What is tokenization?

What

In short, it is the process of converting real things into digital assets.

Let's imagine, you have a real and relatively successful company with a total value of $ 1 million. This includes the price of land, the value of buildings, equipment, production assets and other completely real objects. But suddenly you were in dire need of money, so you decided to sell the company. This can be done the old fashioned way - create a deal, wait for an offer and pay off, or - use the services of intermediaries for all this. But what if you need much less than a million dollars, and you would like to keep the company (at least part of it) for yourself?

Here is the solution. You issue a number of your own digital tokens, give them a certain name, for example - "coinies", and assign the token ownership of a certain share of your underlying asset. For example, each coin will qualify for 0.01% of your company's value.

In fact, you have just developed an algorithm according to which the smart contract will be implemented within the blockchain. Such algorithms should determine all the features of new coins or tokens - value, quantity, name, etc.

But how to make sure that new and unknown coins start to be sold and bought on exchanges? Only through a platform that supports smart contracts. The best option is Ethereum blockchain platforms. To put it simply, when you work with this blockchain, you only need a smart contract template, a text editor, and an Ethereum wallet address.

And, in fact, that's all - coins become reality. And since Ethereum was used to create them, they most likely fall under the definition of ERC-20 tokens. And they can already be released on the market, where their price will fluctuate depending on economic factors.

As you can see, it is possible to tokenize things pretty quickly using blockchain. The real company got digital representation on the network and became a full-fledged tokenized asset.

But this it's not a new idea, is it?

In fact, it is a more modern adaptation of the early economic concept of securitization. This idea arose long before the advent of cryptocurrencies and is still very actively used in practice.

Securitization is the process of combining various contractual obligations, such as mortgages, car loans or credit card debt, with real assets and then selling them to various third parties or individuals. The resulting securities are called collateralized debt obligations or CDOs.

In fact, it was these promissory notes that ultimately led to the 2008 financial crisis. Also because they were structured securities backed by assets. And when the assets suddenly disappeared, the value of the CDO disappeared along with them. But in general, the main idea of turning things into securities is working and quite effective.

What is the difference between securitization and tokenization?

The fact that tokenization requires a blockchain.

But first, let's figure out the terminology. What is a token? In the basic sense, it is a digital representation of a specific asset or useful activity. It sounds too abstract, so it is worth focusing on specific types of such tokens.

  • Currency. Yes, cryptocurrency in general and Bitcoin in particular. Such tokens are built on their own independent blockchains and are not based on real assets. Their cost is determined solely by the distribution mechanism. The main purpose is to serve for trading and storing values, in what way they are similar to fiat currencies.
  • Utility. They provide their owners with access to a certain product in the future, and their cost goes exactly to the implementation of this very product. A good example is BAT or Basic Attention Token - a tool for more effective digital advertising. With these tokens, advertisers buy ad space and time, and the tokens themselves are then distributed between those who offer viewing platforms and those who view those ads. Sure, if advertising is not imposed, and even offering compensation for it is a great reason to meet advertisers halfway. In addition, some people consider utility tokens as an investment, hoping that their value will increase over time, along with the price of the advertised product and the company that produces it.
  • Security. Simple investment. For them, the so-called Howie test, which the US Securities and Exchange Commission has been using since 1946, is actively used. True, mainly for ordinary assets, but it is also suitable for cryptocurrencies. The test is as follows. Is the asset sold as an investment? Is profit expected from it? Is this profit solely dependent on the efforts of the promoter closing the deal? If the answer to all three questions is yes, then we are dealing with a security token.

Well, what is our company? Let's use the Howie test. Yes, it is being marketed as an investment opportunity. Yes, it depends on you whether the company that provides the value of the Asset remains profitable. Yes, profit is expected from it too. So yes, Asset is a security token. And due to the fact that such tokens don't have long technical descriptions and "white papers", these are not smart contracts, but, in essence, shares that are traded within the existing blockchain.

Why is blockchain needed here at all?

Because the main properties that define it are transparency and immutability.

So, every transaction using "coinies", created before is recorded on the Ethereum blockchain. Since this is an immutable public ledger, no one can delete this transaction or tamper with it. And anyone can make sure that it is genuine. So your rights and legal obligations are clearly defined and inextricably linked to this token.

Additionally, blockchains make the tokenization process much cheaper. There is no need to pay intermediaries for paperwork since a smart contract can be created independently and it will still work. And the commission for buying and selling "coinies" will also be small - also due to the absence of intermediaries.

Plus, the coins can be sold 24/7 and anywhere in the world - like any other cryptocurrency.

But don't forget - each coin is not only an investment object, but also gives the right to own a certain percentage of your asset, which is also a positive thing.

This is the so-called "partial ownership", allowing investors to significantly improve the diversification of their portfolio. Not everyone can afford even one share of Amazon. It costs more than one and a half thousand dollars, plus there are restrictions on the number of shares for individuals. But owning a stake in that share is another matter entirely. This is how tokenization works - now any material object - stocks, works of art, even a banal pizza, can be sold gradually as a digital asset.

The situation already described - you urgently need money, but you have a company. You sell as many coins as you need, and then when extra money appears, you buy it back at market value.

However, this is not a new idea either - shared ownership has existed before, in the form of “club deals,” for example. But only a few had access to them.

In addition, asset tokenization is extremely useful for areas that have traditionally been considered illiquid - fine arts, for example. If earlier only a few could afford to buy a painting by a renowned artist, then after tokenization anyone can buy its “digital part” for affordable money. And the underlying asset begins to generate income much faster and more efficiently. And it's also beneficial for investors - the prices of works of art tend to rise, so by investing $ 30 early, you can get much more in the future when the value of the asset rises.

What's the catch?

The main catch is that tokenization is not very well regulated at the legislative level. It is extremely difficult to ensure that tokens start to comply with the letter of the law. Alas, even notarized trust contracts, carried out using smart contracts and blockchains, do not look convincing for the jurisdictions of most countries.

On the one hand, this is correct. For example, because the connection between tokens and the underlying assets that provide them must be inextricable. What will happen to the tokens if the company providing their price burns out? And what will happen to their owners? Who will protect their rights? Only the regulatory authorities, which, for now, don't know how they need to act in this situation.

Yes, there are already startups out there that can provide a solution to this problem, according to their developers. Take, for example, the Standard Tokenization Protocol (STP) company. The developers claim they will use official validators to ensure that transactions within the blockchain comply with regional rules. At a minimum, check transactions for KYC and AML. Plus, check various firms for adequate digital identification. The idea seems to be not bad, but so far in practice, it has not yet been fully implemented.

There are other options as well. A company named Tokenized, for example, creates tokens that provide some rights in the real world - membership cards, access rights, loyalty points, and more. All this is built on the basis of the Bitcoin SV (BSV) blockchain. According to the developers, such tokens are extremely easy to regulate. Up to providing access to the platform to official legal entities, which will be able to create court orders with a special digital signature on it, which can freeze other smart contracts and even withdraw tokens from circulation. For regulators, this is extremely promising, but alas, this project has not yet been implemented either.

But at the moment there is still the possibility to sell legally clean security tokens legally. The so-called Security Token Offering (STO).

What is STO?

In fact, it is a fundraising platform that can significantly facilitate and legalize the tokenization process.

Many people still remember the so-called initial coin offering (ICO) boom. Yes, this is when a still non-existent project issued its own tokens, which made it possible to obtain various rights, if the idea was still implemented. And absolutely anyone could buy them.

The regulator, of course, did not like the fact that someone was collecting millions, moreover, outside the tax system and on ideas that were not even clearly formed, so they began to actively fight ICO. In response, the issuers participating in the ICO stated that their digital assets are not securities, but full-fledged utility tokens, so they do not fall under official jurisdiction.

However, they did not succeed, since the criteria for the value of an asset are determined not only by those who issue this asset. As a result of the proceedings, the SEC ruled that only bitcoin and ether are not securities, since they have a decentralized governance model. Everything else is security tokens that are subject to regulation. In addition, it turned out that a significant part of ICO projects is fraudulent. So, for example, in 2017, their share, according to official reports, amounted to 80 percent of the total.

The conclusions were made, so that the STO, which is very similar to the ICO, is now much more in line with the official norms. Each such project is now supported and provided with real assets, can cooperate with regulators and is involved in paying taxes.

Alas, even this is not enough - in most countries, there is simply absent any regulatory framework, according to which such projects could be effectively regulated. Therefore, in a number of countries, they are simply banned - in China, India and South Korea, for example.

But in other countries the situation is different. In Estonia, for example, security tokens are officially recognized, so local companies can work with them without any problems. This was immediately used by stakeholders - a decentralized cryptocurrency service "Exchange" was launched, and it works with shares of popular companies listed on the international Nasdaq exchange, including Apple, Tesla, Facebook and Netflix, through security tokens.

Moreover, Exchange made it possible for its users to carry out STO not only with the help of cryptocurrency, but also through the fiat currency. Of course, investors must pass additional KYC levels in order to confirm their compliance with the European Union directives in this regard. Especially - "Markets in Financial Instruments Directive II."

Let's go further. Is the tokenized economy real?

In theory, yes. practically - time will show.

If the regulatory framework is properly adjusted, at least in the most important countries of the world, then the chances of this will significantly increase. However, many large companies have already appreciated the potential of tokenization. In the United States, for example, a large company Big Four EY has begun to tokenize wine, chickens and eggs using its own blockchain platform. And in Russia, for example, a project to tokenize palladium stocks raised about $ 7 million.

So when STOs receive official approvals from most of the major regulators, they can have a big impact on the existing financial system. And this will be another change in the world that became possible thanks to the blockchain.