Why Tokenizing Assets is Changing the Finance Industry
“Would you swallow a random pill that you saw on the counter in the pharmacy? Of course not. You don’t know anything about it! But what if this pill came in a package with details from the manufacturer? And you had a prescription from your doctor? Further, what if you could independently test the pill’s chemical composition and make sure it matches the label and prescription? Would that pill be more valuable to you? Undeniably. Its value increases depending on how much reliable information about it you have, even though the properties of the pill did not change.”
- Dr Pavel Kravchenko, founder of Distributed Lab
Today, financial assets are too much like that loose pill on the counter. We only have to think as far back as 2008, the start of the global financial crisis. One of the major causes of the collapse instigated by the creation of complex financial products, such as Collateralised Debt Obligations (CDOs). These instruments combine and merge assets — mainly mortgages — and split the risks of those packaged assets into tranches. However, over time, the economics of these financial products became ever more elaborate and multifaceted. CDOs became almost impossible for the average person to understand. Extreme risk was hidden under layers of complex mathematical engineering. Investors did not know what they were buying yet CDOs were marketed as investments with a defined risk and reward. It was only the investment banks who knew exactly what the underlying assets of the product construed of. Information asymmetry surrounding CDOs lead to over-confidence in the market which saw huge amounts of capital flood in. The default of sub-prime mortgages hidden deep in these layered products created a domino effect, which saw the start of one of the largest financial crises in history. The global markets are still recovering from the financial meltdown. Still, today there is an estimated $256 trillion worth of assets in existence. Many of these assets, remain illiquid, opaque, difficult to sub-divide and exchange. However, a break through in cryptographic technology and the emergence of blockchain will bring major innovation and disruptive change to an industry which has lacked clarity and efficiency for decades.
But how?
Enter tokenization. When an asset is tokenized, it is representative of the right of ownership of the asset. Essentially, the token can be seen as an intellectual cargo vehicle that holds the history of the underlying stream of data associated with that asset, including transaction event series, performance, ownership, regulatory compliance and document formation, which is all recorded on the blockchain. Therefore, tokenization enables the process of transforming the storage and management of an asset which is referenceable by way of the associated smart contract ownership information stored on an immutable blockchain. For those unfamiliar, a smart contract is essentially a computer protocol that facilitates, verifies or enforces the negotiation or performance of a contract without the need of third parties, of which are traceable and irreversible. This technology will create a verifiable, auditable consensus around any financial asset across ledgers in near real time, ubiquitously and at low cost. Tokenization also brings unexpected results. The ability to prove the history of ownership, the opportunity to divide assets into the smallest fractions, and the ability to integrate principles of management into the asset itself are further reasons as to why tokenization will be the new way assets are managed.
Why is this important?
Returning to the example of the financial crash, a lack of fundamental information surrounding financial products such as CDOs played a major part in the collapse. In the case of CDOs, the process of tokenization will provide an unprecedented level of information on the underlying MBS (Mortgage Backed Security), not only helping to create a more transparent marketplace for the product and subsequently more accurate pricing mechanisms, but also attract a greater variety of market participants, increasing market depth and liquidity.
Tokenization can be entwined into a huge array of assets, not just CDOs. The age of tokenization introduces the important innovation that assets are managed directly by the owner instead of managing assets through issuing orders to a middleman. As a result, this enables an owner to easily buy and sell their asset without the need to pay for expensive fees such as brokerage, which, in the case of the mortgage industry, can typically be between 1% to 2% of the transacted amount. This is due to the fact that trading infrastructure — which includes a depository, an exchange, a clearing house and client software — will be far more integrated. Consequently, the trading of assets will be able to be conducted quicker and cheaper than traditional methods that are currently in play. Decentralization, a core component of blockchain technology, will make the system more resilient, since there will be no single point of failure, reducing the need for trust in a central provider whom are vulnerable to attacks.
Although blockchain and tokenization have potential major advantages to traditional financial methods, significant complexities still need to be ironed out. For example, the transformation of assets, particularly in the financial markets will require the tokenized assets or securities to interact with a series of legal agreements. Although blockchain enthusiasts envisage a utopia of smart contracts operating independently of an external legal framework without human intervention, this vision does not reflect the reality of financial markets. The complexity of common law is neither rational nor reasonable for market adoption in this lifetime and it would be highly unlikely at this moment in time for code to cover every possible outcome. An attempt to reduce all agreements to a Boolean derived code, and to see that code as the source document, would represent a substantial weakness in the case of dispute or instrument failure. What code can do, is make the discovery of events and facts clear, and make actions indisputable. In essence, code can serve to make the law more officious and equitable. But code does not replace law. Nonetheless, regulators will still have access to the event series data created by regulated smart contracts. Compliance events, trade execution, and counterparty activities will all be recorded in a transparent and auditable system, time stamped and verifiable through cryptographic means. In the perfect world, with the use of tokenization embedded in financial markets, regulators such as the SEC will be able to audit and regulate in real time on blockchain-enabled systems.
Conclusion
We at Lendflo believe that tokenization is a game changer in the world of finance. Progress has been welcomed within the financial industry and major players are striving towards embedding blockchain enabled tokenization within their infrastructure. Creating an infrastructure that will enable the support of financial instruments as a legal document, providing clarity and efficacy for the execution of those agreements through the underlying base of code is a huge challenge, but also presents great opportunities within finance in particular. In Lendflo’s case, we recognize that the social implications of this are vast and will likely reconfigure financial markets, empowering the broader subset of market participants. This is why we are working on tokenizing invoices to help provide better liquidity and transparency to our investors, so they know exactly what pill they’re swallowing!
Learn more about Lendflo at http://www.lendflo.com/ , or follow us on Twitter @LendfloUk
