What is an Asset-Backed Token
Asset backed tokens are one of the best applications of blockchain technology to traditional financial instruments, bringing liquidity and price discovery to illiquid markets, with the potential to free up trillions in economic value.
Most utility tokens have no intrinsic value. They are not backed by anything tangible. Utility tokens only rarely perform a function that is both unique and valuable, although they are all promoted this way. Thus, utility token valuation, both during ICO and post-ICO, is driven more by speculative demand than the soundness or even legitimacy of the tokenomic framework.
An asset-backed token does have intrinsic value. Their value is linked directly to the value of an external asset. Asset-backed tokens can facilitate fast, secure, and low-fee trading of real-world assets on the blockchain. So asset-backed tokens provides a common-sense investment alternative to ‘spray and pray’ utility token speculation.
Why tokenize an asset?
Besides the crowdfunding potential native to any ICO-issued investment, the primary reason to tokenize an asset is to improve its liquidity, as defined by how quickly and easily an asset can be bought or sold. Liquidity correlates strongly with the asset’s trading volume. Stocks and bonds are liquid, whereas cars, real estate, jewelry, and collectibles lack high volume secondary market trading activity and liquidity.
Liquidity enhances the value of the underlying asset because it mitigates the risk attached to not being able to exit quickly. A 24/7/365 token trading market improves price discovery, minimizes price volatility, and reduces “flash crash” risk.
Asset-backed tokenization use cases
Though a token backed by an external asset is broadly comparable to a paper currency backed by gold, things get more complicated and interesting when we look at asset-backed tokens linked to non-fungible assets such as real estate. Illiquid markets afflicted with multi-tier value chains, wherein middlemen extract portions of investment value in exchange for the assumption of counterparty risk, can be “freed up” and made more valuable via asset tokenization.
So, some of the most compelling asset-backed token use cases arise from tokenomic architectures backed by illiquid assets with limited commerce such as private equity, derivatives, real estate, fine art, investment-grade wines, and other non-fungible assets. These asset classes suffer from illiquidity, with trillions of dollars asset value parked in vaults around the world as a hedge against inflation. That said, the largest asset-backed token uses cases, defined as those use cases that can raise the most money the fastest, arise from the tokenization of an large established company’s equity or debt.
Examples of use cases for asset tokenization:
- Tokenization of corporate equity or debt.
- Tokenization of a basket of REITs for those investors who want diversify their exposure to real estate cash flows. Tokenized REIT bundles can be customized and sold to investors looking for a specific level of credit risk and duration.
- Tokenization of commercial real estate equity or rental income. The commercial real estate investment sector is currently walled off and unaffordable to millions of people who might otherwise be interested in a relatively small investment. Fractionalization of ownership through tokenization could democratize commercial real estate investing.
- IP asset tokenization of a multi-pronged cash flow like licensing or royalty payments going to everyone that has a claim to a patent, movie, or book.
- Tokenization of debt collateralized by payables and receivables could replace factoring and other supply chain financing, with data and tokens flowing between AP (accounts payable) and AR (accounts receivable) modules in an ERP (Enterprise Resource Planning) system.
Tokenization of a real-world asset increases its value via enhanced price discovery and the concurrent elimination its illiquidity premium. The tokenization of real-world assets, thus, opens up potentially enormous addressable markets. Whereas High Net Worth (HNW) investors can pay a lawyer and others to manage due diligence before taking on a new investment, smart contracts built into asset-backed tokens can partially automate this process, which may, in turn, open up markets to average investors lacking external due diligence support. This dynamic creates even more liquidity.
A token backed by private equity can be augmented with protocols that add dividend and share of profit functionalities, bringing this previously illiquid asset class into the passive income class of investments. This may present startup founders and venture capitalists with new opportunities for funding, profit, and cost-savings.
Four Categories of Asset-Backed Token Use Cases
Here we will look at the tokenization of:
- Equity and debt
- Non-fungible hard assets
- Non-fungible soft assets
Tokenization of equity and debt
Equity and debt tokens are instruments for crowdfunding early-stage companies while disintermediating investment banks, middlemen, and stock exchanges.
Fractional ownership of equity is, of course, nothing new — stock certificates, mutual funds, and timeshares have been around for a long time. What has changed is that the invention of equity and debt tokens makes possible trustless, immutable, and liquid digital representation of a percentage ownership in a company’s equity or debt. Anyone, with access to the conjoined blockchain, including token exchanges, can verify ownership and authority to trade. Market maker arbitrage opportunities should then keep the asset-backed token’s trading valuation at a value close to its NAV (net asset value).
So, though equity and debt are assets that can be bought and sold today, blockchain technology makes the process much more efficient. This represents not an incremental advance, but rather a radical breakthrough akin to Henry Ford moving garage-based automobile fabrication involving a few people over to a factory assembly line. A rise in efficiency this dramatic is bound to grow the market for STOs. A 50% drop in price (asset value destruction) could be easily counterbalanced by a 1000% increase in volume (asset market value creation). This may help entrepreneurs and incumbents who want to pivot quickly to a new production or marketing paradigm that is expected to grow asset value and market share.
Venture capital and other private equity funds hold illiquid assets and require investors to commit to holding their stake for one or more years. Hedge funds hold moderately illiquid assets that require investors commit to holding for a few months at least. Liquidity enhancement via asset tokenization could increase asset value for both of these private equity classes and enable private equity ventures to more quickly adapt to the market fluctuations via portfolio adjustments.
Tokenization of commodities
Exchange-tradable commodities can be converted into fungible asset-backed tokens. No matter if it is oil, natural gas, sugar, wheat, or orange juice concentrate, a commodity that is already electronically exchanged through trusted intermediaries can be tokenized. Cross-border trading of commodities such as renewable hydro, wind, and solar energy could also be done through an exchange tied to a blockchain. Governments, utilities, and individuals could all participate together on a single platform.
Tokens backed by real-world assets require physical verification to establish the token value’s veracity. There is an already mature market all through the supply chain for third-party auditors who verify custodial storage of commodities. Those same third parties may find a new market working in the interest of both asset-backed issuers and holders, using real-world assessment tied to blockchain tracking that relies on technology rather than altruism to create market confidence.
Gold trades as a paper asset through ETFs. Tokenized gold different. Each token matches the whole or part of an actual bar of stored gold that is audited by a third-party “oracle” for weight, purity, and authenticity (some supposed gold is really gold covered tungsten). Tokenizers of gold and other commodities must solve the “oracle problem” to fully realize widespread adoption.
Bitcoin, today’s digital gold, could someday be replaced by tokenized gold. The advantage Bitcoin has over gold today is that it is easily divisible and transmittable. It is easy for a token exchange to take a bitcoin worth, say, $3,000, and “chip off” 1% and send the equivalent of $30 worth of bitcoin into second party’s cryptocurrency portfolio. It is much more difficult to take a one-kilogram gold brick worth about $30k and “chip off” 0.1% and send the equivalent of $30 to someone. Tokenize a gold brick and you can easily sell/transmit a percentage of it in much the same way that gold was moved between parties with the gold-backed paper currencies of old.
Tokenization of non-fungible hard assets
Real estate tokenization
As compared with REITs or private ownership, tokenized real estate is expected to become a more profitable, borderless, and democratic (“real estate for all on the blockchain”) means of investing in things like of basket of rental homes, a senior-care community, or a chain of regionally-branded motels.
Moreover, with tokenized real estate and rental income, all investors, not just institutional and high net worth investors, can build a diversified, flexible portfolio with low or no fees.
Bitcoin is a fungible token. Each bitcoin is interchangeable as are Euro and dollar bills. None of them is distinguishable from others in a way that would create more or less value. Asset-backed tokens representing exotic non-fungible assets such as collectibles are, by design, distinguishable from one another. Each token is unique, creates digital scarcity, and everyone on the blockchain network knows how many there are and how to distinguish one from another.
The logistics of the backend component of the tokenization of an exotic non-fungible asset must be sophisticated. Established asset management firms may find new work as oracles who work the backend around ensuring safe storage in tamper proof packaging, audit certification, insurance, and mechanisms to convert a token to physical delivery. Auction houses do this today with art, furniture, wine, and jewelry.
The majority of people have no opportunity to take an ownership stake in rare artwork. Auction houses Sotheby’s and Christie’s control most of the secondary art market from the world’s wealthiest cities, far from the purview of the average retail investor. Smart contracts could be used to create museum borderless co-ownership of an artwork of art collection, with exhibit dates for which each museum can display the asset encoded on the blockchain.
It is possible to tokenize an individual object as an appreciating asset. Say there is a rare and very valuable painting left to several siblings. The piece is tokenized and distributed to the siblings on a blockchain, with each sibling then owning tradable “shares” of the painting, for which there may be a public exchange where the tokens can be sold if one sibling decides to forego the investment potential in exchange for cash now. Token holders like the siblings in this example have liquidity if and when they need it, while investors can easily expand their portfolio by buying such tokens on a public exchange. Thus, a new class of non-fungible securities is born into liquidity.
This concept has limits. It’s doubtful that an individual person would be interested in purchasing shares in a single classic automobile or a single item of mint-condition sports memorabilia owned and held by another private individual, though they may be interested in buying a token that represents a share in a car museum’s or sports museum’s collection of mint condition pieces.
Tokenization of non-fungible soft assets
Intellectual property (IP) assets are generally illiquid and have no secondary marketplace on which to trade. Conceptually it is not difficult to tokenize intellectual property ownership, and the benefits are many. Copyright, trademark, patent, and royalty equity and income can all be tokenized, enhancing the liquidity and increasing the value of the underlying asset.
Digital asset tokenization
CryptoKitties and other tokenized digital collectibles are examples asset-backed tokens that create scarcity and value. This contrasts with digital collectibles ownership managed on a centralized database, such as virtual farmland earned during play of an online game. Marketplaces for these virtual goods and digital collectibles can be created via tokenization.
Stablecoins are atypical asset-backed tokens
By some definitions, fiat-linked stablecoins are a type of asset-backed token. The stablecoin issuer promises to maintain fiat reserves in a bank at a one-to-one ratio equivalent to the total number of stablecoins in issuance. However, stablecoins are distinct from asset-backed tokens as they are not meant to be an investment. Their value is linked to a specific fiat currency as a hedge against cryptocurrency and utility token volatility. Stablecoins aim to provide quick and easy exit and re-entry points for investors trading on public token exchanges.
Challenges and opportunities
Compared with fiat currency, Bitcoin is more fungible, divisible, transferrable, scarce, and durable.
Asset-backed tokens capture some of those same benefits and apply them to traditionally valuable real-world assets.
Corrupt governments in developing countries seize property, such as land and vehicles, simply because a deed has a minor lean history recording error. A developed country’s government can legally seize land for public use using the right of eminent domain. However, blockchain-encoded deeding cannot be destroyed or maliciously altered as can a paper-based deed verification that is dependant upon a central authority.
Regulators see a vast stretch of uncharted waters around the nexus of decentralized ledger technology and asset ownership distribution. There may be a high risk with for user error when newcomers first enter the market, meaning, for example, that an investor who is anything less than cautious could lose their asset-backed tokens through a wallet addressing mishap.
Some countries have completed banned the issuance of asset-backed tokens (China and Qatar). Other countries allow asset-backed token issuance with loose restrictions and muddled regulatory oversight (Bermuda, Switzerland, Estonia, and Liechtenstein). Malta places no restrictions or limitations on the concept of asset tokenization, but approval, certification, and licensing requirements are legislatively well-defined and regulatorily stringent. This makes Malta the ideal jurisdiction from which to launch an asset-backed token.
Asset-backed tokens are less volatile than cryptocurrencies and utility tokens. Exchange-listed asset-backed tokens can trade 24/7/365 with full price discovery. The ability to open markets regardless of geographical or time zone dissymmetry may soon provide asset-backed token trading opportunities for investors around the world. Moreover, it is likely that established asset-rich companies will soon issue billions of dollars in asset-backed tokens into those token exchanges.