Tokenization is the process of representing a real world asset on a blockchain. Tokens can represent many different types of assets, both financial and non-financial: cash, gold, stocks and bonds, royalties, art, real estate, and more. The limit of what can be tokenized is only what can be tracked and put on a ledger.
This transition to a blockchain ledger facilitates many important potential changes that can reduce risk thanks to the properties of the rails on which assets can now be transferred and traded. These significant changes will be explored by the Coinbase Institute over the coming months in a series of papers on asset tokenization and its benefits.
I. Why Tokenization is Important
Blockchains are distributed ledgers that contain an immutable record of transactions. They can also store software onchain in the form of smart contracts, which enable tokenization by controlling and executing tokens that represent the underlying asset. Because they are programmable, smart contracts can incorporate predetermined rules on origination, issuance, trading, and servicing assets. Certain public blockchains themselves also incorporate some of the security features and functionality of smart contracts into their core functions. Each method allows parties to transact directly peer to peer, via self-enforcing and self-executing code. This technology not only ensures that transactions are accurate and efficient but also that transaction data (which is immutable) remains visible on the blockchain.
Tokenization, while nascent, is already bringing significant benefits to many types of assets that are being brought onchain. Tokenization of cash has driven hundreds of billions of new purchases of Treasury bills, and tokenization of assets as varied as gold, real estate, diamonds, and art are cropping up globally to reap the benefits of tokenizing assets on blockchains, namely:
1. Risk Reduction
Tokenized assets offer the possibility of instantaneous spot settlement of trades or exchanges without counterparty credit risk. Autonomous smart contracts can settle trades, or revert assets to the original sender in the case of failed settlement. This replicates the function of centralized custodians or clearinghouses but eliminates the risk of the centralized entity itself failing. And by decreasing the number of intermediaries, the technology minimizes the need for trust in other parties. This makes transactions safer and reduces the need for regulatory oversight of multiple different players.
Similarly, the 24/7 operation of a blockchain means that the settlement process can occur continuously, globally, completely eliminating the overnight and weekend risks in spot settlement or margining. Notably, a blockchain ledger with tokenized assets would have either reduced the severity of some major disruptive events in financial history, or perhaps even completely eliminated their impact. Put differently, had Herstatt Bank been operating using a blockchain with instant settlement capability, its failure would have been a non-event and the highly centralized entity of CLS Bank would not be necessary.
2. Transparency
Public blockchains, or those operated by consortiums (rather than single entities that centralize data), provide significantly more transparency into market structure and activity than is available in current financial markets. By giving a 24/7 real-time representation of the location and ownership of all assets (which, even if publicly pseudonymous, could be privately known by certain actors such as regulators), risk can be observed in a system in ways that are not apparent in the current financial structure.
Does a regulator need to know who owns the majority of CDs on an index or a specific name? Does a bankrupt entity need to find the endpoints of a massive web of rehypothecation of bonds in order to unwind trades? Does an exchange need to show that no, in fact, there is not a huge amount of naked shorting of a stock?
All of these tasks, which currently range from complex to impossible in the current system, become trivial with a blockchain and a decent block explorer.
3. Interoperability and Open Access
Open-source and open-access blockchains are fundamentally different from the current structure of closed-source financial systems. This means that new vendors, innovative firms, and simply newly-formed companies can all interact on an even playing field with incumbents, rather than having to fight legacy systems that may exclude them and resist competition and innovation.
Already, open-source systems of this sort have radically transformed markets for the better in short order (e.g., Brazil’s instant payment system Pix), and blockchain technology can do the same for multiple types of financial market infrastructure, from core banking systems to exchanges.
4. Liquidity
Tokenization can also allow markets to become more efficient and liquid. Blockchains that serve as an omni-ledger for multiple types of tokenized assets can eliminate many of the delays and fragmentation associated with the current system. Currently, the purchase of a gold ETF with money held in a savings account will take multiple days to settle. But moving assets onchain and allowing them to be effectively converted for each other—tokenized deposits for tokenized gold, in this example—dramatically reduces the friction between endpoints.
5. Cost and Efficiency
Blockchains allow for automation in areas where traditional financial systems rely on manual operations or private processes. This core functionality leads to both lower cost structures and greater efficiency for all parties utilizing the chain.
II. Regulatory Considerations
To fully realize these benefits, several considerations should be taken into account by policymakers and regulators, namely:
1. Blockchains and/or smart contracts used for tokenization should have the appropriate technical capabilities required to represent an asset onchain.
The appropriate technical capabilities may not be identical on an asset-by-asset basis, but at a minimum, blockchain and smart contracts that support tokenization should have capabilities like “freeze and seize.” This feature will allow issuers to respond to court orders, track tokens effectively to ascertain ownership, and so on. For other types of implementations, even more functionality may be required. Thus, any tokenization regulation or legislation should require that tokenized assets retain the relevant legal and functional characteristics of the non-tokenized version of the asset.
2. Blockchain structure itself should be considered for tokenization.
The functional attributes of the blockchain itself should be considered when evaluating tokenized assets that can exist on a blockchain. Some entities may prefer not to use a public, permissionless chain for something as complex as an interest rate derivative (currently only for qualified institutional buyers in the United States, for example), but a private, permissioned bank chain may be inappropriate for something as simple as tokenized gold or luxury goods. Currently, the utilization of assets varies wildly from lightly permissioned on public chains (Paxos’ tokenized gold) to highly permissioned on public permissioned chains (Franklin Templeton’s tokenized money market fund on Stellar) to private bank chains (JPMorgan’s Onyx). In general, the less restrictive environment should be preferred wherever possible to avoid eliminating the core benefits of blockchain technology.
3. Legal rights and technological rights should be unified where possible.
Owning the token that represents the assets should, legally speaking, be as similar as possible to owning the actual asset. As noted above, if tokenization is meant to simply move the record of ownership to a different ledger (or, in some cases, allow the previously untracked ownership, as for luxury goods, to be recorded), then the token itself should represent ownership with the same rights on both ledgers. If tokenization succeeds, the financial system should no longer need to maintain each existing database and process in addition to representing assets onchain. The goal should be to phase out legacy infrastructure so that the onchain asset is the real asset—not just its representation.
4. Technological benefits of blockchains should be preserved whenever possible.
While tokenization can allow many of the benefits of blockchain technology to be realized, this outcome is not a foregone conclusion if a tokenization regime is unduly burdensome or restricts the uses of the technology in ways that render it useless. For example, tokenized assets that cannot be transferred under any circumstances are at best backup ledger placeholders, and tokenized assets that have no ability to be exchanged for other assets cannot take advantage of instant, riskless settlement. Tokenization makes the most sense, and accrues the most benefit, from public blockchains, which offer the greatest increases in access, liquidity, integrations, and more. Private blockchains, on the other hand, are in many ways similar to legacy databases, and offer far fewer inherent benefits.
Conclusion
Tokenization will unlock important benefits for economies and financial systems. Fundamentally, tokenization is simple: putting an asset on a blockchain. This choice of ledger technology alone should not drive regulation. Tokenized assets, after all, are simply assets on a different ledger. Treating on- and off-chain assets differently would threaten many of tokenization’s important benefits while also creating opportunities for regulatory arbitrage, particularly in cases where tax treatment differs or tokenized assets have more restrictive underlying frameworks. Put differently, if a bank moved an accounting system from Excel spreadsheets to an Oracle database, should the tax treatment change? Regulators should aim to prevent arbitrage by harmonizing rules not only across jurisdictions, but across technologies—and in this case, across ledgers.
Building on this basic principle, it makes sense that different types of tokenized assets will have different regulatory requirements. For example, issuers of tokenized cash, including stablecoins, should likely be required to show proof of reserves and sufficient capital requirements. For tokenized tangible assets, such as real estate or artwork, considerations of physical custody, insurance, and intellectual property will come into play. These will have to be tackled asset class by asset class, not because of any fundamental property of blockchains, but rather because of the nature of the assets themselves.
To this end, we believe it is imperative that laws and regulations around tokenization account for these two simple truths: that assets on blockchains can unlock significant risk reduction, transparency, and economic benefits, and that tokenized assets are simply the same assets, on a blockchain.