Tokenization: Making the Illiquid, Liquid

Few observers doubt that tokenization - the digital representation of ownership rights - is going to play a major role in the evolution of the global digital financial system.

High profile projects, such as Project Guardian (an MAS project lead by DBS, JP Morgan, and Marketnode), are leading the way to enable secured borrowing, lending and trading on a public blockchain-based network through execution of smart contracts where financial institutions act as gatekeepers, custodians and issuers.

The tokenization of real-world assets on the blockchain opens up use cases to Capital Markets that offer access to a global marketplace (primary and secondary markets), price and transaction transparency, faster transaction and clearance, and automated and streamlined workflow processes.

Improved liquidity is central to the value proposition of tokenization, so to understand the uses and benefits of tokenization, it is important to examine some of the key factors that influence liquidity (a relative, not an absolute concept).

Liquidity

Market Economics

The mechanisms designed to allow buyers and sellers to find each other, interact and agree on price, designated as market economics, often make a huge difference in market liquidity.

A liquid market is a market where buyers and sellers find each other easily (liquidity discovery) and the price of the asset they are looking to trade (price discovery) can be readily established, and easily traded.

Information

The quality and quantity of information available also impacts liquidity:

Quality of information: Is the information accurate and available in a timely manner? Quantity of Information: Is there enough information? (Not enough information or too much ‘noise’ reduces liquidity.)

Information’s materiality impacts price, while information asymmetry has always been lubricant for transactions.

Risk

Different types of liquidity-reducing risks make it harder to buy and sell with confidence: Market Risk: risk of unexpected changes in price

Credit Risk: risk counterparties will not honour debts

Settlement Risk: risk payment will be delayed or not received

Operational Risk: risk people or technology will fail to perform

Trust is the flip side of risk. People who trust each other also contribute to make more liquid markets. When there are buyers and sellers willing to trade, the asset doesn’t even have to physically exist.

Legal and Regulatory Framework

Laws and regulations affect market liquidity by creating the framework within which parties can transact effectively (safely, soundly and transparently). Their absence creates uncertainty and confusion - which negatively impact on liquidity.

Understanding Tokenization

Tokenization is the process of converting ownership rights into purely digital representations of an asset that can be subdivided, traded, and stored on decentralized ledger technology (DLT).

A token can theoretically represent any asset type, but they are usually considered either native to the blockchain and have no physical presence, such as Bitcoin, or are not native to the blockchain and represent some form of a real-world asset.

In this article we are examining the tokenization of real world-assets and to explain how it works, we will use the example of real estate - traditionally a highly illiquid asset.

Unbundling of Assets

Real estate may be decomposed into three different assets: habitation rights, mortgage liability and ownership rights / equity - each of which may be priced and traded individually.

Tokenization makes it is possible to efficiently unbundle these rights into tradable assets using standard asset formats, secure shared transaction history, and automated execution.

Fractionalisation of Assets

Fractionalisation is a similar concept to unbundling in that it allows the subdivision of an asset into multiple, interchangeable (fungible) tokens, each representing a fraction of the overall value and thus allowing for fine tuning of exposure to risk via the amount of investment.

In our real estate example, not only can the ‘house’ be unbundled into three separate assets but each of these can also be fractionalised, thereby reducing the cost of investing in real estate.

(One house became three assets, represented by three different types of tokens - issued in as many fractions as one cares to define.)

Unbundling & Fractionalisation

Tokenization, through the combined effect of unbundling and fractionalisation, has a positive effect on asset liquidity:

Market Economics

Any asset, physical or not, tradeable or not, may go through the process, thus increasing the number of potential sellers. The cost to invest is significantly reduced, and within reach of more modest investment budgets, thus increasing the number of potential buyers.

Public blockchains used for tokenization offer a global audience. Once KYC / AML obligations are fulfilled, participation in fundraising or investing in asset-backed tokens is no longer local, but global.

Information

It is important to keep in mind that unbundling is a legal process not a technological one. Though by utilising tools such as openlaw.io (ethereum based platform for contract / smart contract writing) it is possible to standardise and digitise legal paperwork and tie the underlying contracts/paperwork to the respective tokens.

Tokenized assets tied to digital legal paper can streamline negotiation and dispute resolution. Digitally available and verifiable information about rights and obligations reduces the paper processing costs of lawyers and auditors involved in verification of asset ownership and owner identity.

Tokenization can thereby facilitate access to required information, reduced transaction costs, trade in the asset and dispute resolution.

Risk

Tokens on a blockchain eliminate both credit and settlement risk - transactions do not go through without definitive settlement. The speed at which settlement is verified, and the inherent transparency of blockchains, serve to eliminate credit and settlement risks.

Tokenization also improves asset-liability risk management via quick transactions and better transparency and broadens the variety of available and acceptable collateral beyond traditional assets - significantly expanding the options available to market actors when choosing non-cash holdings as collateral in securities lending.

Conclusion

Asset tokenization is the process of converting rights or asset ownership into a digital token on a blockchain network. Examples of tokenizable assets include regulated financial tools (equities, bonds), tangible assets (real estate, commodities, luxury products) and intellectual property.

Knowledge of the asset, the buyers and sellers, the legal requirements and servicing needs is essential to proper tokenization processes.

Asset tokenization brings multiple benefits to both investors and companies looking to fundraise: - A larger pool of investors

- Wider geographic reach

- Reduced settlement period

- Reduced cost for reconciliation in security trading

- Heightened asset-liability management

- Increase in available collateral

There is a slow but increasingly accelerating trend from regulators globally of laying the regulatory framework pillars for the issuance and trading of asset-backed tokens. The almost real time data and the tamper proof nature of blockchain networks facilitate increased clarity and protection for investors, which is a very desirable feature for regulators. (There is also the possibility to conduct enhanced regulatory functions on a blockchain – but that is another day’s article.)