The decade following the launch of Bitcoin in 2009 has seen blockchain and distributed ledger technology — the driving forces behind cryptocurrency networks — attract the attention of traditional financial institutions and major technology firms. The advantages of tokenization in particular are starting to be realised.
In the case of cryptocurrencies, blockchain networks facilitate the creation of tokens that represent units of value. This ability to exchange units of value is why they are also termed “payment tokens*”. Distributed Ledger Technology (DLT) based tokens, however, can be used to represent virtually any asset, digital or physical. It’s possible to represent currency, real estate, or even equity on the blockchain in the form of an immutable token — a fact that is rapidly transforming the way in which companies raise capital.
ICOs to STOs: The Evolution of Tokenization
The rapid rise of the initial coin offering, or ICO, is the most obvious application of blockchain technology and tokenization applied to capital generation. Many blockchain networks exist as decentralized, open networks that allow anybody to participate in maintenance and growth of an ecosystem, regardless of geographic location.
Many blockchain developers and enterprises have attracted significant startup capital to launch new blockchain ventures and have established an entirely new market by allowing investors to purchase tokens – before the platforms upon which they were designed to operate even existed.
To date, the ICO market has generated over $20 billion and has assisted in the creation of some of the largest blockchain platforms in the world, including Ethereum, EOS, and Stratis. As the regulatory framework surrounding the issuance and trade of blockchain tokens has matured, however, initial coin offerings have taken a backseat to the next generation of tokenized assets — regulatory-compliant, legally-recognized digitized assets, or “security tokens”[1].
Tokenization now offers smaller market participants the opportunity to access capital outside of traditional private equity and venture capital models, disrupting traditional capital generation markets.
What is Tokenization?
Tokenization is a method that creates a digital representation of an asset that lives on the blockchain, on both public and private configurations. These entries, once recorded, cannot be altered, making the ownership information of these tokens immutable.
Tokens on blockchains can represent both digital and real-world assets, possess a wide range of applications, and can be split into three generalized categories. Payment tokens, such as Bitcoin, typically exist in the form of cryptocurrencies and are designed for use as a method of storing and transferring value.
Utility tokens* are designed to allow token holders to gain access to the services of a platform and can only be used within the confines of the platform or blockchain application for which they are created.
Asset-backed tokens, however, represent real assets, digital or otherwise. “Tokenizing” assets combines the accessibility, security, and transparency of blockchain technology with the reliability and regulatory oversight of traditional investment vehicles.
Tokenization and Capital Generation
Tokenization presents enterprises and new ventures with an alternative to traditional capital raising models. Smaller companies typically have restricted access to capital, which can slow innovation and growth even when there is high potential investor interest.
Venture capital, for example, is a highly centralized ecosystem. The current venture capital paradigm is centred around limited partners — small pools of investors that are able to reliably act on capital calls. The current VC ecosystem and its’ players business model is fuelled by information asymmetry. Asset tokenization has the potential to increase information symmetry and thus to democratize access to capital.
The ability to raise tokenized funds based on blockchain technology – just one of its applications – has the potential to expand capital raising to reach a global market of investors.
Tokenization and Liquidity
Tokenization also holds the potential to address the liquidity issues present within the private company securities ecosystem. The high-friction private company securities ecosystem is beset by due diligence roadblocks and transaction execution issues, with accountancy and legal process restricting capital flow.
The representation of private company securities on a blockchain platform would facilitate the creation of an ecosystem in which participants are pre-vetted, streamlining the interactions between investors and private companies. In the future when secondary markets infrastructure is more developed, tokenization can also be applied to private equity and hedge funds, allowing investors to exit early by selling tokenized investments.
Tokenization streamlines the way in which assets are represented and traded, reducing friction between market participants. Shifting regulatory attitudes towards DLT-based tokens now allows for the creation of digital assets that can be freely sold and purchased in full regulatory compliance, with fewer middlemen. By streamlining the issuance and trade of securities, blockchain technology and tokenization is removing the barriers to entry that restrict private companies from accessing capital.
[1] Sygnum takes an additional view of tokens according to their property, systematic approach to embed digital assets into regulated banking (blockchain crypto property or BCP for short token categorization) and distinguishes between those which do not have a right towards a counterparty (BCP 1) and those that do (BCP 2). The first instance includes utility and most payment tokens, while the second instance includes asset tokens and potentially some payment tokens, such as stable coins issued by a central bank. This view builds on and complements the functional classification, providing a legal and risk perspective to token ownership.