Common misconceptions and the latest updates of tokenizing assets
Photography: Matthew Henry
Here we go. You’ve heard about blockchain, about tokens, tokenization of illiquid assets. What
does all of this mean for real-world businesses, consumers and investors? With the first jurisdictions starting to list regulated security tokens on their national stock exchanges (special shout-out to Seychelles), time is ripe for a real discussion of what is.
What is tokenization?
Simply put, tokenization means digitalization of an asset through blockchain. Any asset with real-world value such as real estate, land, arts and trademarks can be converted into a digital representation by issuing a token. A common token used to represent an asset is the Ethereum-based ERC-20 token modified to comply with security laws. Therefore legally speaking, these assets are viewed as securities.
Say you’re a property owner. Your property is your asset. Tokenizing that would mean issuing a number of tokens to represent the value of that asset. You can slice your asset into a million pieces and trade them on the market for greater liquidity and asset appreciation.
Simple and easy, right?
Not so fast.
Steps to tokenize and its current challenges
While in theory, the benefits of tokenizing assets come with multitude: increased capital, greater liquidity, immutable tracking and streamlined transactions... in reality, we still have a long journey ahead before achieving any compliant tradability on the market.
In order to tokenize any asset, these are mandatory processes that need to happen one way or another. In minimum, we need to be able to answer these questions:
1. What is the real legal representation of the token?
Easier than sounds. In real estate, there are numerous different types of ownership rights from direct property ownership to rental income rights. What does your token legally represent: the right to use the property or perhaps shares in a SPV (Special Purpose Vehicle) that owns the property?
This will not only affect the type of security laws or tax implications you are subject to but also your direct claims rights and legal issues caused by those different rights.
2. What is the logic of smart contracts and protocol?
What we’re talking about here is essentially programming securities. Smart contracts can automate processes such as paying out dividends with built-in compliance. Therefore, pre-conditioned terms and agreements, market conditions and complications need to be taken into consideration.
3. How to legally store and transfer ownership of tokenized assets?
This is where things start becoming tricky. One way or another, you need to have a blockchain platform that has the legal authority to store those rights to the assets. A regulated marketplace, if you will. OR you will need a license to issue security tokens, which is a whole another chapter.
Being able to legally store assets on blockchain is one thing. To achieve greater liquidity, you also need to be able to transfer ownership to investors and other stakeholders in a compliant way.
To date, we still don’t have a single regulated security token exchange to enable this for mainstream use, for unaccredited investors.
4. How to legally trade and convert tokens into real-world value?
Tokenizing an asset makes no sense if you have no place to sell, buy and ultimately convert the represented value into a real-world figure such as fiat currencies.
We already have a number of unregulated marketplaces where all types of trading happens, but in order for this to be legally compliant, we’re looking at an not-so-easy process of tracking ownership, investors and other stakeholders, private valuations and AML/KYC (Anti-Money Laundering/Know-Your-Customer) requirements which are all different per country.
5. How to structure and manage decision-making with compliance?
Something we don’t talk about enough. Many would happily tokenize their illiquid assets but not worry about how things are being managed afterwards.
As an asset class, securities are some of the most regulated types in the world today. This means that the size of investments being placed are relatively predictable. In a tokenized world, a property could literally be sliced down into tens of millions of fractions which are no longer limited by fiat decimals such as US$0.01. The governing, voting and structuring of these instruments would then ultimately also need to be built to reflect that scalability.
To most of the above questions, we simply don’t have answers yet.
Having been at the heart of this development and seen the play between tech and law,something seemingly simple like an e-signature may take a lifetime to get legally approved.Therefore tokenizing assets to be tradable by the mainstream on a global scale is still very, very new.
That said, however, there is another way.
An alternative way of tokenizing
Like in anything in life, there is always an alternative.
Which way to go? Photography: Caleb Jones
Smart Companies = tokenized legal entities
Just like tokenizing assets such as real estate, why not tokenize an entire company?
If you don’t know what a Smart Company is, learn more here
In essence, this means that corporate shares of a legal entity can be converted into tokens.Similar to tokenizing illiquid assets, tokenized corporate shares are a digital representation ofassets owned by the company. So instead of tokenizing real estate, you’d tokenize the legalentity that owns the real estate. In our case, we convert corporate shares into ERC-20 tokensmodified for security laws per each jurisdiction we operate in.
And why would anyone want to do that?
Simple. To get real legal ownership over tokenized assets. And to be able to manage all thingsrelated to those assets directly on Ethereum.
The common misconception
Here’s what’s happening. Due to lack of regulations in this field today, the currently used method to tokenizing real estate is this: real estate → security tokens → unregulated trading → OR regulated trading only for accredited investors.
Frankly, to trade with accredited investors, we don’t even need blockchain in place. We have perfectly established ways of doing that already through regulated vehicles like REITs (Real Estate Investment Trust) for instance. So what exactly is the purpose of tokenizing an asset in the first place?
But if you tokenize the legal entity that owns the real estate, you have compliant ownership over the asset, direct custody. Therefore, you can sell, buy, trade and merge - virtually anything that can be done as any legal entity. This is what Smart Companies were designed to do.
So what can one do with a tokenized legal entity?
Let’s see.
1. Legally own, store, buy and sell tokenized corporate shares
2. Tokenize anything of value in the form of a limited company such as real estate, land and yachts or IP rights and trademarks. And then convert those shares into fiat currencies the same way companies would do today on the real markets.
3. Track, manage and vote with all shareholders digitally on an Ethereum-powered dashboard with immediate legal validity
4. Tokenize certain corporate assets with pre-conditioned terms that are placed on an automated smart escrow
And the list goes on… you get the point. We like this ocean of possibilities.
Now, of course, tokenizing entire companies makes things easier navigate from legal point of view today, but this certainly raises other set of challenges such as entity governance, dividends and misaligned incentives. These all belong to corporate governance, which we’ve talked more extensively about in our previous post.
Conclusions
From all aspects, we are still in early days. In diapers.
Tokenization of illiquid assets has transformative potential in simplifying today’s complex procedures in the world of investment. But for now, a good deal of regulatory consensus and reform is still needed before things will leap forward.
The good news is that we’re starting to see more and more jurisdictions jumping in the bandwagon and making serious effort in passing blockchain-friendly bills. One of our favorite examples on this has to be the state of Wyoming, U.S that has been pioneering in this movement bill after bill (total 13 to date). Others taking giant leaps have been the Seychelles government as well as Malta - opening doors for regulated security tokens.
So a long journey ahead - but one thing is for sure, with the crazy community of ours and progressive lawmakers in the game, impossible is nothing!
Lu Ying is the Chief Operating Officer of Korporatio. Lu has a diverse background from business strategy to C-level execution and startups to Fortune 2000s and intergovernmental organizations. Wildly curious about human behavior, macro trends and future, Lu explores systems shifts in the space of circular economy and decentralized models through blockchain governance. Interdisciplinary and nonlinear, Lu is also a World Economic Forum Global Shaper and sits on the Board of Entrepreneurs Organization Shanghai.