Asset tokenization is not necessarily an entirely new concept in finance. However, what’s relatively new is the concept of digital tokenization, which aims to replace personal and potentially sensitive information with a non-sensitive and digital equivalent. In blockchain contexts, this means replacing digital or physical assets with digital tokens recorded and verified on the blockchain.
How Was Asset Tokenization Born?
Asset tokenization was first introduced in 2001 by TrustCommerce, a US-based payment processing company. Before this, merchants stored cardholder data within their own servers. Anyone with access to the servers could easily look up the potentially sensitive account information. To protect such information, TrustCommerce began using digital tokenization, in which a particular user’s primary account number (PAN) was replaced with a token consisting of a randomly generated identifier. When merchants received an incoming transaction, they could reference the token, and TrustCommerce would process it. Through this method, merchants no longer needed to store credit card information in their own servers, improving data security.
What Are the Types of Tokens in Asset Tokenization?
Similar to cryptocurrency, an issuer can use different types of tokens to replace or represent their asset of interest. The three main token categories are currency tokens, utility tokens, and security tokens:
- A currency token represents a currency on a platform through which users can pay for services and products. An example of a currency token is Bitcoin.
- A utility token allows users to influence platform governance, pay for a platform’s services, and access other functionalities. An example of a utility token is Ethereum (ETH).
- A security token functions as a traditional security asset and represents the financial value of a stock, bond, or option.
These three types of tokens can also be fungible or non-fungible tokens (NFTs) depending on the asset type and the issuer’s objectives.
- Fungible tokens refer to divisible tokens. For example, Bitcoin is a fungible token divisible to eight decimal places, with the smallest unit referred to as a “satoshi.” Such tokens are interchangeable, meaning that each unit will have the same value, validity, and functionality.
- Non-fungible tokens (NFTs) refer to tokens that are not interchangeable and usually not divisible. Unlike fungible tokens, each NFT is unique and cannot be replaced with another NFT.
What Types of Assets Can Be Tokenized?
The assets that can be tokenized are split into two categories — intangible assets and tangible assets.
Intangible tokens exist only due to the operation of law and do not represent a physical object. Such assets are representations of ideas, concepts, and designs. Examples of intangible assets include copyrights, trademarks, and patents. As these assets do not physically exist, issuers do not need to worry about storage or shipping.
Conventionally, intangible goods are detailed on paper and digital documents stored on servers. With blockchain technology, these intangible goods can be represented by a token or tokens on the blockchain. Like NFTs, the issuer can also assign a unique identifier to a particular intangible asset to act as a certificate of authenticity or proof of ownership. When such tokens are traded, the buyer receives the token representing the asset, and the seller receives money in return.
However, compared to tangible goods, intangible assets are hard to price. As with real-world assets, the issuer requires the advice of third parties such as patent lawyers. Another challenge is to ensure that the asset transfer model on the blockchain matches that of the real world. In the real world, the exchange of intangible goods, such as copyrights and patents, works differently across different jurisdictions. Blockchain technology features fast transactions and instant verifications, but jurisdictional differences still need to be considered.
Tangible assets usually have a physical form. These assets include paintings, cash, buildings, and so on. Compared to intangible assets, tangible assets are easier to price. Tangible assets can be further separated into two categories:
- Fungible assets are divisible and interchangeable. Fungible goods are typically commodities such as oil, wood, and gold. They also include stocks and any assets backed by a physical resource. The tokenization of such assets will typically utilize fungible tokens, wherein a set of tokens represent a set amount of the asset components. For example, suppose one token represents a set amount of grain. With blockchain and smart contracts, a buyer can immediately purchase a particular amount of grain without intermediaries. The whole process is automated, and the buyer will receive verification and the relevant shipping and storage information.
- Non-fungible assets are unique, non-divisible, and non-interchangeable in the real world. Examples include paintings, property, and diamonds. Each of these assets has unique characteristics that affect its value, and cannot be simply exchanged with another asset. Nonetheless, with the power of tokenization, there is a concept called “fractional ownership,” wherein these assets can be split into smaller units and be represented by tokens on the blockchain. For example, suppose a piece of property worth $500,000 is divided into 100 tokens worth $1,000 each. Users can buy or sell the property by units. Each unit can be an NFT, which represents a unique part of the property.
What Benefits Does Asset Tokenization Provide?
Asset tokenization may benefit both asset holders and the enterprises that tokenize their assets. The primary benefits are as follows:
- Secure and transparent asset management: When the assets undergo tokenization and are issued on the blockchain, information about the ownership records, relevant details, and important documentation is stored securely on the public ledger. The data stored on the blockchain is transparent and immutable, meaning that anyone can easily verify the asset transfer and no one can remove or change the ownership.
- Faster and cheaper transactions: The asset transfer process is simplified through the incorporation of smart contracts, which automate record-keeping, accounting, and other tasks. With no need for manual verification and paperwork, the transfer of a tokenized asset on the blockchain is completed almost instantly upon payment. Moreover, smart contracts reduce the involvement of intermediaries such as brokers, thereby reducing costs.
- Better liquidity and increased accessibility: Liquidity limitations are a common issue among real-world assets, such as artwork, cars, and real estate. It takes time for owners to sell such assets and exchange them for fiat. Asset tokenization and fractional ownership remove such barriers. Blockchain technology opens up the market to investors worldwide, expanding the pool of potential investors. Moreover, the concept of splitting an asset into smaller parts allows more investors to purchase a particular asset, thereby increasing liquidity.
What Challenges Does Asset Tokenization Involve?
Plenty of challenges and issues must be addressed before asset tokenization enters the mainstream:
- Regulatory uncertainty: The concept of tokens representing some form of investment is still not clearly regulated at the global level. Different countries have different regulations on handling cryptocurrencies. Blockchain technology has reduced the need for intermediaries, but a regulatory authority is still required to ensure legitimacy. A lack of a uniform regulatory structure poses a challenge, as many companies and institutions are wary about tokenizing their assets and investing in other tokenized assets without protection. Unfortunately, forming such a regulatory structure is also difficult, as local and global governmental authorities and the financial sector must work together to define a complete legal framework.
- Insufficient protection against attacks: Unlike traditional finance, digital assets lack institutional-grade infrastructure for safe and secure trading. Even though blockchain is regarded as secure, attacks are unavoidable. For example, the Poly Network hack and SushiSwap auction bug discovered by a white hat exposed the possible weak points of digital asset trading platforms. It is vital to have a comprehensive and reliable platform with strong protection against cyberattacks. However, fully preventing cyberattacks is tough, even for tech giants like Microsoft and Facebook.
- Key management issues: Key management is a critical aspect of the blockchain world. In many situations, users have lost the private keys to their wallets, resulting in losses worth millions of dollars. If a token representing an asset is stored in a wallet, and the key to that wallet is lost, the asset can no longer be accessed.
Asset tokenization enables tangible and intangible assets to be traded securely, quickly, and cost-effectively across the world. The utilization of blockchain reduces the need for intermediaries, thereby saving cost and time. Additionally, increased liquidity and better accessibility are enabled through fractional ownership and splitting up assets, such as commodities, real estate, and property.
However, asset tokenization faces many challenges, such as regulatory uncertainty, insufficient protection against attacks, and key management issues. Fortunately, there is progress on the regulatory front. Since last year, the European Union (EU) has been pondering over proposals about a comprehensive crypto-asset framework, which will lay down the foundation for tokenized asset markets. If the proposals are approved and its implementation is successful, it could inspire others to follow the EU’s footsteps and promote cooperation between countries for a global tokenization.