Tokenising Everything

TLDR: Tokenisation refers to the process of securitising real world assets using digital tokens, instead of custodied contracts (like shares, bonds, REITs, etc.). Tokens provide functionality additional to that offered by traditional securities, apart from facilitating the same functions they do.

If you don’t want an introduction to securities and want to get on with tokenisation, skip to the title “Tokens”.

Introduction

If you made an investment before the advent of the internet, you were given a paper certificate or note of some sort that acted as proof of said investment, with its underlying terms. Such paper certificates were referred to as securities, and they proved your rights as an owner. Paper securities could be bought and sold, just as we buy and sell mutual funds, stocks, bonds or shares today.

Today, the term security refers to just about any negotiable financial instrument, such as a stock, bond, options contract, or shares of a mutual fund and are mostly digitised.

Categorising Securities

Securities fall into three broad categories: debt, equity, or derivatives.

Debt Securities

When an entity (like a company) borrows money to grow, it will borrow first using traditional means: banks. But when banks aren’t willing to take on certain risks, these entities have no other choice but to borrow from the public. When buying a debt security, the buyer is indirectly lending money, which comes with the obligation of paying interest from the borrowers side (the debt security issuer). Such interest payments are usually given in fixed time periods or at the maturity of the debt security, if any.

Equity Securities

When an entity takes on additional owners to raise capital, it can either find private investors or go to the capital markets to issue publicly traded securities. These publicly traded securities are called equity because they entail ownership in the entity issuing it. As an investor, if you buy equity, what you’re doing essentially is buying ownership in an entity (like shares in a company, for example). As an owner in this company, you are also obligated to receive the benefits of being an owner such as getting a cut of the dividends (profits distributed to shareholder) and governance rights, to name 2.

Derivative Securities

With derivatives, instead of buying any asset outright, you trade on the value of said asset or agreement using contracts within terms that have been agreed upon in advance. Derivatives are just contracts between two or more entities that “derive” value through some real world asset, like shares in a company or the commodity of gold.

Options, for example, are a form of derivatives. These give you the right to purchase or sell the asset the options contract is derived on at a specific, agreed upon price on a pre-decided future date.

Markets

Being transferable and tradable, securities brought about the creation of markets around them. And the creation of markets is one of the reasons that assets are securitised in the first place — Liquidity. Most assets are siloed as they remain private and don’t reach a wider audience of prospective buyers and sellers, limiting value discovery and access. But with the help of securities, asset owners have been able to sell off pieces of their asset to the public, and even to private pools of capital.

Just like any market, securities markets are run on the basic economic concept of demand and supply, where said relationship decides what the security should be priced at.

Issuance of securities

When the owner/s of an asset decide to securitise it, they go through the following entities:

1. Government agencies — They first head to government agencies to cover the necessary compliance and legal activity to get a sign off on issuing the asset, either publicly or privately.
2. Investment Banks — If they decide to issue the asset to the public, they employ an investment bank or a corporation of similar nature who undertake all the financial + issuance related activity in order to officially prove contractual ownership of the asset via securities.
3. Brokers — Then the Investment bank, through multiple brokerages, issues the asset to the public via the asset’s dedicated securities market.

Securitisation might have made it easier for asset creation, issuance, ownership, transfer and representation, but also came with its own set of hurdles:

1. Relative illiquidity — As securities are limited to the borders of their jurisdiction, they can only access capital within said borders.
2. No common standard — As securities are regulated based on their jurisdiction, they do not share common practices. They are built, issued and used in different ways, with different limitations and cannot be interoperable. For example, A resident of India cannot use his brokerage account to buy shares of Apple inc. in the US.
3. Expensive process — Issuing securities isn’t democratised. To be able to issue securities, an individual or entity has to go through an intensive process that costs a lot of money that can only be accessed by corporations of a certain size.
4. Requirement of Middlemen — Intermediaries like investment banks are required to be able to issue or even access securities. No security can be issued without an investment bank or an entity of similar nature.

As the world has gotten more interconnected via globalisation, trading between borders seamlessly has turned out to be a problem with how the current system works. With more capital flowing into certificatw ownership (for example, equity shares) there is a greater requirement of not just liquidity, but access, ease and standardisation.

This is where tokens come in.

Tokens

Tokens aren’t new. If anything they’ve existed since the beginning of human coordination. Tokens can be defined as representations of economic value. Stones, shells, beads and metals were the earliest types of tokens in use. Newer, more current types of tokens are, for example, stock certificates, bonds, REITs, casinos chips, vouchers, gift cards, flyer miles, loyalty program points, tickets, , memberships, etc. Even securities are tokens.

Digital tokens are a specific classification of tokens that represent some form of value, digitally. The concept of digital tokens were in the theoretic realm until a pseudonymous entity going by the name ‘Satoshi Nakamoto’ introduced the first functioning digital token, ‘Bitcoin’. The introduction of Bitcoin gave way to a technology titled ‘blockchain’ which made the immutability and decentralisation of records possible. And this possibility is what enables us to issue assets in the form of digital tokens, instead of traditional securities.

Tokenisable Assets

Almost anything you can possibly own can be tokenised, such as: property, utility, contracts, agreements, etc. These tokens would just act as representations of ownership or access.

Intangible Assets

As a result of organisational law this category of commodity does not exist in physical form. They include-patents, copyrights, shares in companies, etc.

Fungible Assets

These assets include those that can be exchanged by another identical item. Examples include- metals, grains, etc.

Non-Fungible Assets

These are physical properties, which cannot be divided in the real world but can be digitally split through tokenisation. Examples include real estate property, art, etc.

Examples

Effectively, digital tokens can represent everything from real estate and exotic cars to equities and debt instruments. Let us look at some of these examples:

• Currencies: A cryptographic coin built to act as a medium of exchange is the most straightforward method of tokenisation. For example, Bitcoin is similar to a fiat currency, in the sense that it is not backed by anything but itself. There are also digital tokens under this classification called ‘Stablecoins’, which are digital tokens that represent real world currencies. For example, USDC is a digital token issued by the company Circle, where each USDC token represents 1 US Dollar. These US Dollar reserves are maintained by the company themselves, who act as the underlying asset’s custodian.
• Equity: Companies can issue tokens instead of shares by pre-coding terms into the token contract/s to function as equity, such as dividend claims, voting rights, preference, etc. Token-holders here would be similar to shareholders.
• Commodities: The tokenisation of precious metals such as gold or diamonds in a defined scheme allows for greater clarity. Furthermore, it enables newer fractional ownership structures. Example: DGX is a token that represents gold where each token represents 1 gram of gold.
• Real Estate: The real estate sector has just recently opened up to the public in the form of REITs and is yet extremely limited due to poor governance and fractional ownership structures. Example: Elevated Returns LLC, A real estate management and consulting firm, issued a token reflecting the ownership of Aspen Digital Inc., a Maryland entity founded solely for the purpose of owning St. Regis Aspen Resort. The project raised $18 million, using ‘Securitize’ (digital security issuance tool) as their issuance platform.
• Physical goods: Illiquid assets, including artwork, wine, ownership interests in private companies, partnership instruments and more, can be tokenised to offer access, ownership, debt and price discovery via digital tokens.
• Carbon Credits: Tokenisation enables the securitisation of a commodity as intangible as carbon credits. Carbon credits are an important way of mitigating the greenhouse gas emissions produced by entities. Although a novel concept, maintaining a list of carbon credits is challenging, due to a lack of international standardisation. Today, tokenisation acts as an effective way to create digital tokens that reflect the carbon credits of a person or company. Such tokens can be further used to mitigate pollution, allowing for practices such as reforestation, which reduces greenhouse gas emissions. Tokenisation promotes an innovative way of monitoring carbon credits on a clear database to ensure comparable environmental protection actions are taken.

The Case for Tokens

The arguments for issuing tokens are various. In this line of thinking, the purpose of issuing tokens tends to be justified by its role in the following dimensions:

1. As a Currency: For the purposes of Medium of Exchange (MoE), Unit of Account (UoA) and Store of Value (SoV).
2. Network effects acceleration: By compensating for early adoption.
3. Governance instrument: By allocating votes/power to participate in formal coordination.
4. Funding instrument: By using the proceeds of a token sale to fund the development team or the community.
5. Utility instrument: For the purpose of utility in a specific application, protocol, platform or service.
6. Representation of ownership: By encapsulating asset-backed or asset-based ownership rights.
7. Profit-sharing: By allocating its owner the claim to dividends or similar rights.
8. Validation incentive: By ensuring distribution consensus and data consistency.
9. Usage incentive: By allowing access or incentivising platform usage.

Use-Cases

Let’s look at some of the processes, applications and functions that can take advantage of tokenisation:

1. Lending — Blockchain-based lending operates in a fully automated way, with the smart contract enabling every step of the loan process, from borrower intimate involvement in investing to the collateral evaluation procedure. Security tokens would be solving a core component of the entire credit cycle and transforming blockchain-based lending into a common borrowing method.

2. Derivatives — Derivatives are tools by which their interest differs from underlying assets. As they are financed they need some kind of collateral backing derivatives. This collateral necessity makes tokenisation, on the blockchain, a necessary process in the capacity to promote the production and tradability of fully digital derivatives. With the aid of tokenisation, users will be able to deposit not only money as collateral but even real world properties.

3. Investment — Investment in assets and entities has become far more accessible with the introduction of securitisation in the past century. Equity shares, Debentures, Bonds, REITs, have made investment in their underlying assets possible for those that did not have access to it before. These assets were initially limited to High Net-worth Individuals or Corporations. Now, with the introduction of tokenization, friction points in traditional securities are dealt with, making investment in illiquid assets, and even liquid assets, more accessible.

4. Custodianship — Custodianship with tokens are far more transparent than traditional securities due to the open nature of public blockchain records. In the current system, custodian holdings can only be verified via third parties such as brokers, investment banks or regulators. With tokens, holdings can be verified directly by viewing the ledger underlying said blockchain.

5. Remittance — With the feature of transactability/transferability, tokens and similar crypto-assets become suitable for moving money from one part of the world to another, into one form or another. Without having to turn the asset into a currency in order to transfer it, tokens become transferable themselves.

6. DeFi — or Decentralized Finance. DeFi is a new category of finance that constitutes financial applications, services and protocols that perform traditional financial functions, but independent of intermediaries and middlemen. DeFi is made possible via open protocols that perform specific functions. These protocols come in the form of smart contracts. For example, money market protocols, lending protocols, derivatives protocols, etc.

Comparison

The best way to understand tokenisation is to understand securitisation as they are one and the same thing. What differs is semantics. Just as securitisation pools assets together and issues shares bearing claims on said assets + what they underlie (cash flows, for example), tokenisation does the same. Tokens are nothing but the digital representation of assets, where it could be considered a substitute for asset-backed securitisation, but on blockchain, instead of an exchange/investment bank. Illiquid assets are turned into liquid marketable securities through both systems, financed and tradable on public markets. Some of the main differences lie in the structuring. Establishing a private pool of assets is costly and usually such investments are buy-and-hold transactions with high minimum tickets for entrance (Example: Real estate purchases). In comparison, the option of fractionalisation calls for reasonable minimum tickets, while also encouraging secondary market trading which leads to more mature price discovery. In terms of legality, tokenisation would follow much of the same regulations as that of securitisation, within the purview of jurisdiction, with more flexibility and caveats in relation to the platforming.

For the sake of comparison, we’re going to narrow down to one asset class, equity shares in a company, and follow along its characteristics in both systems, traditional and tokenised.

Securitisation process

If a company has to issue equity shares traditionally it would require them to go through the following steps:

1. Registration: A business must file a disclosure statement with regulators before selling public-market shares in an IPO. In the U.S., this authority is the Securities and Exchange Commission and is known as S-1 registration as the paper synonymous with a primary listing. The S-1 is used by a corporation to update potential investors about the firm and its competitive position. All the specifics, such as the scale of the bid and price per share, do not need to be made public immediately. Nevertheless, as the start date approaches, transaction parties must continue reporting this financial information in a prospectus which is a document included in the S-1 filing.

2. Underwriting: When officials of the organization agree to sell securities in a public offering, they are required to hire underwriters, which are institutions (primarily investment banks) that will wrap the underlying company shares into securities, and make sure they are bought up if the market doesn’t. Investment bankers help companies publicise the bid before the issue and also set terms. As part of the underwriting process, investment bank underwriters purchase the stocks prior to the IPO and then try to sell those securities to the public on the sale date for more.

3. Listing: When a corporation initially decides to sell public-market stock, it must decide where to list said stock. Shares are traded on a major stock market with companies seeking the most amount of access to capital, such as the New York Stock Exchange or NASDAQ. To retain their listings these companies must meet the standards set by the exchange. According to the Financial Industry Regulatory Authority, companies pursuing less strict listing conditions will list securities in the over-the-counter bulletin board markets which are less regulated than direct listings on major exchanges.

Tokenisation process

1. Creation — To be able to create a token, one must deploy a smart contract on a blockchain. The contract would have to be programmed in such a way that it enables the desired characteristics of the token that the issuer desires. Once desired parameters are programmed in, they are traditionally audited by a smart contract auditing firm to ensure there’s no issue with any of the code. This contract will have to adhere to the standards of other similar contracts for it to be able to interact with them, and protocols that integrate them (I.e. making them composable). For example, If the issuer desires their token to be exchangeable with other security tokens, it will have to follow certain standards, which can be found as standardised templates (for example ERCs for Ethereum) that can be directly integrated into the contract’s code.

Once the foundational contract code has been written, the issuers must use custodians or tokenisation services to help deal with off-chain components such as the asset/s itself. Custodians help in authenticating the asset and linking representation/ownership of said asset to the contract address or identifier, thereby making the token “asset-backed”.

2. Issuance — Once the contract has been deployed it can either be directly or indirectly issued. Under the direct mode of issuance, the issuance functions will have to be programmed into the contract in the Creation phase itself where functions such as “If money received, send equivalent value tokens to participant”. This automates the entire process of issuance. Under the indirect mode, the issuer would have to deploy the contract without the issuance functions pre-programmed, collect the tokens themselves and distribute it independent of the contract, externally. This would enable more control and flexibility as the issuer will be able to decide who, when and how to distribute tokens, and at the same time collect funds off-chain as well.

3. Exchange — Once tokens are publicly distributed they can be traded on centralised exchanges that have listed said tokens or on decentralised exchanges permissionlessly. This aspect also depends on the flexibility of the contracts. For example, depending on jurisdiction and regulations, security tokens cannot be traded without meeting certain conditions — KYC, AML, accredited status, etc. This disallows issuers from allowing the trading of their tokens on decentralised exchanges or limit what addresses/accounts can interact with their token by setting parameters.

Market for Tokens

Just like any tradable security, tokens are liquid and tradeable. Due to the abstraction of middlemen through smart contracts, tokens are no exception. They are traded on exchanges directly between parties buying and selling said tokens, without having to go through an intermediary such as a broker or investment bank. While functioning on different semantics, it maintains economics similar to that of traditional securities: pricing is a result of market demand and supply.

Benefits over Traditional Securities

Fractionalisation

Just as one Bitcoin can be broken down into millions of smaller units, security tokens can do the same. Never before have highly valued assets been able to divide ownership in a simple, convenient, and compliant way. Fractionalisation enables issuers to sell high valued assets to the public without worrying about liquidity for the first time ever.. Instead of limiting buyers to HNIs and Institutions, it removes the entry/exit barriers and opens the door to a much larger pool of investors by significantly reducing the minimum investment sum. Fractional ownership is not unique to blockchain, in fact, joint ownership dates back to the Roman Republic, or the more modern-day Dutch East India Company. Nevertheless, high unit costs tend to define other asset classes such as commercial real estate and fine art.

A typical retail buyer cannot accumulate the resources necessary to purchase a high rise in Manhattan. The buyer has two options left: (1) Forego access in their investment portfolio to Manhattan commercial real estate, or (2) gain exposure through an intermediary, such as a publicly traded Real Estate Investment Trust (REIT), where it is frequently combined with a portfolio of other buildings of varying quality and characteristics. Security tokens provide an efficient route for fractionalizing individual high value assets.

Disintermediation

Disintermediation or the removal of middlemen has been the core promise of blockchain technology and it’s underlying offerings since its introduction. While it might sound like the basic idea of automating their functions and making it trustless, this results in a reduction of costs and a greater degree of control.

Liquidity

Illiquid assets wrapped with conventional securities become liquid as a result of fractional ownership. An owner trying to sell an expensive commodity is no longer confined to a small group of buyers. With further fractionalisation via tokens, through divisibility, the liquidity of an asset multiplies. Instead of that highly valued asset, fractional ownership results in additional liquidity.

Composability

Digitally enabled, tokens will communicate on the network not just with each other but with other smart contracts. This interoperability makes for financial solutions which were not possible before.

Composability is one of the most significant technological principles. The Web itself is basically a set of protocols that allow for the sharing and use of information by many different types of applications (i.e., TCP / IP, SMTP, FTP, SSH, HTTP). That’s why we can use Gmail to write an email, send it to a friend with a .xyz address from a .edu account, who reads the email using Safari.

The evolution of securities to tokenising everything is based on the assumption that everything will interoperate. Once composable, we can hang onto the ownership claims for a commercial building, venture investments, equity shares, government bonds, a home, and a protocol all from one account, while being able to use said claims (tokens) within other functions: lending/borrowing via credit smart contracts, trading via exchange smart contracts, risk protection with insurance smart contracts.

Accessibility

As these tokens are completely accessible via the internet, it enables anyone from anywhere to participate in their benefits, subject to regulation. Currently securities are limited based on their jurisdiction, which stunts the ability for said securities to attain true liquidity and price discovery. The internet is one such tool that is not limited to a jurisdiction, making it borderless. Combining assets with tokens and the access of the internet enables the ownership of value to move like how data moves today.

24/7 markets

The largest exchanges in the world are open only between 9:30 AM and 4:00 PM, and are closed on holidays. During those breaks, a lot of information + communication events occur, making it hard for the markets to remain efficient account and discounting for these events.

Cost Reduction

Advisory services around the issuing of traditional securities are expensive as a result of all the intermediaries involved in the process. Nonetheless, most aspects of the issuance process will ultimately be automated via tools like blockchain technology and smart contracts, which will in the long run reduce these expenses.

Automated compliance

The argument for tokenised assets mostly centers around easing trade frictions, and one of the more complicated frictions is complying with regulations.

A key feature of security tokens is their transparent + programmable nature. Many regulatory parameters can be pre-programmes into the contract. Furthermore, apart from being programmed, blockchains being public and open enable for true transparency, meaning governments can easily track and automatically record any suspicious activity, proving to be a better system for them than the current asset architecture of the world.

Existing Solutions

Mattereum

Mattereum provided the regulatory, technological, and commercial layer of infrastructure for the transition and management of on-chain assets. This uses the “Automated Custodians” principle to validate properties and enable tokenisation of such assets. Unlike other protocols and implementations, Mattereum’s Automated Custodians represents a big step in decentralising the tokenisation process itself. Such digital custodians serve as representatives of the real world upholding the validity of the on-chain contracts deployed. The on-chain contracts implemented using Mattereum come in set models which can be changed on the basis of the issuer’s specifications, while retaining the standard format.

Polymath

Polymath is an end-to-end solution offering issuers every layer of service in the tokenisation stack, from issuance and asset verification, to compliance and identity management. Polymath, unlike other solutions comes with its own smart contract blockchain called the “Polymesh” where they issue contracts of their tokenised assets.

Harbor

Harbor is a company offering issuers and investors solutions to turn illiquid assets into liquid ones through tokenisation. With its “R-Token” standard (a framework for security tokens with in-built compliance mechanisms on the Ethereum Blockchain), Harbor tokenises private assets like real estate, private companies, etc.

Digix

Digix Global was one of the first companies to successfully tokenise gold and issue gold tokens (DGX) on the Ethereum blockchain. They have warehouses of authenticated gold based in Singapore which has been verified and audited by a set of auditors. Each gold token (DGX) is backed by 1 gram of gold. With each buy and sell order of gold, the company issues or burns tokens, at the same time rebalancing their gold reserves to add or remove gold. The company used gold as a proof of concept, and has plans to tokenise other commodities as well.

Compliance and Regulation

As it is a new frontier with new offerings, there is no solid regulatory framework around the industry. Having said that, many countries have started adopting and designing frameworks around this new paradigm.

Standardisation of token protocols

In the early days of tokenisation, a new, independent smart contract on the Ethereum blockchain sponsored each token that was produced. Lack of consistency in designing the smart contracts used in each tailor-made token network raised barriers and issues with stakeholders such as custodians or exchanges who had to conduct due diligence + integration. To this end, pioneers in the space have been leading an effort to encourage the creation of a structured system for standards. ERC20 currently s the most popular standard of tokens, while standards such as ERC1400 are implementations of ERC20 with additional parameters + functions to enable security tokens. ERC1400, for example, is designed to automatically apply specific conditions pertaining to the legal and regulatory standards applicable to securities in different jurisdictions and requires the tokenised asset to be automatically compliant with pre-defined characteristics incorporated in the code. Jurisdictions considerations such as investor recognition and whitelisting is mandatory and investors can only invest if they meet the requirements of approval in accordance with those set by the regulator. Furthermore, it becomes beneficial to security claims management such as dividend allocation or lock-up periods being configured and automatically applied without further interference. Importantly, the use of standardisation eliminates the burden of due diligence for all actors participating in the same process (including regulatory authorities). While the ERC1400 standard is the most popular for asset tokenisation, many implementations and proposals for newer standards are popping up. As the space and new asset-class matures, standards will be formalised and even mandated by authorities. For example, The Swiss Capital Markets and Development Association is publishing and implementation to launch its own basic authentication token, which enforces the minimum requirements under Swiss legislation and suit the blueprint released in 2018 for legal tokenisation.

Conclusion

The tokenisation of assets evidently offers certain benefits over traditional securitisation. The most obvious benefits are the reduction of administrative work, the reduction of costs, the elimination of intermediaries, quicker movements of claims and the freedom to exchange them from anywhere in the world 24/7.

A “tokenised economy” allows for a much more transparent, usable and truly global financial system by significantly reducing the frictions involved in security development, issuance, and acquisition.

Today the total global wealth is over USD 317 trillion. Discounting for exchange-traded financial products and thus paying a liquidity premium of only 10 percent, by rendering reserves more fungible, more than USD 30 trillion in valuation could be issued. In the coming years, asset tokenisation will be the method of choice for doing just that. In fact, countries adopting this new concept and democratising capital markets would achieve a strategic advantage over other nations. Those countries that promote asset tokenisation may shape the world’s future as did those that in the past first embraced the notion of the joint stock company and the stock exchange.

As stated in the following tweet governments are in a game theoretic experiment:

With all the benefits presented by tokenisation over its traditional counterpart, it is an obvious choice for any participant in the financial markets to seriously consider tokens over securities. With the adoption and network effects of this new technology rapidly increasing, we will be able to witness the dawn of a new financial system, one where every component interoperates with every other component, similar to the internet. The “Internetisation” of the financial markets will bring about the same amount of fluidity that the internet brought onto communication.