What Investors Should Know About Tokenization
Originally posted by Forbes on Jul 13, 2022.
Many investors are starting to hear about “tokenization” of assets, but few understand what it means or how it is different from other crypto investments. After years of working in the field, designing the technology and the legal aspects from the ground up for my company, which issues tokenized, institutional real estate investments on the Stellar blockchain, I have an in-depth understanding of the technology, compliance, problems and benefits of tokenization.
With tokenization rapidly growing within the industry, my goal is to break it down to a level all investors can understand, without too much technical jargon.
This piece will focus on five basic concepts: blockchain, financial products (bonds/stocks), compliance/legal, secondary markets/listing and why tokenization is good for investors.
A Quick Primer On Blockchain Technology
There’s a lot of technical jargon thrown around that can confuse people. But in reality, blockchain technology is quite simple. It’s a set of ledgers of transactions that are compared against multiple nodes to ensure their accuracy, and then recorded publicly on the blockchain so that anyone can look them up. Think about it like a credit card statement, where every transaction simply gets recorded to the public ledger, instead of to Visa’s corporate database.
There are a few concepts necessary to comprehend to fully grasp the technology. First, typical blockchains have “wallets” (simply a unique ID that is similar to an “account” in traditional finance terms) that can make transactions happen on the chain with a Public and Secret key. If you have both keys, then you can record a transaction to the blockchain.
The second thing to know is that blockchains typically have a primary “currency,” which is a symbol such as XLM, ETH or XRP (similar to BTC), and they also commonly contain “tokens.” Tokens are technically similar or the same as the base “currency,” except they are usually issued onto the chain by third parties, and represent other things such as “stable” coins, or tokenized assets. Think about a token simply as a quantity unit with a name. The quantity can be bought/sold/traded on the chain, and the ledger keeps track of who holds what quantity in which account.
Third, some confusion comes from the fact that there are many “blockchains,” and each chain may hold the same “currency” or “token.” For example, Ethereum holds USDC tokens issued by Circle, and so does the Stellar blockchain. This creates massive confusion because blockchains—and this is important to remember—do not cross between each other.
Tokenization And Financial Products
Tokenization of real estate or other assets is not much different than issuing stocks and bonds on a publicly traded exchange. The major difference is that the stock/bond is being traded on a blockchain, instead of a public exchange. Pink sheets, alternative trading networks and dark pools are similar to trading on the blockchain, except that the technology is not authenticated and recorded by a group of public nodes.
On the other hand, with blockchain technology, the stock or bond is legally tied to the blockchain token with a symbol name such as ‘ABC,’ so that whoever owns a quantity of ‘ABC’ legally owns the stock or bond and can trade it among other traders on the blockchain.
Inside Legal Compliance For Tokenization
Regulation and compliance for tokenization mostly follows already established (though very outdated) securities laws in the U.S. Across most of Europe and Latin America, there still appears to be no specific laws for tokenization, and even if one country did end up creating a legal framework, most of the other nearby surrounding countries would have differing views and laws, making specific individual territory compliance difficult.
Despite this, there is one primary set of international laws that the majority of token platforms must adhere to which is anti-money laundering laws. Global governments have come together to stop the transfer of funds from terrorists, drug cartels, Russian oligarchs and other dangerous parties.
The Difference Between Centralized And Decentralized Exchanges
There are two types of token exchanges: centralized and decentralized. Centralized exchanges carry a much higher risk of compliance issues with securities and broker registrations. This is because there is one private centralized company that is controlling the trade executions.
Meanwhile, decentralized exchanges allow token holders to trade peer-to-peer with each other, executed by a group of nodes across many jurisdictions. This removes the possibility of portal operators executing any trades, while still allowing token holders to have their own secondary market so there can be increased liquidity in the tokens they hold. This is highly beneficial for the global finance ecosystem and investors because it removes the private company and central government authorities, instead giving freedom to each holder of a token to buy and sell on their own terms, with potentially zero fees and friction.
Why Tokenization Is Good For Investors
Cryptocurrencies, meme coins, utility tokens and others are not backed by any contractual obligation to the token holder. It is simply a ledger which shows a “value.” This means that what the token holder has is a “perception” of value. That value depends on how many buyers or sellers of the token are in the market, along with other factors such as token issuance and burning by the issuer. This creates a highly unstable investment product.
Enter tokenization. Tokens are backed by legal contracts to real assets. This created a stabilization of values and a lower risk profile. Tokenization of assets can generate income streams, such as dividends or interest payments to the holders.
Because tokenization is technologically driven, and can be controlled per issuer, it is now possible to invent new financial instruments that have never been created before. Blockchain technology is exciting because it allows for alternative investment ideas that break the status quo and give investors superior investment products they have never had access to before—while simultaneously reducing issuance costs and ongoing exorbitant exchange fees. This is truly the future, and an exciting time to be alive.
The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.