Tokenizing traditional financial assets, specifically security tokens, have become a favorite topic of late within the cryptocurrency realm. Several platforms are already positioning themselves to become fixtures in the eventual progression to tokenized assets.
While there is a lot of excitement surrounding the topic, there remain several important, and substantial hurdles that need to be overcome before security tokens or other traditional assets can become digital tokens on a blockchain.
The Technical Perspective
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Implementing tokenized assets on a blockchain from a technical perspective is not all that complicated and has already been achieved to a certain extent. On Ethereum, token standards such as ERC-20, ERC-721, and ERC-1155 represent standard interfaces for different kinds of digital tokens across the network.
These interfaces can be optimized for bringing traditional assets on-chain — such as Polymath’s ST-20 that is an extension of ERC-20 — with the general purpose being to increase the flexibility of the asset. Taylor Pearson provides a simple yet excellent breakdown of what a security token really is by stating that:
“Tokenized securities are just securities with an electronic wrapper around them.”
Securities are fungible, meaning that one unit is interchangeable with another unit (i.e., one Coca-Cola stock equals another Coca-Cola stock) which makes them compatible with the ERC-20 standard at a technical level.
However, ERC-20 does not account for regulatory standards or specific parameters that would be required to issue and trade a security token. That is why Polymath is building an extension of the ERC-20 standard (ST-20) to be able to enter that necessary information as inputs that affect the extensibility of a security token.
Read: Guide to Polymath: Turning Stocks Into Tokens
Transitioning other conventional financial assets on-chain would require similar functionality with some slight alterations. For instance, a non-fungible asset such as a home could be represented with a non-fungible standard similar to ERC-721 or ERC-1155.
A standard such as ERC-1155 can even facilitate the batch trading of assets (both fungible and non-fungible) which could eventually come to represent various asset classes.
However, Jimmy Song’s notion of the problem between connecting physical assets and digital representations of those assets still presents some intriguing flaws in the general idea of tokenization of non-fungible physical assets.
Token standards on Ethereum were built for digital assets first even if the long-term implications of them figured they could eventually be used as templates for bringing other assets on-chain. Enjin proposed ERC-1155 as a method for improving the efficiency of digital collectible trading, primarily with crypto collectibles in gaming.
ERC-20 represents fungible tokens on Ethereum and is an excellent model for the effectiveness of standardizing token interfaces, even if many of the ERC-20 tokens issued ended up as abject failures in adoption.
Read: What Are Non-Fungible Tokens?
Bridging conventional assets — that exist on traditional financial systems — with blockchains requires more nuance than launching digital tokens (i.e., an ICO) that are created from scratch on a blockchain, but is nonetheless feasible. Blockchains provide several benefits as a settlement layer and decentralized infrastructure for transitioning assets on-chain, but there are still significant hurdles that need to be overcome to achieve this.
Hurdles To Tokenized Assets
Compared to other bleeding-edge technologies in the cryptocurrency space, integrating tokenized assets on blockchains is not all that complicated technically. Where the sophistication comes in is from the regulatory and governance standpoint.
Regulatory restrictions need to be hardcoded into the parameters of various types of tokens, and they need to be recognized as authentic representations of the asset by the law.
The SEC and IRS have both been frustratingly slow in their approach to regulating the cryptocurrency sector. The proliferation of security tokens or other tokenized assets simply cannot occur without a concrete regulatory framework.
Moreover, for ownership to be effectively transferred to a decentralized network, there need to be clearcut legal protocols for disputes, and there is no precedent for this on a blockchain. Smart contracts remove much of the ambiguity in such scenarios, but they are not perfect tools for mediating disputes.
Read: Are ICO Tokens and Cryptocurrencies “Securities”?
Mike Dudas also identifies a vital consequence of how digital tokens remove intermediaries such as financial institutions and other middlemen from the process of issuing securities:
“Normally financial institutions serve a few functions: underwriting a deal, preparing marketing materials, soliciting investor interest, ensuring high levels of security and regulatory compliance, and ultimately driving a successful execution of the transaction.”
Removing the financial intermediaries sounds great on the front-end, but will inevitably place substantially more responsibility on the buyer and seller in a transaction and is unlikely to be entirely removed any time soon. Eventually, a new framework for issuing security tokens should emerge, but we are still in the very early stages of the broader trend towards tokenizing assets.
Further, blockchains are still in their early stages. The liquidity of decentralized exchanges is not nearly sufficient enough to substantiate a wholesale transition of financial assets to tokens, and there is no primary reason to tokenize several assets, to begin with. Interoperability is still in its experimental phase too, with developments such as atomic swaps between blockchain networks technically feasible but not practically useful for bringing financial assets on-chain yet.
Governance also presents a complex issue for tokenizing assets. An intriguing concept of tokenizing assets is fractional ownership for something such as commercial real estate property. However, incentives in such models are not naturally aligned and require either innovative game theoretic approaches or regulatory standards to enforce effective governance.
For instance, a company that owns a high-value commercial property has an inherent incentive to maintain the quality of the building through maintenance and renovations over time. However, with fractional ownership, this incentive is diluted since potentially thousands of people could own a portion of the building. The largest stakeholder in such a model may not possess enough stake in the building for it to be worth their investment in maintenance costs. Many of the smaller investors also just won’t have the free capital to make meaningful contributions to such costs either.
Advantages of Tokenized Assets
Some advantages of tokenized assets are clearly identifiable at face value while some are more obscure. It is reasonably difficult to refute that the benefits of tokenizing assets are real and that the transition to tokenizing at least some traditional assets is already beginning.
Most of the notable advantages of tokenizing assets stem from the increase in their flexibility. Primarily, this flexibility leads to:
- Rapid Settlement
- Reduced Transaction Costs/Automated Compliance
- Liquidity/Market Depth
- Decentralization/Reduced Barriers to Access
- Asset Interoperability (Eventually, maybe)
Rapid settlement
is one of the more clear benefits of transitioning conventional financial assets on-chain. Blockchains as the underlying settlement layer are vast improvements over legacy systems. Although trade execution on Wall Street still dwarfs cryptocurrency exchanges, the back-end settlement still takes several days. The proliferation of smart contracts will play a sizeable role here, as settling sales of securities currently comes with much more legal complexity than someone trading Bitcoin on Binance.
Reduced transaction costs
are a result of the removal of intermediaries, reduction in counterparty risk, and reduced fees in transactions on blockchains. Middlemen in the legacy financial system retain many of the fees associated with transactions. Smart contracts can automate processes where fees are currently derived, mainly administrative tasks. Automated functions also fit in here and are a result of the transparency and automation of smart contracts. For instance, compliance can be hardcoded into token contracts which manage parameters for the token such as how or when the token is legally allowed to be traded.
Liquidity and market depth
are more projections of potential once decentralized exchanges and interoperability are more refined within the cryptocurrency space. Traditional assets that are typically illiquid — such as VC private equity — can be traded on secondary markets, granting much more flexibility to initial investors and increased access to other investors.
Decentralizing access
to traditional assets where there has historically been a high barrier to entry is also an advantage of tokenizing assets. An example is the fractional ownership in the previously mentioned commercial real estate building. The high costs of commercial real estate effectively bar retail investors from participating in real estate investing. Governance concerns aside, tokenized commercial real estate assets would confer the opportunity for retail investors to access assets previously not unavailable to them.
Decentralized exchanges also remove single points of failure and provide better avenues for investors to trade assets once their liquidity becomes sufficient.
Asset interoperability
is one of the more intriguing possibilities of a system of tokenized assets but definitely requires the most developments regarding regulation, technology, and governance before it can become a reality. Standardization is good. It is how the Internet arose and will eventually allow tokens to be traded between blockchains. An ecosystem of interoperable financial assets including cryptocurrencies, stocks, and derivatives would facilitate a much more open and liquid financial market.
However, regulatory environments vary drastically between many countries and the technology for trading cryptocurrencies across networks is only in its nascent stages. Portfolios of multiple classes of assets trading on standardized, decentralized and universal exchanges with no custody seem distant because they are, yet it is still possible. Standards on Ethereum such as ERC-20 and ERC-721 demonstrate the potential of standardized interfaces for interacting with different forms of value. These standards may just be relegated to one specific cryptocurrency network now, but interoperable blockchains are on the horizon and are the next logical step for the industry once blockchain networks can operate at scale.
Conclusion
Tokenizing assets is a hot topic because of its enormous potential to redefine the financial system. Many of the benefits of bringing traditional assets on-chain are clear, with some developments already in progress on how that can be accomplished. Despite their promise, the viability of a decentralized and interoperable framework for tokenized assets exchanging seamlessly among cryptocurrencies under full legal compliance is still a long ways off.
