Tokenization is the process of converting something with tangible or intangible value into digital tokens. Tangible assets like real estate, stocks or
Tokenization is the process of converting something with tangible or intangible value into digital tokens. Tangible assets like real estate, stocks or art can be tokenized. In a similar vein, intangible assets like voting rights and loyalty points can be tokenized, too. We see Avios as an example of tokenized loyalty points by the traditional credit card industry.
However, when tokens are created on a blockchain, they add a level of transparency that previous iterations of tokens couldn’t achieve. There are several banks that are experimenting with tokenization. But, before diving into the use cases in banking, it would be useful to understand the qualitative advantages that tokenization brings to financial services.
As major financial institutions enter the crypto space, they pay special attention to issues like custody and Anti-Money Laundering analytics and compliance. Now, with the dramatic collapse of FTX, the key qualitative benefits of tokenization are in the spotlight yet again.
Liquidity
Real estate is one of the most illiquid asset classes. When a property is worth a few million dollars, buying and selling the property can take time. Now, imagine a $1 million home is tokenized, with each token representing property ownership. When these tokens are available for purchase in the market, 100 buyers can each invest $10,000 to buy ownership of the property.
This naturally increases the ease with which illiquid assets can be sold, as fractionalized ownership is possible with tokenized assets. Fintech firms like Yielders already implement fractional ownership of real estate without using blockchain tech. Also, illiquid asset classes like private equity and venture capital can benefit from tokenization.
When an illiquid asset like real estate or art is tokenized, the entire asset class benefits from the liquidity created. It also allows for a healthy secondary market and creates more data for better valuation of these assets. Platforms like Reinno and Realt offer global investors access to tokenized real estate.
As a property owner, this opens up options of selling just part of the property through tokens instead of selling the entire property. From an investor perspective, someone in Brazil with $1,000 can invest in property in Manhattan.
For instance, Realt offers investors tokenized properties. While the properties listed on their platform cost from several hundred thousand dollars to a few million, they are tokenized and each token can be valued at less than $50. This makes it extremely affordable for interested investors in most places of the world.
Similarly, fractional ownership of nonfungible tokens (NFT) is being rolled out for the more expensive NFT and art collections. As a result of a liquid secondary market for an illiquid asset, pricing also becomes easier due to transparent supply and demand dynamics.
Liquidity risk management
In addition to these benefits, liquidity risk management within financial services organizations can also benefit from tokenization. That benefit is a lot clearer from the FTX collapse and how tokenization could have helped there.
The FTX collapse had several underlying issues, not the least of which came from its business model using the volatile FTX Token (FTT) as collateral. However, if there were checks and balances in place that were transparent for customers to see, mitigating actions could have been taken in time.
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At no point in their journey did FTX create transparency around how much liquid assets they had to service their liabilities. As a result, FTX managed to repurpose user funds (liabilities) for their investments (illiquid assets). Tokenizing both assets and liabilities would have shown a liquidity gap in real-time and cautioned the market of the looming crisis.
After the FTX collapse, there has been a rushed effort to provide proof of reserves from several centralized crypto exchanges. However, proof of reserves only shows that a firm has some assets to service its debts.
An equally important capability is proof of liabilities. If a firm can transparently demonstrate that it has $1 billion in reserves/assets, but its liabilities, which could be $10 billion, are not clear for everyone to see, its solvency is under question.
The challenge in creating transparency around liabilities is that, often, firms capitalize themselves through debt raises in fiat currencies. As these instruments are not tokenized, real-time solvency cannot be demonstrated. Therefore, in order to avoid an FTX-like incident in the future, exchanges will need to provide proof of assets and liabilities.
One of the key qualitative aspects of tokenization that is apparent from the FTX saga is the “proof of solvency.” The transparency that tokenization brings can also help assess the solvency of a firm in real-time. If both assets and liabilities of a bank can be tokenized, on-chain analytics can be used to…
cointelegraph.com