Asset tokenization creates a digital representation of an asset on a blockchain, meaning they can be freely traded and securely stored.
Ownership can be established, large assets split into smaller portions to increase liquidity, and sales and trades can take place near-instantly, 24/7 and globally. (See here for more detail on asset tokenization.)
In this post, we’ll go deeper into how asset tokenization is actually performed, what the potential pitfalls are and how you should go about tokenizing your assets.
Tokenizing different asset types
Tokenization of tangible assets — physical objects of value, such as artworks, or precious metals and stones — often involves additional steps.
Some assets can be tokenized directly; precious metals and gems often have well-understood market value. If you’re tokenizing a ship, building or artwork, you’ll need to have it assessed and audited by a consulting firm, law firm, accountant, or bank.
You’ll usually also need to obtain insurance against damage, loss or theft of the underlying asset; this can be obviated by using an institutionally-graded custodian that can self-insure.
In the case of some special tangible assets, like real estate, there are further considerations. Real estate typically has a long paper trail, with title deeds going back to the creation of a building. But this isn’t always the case; it isn’t always true of land and it isn’t so in every jurisdiction.
In order to successfully tokenize real estate, it’s necessary to prove control over the asset: to demonstrate that you have legal authority to manage it. (Control is technically different from ownership or possession, though in some cases it is exercised by the same entity.) The real estate most ripe for tokenization is that it is already managed by a custodian, for this reason.
In most countries, a land registry handles the final demonstration of proof of control. Increasingly state registries or trusted private party registries perform this function for other asset types — think of vehicle registries, for instance. These registries make proof of control easier but they also impose a requirement that sales methods include a mechanism to update the registry. This stumbling-block can be avoided by using a custodian who remains the registered owner throughout the life of the tokens.
Tokenizing intangible assets like patents or other IP, stocks and bonds, or even carbon credits can involve more difficulty in proving control. Some such assets rely on registries — patents, for instance. Others can use the traditional financial system for provenance; stocks and bonds are often already custodied. However, intangible assets as a class are very susceptible to fraud, meaning the initial assessment and establishment of control prior to tokenization is crucial.
Is it a security? Regulation and tokenization
The first question you need an answer to is whether or not your token will be a security. While tokens can be generally grouped into utilities, currency and other types, one of the most crucial distinctions is between securities and all other types of token. This is because the SEC (in the USA), SFC (in Hong Kong) and similar regulatory bodies worldwide are much stricter than the regulations that govern other types of token.
How do you know if a token is a security?
The general rule laid down by the SEC: if it behaves like a security, it’s a security, regardless of the form it takes. People have been prosecuted for illegal securities trading using hand-written notes in the past!
This basic checklist can be used to ascertain whether a token is a security:
- It is an investment of money;
- It involves an expectation of profit from the investment;
- The investment of money is in a common enterprise; and
- Profit is expected to come from the efforts of a promoter or third party.
If a token matches all these criteria, it’s probably a security. If your token is a security, its issuance, initial distribution, secondary trading and every other aspect of the tokenization process will be subject to much stricter, securities-specific legislation and regulations. It’s safest to assume that your tokenized asset will be treated as a security by regulators in the US and elsewhere.
If your token is a security, you’ll need to get registered and certified by the relevant authorities. This differs between locations; in Hong Kong it means getting a license and registering under the Securities and Futures Ordinance to conduct Type 1 regulated activities with the SFC.
However, in common-law countries like Hong Kong, it’s not always 100% clear from statute law and precedent; it’s best to seek expert counsel when structuring your token to make sure you don’t fall foul of regulations.
In other countries, regulations are sometimes more clear-cut. In India the situation is simple: all digital assets are currently outlawed.
In Germany, new legislation allows for tokenized assets to be treated as securities, building on Germany’s forward-looking tradition in this area: it was among the first countries to allow banks to handle digital assets, and legislation in 2019 established a licensing regime for businesses trading in digital assets. The new law replaces the requirement for a paper bond certificate with a requirement for an entry in a registry which can be digital, effectively putting tokenized assets on the same footing as other financial instruments.
However, these and other national regulations within the EU will likely be replaced by a Europe-wide law, “Regulation on Markets in Crypto Assets”, which will include specific requirements for asset-backed tokens like stablecoins and normalize the regulatory environment across the bloc.
Malaysian legislation classified tokenized assets assets as securities in 2019, and Japan’s regulators were preempted by the formation of an SRO (Self-Regulatory Organization) led by one of the country’s largest securities token players. Taking the US FINRA/SEC relationship as its model, the Japan Security Token Offering Association is leading the way in creating a functioning infrastructure for tokenized assets in Japan, again treating tokenized assets as securities.
Brazil has not yet formally regulated digital assets at all, though it does have a law regulating electronic payments, whether blockchain-based or not.
And Singapore requires tokens to be regulated if:
- the token grants any legal, equity or other security interests in an entity
- the token grants any right of repayment of the amount (whether in part or full) paid by holders to acquire the token or any right to interest payments over such amount
- the value of the token is related in any way to the value of any underlying property, or holders of the token can participate in or receive returns arising from (whether directly or indirectly) any property or rights relating to any property
Which again puts tokenized assets into the same category as securities, though in Singapore there are additional legal ramifications.
Around the world, tokenized assets are likely to be treated as registered investments, securities, or both; their sale, issuance and custody are often regulated as activities in addition to the relevant entity being regulated. This means tokenizing entities usually can’t register somewhere like the Cayman Islands and reap the benefits of light regulation in their home jurisdiction; instead, they have to navigate a patchwork of global regulations.
Arranging a custodian
Many real assets are already held by custodians. This is true of valuable art works, stocks and bonds certificates, share certificates and the deeds to real estate and other assets. The custodian is selected by the asset’s owner, or by a third party entrusted with its management.
In the case of real assets the custodian often has extensive experience with that asset class or with the relevant law and regulations, but little or no experience with digital assets. Thus, when you decide to tokenize an asset, it’s a good opportunity to consider switching to a custodian which can help you with the whole process.
In addition to the safekeeping of the underlying asset, the tokens themselves may require custody. During the tokenization process, depending on the model you select, tokens may be created but not released; on release, the protocols used to create them may still require the services of a custodian.
Ideally, select a custodian who can offer expertise in the financial, regulatory, and technical aspects of tokenizing your asset successfully.
Most newly-minted tokenized assets are released via an event like an ITO (Initial Token Offering). This involves the technical process of tokenization, operating the ICO and managing ongoing token issuance.
Creating the token
Creating tokens is perhaps the simplest part of the tokenization and distribution process. Ethereum’s ERC 20 standard lets you create tokens based on a smart contract on Ethereum. It’s the most common choice for tokenization of assets because it’s tested, effective and can be done quickly. However, it’s also crucial to ensure that the underlying smart contract is correctly structured.
While it’s the industry-standard solution, ERC20 may not be suitable for all tokenization projects. Other options include the ERC1400 standard, as well as other blockchains like Polymath and Hedera Hashgraph that offer more dedicated solutions for tokenized securities. The decision largely depends on the project requirements. The downside of ERC1400 and Hedera or Polymath is that there is no wide adoption — so there’s almost no secondary market. This emphasis on secondary marketability drives ERC 20 usage, but may be less relevant in some projects.
To carry out an ITO, you’ll need a few basic assets: the token ready to go, offering documents, and sufficient sales and marketing collateral and efforts to attract the right buyers. While all these things are simple on their own, they need to be handled correctly — and are most effective when there are pre-existing relationships with financial and other institutions that leverage their networks to accelerate sales to the right partners.
The retail/consumer-focused marketing strategies adopted by the first generation of token offerings is inappropriate to major tokenized assets, which may be seeking investment only from professional and institutional investors. It’s now clear that some of these marketing strategies are illegal without proper licensing. If you’re selling securities tokens, the process is referred to as an STO (Securities Token Offering) and covered by different regulations.
Some ITOs, like token sales designed to generate funds for startups, operate with caps; only a certain number of tokens can be created. This may suit your needs, but it’s more likely that you will want to control token production in the long term.
The reason for this is that, if shares in a business go up in price, everyone is pleased: the business and its token holders have all benefited. But if an asset — say, a building worth $1 million — is tokenized for 1 million APTMNT tokens, each worth $1 on initial sale, but after trading on exchanges each is worth $2, the building (value $1 million) is represented by $2 million worth of APTMNT. The solution to this is usually to reduce the value of each token to $1 by issuing more tokens.
This is not the only scenario in which you’re likely to want ongoing control over the supply of tokens and this should be handled by experts with experience in the space and an understanding of the economics of tokenization in practice.
A brief overview of the regulations
The specific regulations vary between jurisdictions and depending on how your tokens are to be classified. This section will give a bird’s-eye view of the general regulatory situation. (Check out this general guide to the regulations general guide to the regulations governing digital assets around the world.)
In general, the relevant regulations are determined by the underlying asset: if the asset is regulated in some way, the token are regulated the same. The exception is if the tokens are classified as securities; then they’re subject to securities regulations, as we’ve already discussed.
There’s no specific regulation for tokenized assets, so what you’ll have to do is look at the regulations governing digital assets in the jurisdiction where you set up your tokenization, as well as any regulations that already govern the underlying asset. This is best done with expert guidance.
Primary and secondary markets
The primary market for your tokens is the initial offering. Establishing the right secondary market can extend the field of potential investors to and retail and professional digital assets investors.
Once the tokens have been purchased by investors, you might want to arrange for those tokens to be traded on exchanges; for that to happen, they have to be listed, and some technical arrangements have to be made to “translate” your tokens into a form that some exchanges — particularly decentralized exchanges — can work with. In addition, there’s competition to be listed on the most liquid and popular exchanges.
Managing this process successfully and integrating it with the rest of your tokenization strategy can benefit from professional assistance, especially with pre-existing contacts in the space as well as relevant expertise.