Tokenization of Assets

V&IApproaches and Challenges

When we talk about blockchain technology, the first thing many people think of is cryptocurrencies such as Bitcoin or Ethereum. However, there are other smart contract-capable blockchains that all compete for one thing. The first use case in the real economy to be widely adopted. There are some voices suggesting that this use case is the tokenization of assets.

In this article, we would like to look at what tokenization means and what challenges are associated with it.

What are Tokens?

In the traditional understanding, tokens were basically the representation of a certain value. These could be scooter coins, food tokens or a winning lottery ticket. The use of such tokens brings various advantages. These include the simplified transfer of specific values and the possibility of dividing an asset into partial values.

In the blockchain world, a token is a virtual object that exists within the blockchain network. They can be linked to rights, access and identities. They are created on the basis of a smart contract, which not only regulates the emission of the token, but is also responsible for its monitoring.

What are Token Standards?

To create a token on a blockchain, you first have to choose a blockchain with smart contract capability and (in most cases) set up a smart contract that regulates and monitors the issue of the token. In practice, various token standards have been established over the years to serve as a guideline for the creation of certain tokens. For Ethereum, the largest smart contract-capable blockchain, the following three most commonly used token standards can be defined:

The ERC-20 token is the earliest form of the token standard and was first proposed in 2015 in the Ethereum Improvement Proposal (EIP) by Vitalik Buterin. The token standard allows the creation of fungible tokens that are interchangeable and follow the same rules. Examples of ERC-20 tokens is the USDC stablecoin. 

The ERC-721 token is currently the best-known token standard when it comes to the definition of non-fungible tokens (NFTs). Each individual token from a collection has a token ID that is unique to the token address. For this reason, NFTs created with this token standard are not considered interchangeable.

The ERC-1155 is a multi-token standard that allows both fungible and non-fungible tokens to be created. In addition to these features, this token standard also allows the so-called batch transfer, in which several assets can be sent simultaneously

Over the years, many different token standards have been developed that can be used depending on the use case. Be it to enable metadata customization within the token or to meet compliance guidelines for security tokens.

What does Tokenization mean?

Tokenization is an economic system based on the principle of linking goods and services with tokens managed in the blockchain. Here, a token represents a specific good to which an intrinsic value is assigned. The associated token economy can generally be divided into two areas:

The first area relates to Token Incentivization. It aims to create a system in which participants are rewarded with tokens for certain actions. These tokens can then be exchanged for physical and digital goods, services or FIAT money. Token incentivization therefore aims to establish tokens as incentives for desired actions.

The second area concerns the Tokenization of Assets. These can be securities, capital goods, commodities or digital media. The tokenization of assets pursues the goal of mapping ownership from the real and digital world in the form of digital tokens on the blockchain in a forgery-proof manner. In this way, the ownership and transfer of these assets can be digitally recorded and verified using blockchain technology without having to rely on a middleman.

Both types of token economy open up a wide range of potential use cases. The tokenization of assets is currently considered to have the greatest potential to reach mass adoption.

Tokenization of Assets explained with examples

Looking at the development of the tokenization of assets, the first thing to note is that the market for this is still relatively young. Nevertheless, there are already initial approaches to the tokenization of physical and digital assets.

Tokenization of Art is probably the most obvious example when it comes to understanding how physical assets can be mapped using blockchain technology. Two forms of tokenization can be distinguished here.

Holistic tokenization is primarily about creating a certificate of ownership for an artwork. Holistic tokenization allows the ownership of a painting to be represented digitally on the blockchain. The artworks themselves are often digital, but tokenization is also possible for physical pieces of art.

Fractionalized tokenization involves dividing a work of art into pieces and assigning an NFT to each of these pieces. A painting can be divided into one hundred, one thousand or ten thousand parts and offered for sale. Fractionalization allows a physical object to be distributed among several owners, which also makes it possible to acquire shares in high-priced works of art.

In the Tokenization of Real Estate, there are two forms of tokenization. A distinction can be made here between the strict and the extended definition.

In the strict definition, the intention is to digitally certify the ownership rights associated with a property. The buyer of the token therefore acquires a corresponding part of the property and the resulting income and expenses as well as the legal claims and obligations arising from this.

In the extended definition of tokenization, on the other hand, the token holder is entitled to a portion of the income generated by the property in certain periods. These tokens have similar characteristics to shares or securities.

The Tokenization of Commodities includes the mapping of commodities such as gold, oil or coffee. As with works of art, the advantage of tokenizing commodities is that both holistic and fractionalized commodity tokens are available for purchase and trading. Offering, buying and selling these goods can be done more cost-effectively and efficiently.

In practice, the tokenization of commodities has emerged in the form of so-called commodity-based Stablecoins. Each token is backed by a corresponding quantity of the commodity, which means that the price of these stablecoins reflects the real price of the commodity.

Tokenization of Assets - Advantages and Challenges

In theory, the tokenization of assets seems to offer only benefits through the elimination of intermediaries.The tokenization of real assets through smart contract technology promises great efficiency gains in purchasing and administrative processes. While the use of smart contracts automates processes, the underlying blockchain synchronizes payment flows, which simplifies the process of buying and selling assets. In this way, many manual steps and involved third parties become obsolete. The result is a streamlined process in which all relevant information is available on a blockchain.

In practice, however, many hurdles still need to be removed in order to create an actual token economy of real or digital assets. The first aspect involves regulatory requirements. It is still not clearly regulated what a tokenized secondary market could look like and which rights can be granted with the respective tokens.

Further questions regarding the tokenization of real and digital assets also relate to the technological side. It must be clarified which blockchain (layer 1, layer 2, sidechain, public, private, hybrid) can be used for tokenization, what a KYC process should look like, how the internal business workflow will function in the new business model, what the customer journey should look like i and how data security will be guaranteed. All of these questions require well-founded answers that can only be provided by interdisciplinary collaboration between blockchain specialists, technical experts and a connecting, generalist instance of the Web 3 Business Analysts.