Tokenization, Explained

Tokenization is the process of turning things into digital assets.

Assume you have a farm that is worth $1 million. It has a big barn, cows, rabbits, a hedgehog — you name it. All of a sudden, you are desperately in need of money, you can sell that farm the old way — fill out the paperwork, wait for an offer, close the deal, etc. But what if you need less than $1 million and would prefer to keep most of the farm to yourself?

Imagine digitally printing 1 million tokens under the symbol “COW,” for instance, where each COW is worth exactly 1% of your property — or any other amount, just as long as each token represents a certain share of the underlying asset (in this case, your farm).

Technically speaking, you would be developing an algorithm that would be implemented as a smart contract on a blockchain. This algorithm defines all the features of your future token: its value, quantity, denominations, name, etc.

So, how do we actually get those COW tokens out there so that they can be freely bought and sold on different exchanges? For that, we need a platform that supports smart contracts. Ethereum would be the most popular choice. Rather than getting into the technical details about how tokens are created and getting too far off topic, let’s just say you’ll need a smart contract template, a text editor and an Ethereum wallet address.

Voila, COW tokens are now in circulation! Technically, they are ERC-20 tokens — basically meaning that they are powered by Ethereum blockchain. Now that they have entered the market, their value can either go up or down in accordance with demand.

See how blockchain can allow us to tokenize things now? We took a farm and created its digital representation that exists on a blockchain. In short, this farm is now a tokenized asset.

Not really, but it has a modern twist.

Of course, the concept of securitization (as a more general form of tokenization) goes way back before the emergence of cryptocurrencies.

Securitization is the process of pooling various types of contractual debt obligations — such as mortgages, auto loans or credit card debt — and selling their related cash flows to third-party investors as securities, which may be described as bonds, pass-through securities or collateralized debt obligations (CDOs).

Remember the 2008 financial crisis? Think of those CDOs, which eventually became the cornerstone of the default, as boxes that collect monthly payments from multiple mortgages for Wall Street. They were technically a type of the so-called structured asset-backed securities (ABS).

So yes, the essential idea is to turn various things into securities — and we've seen how this works before.

In short: It’s on a blockchain.

But let’s dive a little deeper and see what “token” even means in our case. Of course, as with many other crypto-related terms, there is no single, agreed-upon definition.

At the most basic level, a token is a representation of a particular asset or utility. Sound too abstract? Let’s outline three types of tokens you might come across on a regular basis and break them down:

Currency tokens

These are the most obvious ones. Just think of classic cryptocurrencies. Bitcoin.

Currency tokens are built on their own independent blockchains. They are not based on assets — instead, their value is directly linked to the very mechanism that distributes them.

As per their name, currency tokens’ purpose is to be traded, spent and received. Just like conventional currencies. Paying for Frappuccinos with bitcoin? This is an example of currency tokens at their finest.

Utility tokens

This one is a bit trickier, so bear with me on this.

Utility tokens give you future access to a given product or service, while the money you paid for them allows startups to raise enough capital to actually develop this product.

A prime example here would be the Basic Attention Token (BAT) — a tool for the enhancement of digital advertising. Advertisers buy ads with BAT tokens, which are then distributed among both publishers and browser users as compensation for both hosting ads and viewing them, respectively.

Utility tokens are not supposed to be investments by design; however, people often treat them that way and buy these tokens with the hope that their value will increase along with the demand for the company’s product or service.

Security tokens

Security tokens, in turn, represent a straightforward investment. Defining this type of tokens is surprisingly simple, especially if you refer to the Howey Test, which the United States Securities and Exchange Commission (SEC) has been using since 1946 and, oddly enough, still applies to cryptocurrencies as well.

When you see a token, ask the following questions: Is it being sold as an investment? Are profits expected? Will those profits depend solely on the efforts of the promoter who is putting the deal together or another third party? If you answered “yes” to all three, then you’re dealing with a security token.

Remember our COW token? Let’s apply the Howey Test here.

It is being sold as an investment opportunity. Investors do rely on you, as the farm’s owner, to keep it profitable and ideally not run it into the ground. Are profits expected to be made? Sure, why else would investors buy a token named COW?

To sum up, security tokens can represent any asset that is tradable and fungible. They are not backed by white papers with lengthy technical explanations — security tokens are essentially shares that live on a preexisting blockchain.

Because blockchain makes tokenization transparent.

Every transaction you’ve made with COW has been recorded on the Ethereum blockchain, because COW is an ERC-20 token. Given that it is an immutable public ledger, nobody can question or forge your ownership of COW tokens. Your rights and legal responsibilities are now embedded directly into the token.

Besides, blockchains make tokenization extremely cost-efficient. Instead of paying all those intermediates for the paperwork, you just program a smart contract to do the job. And yes, the administrative costs of buying and selling COW are almost zero.

Moreover, as with the rest of crypto trading, COW can be on sale 24/7, anywhere in the world, so it’s accessible.

As for the 0.01% — you owning that tiny bit of a farm in COW tokens is actually one of tokenization’s main benefits.

It’s called fractional ownership of real assets, which gives investors more options to diversify their portfolios. Can’t afford an Amazon share? Fair enough, since it costs around $1,800 and can only be bought in one piece. But what about a quarter of that piece — an eighth? Tokenization makes that possible: Anything from Amazon shares and real estate to artwork and pizza can now be sold in fractions as digital assets.

Don’t have enough money to go to college? Tokenize your farm, sell as many COW as you need and buy those tokens back at market value as soon as you get a job after graduation.

Of course, the concept of fractional ownership has existed before in the form of club deals, for instance. But has it ever been so democratized?

When assets are tokenized — especially the traditionally illiquid ones, like fine art — they become accessible to a much larger audience. As a result, the so-called “illiquidity discounts” are removed, and a greater value is captured from the underlying asset. Investors, in turn, get more access to opportunities for growth-stage investment.

In other words, the ability to invest $30 dollars in a $30 million Basquiat painting could unlock millions of dollars in currently illiquid assets — and boost the overall volume of trades globally, as there is $2.4 trillion in private fundraising in the U.S. alone. That’s what this new “Token economy” could offer to the financial world.

Tokenization is difficult to regulate, while it’s supposed to be fully compliant with the law.

These tokens have to be compliant with the law, and it is difficult to achieve. Substituting special-purpose vehicles (SPVs) — legal entities used by companies to isolate the buying firm from financial risk in a deal — with notarized trust agreements conducted through smart contracts and blockchain would hardly seem convincing to any jurisdiction at present.

That seems fair: The link between a token and its underlying asset should be inextricable. What can one do with COW tokens if your farm gets destroyed by a tornado? They should be entitled to investor protection rights, and only regulators can actually enforce them.

However, some startups claim that they have a solution. For instance, a company called Standard Tokenization Protocol (STP) claims it will be using an on-chain validator to ensure region-specific regulations: Basically, it would check if all the Know Your Customer (KYC) and Anti-Money Laundering (AML) requirements are met and assesses different digital identity management firms for the task — all while staying on the blockchain. In this case, a deal could only go through if all regulations are followed. Still, it is not clear if this model will ever succeed, as it is still yet to be implemented in real-life conditions.

Another firm, called Tokenized, aims to create tokens for real-world assets — shares, loyalty points, admission tickets and memberships — on the Bitcoin SV (BSV) blockchain, while stressing that its product is regulation-friendly. Additionally, the startup says its platform allows legal authorities to issue digitally signed court orders that can lead to smart contracts being frozen, also opening up the potential for tokens to be confiscated. That could potentially convince the regulators — but still, nothing is certain at this point.

Generally, the process of selling legally compliant security tokens is referred to as a Security Token Offering (STO).

STOs are a fundraising platform that can facilitate tokenization.

Remember the initial coin offering (ICO) boom, when every project had its own “disruptive” token for anything one could ever imagine? The fundraising model was so inclusive that virtually anyone could participate in the sale.

Of course, the watchdogs didn’t like the idea of people raising millions of dollars on the back of some abstract, often poorly articulated idea on the internet and began to crack down on ICOs. In turn, issuers tried to outsmart regulatory requirements by arguing that their tokens were actually utility tokens and not securities, but the SEC wasn’t having it — remember the Howey Test?

In the end, it is not for issuers to decide whether their tokens have utility or not — according to the SEC, only bitcoin and ether are not securities among cryptocurrencies, due to their decentralized model of governance. The rest are security tokens, which are trying to present themselves as utility tokens instead. Thus, ICOs ignored the legal aspect, which partly explains their fiasco (according to a report, as much as 80% of ICOs in 2017 were scams).

Here, STOs make an entrance: a model similar to ICOs, but with a greater degree of compliance in mind. Powered by the concept of security tokens, STOs are actually backed by real assets and, unlike ICOs, are fine with the idea of paying taxes, following the regulator’s guidance and playing by other mainstream rules.

Again, STOs aim to be compliant, but the required regulatory frameworks aren’t there just yet. In fact, many countries have de facto banned STOs (along with cryptocurrency trading in general), including China, South Korea and India, just to name a few.

Other countries are still undecided as to how STOs should be regulated. For instance, Thailand’s Securities and Exchange Commission argued that Thai-related STOs launched in an international market would break the law.

Finally, some jurisdictions, such as Estonia, actually recognize security tokens and allow local companies to work with them. As a result, DX.Exchange, an Estonia-based crypto firm, has launched a trading platform that lets investors buy shares of popular, Nasdaq-listed companies — including Apple, Tesla, Facebook and Netflix — indirectly through security tokens.

More recently, DX.Exchange claimed an industry first with its launch of STO listings. Since March 2019, the platform allows investors to purchase security tokens using both fiat and major cryptocurrencies. To trade in security tokens reportedly requires investors to undergo an additional layer of KYC checks, in compliance with the European Union Markets in Financial Instruments Directive II.

It is a fair assumption, and — as described above — there are signs to suggest an industry is emerging.

Yes, the regulatory frameworks should be adjusted, if not for all the countries on the planet but at least in the key countries like the U.S. However, it is already becoming clear that the potential of tokenization is now being widely recognized. For instance, the Big Four firm EY has recently started tokenizing wine, chickens and eggs with its blockchain platform.

In fact, during the past month alone, a report by an EU forum concluded that the tokenization of physical objects could enhance trust. Also, a Russian billionaire confirmed that he is planning to tokenize a rare metal called palladium, and a tokenization startup raised $7 million in funding.

Once STOs get a definitive greenlight from regulators, the token economy could be upon us, giving a large boost to the global financial system — all thanks to blockchain.