What are the real benefits of Tokenization then?

Numerous research pieces have talked about various benefits of tokenization, but these various benefits can be categorized into three core principles: 1) liquidity, 2) programmability and 3) immutable proof of ownership.

 

Key Principle 1: Liquidity

World Economic Forum predict that over next ten years, 10% of world’s GDP will be stored in crypto assets, amounting to $10 trillion. This is primarily due to increased fractional ownership, and unlocking of liqudity premiums.

Assuming no legal and regulatory barriers, tokenization allows for increased fractional ownership. Most tokens can be broken into 18 decimals, as compared to fiat which only goes to $0.01. Fractional ownership lowers the barriers of entry for new investors. For instance, instead of paying $1 million for a new apartment, I can pay $50,000 for a tokenized fraction of the real estate. For investors, fractional ownership and lower barriers help them to increase portfolio diversification and construct a “truer” market portfolio.

 

The increase in liquidity helps unlock value for markets through liquidity premiums. When illiquid assets become more liquid, a liquidity premium of approximately ~20–30% is unlocked. One example is real estate: Even a fractional improvement in the sales price of such investments could result in trillions of dollars of new value for issuers and resellers.

Key Principle 2: Programmability built into tokens

Programmability refers to the ability to introduce certain business logic into smart contracts, allowing for automated events to occur. Tokenization can also lead to easier management of investors and their rights. Secondary transactions can be easily tracked by collaborating with third-party exchanges. And investors can receive distributions and exercise their other rights (e.g., voting) through the blockchain, simplifying those processes considerably.

Programmability is especially useful in increasing the speed of settlements. In traditional finance, settlements refer to the documentation of transfer of ownership (of an asset), till the ownership actually changing hands. Compliance can be programmed into the tokens, if all participants have a digital identity that has gone through the relevant compliance/KYC/AML checks.

 

Key Principle 3: Immutable proof of ownership

Blockchains are immutable and keep a public trace of every transfer and owner. This digital trace of transactions not only proves history of ownership but also ensures less fraud. This structure makes it impossible for a tokenholder to “double-sell” a token — accepting a transfer for the same token to two different sources. This helps assure investors that no one can falsify transactions after the fact.

Let’s dive deeper into tokenization.

Tokenization is the process of digitally storing the property rights to a thing of value (asset) on a blockchain or distributed ledger, so that ownership can be transferred via the blockchain’s protocol. What are the other challenges?

Issue #1: What are the requirements for tokenization to take place?

There are 3 fundamental requirements:

 

1. The rights to an asset can be stored digitally on a blockchain

Let’s go back to the real estate example. If I want to tokenize my house, I must be able to record my ownership of my house on a token itself. This means that to regulatory authorities, holding a token represents an ownership right on the house itself. (We will go into ownership rights in a bit.)

2. These rights can be legally transferred via blockchains

Not only should I be able to document my rights to my house in a legally-recognized way, I should be able to transfer these rights to anyone I want and that person will have legal ownership of my house, assuming my tokens are imbued with ownership rights.

3. Tokens can be easily exchanged for value, giving the assets “value”

Lastly, like any security, I must be able to exchange my real estate token for value easily — so I can subscribe value to the asset.

Issue #2: What are the other legal issues to consider?

Apart from the 3 requirements, what is more crucial to take note is the exact asset you are tokenizing: Does the token represent a claim on the asset or does the token represent actual ownership of the asset itself? Investors and token issuers must think carefully about what exactly a token represents.

The truth is: it depends on what you want to tokenize. Tokenization is flexible. Using real estate as an example again, what can be tokenized could be a direct ownership in the real estate (being a partial equity owner), right to rental income, or even the right to use an asset (renting the apartment).

Hence, atoken could represent ownership of the underlying real asset, an interest in a debt secured by the asset, an equity interest in a legal entity that owns that asset, or a right to the cash flow from the asset.

There are 3 basic categories of rights to understand.

The rights bestowed by tokenized securities (or security token) can be very complex to understand. However, tokenized securities can include claims to the assets (and usually the resulting cash flows), direct ownership rights, governance rights or a combination of all.

1. Claim rights: Claims to only certain specific uses (and claims) of the asset
2. Ownership rights: Equity ownership and control of the asset
3. Governance: System by which a group of people — usually a set of joint asset owners — can come to unified decisions

Let’s illustrate this with real estate again, with a few examples on the token holders’ rights:

1. Claim rights, but no ownership rights: Token holders are entitled to cash flows from ongoing leases, but they have no ‘equity’ and ‘ownership’ of the underlying real estate
2. Claim rights, AND ownership rights: Token holders are the ‘owners’ of the underlying real estate with claims to the cash flows. They can make decicisions directly: how much to charge for rent, investments made to maintain the real estate, hiring staff and given the proceeds from the sale of the reale estate.
3. Only ownership rights: This example is rarely the case, but it means that token holders are now the ‘equity owners’ of the real estate.

What are the challenges that arise from these different rights?

It is possible that there is a separation of claim rights and ownership rights, and this creates misaligned incentives between both parties.

What if… the tokens have ownership rights for token holders? How do 1,000 token holders make decisions collectively for the best of the assets? Is there a need for delegated voting or decision making?

What if… the tokens only imbue claim rights for token holders? The token issuers (owners) can reduce profits and cash flows to the token holders, by re-investing the profits. This will be to the detriment of token holders who originally look towards the future cash flow.

The smart contract geek might ask: can’t one automate all these logic in smart contracts?

No, smart contracts cannot solve all these issues.

Contracts and smart contracts are incomplete:

1. Contracts are only enforceable when events and actions can be verified by a third party

This is the long-standing problem of “oracles” in tokenization. There are some events that can be captured in code, but near impossible for any arbiter to determine if they really happened.

For instance, I issued out real estate tokens to holders so they can reeive a portion of the rental income. However, it is possible that I do not document down all the rental agreements so token holders do not know what is the real amount of rental income. If this cannot be enforced effectively, there is no rational reason for parties to abide by the smart contract.

2. It is near impossible to write a contract that contains all possible conditions and events, hence achieving “completeness”

The problem with contracts is not what is in them, it is what is not in them. It is very costly and operationally challenging to write down every condition and event. Furtheremore, events and conditions change in real life — and contracts have to adapt to these real life changes.

Given the limitations of smart contracts as inherently incomplete, there are various challenges to tokenizing certain types of assets.