What is Tokenization?
Generally speaking, tokenization is a process similar to the traditional process of securitization, where the primary difference is that ownership (and its features) is represented via smart contracts. These are coded into a digital asset that will be traded on the blockchain. Owning a certain percentage of the digital asset represents ownership of the underlying entity.
“Cryptocurrencies” vs. Digital Securities
According to the traditional spirit of Bitcoin upon its creation, “cryptocurrency” would be a misnomer here. Furthermore, since the phrase’s namesake and root word (token) can also represent a number of different meanings, we will instead use the more specific phrase of “security token”.
Traditional cryptocurrencies (namely Bitcoin) intended to provide a decentralized, deflationary alternative to fiat currency while retaining the three core functions of money as…
1) a medium of exchange,
2) a store of value,
3) a unit of account.
However, we will contend that many of the remaining players in the cryptocurrency sphere have long since abandoned this goal. For starters, the relative volatility of cryptocurrencies, especially in the last 18 months, has rendered them unreliable while meeting the three core functions of money. Even if investors accepted this volatility, few vendors accept bitcoin as a consistent method of payment. Large scale OTC bitcoin transactions (while well publicized) are not that common. The list goes on and on.
In addition to these challenges, many people ask about the value of cryptocurrency and why people would want to invest in it. Investors would like to know where its value comes from.
The Woes and Throes of Initial Coin Offerings
The same principle applies to initial coin offerings (“ICOs”). ICOs are an alternative way to raise funds as opposed to traditional financing options (i.e. bank loans, capital markets, or even crowdfunding). The issuer raising the funds distributes a given amount of “coins”, where the total amount of funds raised will be split to arrive at an individual coin value. This coin may then be traded in secondary markets.
While ICOs have the potential to be used for legitimate purposes, it has not only presented challenges, but has even been a source of fraudulent activity. created an environment ripe with governmental grey areas (such as taxation) and, in many instances, outright fraudulent activity.
There are many questions and controversies over cryptocurrency value and the opacity of ICOs. These include buyback protocols (not mandated to be disclosed or enforced), ownership rights/representation, and appropriation of funds.
The Tokenizing Solution
Security tokens can be viewed as a digital version of a traditional security according to the Howey test (SEC vs. Howey, 1946). The four components include...
1) an investment of money,
2) from which there is an expectation of profit to be earned,
3) in which the investment is in a common enterprise,
4) from which the profit to be earned is as a result of the efforts of the proprietors of this common enterprise.
Perhaps most famously with a New York City apartment building, tokenization is already hitting real estate. The implications are impressive. Tokenization can provide liquidity to previously illiquid asset classes, making them more accessible to the public. The possibilities for asset tokenization make themselves quickly apparent. The value of the tokens is directly connected to the value and cashflows generated by the underlying. The owner can act as the custodian, as the security tokens are held on their digital wallet. This may eventually change to a new and innovative way for smaller companies to obtain equity financing without subjecting themselves to the expensive and complicated processes normally associated with an initial public offering (IPO).