What is Asset Tokenization: Why & Why Now?
As real world use cases and applications increasingly adopt blockchain technology, it is more important than ever to understand the impact this innovation can have on asset management and ownership.
Tokenization is the process of using blockchain and smart contracts to create digital tokens that represent ownership or rights associated with that underlying asset. These tokens can be issued, traded, and managed on the blockchain. While a common example is a financial asset like company shares, physical goods or commodities can also be tokenized. Tokenization is increasingly considered one of the most promising applications of blockchain, with the potential to revolutionize the global economy in several ways.
Improving capital markets has been a consistent endeavor in the past few decades, ranging from potentially reducing fees to data transparency. Tokenization single-handedly fulfills multiple aspects. In their recent report on tokenization, Citibank predicts that tokenized private financial and real world assets will reach almost $4 trillion by 2030. Going one step further, Boston Consulting Group (BCG), in collaboration with ADDX, predicts an even larger market share for tokenized illiquid assets, which includes private securities in addition to other asset classes, and BCG projects that the total size of illiquid asset tokenization globally would be $16 trillion in the same time frame. Currently, tokenized assets trading on the secondary market represent only around $25 billion in market capitalization, according to research firm STM, so these predictions are expecting a 200x growth in this decade alone.
In this article, we will break down some of the new opportunities presented by tokenization technology.
Examples of Off-Chain Asset (OCA) Tokenization:
Real Estate Tokenization
When Real Estate assets, such as properties, are tokenized, each token can represent fractional ownership of the property, allowing investors to buy and sell smaller portions of real estate.
Art and Collectibles
When valuable artwork or luxury items are tokenized,investors will have the ability to own a share of the artwork or collectible, increasing access to the art market.
Equity ownership in companies, whether small startups or large corporations, can be tokenized. Established companies can raise capital and issue tokens representing the corresponding equity. Alternatively, companies with existing investors can issue tokens representing their pro-rata shares to also reap the benefits of the blockchain. Each share class (i.e. common vs. preferred) can be represented by a different security token.
Limited Partnership (LP) rights can be tokenized. Creating secondary markets for LP interests allows for LPs to trade amongst each other, creating exit opportunities. This in turn results in GPs to not be required to issue redemptions. This keeps deployed capital generally active without having to liquidate the fund’s positions to satisfy LP redemption requests.
Companies can issue debt in tokenized form. Each token holder may have loaned the issuer capital in exchange for interest paid, whether at maturity or via periodic coupons payments. When debt issued by companies is tokenized, creditors can more easily track and trade their debt instruments on the blockchain rather than the methods used today.
Tokenized intellectual property (IP) may open the doors to greater investor participation via fractional ownership. Initial IP owners can tokenize a portion or 100% of their IP. This may provide them with early liquidity while investors participate in corresponding revenue/profit share or otherwise upside of owning a portion of the IP.
Key benefits of blockchain and OCA tokenization:
- Automation and cost reduction
- Transparency and auditability
- Accessibility and inclusion
- Engagement and utility
- Increased liquidity and asset productivity
- Portfolio Diversification
Automation and Cost Reduction
Smart contracts are programs that allow blockchains to automate transactions and transfers; they execute certain pre-programmed actions when certain predetermined conditions are met. They can be used for on-chain asset issuance, administration, and settlement processes and, as such, can reduce the need for various third party service providers as well as the incremental costs associated with each intermediary. For example, they can help lower data, analytics, and reporting costs for things like underwriting and verification, asset monitoring, corporate actions, and other periodic fund disbursements, which historically are operationally burdensome, manual, and protracted.
Transparency and Auditability
Any transaction involving tokenized assets on public blockchain will be publicly visible; and therefore, auditable. The blockchain has the potential to enhance the valuation mechanics and reporting behind traditional assets themselves. For example, real estate investors are familiar with the difficulties in evaluating a property’s current valuation. This estimation is usually subjective, and can be quite a burden to assess due to the manual nature of the calculations combined with the lack of technical infrastructure to support the paper-based documentation process that is common across real estate. By leveraging cloud databases to manage these documents online in addition to advanced webhooks to standardize each dataset, regardless of the asset type or size, it is now possible to offer real-time transparency into a property’s valuation, a hedge fund’s portfolio NAV, or a debt product’s market value.
In addition, real-time data is only valuable when we can trust the information that is being stored and presented, which can be incredibly difficult to prove when dealing with assets and investors from different countries and regulatory environments. With improved recordkeeping and provenance through cryptographic hashing of each data upload, change, and download, we can establish a digital audit trail of information over the lifecycle of an asset and tie those records directly to the underlying tokens on-chain.
The transparency, auditability and real-time data of tokenized assets essential for institutions or individuals who are looking to invest in or to take a loan or collateralized position on an asset and need proper analysis of its value.
Accessibility and Inclusion
Tokenization has the potential to democratize access to capital markets for borrowers and to investment and capital allocation opportunities for lenders. Because of the potential cost savings and efficiencies afforded by on-chain issuance and management, smaller deal sizes and lower investment minimums are made more economically viable. This becomes especially relevant for those assets considered traditionally illiquid or private market securities where manual and operationally intensive processes have historically precluded a wider set of individual, qualified investors from having access, as well as for companies raising capital from retail investors through Regulation Crowdfunding.
Engagement and Utility
With token holders on a blockchain, it may be easier to engage with them more directly and to provide incremental utility. Block explorers provide a direct access registry to understand each underlying wallet that owns tokens. In regulated and KYC-compliant ecosystems, the broker or transfer agent needs to link each wallet with an investor’s identity, allowing the involved parties to engage directly with each underlying wallet through airdrops, governance votes, and exclusive events. Providing benefits to and directly engaging to tokenholders, as seen in the Web3 industry, can create a much stronger sense of community and brand loyalty.
For this reason, end-to-end Web3 community-powered loyalty solutions on blockchains are on the rise. These platforms enable brands of all sizes to form a direct relationship with their biggest fans, and directly connect and reward fans for taking valuable actions.
Increased Liquidity and Asset Productivity
With its ability to enable greater fractionalization and a wider investor base, tokenization also has the potential to facilitate greater supply and demand – enabling a more liquid, transparent, efficient and less fee-intensive secondary market. Especially when combined with some of the previously mentioned benefits, tokens can also be used in conjunction with self-executing blockchain applications to enable greater asset productivity. Because of tokenization, assets that were previously difficult or incapable of being used as collateral can now more easily be used for such purposes, such as fractionalized artwork and real estate.
While investors traditionally participate in public markets, bonds, and other asset classes, alternative investments and private markets have not played as significant of a role in the average person's portfolio. This can be attributed to a variety of factors, including prohibitively high investment minimums and lack of liquidity. When issued compliantly under existing regulatory frameworks (e.g., Regulation D, S, A+, and CF), tokenization can help to solve these two blockers from a technological perspective.
Fine art is a great example. The average person does not invest in art due to high investment minimums. Companies are fractionalizing museum-quality art such as Andy Warhol or Banksy paintings using crowdfunding exemptions where anyone, accredited or retail, can participate. This allows investors to allocate a portion of their portfolio into art while being able to sell their positions to other investors in the event they cannot wait for a liquidity event.
We are at the forefront of an exciting era in asset management and ownership as tokenization gains momentum. Tokenization provides the rails for banks, financial services firms, and asset owners to issue and manage any type of asset - no matter if it is ownership in companies, real estate, fine art, or non-traditional assets - within the same ecosystem anywhere around the world. Dealing with these types of assets traditionally required manual processes to service and validate each individual transaction. However by standardizing the flow via tokenization, firms can automate each transaction to drastically reduce costs and increase the speed of transfer and settlement.
Tokenizing real world assets is a growing trend in the blockchain industry with a mission to upgrade much of the financial services infrastructure that exists on Wall Street in a more transparent, efficient, and accessible manner. As institutions continue to adopt this technology one can expect new standards to be set, regulation to adapt, and finance to evolve.
Accredited investor - An individual or business entity that meets certain characteristics, allowing it to trade securities that are not generally available to the public.
Block explorer - Software application that allows users to extract, visualize and review historical transactions on a blockchain.
Blockchain - Infrastructure of distributed and decentralized databases that maintain a continuously growing list of records that are linked using cryptography.
Bond - Financial instrument representing debt from an investor to a corporate or governmental borrower.
Collateralized position - Using a valuable asset or basket of assets as collateral for debt.
NAV - Net Asset Value refers to the total value of a portfolio of assets in a fund or portfolio.
On-Chain Finance - OnFi is the use of DeFi primitives and smart contracts to upgrade legacy financial services infrastructure and workflows.
Real estate - land and any permanent structures attached to the land.
Standardization - The process of creating a generally-accepted template and streamlined methodology for servicing clients and transactions.
Stock - a security that represents the ownership of a fraction of the issuing company.
Tokenization - Issuance of a blockchain token representing a share of a real world asset that is used within on-chain infrastructure for more efficient ownership, settlement, and management of an asset throughout its lifecycle.
Valuation - the process of determining the value of a potential investment, asset or security.
This report was commissioned by Ava Labs and is provided for informational purposes only, without representation, warranty or guarantee of any kind. None of this is as an endorsement by Ava Labs, Inc., the Avalanche Foundation Limited or any of their respective subsidiaries or affiliates, nor is any of this investment or financial advice. Please review this Notice and conduct your own research to properly evaluate the risks and benefits of any project.