What is an Asset-Backed Token? A Complete Guide to Security Token Assets.
As originally published on: medium.com
Utility tokens have traditionally been the modus operandi for new blockchain company funding rounds, through the initial coin offering (ICO). But although utility tokens supposedly have value within the platform they operate on, they often lack a unique value proposition and likewise, by definition they do not represent an actual tangible asset. In fact, utility tokens are so far removed from real world assets, that the U.S. Securities and Exchange Commission (SEC) have recently been cracking down on those ICOs which cross the boundaries into the territory of being a security in their efforts to provide fundamental value to holders.
This is one of the main reasons that the value of utility tokens, either during their token sale or once they are trading on third party exchanges, is driven predominately pure speculation, rather than the robustness of their tokenomic model.
However, asset-backed tokens, often offered during a Security Token Offering(STO) carry an actual value, because they are correlated with an external, real-world asset’s value. Asset-backed and security tokens offer secure, rapid and minimal cost trading of traditional assets via blockchain technology, and increase liquidity for traditional securities.
Why Make an Asset-Backed Token?
Security tokens, or asset-backed tokens, increase the potential initial raise for fund operators and other parties who issue securities. However, the main reason it’s beneficial for crypto fund managers to create cryptographic analogues of traditional assets is to increase the underlying assets liquidity — defined as the ease and speed at which assets are purchased or sold (liquidated) at market price. Generally, bonds and stocks are assets with high liquidity, in contrast to assets such as vehicles, real estate, jewellery, art and collectibles which lack access to high trading volumes, trading opportunities on exchanges, and liquidity.
But why is liquidity so important? Liquidity correlates strongly with an asset’s trading volume, and subsequently affects that assets price. Good liquidity can enhance the underlying assets value, as it negates the risk associated with being unable to exit a position in a given asset quickly. For example, whilst it’s easy to exit a position in a stock via a third-party exchange, liquidating your position in a piece of real-estate is a significantly longer process, as in simplest terms, it takes longer to find a buyer.
A tokenized asset trading market which trades 24 hours a day, 7 days a week and 365 days a year not only provides enhanced price discovery and reduces price volatility, but it may also reduce the risk of a sudden price crash in asset value.
An Overview of Asset-backed Tokens Use Cases
Tokens which are backed by external assets are somewhat comparable to gold backed paper currencies, like many traditional fiat currencies were under the ‘gold standard’. But the situation becomes more complex when we examine tokens associated with assets which are ‘non-fungible’— for example, real estate.
The real estate market is fairly illiquid, and heavily afflicted with multiple inefficiencies; such as middlemen who receive a portion of an investment for taking on counter-party risk. However, these pain points could be alleviated and given greater value with asset-backed tokens, which would tokenize a portion of an individuals position in a real-estate asset.
The most novel use cases for asset-backed tokens are therefore emerging from tokenomic models which are backed by limited liquidity assets — such as derivatives, private equity, real estate, collectibles, and other assets which have been traditionally difficult to find immediate buyers for. Currently, assets which are non-fungible are worth trillions, but are for the most part they are stored in vaults worldwide as hedges against inflation rates.
Illiquid assets aside, the largest use cases for asset-backed tokens, which have the highest potential to raise funds during an STO, generally manifest from tokenizing a portion of a large established company’s debt or equity.
A quick look at some examples of asset-backed token use cases include:
- The issuance of corporate debt or equity via a security token.
- Real estate investment trusts (REITs), for investors that wish to diversify their portfolio to include real estate. Real estate investment trust tokens would also allow customization, and may be purchased by investors willing to accept a certain credit risks, for a pre-determined duration.
- Equity from commercial properties and rental income. Retail investors who have a relatively modest amount of capital are currently unable to diversify into the commercial property and rental market. Ownership fractionalization through security tokens offers the opportunity to democratize commercial and rental investing.
- Intellectual property asset backed tokens, such as film licenses and royalty payments, may be distributed to every party who owns a portion of a patent, film, or book.
- Accounts payable and receivable, represented by security tokens, has the potential to replace supply chain finance and factoring, with tokens and data flowing between accounts receivable and accounts payable, in ERP systems.
Real world assets represented as tokens on the blockchain therefore provides access to potentially large addressable markets.
Smart contracts associated with tokenized assets may likewise improve access to trading opportunities. Although professional investors can currently use the services of lawyers and other service provides to perform due diligence on new investments, investors with lower capital amounts can generally not afford to take on such risk. Tokens with built in smart contracts can automate due diligence to an extent, which in turn has the potential to open markets to retail investors who lack access to due diligence providers— creating even greater liquidity.
Likewise, a private equity backed token can be developed to feature protocols with inbuilt dividend and profit share functions, transforming an asset class with traditionally low liquidity into a passive income generating investment. This offers startups and VC firms a greater opportunity for funding, cost-savings and profit.
Below, we examine the four main asset-backed token categories in greater detail.
What are the Main Asset-Backed Token Categories?
Earlier we introduced an overview of asset-backed tokens, why you would want to tokenize an asset, and looked at some of the most obvious use cases for asset-backed tokens.
Now, we are going to break asset-backed token use cases down further into the following four categories:
- Debt and equity tokenization
- Asset-Backed Tokens for Commodities
- Hard Assets which are Non-Fungible
- Soft Assets which are Non-Fungible
Debt and Equity Tokenization
Debt and equity asset-backed tokens are used predominately for funding start-up companies, which in turn circumvents intermediaries such as investment banks and traditional exchanges (for IPOs).
Fractional ownership for equity isn’t a new concept — stock certificates and mutual funds have already existed for decades. But what asset-backed tokens now offer is a percentage digital ownership of an immutable, liquid and trustless representation of company debt or equity.
Anyone may access the blockchain protocol on which an asset-backed token resides, including security token exchanges, and may verify the ownership of the token and the authority of a specified individual to trade. Arbitrage opportunities for market makers should maintain an asset-backed token’s trading closely within its true net value.
Debt and equity are already assets which can be traded today, but blockchain makes this process more efficient, which could significantly grow the STOmarket. Subsequently, a 50% decrease in price (via destruction of asset value) could easily be counter-balanced by a thousand percent volume increase (via creation of new market value). This would assist both incumbents and entrepreneurs alike, who would need to react quickly during emerging production and marketing industry shifts, which are expected to enhance value of company assets and company market share.
Holdings of private equity funds are most often low liquidity assets which require investors to hold for over one year. Likewise, hedge funds often hold assets with relatively low liquidity which often require investors to hold assets for at least a few months. Therefore, enhanced liquidity via asset tokenization would increase the value of assets for both private equity funds and hedge funds, enabling private equity ventures to adapt easily to market fluctuations.
Tokenization of Commodities
Exchange traded commodities can likewise be converted into security tokens. Regardless of whether it’s oil, natural gas, wheat, or sugar, commodities which are already traded on third party exchanges can be effectively tokenized.
Trading of other more fringe commodities, like renewable hydro-electric, wind, and solar electric energy can also be facilitated through a blockchain based exchange. As a result, governments, utilities companies, and individuals could participate and transact together on one platform.
However, tokens which are backed by physical assets require verification to establish the tokens validity. A mature market already exists for auditors who verify the security and trustworthiness of custodial storage facilities for commodities. Those same auditors could take advantage of new opportunities using blockchain technology, by utilizing manual assessment methods in conjunction with blockchain tracking — relying upon technology to create confidence in the market.
Although gold commonly trades as paper assets through gold ETFs, gold which has been tokenized is fundamentally different. Each gold backed token represents a whole or fraction of a a gold bar which is stored and audited, through the services of an“oracle” provider, for it’s weight, purity level, and it’s authenticity — Therefore, those who tokenize gold or other commodities have to first solve the issues with oracle providers to realize widespread asset-backed token adoption.
The leading cryptocurrency, Bitcoin, often referred to as ‘digital gold’, may potentially be replaced as the primary store of digital value by using tokenized gold. Current advantages which Bitcoin holds over physical gold, is it’s relatively easy divisibility and transferability. For example, it is simple for token exchanges to take 1% of a Bitcoin, sending the equivalent dollar value of BTC into an individuals cryptocurrency portfolio.
In contrast, it is conceivably of far greater difficulty to take a gold bullion bar, fractionalize it, and send it to an individual. If that gold bar were to be tokenized, one could easily sell and transfer any given percentage of gold in a similar way to traditional paper currencies backed by gold— and the same is true for other real-world commodities.
Hard Asset Tokenization
Hard assets are tangible and physical items or objects of worth that are owned by an individual or company. There are many possibilities for the tokenization of hard assets on the blockchain.
Tokenization of Real Estate
As we briefly touched on earlier, when compared to REITs or private property ownership, real estate token funds could become a borderless, more profitable, and a more democratic way to invest in things such as a portfolio of rental properties, senior-care homes, or a hotel chain.
With the rise of real estate backed tokens and tokenized rental income, investors of every wealth bracket can build out a diverse and flexible real estate portfolio with minimal exchange fees.
Collectibles tokenization
Bitcoin’s are fungible. Every Bitcoin is interchangeable, just as Euros, Dollars, and Pound Sterling. They are indistinguishable from each other, as they are all, at their core, units of currency and exchange.
In contrast, asset-backed tokens have the ability to represent exotic and non-fungible assets, like collectibles, and therefore they are distinguishable from one other tokens by design. Each token is unique, creating digital scarcity, with blockchain network participants knowing how many are in circulation and their distinguishing features.
The back-end component of non-fungible asset tokenization for exotic assets have a sophisticated design. Asset management firms which currently deal with traditional assets may fill new roles as oracles, ensuring the back-end of non-fungible tokens are kept in safe storage, undergoing regular audit certification, asset insurance, and conversion mechanisms from tokens into a physical asset delivery. Auction houses currently fill this role with fine jewelry, furniture, art, wine, and other collectibles.
For example, as it stands, most retail investors lack the opportunity to buy an ownership share of a rare piece of artwork. Incumbent auction houses such as Sotheby’s and Christie’s control a majority of secondary art markets from the world’s financial centres, far from reach for retail investors. However, smart contracts are being used to create joint ownership of artworks or art collections stored in museums. These artworks can still be displayed publicly, but the asset will be encoded on a blockchain.
Likewise, it’s possible for individual objects to be tokenized, acting as appreciating assets. For example, a rare, valuable painting may be inherited by several siblings. With asset-backed tokens, the painting could be tokenized and then distributed to each sibling via the blockchain, becoming “shares” representing a portion of the original painting. These shares, represented by asset-backed tokens, could be sold via a public security token exchange, if a sibling wishes to sell their holdings. In this simplified example, the token holders have access to immediate liquidity, while private investors can add a valuable exotic asset to their portfolio, which they would normally not have exposure to — therefore, a novel class of exotic assets are given previously unrealized liquidity.
Non-Fungible Soft Asset Tokenization
Soft assets, in contrast to hard assets, are intangible assets, which have been traditionally hard to quantify and evaluate. Asset-backed tokens can likewise bring price discovery and liquidity to these assets.
Intellectual Property (IP) Tokenization
Somewhat harder to quantify than other assets we have examined, IP assets, such as copyright licences, trademarks, patents and royalties from music and media rights generally have low liquidity and currently lack a secondary marketplace to trade on. It is not a difficult concept to tokenize the IP ownership, but the realized benefits could be many — such as enhanced liquidity and increased value of IP assets, bringing benefits to media producers and artists.
Digital Asset Collectibles Tokenization
Digital collectibles, such as CryptoKitties, are examples of asset-backed tokens which generate value and scarcity. This is in contrast to ownership of digital collectibles, which is managed via central databases, such as vanity items earned during whilst playing online games. These assets have been traditionally difficult to prove ownership over, as they are often just represented as contracts with the software provider. However, blockchain could offer digital collectibles specialized marketplaces, created with asset-backed tokens.
Stable Coins are not Typical Security Tokens
By certain definitions, stable coins linked to fiat are a form of stable asset-backed token. Stable coin issuers in this case maintain fiat reserves, so they retain a stable ratio with their chosen fiat currency, which is then matched to the circulating supply of the specific stable coin.
Stable coins are distinctly different from security tokens as they’re not a means of investment. Instead, they are created to represent currencies rather than assets. Stable coins provide an easy exit for investors who trade cryptographic assets on token exchanges, and remain fundamentally distinct from security tokens representing assets.
Opportunities and Challenges for Security Tokens
Compared to traditional currency, Bitcoin has been generally regarded as having greater fungibility, divisibility, transferability, scarcity, and durability. Likewise, asset-backed tokens retain most of the same benefits, applying them to real assets.
Regulators are eyeing security tokens with caution. There could be high risks for new user error whilst using exchanges, and investors who are not cautious may lose their tokens through wallet address mishaps for example, something protected against when using traditional third-party exchanges.
As a result of regulatory uncertainty, some countries, such as China and Qatar, have completely banned asset-backed tokens being issued. Other countries, such as Bermuda, Switzerland, Estonia, and Liechtenstein, allow security token issuance, albeit with certain restrictions and confusing regulatory oversight.
Malta, by contrast, places no limitations or restrictions on asset-backed tokens. Approval, fund certification, and fund license requirements are legally well-defined, with regulatory stringency. These conditions make Malta the premier jurisdiction to issue asset-backed or security tokens.
Asset-backed and security tokens are, by design, prone to lower volatility than utility tokens and cryptocurrencies. As discussed, tokens listed on exchanges may trade constantly, offering greatly enhanced price discovery. Markets which operate irrespective of geographical location or time zones may provide security token trading opportunities to investors worldwide. Likewise, established companies may soon begin issuing security tokens worth billion of dollars into token exchanges — creating one of the most exciting asset classes seen in decades.
