Benefits of Tokenisation

Tokens are digital representations of assets, that are issued and traded within a distributed ledger. In this note, which is the first in a two-part series, we examine the benefits of tokenisation that stem from adopting the Distributed Ledger Technology (DLT). In the second part, we discuss the risks and challenges faced by this technology.

Introduction

A token is a digital representation of an asset. It is issued within a distributed ledger network, such as a blockchain, where it can also be traded. The process of digitally representing an asset is called tokenisation. The asset that the token represents can either be real (off-chain) or digital (on-chain). Examples of off-chain assets are commodities, fiat currencies, real estate, or even future earnings from an NBA contract.1 On-chain assets exist exclusively on the ledger. An example is getting an on-chain payment for participating or contributing in a network. Although the value of these tokens can be influenced by what happens in the real world, they do not have a direct link with off-chain assets. For example, in an Initial Coin Offering (ICO), tokens are created and then sold to investors. The equity of a non-listed company can also be represented by tokens. In that case, a token represents a share of the company, without the need for having a physical paper-based share as well.

Issuing tokens in a distributed ledger is qualitatively different from tokens or coins that are just digital, because of the unique features of Distributed Ledger Technology (DLT). In this first of a two-part series, we examine the benefits of tokenisation, whereas in the second part we discuss the risks and challenges.

Efficiency gains

The immediate benefit of tokenisation stems from the potential efficiency gains that it can bring in issuing and trading tokens, thus providing a better securitisation of assets. Clearing and settlement can occur faster if it is programmatically coded in the distributed ledger. For example, payment of dividends and coupons, or even voting, can be programmed using smart contracts, resulting in a quicker and more transparent procedure. Change of ownership of a token can be as simple as registering a transaction on the blockchain, and this can happen within seconds. The rights and potential claims of the token holders can also be enforced in an easier and faster way, as they can be encoded in the blockchain using smart contracts. Moreover, when the distributed ledger becomes accepted as the only authoritative data source for transactions, the process of reconciliation becomes obsolete, reducing settlement times, from 2 days currently to almost real-time. Finally, another, often ignored, efficiency gain comes from software standardisation. Currently, there are many different IT systems that handle different types of tokens and they are usually incompatible with each other. DLT has the potential to consolidate these systems, increasing interoperability.

Operating without trusted intermediaries

Efficiency gains occur not only because we move from an off-line representation of assets to an online one. After all, digital representations of assets have been around long before the emergence of DLT. The main innovation of DLT is that it is designed to operate without trusted intermediaries wherever possible and provide a fully automated process, but at the same time taking into account the incentives and economic behaviour of all market participants. For example, a well designed distributed ledger has multiple copies of the database that records all transactions, so that there is no single point of failure. It also provides mechanisms that can withstand attacks from malicious actors, who want to take over the control of the database and manipulate transactions. It operates by achieving consensus on how it is governed. At the same time, it provides transparency, because there is not one single entity that “owns” or controls the ledger. When a transaction occurs, core participants (which anyone can become) have direct control over what information is disseminated in the network. In more traditional and centralised infrastructures, whether off-line or online, those who own the network also control the information.

Automated compliance

Transparency and the automation capabilities of DLT cut costs not only because they remove the middlemen. They can also reduce costs by enabling a more automated process of compliance, where rules are built-in using smart contracts and execute automatically, when a particular clause is triggered. This can reduce the time it takes to get approval for buying a regulated token and complete KYC and AML checks. For example, if approval rests on the types of investors that are participating (e.g. country specific investors) and their number, the approval can be built-in programmatically, so that when the requirements are met, the approval is automatic. Moreover, if all the aspects of how the tokens are handled are specified in open-source code that is freely available, continuous monitoring of compliance can be more rigorous.

Hold-up

Another problem of centrally controlled networks is that the owners can unilaterally decide to change the terms of service. For example, a securities exchange can decide to increase transaction fees, after they have secured a big market share. A social network can decide to use the information generated by its members differently, once it has secured a big enough membership. This can be a big problem if the participants are “locked in” the network, because they have made a substantial investment that they cannot recoup if they leave and join a different network. For instance, the network benefits of transacting in a common marketplace may be so high, that each participant may not be able to leave, therefore they have to tolerate the increased fees. Effectively, the bargaining power of the network owner increases after the participants have made an investment that is not easily transferrable. This is the hold-up problem, analysed in economics, which may induce reduced participation, in anticipation of these problems, especially for smaller-size participants.

This problem can be solved or at least be alleviated if the network is more transparent and not centrally controlled. Shared ownership, which requires consensus for big changes in the terms of service, provides a better guarantee that smaller-size participants will not be adversely affected. This can induce them to participate, leading to a bigger marketplace and an opening up of asset classes that were, up to now, reserved for big-size players. This opening up can occur both on the demand side of investors, such as retail investors, but also on the supply side of firms that seek finance, such as SMEs, which are currently under-represented.

Conclusion

Tokenisation, or the process of issuing and distributing tokens, can be thought of as an evolution of securitization, as long as it can deliver efficiency gains, by leveraging the unique advantages of DLT, such as decentralisation, automation using smart contracts and greater control of one’s information. However, several obstacles need to be overcome before there is mass adoption, such as scaling of transactions, putting safeguards in place, accountability and regulatory certainty. We discuss them in the second part of this two-part series.

Footnotes

1 See https://news.bitcoin.com/nba-star-spencer-dinwiddie-just-tokenized-his-own-contract/ for the case of NBA player Spencer Dinwiddie, who want to tokenise the future earnings from his contract.

Disclaimer

The material provided in this article is being provided for general informational purposes. Aaro Capital Limited does not provide, and does not hold itself out as providing, investment advice and the information provided in this article should not be relied upon or form the basis of any investment decision nor for the potential suitability of any particular investment. The figures shown in this article refer to the past or are provided as examples only. Past performance is not reliable indicator of future results.

This article may contain information about cryptoassets. Cryptoassets are at a developmental stage and anyone thinking about investing into these types of assets should be cautious and take appropriate advice in relation to the risks associated with these assets including (without limitation) volatility, total capital loss, and lack of regulation over certain market participants. While the directors of Aaro Capital Limited have used their reasonable endeavours to ensure the accuracy of the information contained in this article, neither Aaro Capital Limited nor its directors give any warranty or guarantee as to the accuracy and completeness of such information.

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