Security tokens: tokenization of real-world assets
Blockchain looks set to change the financial world — and security tokens may lead the field in making this happen. These tokens solve problems for owners, investors, buyers and the overall crypto market.
Tokenization of real-world assets? What in the world does this mean — and does it matter?
Much of our traditional understanding of financial terms like “assets” and “securities” has been somewhat up-ended by the introduction of “crypto assets” and the debate about what is or isn’t a security.
Perhaps it would be useful to unpack some of the terms, to help you decide whether or not you should be supporting a start-up promoting tokenization, investing in a security token or, indeed, converting your house or your art collection into a crypto asset!
1. Understanding the terms
Assets
A dictionary defines an asset as “an item of property owned by a person or company, regarded as having value and available to meet debts, commitments, or legacies.” Synonyms include property, resources, real estate, possessions, capital, funds, reserves, savings and securities.
A business definition gives more attention to the ability of an asset to generate income, and to the way it is classified depending on the ease with which it can be converted into cash. Types of assets include
· Tangible assets: They add to an entity’s current market value, can be used as collateral to raise loans and can be sold to raise cash in emergencies
o Physical assets: cash, inventory, land, a building, machinery
o Enforceable claims: accounts receivable
· Intangible assets: They add to an entity’s future worth
o Rights: patents, trademarks
o Assumptions: reputation, goodwill, intellectual property, knowledge
Securities
A security may be defined as a tradable financial asset — that is, it can be traded in financial markets such as stock exchanges. There are all sorts of technical terms used here, including bonds, debentures, notes, options, shares, warrants, equities, debt and derivatives.
The traditional reason for individuals or institutional investors to acquire securities is as an investment, to receive income or capital gain. However, the definition is different in different jurisdictions.
It is this difference in interpretation that has led to the debate around the legality of ICOs, especially in the United States. In essence, the Securities Exchange Commission (SEC) considers an investment a security if it was made on the expectation that the investor will make a profit, not through his/her own actions, but through the efforts of others.
Crypto assets
Crypto assets are assets in digital form. They are registered on a blockchain, using cryptography, peer to peer networking and a public ledger to generate and control units, and to execute and secure transactions.
There are many forms of crypto assets and they have been classified into different groupings, depending on who is doing the analysis. Some of the types include
· Cryptocurrencies (eg, Bitcoin, Bitcoin Cash, Monero and Dash)
· Platform tokens (eg, ETH)
· Utility tokens (eg, GNT of Golem)
· Transactional tokens (eg, Ripple, IOTA and Stellar)
· Stablecoins (eg, Tether, Goldmint)
· Security tokens (representing ownership of real-world or traditional assets)
Look out for our descriptions of these classifications in a later article.
In the meantime, we are going to focus just on security tokens.
Security tokens
Security tokens are a digital representation of ownership of parts or fractions of a real-world asset.
In many ways, security tokens are similar to stocks, which are paper or electronic representations of ownership of a tangible or intangible asset.
Tokens might represent ownership or part ownership of a house, a car, a painting, equity in a company or intellectual property. Investors know that their ownership stake is secured on the blockchain, that governance and regulatory requirements can be built directly into a smart contract, and that they can sell their stake, if they choose, in a way that is transparent to all.
Security tokens bridge the gap between the traditional finance sector and blockchain. They are likely to be regarded as a “security” as defined by the SEC in the USA and will have strict regulatory control.
The security token is a relatively new form of token but promises to be one of the most utilized and valuable in the future.
2. Tokenization of real-world assets
Problems in traditional investments
According to Bloomberg, the global stock market is worth $80 trillion. However, it faces the following major problems:
· Participation is limited to accredited — generally very wealthy — investors
· Investments are illiquid
· Costs are high
What does this mean?
In the first place, there are significant financial barriers to entry for buyers. A typical hedge fund, which may have investments in land, real estate, stocks, derivatives or currencies, requires that an investor has an annual income of >$200,000 for the past two years or a net worth exceeding $1 million (excluding primary residence). There are also limitations placed on some trades. For example, options contracts are presently traded in sets of 100 shares, and so the price for one options contract for a stock like Amazon (AMZN) @ $100 per share, can cost over $10,000. This excludes many participants from the options market and reduces liquidity and fairness.
Secondly, owners and investors often have to wait for significant lengths of time before they are able to either sell or get a return on the investment. In hedge funds, for example, funds often are subjected to a “lock-up” period of at least a year.
Thirdly, the costs of the management and administration of funds tend to be quite high and often also are not transparent. For example, the “two and twenty” fees structure for hedge funds (2% on assets and 20% on profits) eats into investor returns. In addition, regulations imposed by bodies such as the SEC may be intended to protect investors but can be quite onerous and expensive.
Security tokens as the answer
Security tokens are increasingly being seen as the answer to these problems.
There are no limitations as to the size of investment needed, geographical location or lock-up times. They can be bought and sold at any time in an open and transparent manner.
Assets can be divided or “fractionalized”. For example, tokens could be issued to represent Amazon stock. If you had only $3,000 to invest and would like to hold a 10% position in Amazon shares, you can currently not do that. However, with a tokenized version of stock, you could hold 0.15 AMZN tokens representing 15% of one share. It means that you will be able to hold call or put options for whatever amount of shares you want, be it 0.1 shares or 100 shares.
Similarly, other assets that are illiquid or physically difficult to subdivide or transfer, can be tokenized and turned into tradable units. Some ideas include real estate and sports teams, but Julia Krauwer from Dutch bank ABN AMRO, is suggesting that banks ought to consider helping clients tokenize and monetize such assets as an underutilized vehicle, a house already paid off, or data generated through a website. If this were to be considered, then all of the assets in the world, valued at about $256 trillion, could be added to the trading market.
What makes security tokens different from stocks is that they have utility. They are not just locked up in a safe or database. They are driven by smart contracts, that automate several functions:
· Regulatory requirements, dividend payments and schedules, corporate governance and proxy voting can be embedded directly into the token.
· There is 24/7 access to the global market. This provides liquidity.
· Transaction fees are transparent and low, due to the automation of many back office functions.
3. Benefits of security tokens
Tokenization and fractionalization of assets solves problems for owners and investors
· Opens the market to a wider range of buyers
· Has the potential for peer-to-peer trading, eliminating middlemen altogether
· Makes assets more liquid
· Mitigates the risk of ownership of high-value tangible assets
· Assets not considered by Wall Street can be added to the market
Tokenization and fractionalization of assets solves problems for potential buyers
· Barriers to investment are removed
· High-value assets are accessible
· Funds can be invested across a range of diverse assets
Tokenization and fractionalization of assets solves problems for the crypto market
· Brings institutional money into the crypto market
· Provides options for current crypto owners
· Opens a new market for investment; even the unbanked can now participate
The market cap for cryptocurrencies peaked at about $800 billion at the end of 2017. It has subsequently halved and halved again during 2018. However, it will take a move of only a small percentage of the current assets market into security tokens to push this market cap into trillions of dollars.
4. In summary …
Security tokens, tokenizing real-world assets and opening the world of trading, are probably the best embodiment at the moment of the prediction by JP Morgan:
“Blockchain will bring a radical shift in the way we think about financial assets and the way the financial industry will operate in the future.”
Hopefully, this article will start you thinking about this new way of investing and trading.
