How do you turn real assets into electronic bits?

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Tokenisation of real assets via blockchain technology is the answer. The topic has been growing in interest for a couple of years. This is due to several factors including 1) the growth of private capital looking for non-publicly traded assets 2) public capital investors increasing their asset allocation to alternatives 3) development of technology opening up new ways to re-imagine financial services. There is every reason to believe interest in the digitization of real assets will continue to develop.

Components

Firstly, let’s break down the concept into its components.

Tokenization

This is a securitization process. An underlying asset has an owner and that owner issues tokens in the asset which represent legal rights including economic interests. This is not new in concept, for example:

  • Money: banknotes first came about as a promise to redeem the note for gold or silver
  • Bowie Bonds: an asset-backed security issued in 1997 by the singer, David Bowie 

Real assets

In a world where digital is everywhere, real assets will remain in significant demand. Some assets like real estate will continue to be needed for practical purposes. Others such as jewelry and art provide an aesthetic pleasure. Beyond this, such assets have a financial attractiveness for capital and/or income gains. 

Blockchain

Blockchain, based on distributed ledger technology (DLT), allows the authentication of transactions and ownership records to be distributed without the need for a single central counterparty and the associated infrastructure.

Tokenization of real assets via blockchain is not the ‘dark arts’. Rather, it is quite straightforward and each of the individual components are proven. Combining them together, is maybe, a little trickier. So, what are the benefits and concerns?

Benefits

  • Liquidity – probably the biggest headache of investing in real assets is the associated liquidity. It is difficult to buy and sell real assets in a friction-free and swift manner. Tokens on the other hand, can be traded with other investors directly or via an exchange, leaving the ownership of the underlying asset unchanged.
  • Investment returns – real assets offer potential alternative correlation returns to public assets
  • Financing – contrary to assumptions, it is not necessary to use crypto currency to make this tokenization of real assets to work. Using normal fiat currency is also fine.
  • Custody – real assets need to be stored, made safe, maintained and looked after. This brings cost and stress. Owning a token relieves the investor of all that worry associated with the underlying asset. Nevertheless, safe keeping of the token is critical.
  • Trust – in the real asset world, which lacks the massive public market pre- and post-trade infrastructure, who are the central counterparties that you can trust? Blockchain removes the need for central counterparties.
  • Trickle down of wealth – one of the cornerstones of capitalism is the ‘trickle down of wealth’. It is well known that private markets offer a lot of wealth creation opportunities. However, traditionally these markets have been hard to access except for the very wealthy. This has reduced the trickle-down rate and contributes to growing division in society.

Concerns

  • Blockchain hype – for some folks, blockchain has an air of hype around it, so will it impede the gaining of traction for tokenization? Maybe, but there is a lot of interest from all the mainstream financial services firms in the DLT concept upon which blockchain is based. Therefore, blockchain or at least DLT looks set to stay.
  • Alternative to DLT – even if DLT does not gain greater acceptance, it is still very possible to digitize real asset without the use of blockchain. Instead, central counterparties would need to be established. There is a multi-billion-dollar industry watching this carefully for both threats and opportunities, namely the likes of the custodians, central securities depositories and brokers. This is evidenced by the fact that the International Securities Standards Association issued a report on crypto assets in 2018.
  • Valuation – who do you trust to value the underlying real asset on a regular basis so that the token can be priced? Doing this on a small scale with individual assets is quite feasible. How do you scale it?
  • Trading – with no existing exchanges of any scale, current reliance is more upon private trading between investors who want to buy and sell the tokens. This limits investment into inter-operable standards, hence limiting economies of scale/scope.
  • Post trade – with very limited post trade inter-operable standards, operational risk is higher than public markets and economies of scale/scope are not yet captured.
  • Settlement – if investors are settling their trades in tokens using non-crypto currencies, it will be necessary to connect the current banking system to the new real asset tokenized trading world.
  • Regulation – will investors really know what they are buying if there is a rush to tokenize the world around us? How are investors protected so that they make educated decisions and mis-selling is avoided?
  • Fraud – how will investors know that the underlying real asset actually exists and in what condition it is? Or how safe are the tokens from hacking?

Way forward

Notwithstanding the real concerns to be overcome, it is hard to see this transformational trend of digitization of real assets going away. The ecosystem necessary to create vibrancy and trust does not yet exist so it is unclear as to the speed at which volumes will grow. However, there are signs that the current development period of this concept is emerging from below the radar. Dematerialization of real assets is on the way.

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