues and not be enforceable, etc.
What you need as a token holder is the guarantee that it was really the (trusted) auditor who actually wrote and sent the report. The aforementioned difference between real world audits and audits for items on blockchain is that the token as well as the audit-report are both digital items, and on blockchain everything has a unique identifier, just like a fingerprint. Blockchain technology is ideal for creating forge-proof records, because these records, by very nature of how the tech works, come with forge-proof timestamps and the author’s unique address.
Cryptography: Signatures, Private Keys, & Addresses
It’s important to remember that Blockchain technology is essentially about a very specific application of cryptography. Not the kind of cryptography you might have seen in spy movies where information is encrypted in order to be secure from someone who tries to read it, but one which allows you to verify a cryptographic signature without having to know or trust the other party.
A cryptographic signature is similar to a real life signature in that when a person puts pen to paper it will always be unique to them. The one who signs has his so-called private key, but he also has something called an address. The private key and address are a cryptographic key-pair; they belong together. It is advisable to keep the private key secret (as the name suggests), but the address can be shared freely with the world. If someone signs a document (e.g. an audit report) with their private key and publishes it together with their cryptographic signature and address (both public), then any third party (e.g. the token holder) can easily verify the authenticity of the signature, that it has indeed come from the trusted auditor. They can also verify the authenticity of the audit report, because if it has been changed (e.g. by a malicious token issuer) the signature would be different. And only the auditor, the author of the report, has the means to sign a new text.
An elegant digital solution to a very real problem
Let’s recap. In order to prove the existence of an asset backing a digital asset, and thus prove its value, we need an auditor, just as we would with any other kind of asset in the real world. This auditor must be a credible, trustworthy third party who can simply make an audit report and confirm that what the token claims to represent does in fact exist. Once this audit report is complete, the auditor digitally signs it. He then publishes his cryptographic address publicly so that everyone who reads the report can verify the authenticity of the report itself and its author.
It’s the final step that turns this whole process into a masterpiece. We mentioned above that items on blockchain have a unique identifier, which is public. This is critically important because it allows everyone to see and verify the identity of something; it cannot be surreptitiously changed. All the auditor has to do is to create another record on blockchain linking the digital item that represents his audit report to the token which represents the asset he audited. This linkage is again signed with his private key, and the linkage can then be checked and verified by anyone. In this way, the trusted audit of the real asset is inextricably linked to its token. And that’s it, an elegant, simple, and incredibly secure melding of traditional and cutting edge methods!
Hopefully you can see that digital titles with asset backing are in fact superior to traditional financial titles with asset backing because their validation can be beefed up by cryptography to eliminate virtually all possibility of manipulation by malicious actors.
While this all might sound complicated, we’ve actually made it a very simple click & go process for our customers. At CoreLedger, we believe that blockchain is a practical technical solution to improve and solve a wide variety of issues across industries and sectors, which is why we try to cut through the hype and focus on real world applications, not just what’s technically possible.
CoreLedger’s mission is to help businesses of all sizes quickly and affordably access the benefits of blockchain technology. From issuing a simple token, to enterprise- grade token economy solutions, we have all the tools you need to integrate blockchain into your business.
Interested in our results-focused, real-world approach? Then visit our website for more information, or get in touch with us directly to discuss your project.
