Crypto Basics

Asset Tokenization Explained: Benefits, Risks, and How It Can Work

The growth of cryptocurrencies like Bitcoin, Ether, and a wide array of stablecoins has proven that investors see unique benefits in blockchain-based digital assets. Now, many in both the crypto world and mainstream finance are working to bring those benefits to traditional assets, in an emerging sub-field of digital assets called asset tokenization. At its core, asset tokenization means putting the record of ownership for traditional assets on blockchains. Asset tokenization has the potential not only to facilitate more efficient transactions, but also to democratize access to certain kinds of investment opportunities and bring more liquidity to traditionally illiquid asset classes, such as real estate and art. In this blog, we’ll tell you everything you need to know about the current state of asset tokenization and how it works. 

In this article, we discuss:

What is asset tokenization?

Asset tokenization refers to the process of recording the rights to a given asset into a digital token that can be held, sold, and traded on a blockchain. The resulting tokens represent a stake of ownership in the underlying asset. Virtually any asset, whether something physical like real estate or intangible like stock in a corporation, can theoretically be tokenized. Turning these assets into digital tokens makes them more easily divisible, allowing for fractional ownership that enables more people to invest, which can in turn make the markets for those assets more liquid. Asset tokenization can also enable direct, peer-to-peer trading of traditional assets that currently require middlemen, and can also bring greater security and transparency to the marketplace. 

Blockchain technology

Blockchain technology is at the core of asset tokenization. Blockchains are digital ledgers of transactions and asset balances stored across networks of computers, resulting in an immutable database that acts as a single, shared source of truth. Blockchain technology underpins cryptocurrencies like Bitcoin and Ether, providing a secure, transparent, and decentralized platform for tracking the ownership and transfer of tokens. The decentralized nature of most blockchains means that no single entity can alter the ledger, thereby enhancing asset security and lowering the risk of fraud. 

The tokenization process

How does one convert a real world asset into a digital token on a blockchain? The answer will vary based by project, but here’s an example of how it could work, using a piece of real estate as our example.

  1. Create the digital tokens. The first and most important step is to create the tokens that represent shares in the real estate property. In order to do this, one could create legal entity that would exist solely to own the actual real estate being tokenized. The digital tokens would simply represent shares in the entity, thereby entitling holders to a portion of the real estate’s value and benefits, such as rental income or appreciation.
  2. Smart contract implementation. The issuance, balance tracking, and payouts of benefits associated with the digital tokens representing a tokenized asset would all be governed by smart contracts. Smart contracts are decentralized programs built on blockchains that fulfill specific functions and run based on transparent, auditable code. In the case of a tokenized real estate property, the associated smart contracts could handle critical functions like the distribution of rental income, implementation of governance decisions voted on by token owners (similar to a DAO), and payment of expenses associated with maintaining the real estate.
  3. Token distribution and sale. Once the digital tokens and necessary smart contracts have been created, the next step would be to sell the tokens to investors. This could be done via private sales, an open sale to the public, or a combination of the two using a whitelist model, as many other crypto projects have done. The efficient fractionalization of the asset enabled by tokenization could create a bigger, more liquid market for the asset.
  4. Asset management and governance. As we alluded to earlier, once the tokens have been sold, holders can take a role in management of the underlying real estate, including physical maintenance, tenant relations, property improvements, and more. The exact level of control given to token holders and as a collective and the process for voting on decisions would have to be laid out in the relevant legal entity’s charter and encoded into the smart contracts associated with the asset. 
  5. Secondary market trading. Tokens representing shares in the real estate property could also be traded on secondary markets after launch. This is where the liquidity benefits come into play. Rather than being stuck with an unsellable property as so many real estate investors have over the years, token holders in this example would have greater flexibility and a potentially broader ecosystem of buyers with whom to explore price points. 

Asset tokenization requires significant financial and technical know-how, as well as the meeting of various legal requirements. But as the step-by-step process above shows, it’s hardly inconceivable, and could foster more inclusive, efficient, and transparent markets for traditional asset classes like real estate. 

Benefits of asset tokenization

Asset tokenization is more than just a technological innovation. It could be a paradigm shift in asset management, with benefits for both retail and institutional investors. The transformation of traditional assets into tradeable, blockchain-based tokens can reshape the investment landscape with enhanced accessibility, market efficiency, and security.

Democratization of access

One of the most significant potential benefits of asset tokenization is the ability to democratize access to investment opportunities, while still maintaining appropriate safeguards. Traditionally, asset classes like commercial real estate and fine art have been the province of institutional investors or the very wealthy, with high barriers to entry. Asset tokenization can break down those barriers by enabling fractional ownership of assets, meaning investors can own tokens representing small shares of that asset. Fractionalization could lower the minimum threshold for investing in these assets, and allow retail investors to participate in markets previously out of their reach. This would in turn allow a broader range of investors to diversify their portfolios in new ways. 

Market fluidity and efficiency

Asset tokenization can enhance market fluidity and efficiency in several ways. First, fractional ownership can increase the liquidity in traditionally illiquid assets like real estate, as investors can buy or sell tokens representing partial ownership quickly and easily, whereas real estate transactions today are lengthier, more complex, and typically require the sale of the entire property. Secondly, blockchain technology and smart contracts can streamline the transaction process, reducing the need for intermediaries, cutting down on transaction times and costs, and enabling a 24/7 global market for tokenized assets with the right framework. These increased efficiencies could have the knock on effect of making the markets for tokenized assets more attractive to investors, thereby increasing the value of the underlying assets.

Security and transparency

Blockchain technology can bring increased security and transparency to tokenized assets. Blockchains’ decentralized nature makes them immune to tampering, giving investors confidence in the integrity of their holdings and transactions comparable to or even greater than what they have now. Furthermore, the transparency of blockchains can reduce the risk of fraud in tokenized asset markets — the holdings and transactions of all wallets are visible and updated in real time, so any sale or transfer would be easy to identify and evaluate.

Of course, it’s no secret that cryptocurrency projects have faced security challenges even though the underlying blockchains generally remain safe, mainly in the form of hacks of DeFi protocols that have led to the theft of billions of dollars’ worth of crypto assets. Will tokenized assets fall victim to the same problems? Not necessarily. Innovations in digital asset security, such as improved smart contract audits, can address these problems and help cut down on hacking activity. Additionally, many traditional finance participants will likely opt to deploy tokenized assets on permissioned blockchains, which despite reducing decentralization and trustlessness, would likely be more resistant to hacking attempts and other forms of malicious activity. 

Asset tokenization use cases

Tokenization of real world assets can improve markets for several different asset classes. Let’s look at a few below.

Tokenized real estate

Real estate is one of the most promising and frequently discussed examples of an asset that can benefit from tokenization, which is why we’ve used it for so many of our examples throughout this article. Real estate transactions often require a combination of money up front and substantial loans since the purchases are typically quite large. By tokenizing real estate assets, investors can buy or sell shares in individual properties much more easily, in more granular sizes and with less need for intermediaries. Tokenization of commercial real estate, for example, could make investment in high-value properties far more accessible to a wider range of investors and introduce more liquidity into a market traditionally known for its lack of liquidity. 

Tokenized bonds

Tokenization of bonds is another promising example of asset tokenization, and one that has already gained steam. Tokenization can streamline the bond issuance process and automate several aspects of bond management, such as interest payments and maturity settlements. That, along with other benefits like reduction of intermediaries and lowered transaction costs, could make bond markets more efficient and accessible. 

Tokenized carbon credits

Carbon credits are financial instruments that represent a business’ successful reduction in carbon emissions by a specific amount, usually issued in the context of laws demanding companies in a given country or region collectively reduce emissions to a targeted overall level. Carbon credits can be traded like any other financial instrument — companies who don’t actually reduce their emissions can buy carbon credits from those that have, essentially allowing them to pay to reduce their on-paper environmental impact and meet their emissions requirements under the law. Tokenization of carbon credits could enhance the transparency and efficiency of the carbon credit market, and also make it  easier for smaller companies to buy and sell credits given the fractionalization of credits that tokenization could enable. Overall, this approach has the potential to create new opportunities within the green economy by increasing the pool of possible participants.  

Other examples of real world asset tokenization

Tokenization can be applied to virtually any asset class, no matter how niche, as long as a market exists for it. For instance, intellectual property in the form of patents and copyrights could be tokenized, giving artists and inventors new ways of monetizing their creations. Unique collectibles like classic cars, luxury yachts, pieces of rare art, vintage wines — all of these present opportunities for tokenization as well. In all cases, the primary benefits are democratization of access, increased transparency, and the fostering of bigger, more liquid markets. 

Risks and challenges of asset tokenization

While asset tokenization presents numerous potential benefits, there are also risks and challenges that must be addressed, as is the case with any emerging technology. Let’s look at a few below.

  1. Regulatory uncertainty. The future of digital asset regulation is uncertain in many parts of the world, including the United States. Among other unknowns, that uncertainty can create risks for prospective issuers and purchasers of tokenized assets, particularly in cases allowing cross-border transactions where multiple jurisdictions are involved.
  2. Market adoption and liquidity. Tokenized assets’ promises of increased liquidity are premised on widespread market adoption. Without investor trust in tokenized assets and blockchain technology more broadly, as well as the necessary infrastructure, this may not happen. Investors attempting to tokenize assets today may find it difficult to establish a robust market immediately.
  3. Current security risks. As we discussed earlier, the some crypto projects face security threats today, mostly related to the hacking of DeFi protocols. While financial institutions tokenizing assets could take steps to mitigate these concerns, such as by employing private blockchains, these steps would likely require tradeoffs on characteristics like openness and decentralization, potentially reducing the benefits of asset tokenization.  
  4. Operational complexity. Tokenization of assets introduces new, complex processes around the integration of traditional asset management tactics with emerging blockchain technologies. This can lead to operational challenges — investors and issuers would likely need robust wallet infrastructure to manage their tokenized assets, different from the technologies they use today. 
  5. Valuation concerns. The valuation of tokenized assets, particularly in niche asset classes or those currently without well-established, liquid markets, could be challenging. This may lead to unexpected volatility or pricing discrepancies, potentially impacting investor returns and market stability.
  6. The education gap. Lastly, there is a significant educational gap in the market. Many potential investors and participants in the tokenization ecosystem are not fully aware of how it works, its benefits, and its risks. Overcoming this knowledge barrier is crucial for the widespread adoption and success of asset tokenization.

While challenges associated with asset tokenization are non-trivial, they’re solvable with the right strategies and advancement in both technology and regulation associated with digital assets. The ongoing integration of traditional finance and digital assets, one example of which we see in the recent momentum on establishment of ETFs devoted to crypto assets like Bitcoin, suggests the appetite to solve many of these problems exists and is robust. Overall, the key to overcoming these challenges is collaboration between blockchain technology experts, traditional finance leaders, and regulators, to ensure that asset tokenization can move forward productively and safely. Education of potential investors and other market participants on the benefits and challenges of asset tokenization is also essential. Ultimately though, if all stakeholders can agree that the potential benefits of asset tokenization outweigh these challenges, we’re likely to see progress on solving them. 

Asset tokenization today: Examples of active projects

There are several asset tokenization projects underway today, from both crypto native and traditional finance businesses. Let’s look at a few below. 

    1. Securitize. Securitize is a prominent company in the asset tokenization space, using the Ethereum blockchain to issue various types of security tokens.
    2. Ondo Finance. Ondo offers access to tokenized tradfi assets, such as short-term U.S. Treasuries via its on-chain Ondo Short-Term US Government Bond Fund
    3. Centrifuge. Centrifuge is a specialized blockchain designed for individuals and businesses to borrow against tradfi assets from DeFi-based lenders.
    4. Onyx by JP Morgan. Formed in 2020, Onyx is banking giant JP Morgan’s permissioned blockchain, where users can trade tokenized assets like U.S. Treasuries and mortgage-backed securities, as well as JP Morgan’s own JPM Coin, a U.S. dollar-pegged stablecoin designed for interbank payments.
    5. Goldman Sachs. Goldman Sachs recently launched its Digital Assets Platform in partnership with blockchain software provider Digital Asset. Using Digital Asset’s purpose-built Canton Network blockchain, Goldman Sachs’ platform can facilitate the issuance, registration, settlement, and custody of various tokenized assets.

These are just a few of the asset tokenization projects in motion today. Many others have launched or are in development, and many more are likely to follow in the coming years. 

Asset tokenization is an area to watch

Asset tokenization is one of the most exciting areas of blockchain technology, and one that many expect to grow in the near future. While challenges remain, asset tokenization has the potential to merge the new world of the crypto economy with the old world of traditional finance, giving more people the opportunity to invest in assets currently not available to them, while also enhancing market efficiency. 

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