Business Update #2: Overview of Tokenization and its Value
This is the 2nd part of our #BusinessUpdate Series, where we aim to inform and educate the community on the wider implications of blockchain technologies.
For the 1st part on disrupting financial services, you can read here.
1. What is Tokenization?
Tokenization is the conversion of the rights to an asset into a digital token on a blockchain. As data on the blockchain is immutable, it ensures that ownership information is secure and there is a digital representation of the asset on the blockchain.
To explain this concept further, we will use an analogy.
Oftentimes, many people want to invest in property but simply don’t have enough capital to be able to do so. So how does Tokenization solve this problem?
Tokenization allows you to easily invest in a percentage of that property instead. For example, if the house was valued at $100,000, it can be tokenized into 100,000 fractional tokens (where 1 fractional token = $1). What this means is that for you to own 50% of the house, you simply have to purchase 50,000 tokens.
What can be Tokenized?
Almost everything can be tokenized, and they are generally classified in the following categories:
Type 1: Intangible Assets
Eg. Patents, carbon credits, brand names, copyrights etc.
These are the easiest types of assets that can be tokenized on the blockchain due to limited concerns regarding storage and shipment. However, it is important that the transfer system on the blockchain matches that of the real world legal model. Still, there may be some difficulty relating to different jurisdictions and different copyright laws as they differ around the world.
Type 2: Fungible Assets
Fungible assets are those that can be replaced by another identical item.
Fungible assets refer to individual units of goods, commodities or items that can be interchanged. For example, 500 grams of pure gold is equal to any other 500 grams of gold, whether in the form of gold bars, ingots and so on.
There are legal differences between fungible and non-fungible assets. Fungible assets are easier to convert to tokens as they can be broken down into smaller units of measurement (e.g. Bitcoin can be divided down into 8 decimal places), and a token can represent a group of objects (like a pile of gold).
Type 3: Non-fungible Assets
Non-fungible assets can also be tokenized, even though the process is more tedious.
For non-fungible assets, it is more troublesome to tokenize but still possible to do so. There is an additional abstract layer needed to tokenize the non-fungible asset. It is similar to securitizing mortgages, and bundling a group of mortgages together to get a product of approximately similar characteristics.
Transfer of Ownership vs. Transfer of Limited Rights
There is a clear difference between the transfer of rights and the transfer of limited rights. For the transfer of rights, it can be considered a transfer of ownership, such as when you are buying tokens backed by property. For the transfer of limited rights, an example would be purchasing music rights, where you have the right to listen to the song but not to own the song itself.
2. Why Should We Tokenize?
Tokenization brings many benefits, some of which are highlighted below.
Benefit #1: Lower Fees
Many of the fees related to the transfer of ownership, securities and investments get passed to the middleman of these transactions, who are normally bankers. The removal of this middle man reduces fees, and makes deal execution much faster as well.
Benefit #2: Security of transfers
Due to the immutable and unalterable nature of blockchain technology, tokenizing property allows the transfer of ownership and storage of ownership information to be as secure and efficient as possible.
Benefit #3: Reduce paperwork
The ability to store ownership rights on the blockchain is, in comparison to the traditional paper system that we are using, revolutionary. In the traditional paper system, not only is it difficult to transfer ownership of assets through complex paper legal agreements, it is also difficult to keep track of agreements.
Currently, commodity exchanges have already started to replace physical paper with electronic transactions and standardized agreements. However, the overhead costs of these systems are expensive and require trusted parties.
Benefit #4: Ease of transfer
Transferring the information from a real world asset onto the blockchain allows ownership rights to be transmitted and traded on a global and secure digital platform.
Once an illiquid asset (eg. real estate) is tokenized on the blockchain, it instantly becomes tradable on markets. Blockchain will make transferring properties as easy as transferring Bitcoin.
Furthermore, tokens can be divisible up to 18 decimals, making entry costs lower, which in turn lower ownership barriers to entry.
You can easily become a co-owner of a fraction of a valuable asset, and ownership rights are embedded on an immutable digital ledger which tracks and records the history of the asset every time it changes hands.
Benefit #5: Facilitates global trade
Once the tokenization of assets is readily adopted, there will be a global trade of previously illiquid assets on the blockchain. Global trade becomes much easier and creates opportunities for everyone to leverage on their previously underutilized illiquid assets.
Benefit #6: Programmability
After an asset gets tokenized, we are able to add metadata to it, this allows us to track previous owners, locations, various stats and analytics, add images and legal documents, to name a few functions.
Benefit #7: Creation of new assets
Tokenization also gives us the opportunity to create a new asset class of smart assets, with the help of smart contracts. These smart contracts can be embedded with features such as voting, distribution of dividends and fast transfers of ownership.
3. Legal Concerns
Despite the various benefits of tokenization, it remains a very nascent field for the following reasons:
Concern #1: Bypassing securities laws
Under most countries’ securities laws, sellers are unable to sell a fractional interest of an asset to the public as they require permission from the government. Such situations are further complicated if buyers and sellers reside in different regions as they have their own country security laws to abide to.
Concern #2: Transfer of intangible products
When transferring intangible assets such as copyrights, it is important to be clear of the different legal transfer structures that must be abided by. Legal transfer structures for these intangible assets vary across different countries. Hence it is important to take note and follow these structures to ensure that the transfer of ownership of the copyright is legally binding on an international level.
Concern #3: Assurance that real world assets are tied to tokens
In the real world there is the possibility of assets losing their intrinsic value, such as in the case of gold bars getting stolen, houses burning down, and music samples that are not properly licensed. The challenge for any system that involves tokenizing real-world assets is to ensure that the digital token stays linked to the real-world asset.
If the buyer of a token cannot be absolutely sure that the token is properly linked to the real world asset, then the value of the token will fall or become zero.
Furthermore, there is also the chance that the company holding the real world asset may fail, and this will lead to the failure of the entire token system as well. To ensure that the tokenization scheme succeeds, we need to connect the real world owner of the real world asset to the many token holders. This can be done through a mix of digital token schemes, contracts, insurance, auditing and third party-guarantees. Another answer to this problem is to rely on a centralized party that has trust because it is the relevant government authority that decides who owns what.
Concern #4: Inability to hide from regulations
Digital tokens are linked to real world assets, and these real world assets are held by a real world company. Even though the purpose of the blockchain is to be free from centralized parties, tokenization will still be regulated to some extent, as the real world entities can be tracked down by the relevant regulators. In comparison to platforms that are purely software-focused or which involves peer-to-peer activities, tokenization will require some regulation.
5. Governments’ Viewpoint
Who is Responsible?
With tokenization, assets such as real estate can be owned by many more owners than if we were using the traditional system of transfer of rights. Hence, a building may be owned by 5,000 owners instead of 2 or 3. The concern here is who is responsible for any liability and maintenance of the building, as ownership is spread so thinly.
Who are the Real Owners?
Due to the lack of a solid regulation for cryptocurrency in every country, there are many concerns regarding ownership of actual real-world assets. For example, if the company which handles tokenization sells the property, what will happen to the token holders? The token holders only own the tokens and have no legal rights to the linked property. We do not have laws and legal regulations to protect token holders as of yet, and there are many legal changes which need to be made to accommodate to the blockchain business.
Are token holders able to execute the transaction?
In the case of security tokens, the combination of tokens with traditional financial products, banks and other middlemen are the ones normally responsible for deal underwriting, preparing marketing materials, soliciting investor interest, ensuring high levels of security and regulation compliance etc.
With the use of tokenization on blockchain technology, all these responsibilities are transferred to the buyer and seller and there is much concern whether the potential token issuers are able to execute these functions without the help of traditional financial institutions.
Can tokens replace money?
An interesting property of tokenization is that in a world where tokenization is well adapted and utilized, we don’t really need money to transact. Money and money prices are just enabling technology. Tokens — the digital representation of assets on blockchains — can now accomplish all three functions of money with ease. Tokens enable us to swap, or barter exchange across two or more items or sets of items directly.
Current Progress
Many countries are still lacking in legal efforts to make blockchain businesses more accessible to the public. One of the more promising country is United States. The State of Delaware has made legislative efforts to enable companies to use blockchains to track share issuances and transfers on the distributed ledger.
When tokenization is done up properly, they do not infringe on laws and regulations, they only remove the financial institutions and middlemen that make our current system more cumbersome than it should be.
F.A.Q
Why do people buy real estate tokens if you are unable to legally own the property backed by it?
We can visualize tokens like buying shares of a company, likewise if you are buying real estate tokens, it is similar to owning REITS (Real Estate Investment Trusts), and you receive dividends and a portion of rent paid by the tenant. If you were to own 100% of the tokens, you would receive all the dividends from that property.
About Rate3
Rate3 is a decentralised dual protocol for cross-chain asset tokenization and identity management. The Rate3 Tokenization Protocol is an end-to-end protocol for tokenization on both Ethereum and Stellar, while the Rate3 Identity Protocol is a protocol to create and manage a unified cross-chain identity.
To find out more, check out our channels below and watch our video on Youtube — Introduction to Rate3: A New Beginning.
Website: https://rate3.network
Twitter: https://twitter.com/officialrate3
Telegram: https://t.me/officialrate3
