Tokenization on Blockchain, How it really works?
When it comes to mainstream investment instruments, stocks, bonds, cash, and several similar instruments are well known to investors. These can be classified as conventional or traditional investments, and they typically have a large investor base. Another set of investments called alternative investments are types of financial assets which have a smaller investor base and often require significant capital commitment. Alternatives encompass a wide range of investment types, including hedge funds, infrastructure finance, private equity, venture capital, real estate, commodities, natural resources, and more recently, assets such as fine arts.
Blockchain is a network-based distributed ledger technology where data is replicated across multiple nodes, enabling a single source of truth. Applications are built and run on a network of nodes using smart contracts which encode business logic and rules. Such applications are called DApps, which stands for “decentralized applications.” Decentralization is a key attribute of blockchain, as no one person or entity owns the network. Collaboration between participants is peer-to-peer without involving an intermediary. Transaction finality is based on a consensus algorithm which is native to the respective blockchain platform.
Coupled with smart contracts, tokenization can help drive innovation in blockchain-based solutions. On the blockchain, a token can be viewed as a cryptographically secure data structure representing value of an underlying asset. Tokens are held in a wallet and the value can be transferred from one owner’s wallet to the other based on rules coded in a Smart Contract. Tokens are not new: in fact, currency bills (notes) and coins that we use on a day-to-day basis are also tokens, which represent the value of money. Electronic tokens were first introduced and used in the Payment Card Industry (PCI), where tokens enabled protection of card holder’s sensitive data.
A specific application of Tokenization
Blockchain, smart contracts, and tokenization can be applied to a wide range on problems in the financial services organization. Tokens can digitally transform physical assets through the process of tokenization, representing its value on a blockchain. Tokens can be fractionalized, which in turn could mean fractionalizing the asset itself, enabling high value assets to be split into smaller units for fine-grain management.
A review of the alternative asset investment landscape indicates that in the last few years this space has become more attractive to investors around the world. As appetite continues to grow, Preqin predicts a 9.8% CAGR by the end of 2025 accounting to 17.16 trillion USD.
Compared to traditional investments, alternative assets face challenges related to liquidity, transparency, and accessibility. They seem to be less democratized, with control resting in the hands of a few institutional/HNW investors through specialized managers. Use of blockchain, smart contracts and tokenization can make a significant difference leading to transformational impact for all stakeholders involved, including asset managers. The most visible benefits of tokenization include fractionalization, liquidity, transparency, and operational efficiency.
Let’s consider real estate. It is an age-old hedge against inflation strategy where value is derived from inflation-adjusted rent income. But the investment is challenged by high capital commitment, lack of diversification, and time consuming and expensive transaction processing. Additionally, it is also highly illiquid, resulting in higher liquidity premiums. Real estate investment trusts could be looked at as an alternative, but they have their own challenges.
Tokenization can be a potential solution in this case, as it can not only positively impact liquidity, but also democratize access, enable customization, and enhance flexibility. Fractionalization enables access to be provided to a larger investor base with a lower capital commitment, while at the same time providing flexibility to the investors to rebalance the portfolio as and when required. Unlike REIT, tokenization can be applied to a single real estate instead of several assets being bundled together in the portfolio. This provides investors with wider choice and customizability.
Tokenization can deliver value to investors and real estate owners through unlocking liquidity and increased valuation. It can also reduce transaction times and administrative costs. This can be done by improving operational efficiency with appropriately designed smart contracts, which are autonomous in nature and hence can be used to automate compliance (KYC/AML), transfer of tokens, payout, and many other operational tasks.
How It Works
For tokenizing any asset in general, there are a few steps which need to occur, though they may vary based on asset type.
- Tokenization: Once the deal is structured, the asset needs a digital wrapper called a token. This is typically done on a tokenization platform which runs a blockchain ledger and the corresponding smart contracts. This is also when the required number of fractions are created for the underlying asset.
- Distribution: This is the primary distribution of the token, akin to an IPO. Before distribution, compliance must be carried out and investor KYC/AML and other necessary checks must be completed. The investor will hold these tokens in a unique personal wallet.
- Management: These are operational activities coded in one or more autonomous smart contracts. Alerts, communication, updates, voting, distribution of dividends, and other payments are taken care of in this step. Typically, there are many management tasks and activities, including those related to compliance.
- Trading: Secondary trading is when the token is set into motion. This increases the investor base, positively impacts the liquidity, and could potentially further increase the valuation of the asset itself.
Alternative assets are on a growth trajectory, but they are challenged by their inherent inefficiencies. Blockchain and tokenization can improve the situation, but it doesn’t come free of risks – both technical and operational. Several trial runs and platform maturity will be required to gain the confidence of investors, not to mention regulatory requirements. It is important to know that this space is evolving as the technology continues to mature and is being adopted.
The article is contributed by:
Agnelo Marques, VP & Head of Blockchain CoE at Mphasis
He heads the Blockchain CoE at Mphasis. In this role, He is responsible for offering blockchain-related solutions to customers across industry domains, with an enhanced focus on payment and tokenization in the BFSI space. He has been successful in building a strong team of highly proficient architects and engineers who have proved themselves in dealing with and building innovative solutions with this new and challenging technology. As a Blockchain expert, He has been responsible for helping several of our enterprise clients in demystifying this complex and nascent technology by way of building working prototypes & PoC and deep-dive technology overview sessions. He has deep subject matter expertise on Blockchain and Smart Contracts including, Cryptocurrencies, DeFi, and blockchain-based cross-border payments.