Unchained: Why Tokenizing Assets May Not Be All It’s Cracked Up to Be

For many, tokenization is the way of the future. But is tokenizing always the best option?

As the cryptocurrency markets continue to evolve, some analysts believe that tokenized assets are the real future of blockchain technology. They say that the days of the ICO-fundraising free-for-all will soon be gone, replaced by a market that is primarily backed by real-world assets.

Some go so far as to say that we are approaching an era when everything will be tokenized–ownership rights for everything will be recorded, stored and traded on a blockchain network. The idea is that this kind of a system will be far more efficient, less expensive, and clear–disputes over ownership rights will be eliminated, and everyone will be happy. (Right?)

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But is this kind of a future as bright as it seems? There are some voices in the financial community who believe that tokenization may not be all it’s cracked up to be. In order to understand the kinds of situations that may not benefit from tokenization, let’s first establish what tokenization really means, and why the practice has been so widely lauded.

What is Tokenization, Really?

Law, tax, and compliance group MME defines tokenization as: “the process of digitally storing the property rights to a thing of value (asset) on a blockchain or distributed ledger so that ownership can be transferred via the blockchain’s protocol.”

According to Dr. Stephanie Hurder, partner and founding economist at Prysm Group, tokens have two fundamental requirements: first, that “the rights to a thing of value (an asset) are stored digitally on a blockchain or a distributed ledger,” and second, “the rights can be transferred via the blockchain or ledger’s protocol.”

Essentially, the paper contracts that represent ownership of things like stocks, houses, cars, and gold become digital tokens that can be recorded on some sort of distributed ledger. These tokens can be transferred using the ledger’s protocol; the entity who controls the token controls the ownership rights of the house. (Imagine a Bitcoin network where the tokens that could be bought, sold, and traded represented pieces of real estate.)

Fungibility Matters

Tokens on these kinds of networks can either be created as fungible or non-fungible. Fungible tokens are interchangeable with one another in the same way that dollar bills are interchangeable (each represents the same amount of value; no single dollar bill is distinguishable from another in terms of its financial worth).

Non-fungible tokens are intentionally designed to be distinguishable from one another in terms of their value. On a DLT network with non-fungible tokens, each token is unique and everyone knows how many tokens there are, and how to distinguish them.

It wasn’t possible to make non-fungible tokens until the 2017 launch of the ERC 721 token standard, which allowed for the creation of digital collectibles. The most popular example of this manifested in the CryptoKitties phenomenon that took place earlier this year when digital tokens representing cartoon cats were being traded with such voraciousness that the Ethereum network became massively clogged with transactions.

Depending on the kind of asset that is being traded, fungibility may or may not be necessary. For assets like real estate or pieces of art (that have unique value), tokens would need to be non-fungible; other assets, like commodities (i.e., oil and grain) could possibly be traded in fungible tokens.

There are many benefits to tokenizing assets. Blockchain-based records are more secure than records kept on centralized databases or in physical vaults; market functionality and speed is decreased; information is more easily collected and shared.

However, there are a few scenarios in which tokenization may not be the best choice.

It’s ‘All or Nothing’ With Tokenized Assets

Dr. Hurder lays out three separate situations for when tokenization may not be appropriate. The first of these is “when the blockchain platform can’t fully capture the change of ownership of assets.”

In other words, tokenized assets must exist on a network where the blockchain network is the only way that ownership can be transferred. A system where an asset could be transferred via blockchain, as well as other methods, would be difficult – if not impossible – to manage. For example, if a tokenized piece of real estate is sold via a physical contract, the token that represented its ownership becomes worthless.

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Therefore, adopting such a protocol would require abandoning all other traditional systems of ownership transfer – something that most banks and financial institutions are currently unwilling to do.

Verifying Authenticity of Some Tokenized Assets is a Problem Without a Solution

Furthermore, the protocol would need to be designed in such a way that the tokenized assets can be verified. “There are many cases where I can trade digital rights to an asset, but have no guarantee that I receive the corresponding physical asset without expending a great deal of effort or money to verify its authenticity,” Dr. Hurder writes, laying out a scenario in which blockchain is used to track meat through supply chains.

In theory, DNA testing could be done on the meat to ensure its authenticity; however, most customers are unwilling to expend the effort and capital necessary to conduct DNA tests. This “[renders] the functionality of the product obsolete.”

Tokenizing May Not Be the Best Solution for Startups, Either

Asset-backed tokens aren’t the only problematic kind of crypto. Founder and CEO of Hilltop Technologies Ltd. Yotam Amichay has a bone to pick with ICO tokens and explained in a phone call to Finance Magnates why tokenized fundraising may not be the best option for new companies.

Shortly, “we don’t need thousands of tokens to purchase products and services on the internet [as it is],” he said.

In other words, forcing users and customers to change their fiat currency into a crypto token before a service can be used is highly impractical–a barrier of entry that may turn most potential users away at the gate. At the same time, tokenized platforms that also allow users to pay for their products and services in other currencies (i.e., BTC, ETH, USD) essentially render their own native tokens obsolete.

Yotam Amichay, Hilltop Technologies.

Let’s look at an example. Imagine a blockchain platform named ‘FinanceMagnatesCoin’ that has a native currency known as FMC. If the FinanceMagnatesCoin platform requires its users to buy FMC tokens before they can use its services, many potential users will instead seek an alternative platform that doesn’t require them to transfer their funds.

Additionally, if the FinanceMagnatesCoin platform allowed its users to pay for services in currencies other than FMC, then FMC automatically becomes unnecessary. Even if there are some incentives for paying in FMC on the platform, most users may choose to stick with what’s most convenient for them (in other words, paying in the currency that they already have.)

Amichay added that adding tokenized platforms that carry incentives for users to large, pre-existing companies (i.e., Amazon) may provide some benefits to all involved parties–but tokenization isn’t necessarily a good option for early-stage startups. More than one company has realized this–Digipulse announced that it was ditching its blockchain platform in early August; it wasn’t the first to do so.

Not to mention that the practice of holding an ICO is “centralized as hell.” Companies retain total control over ICO tokens until they are distributed, a process that usually takes place months after an ICO is held.

However, Amichay is bullish on the idea of security tokens as a more sustainable way to raise funds for companies, although there is a bit of regulatory catch-up that needs to take place before a tokenized marketplace would be completely viable.

 

Now, Tokenized Platforms Have to ‘Show Their Stuff’ – Or Else

Speculating about possible problems with tokenized platforms and asset-backed tokens is one thing. However, we are entering an age when the blockchain platforms that boomed to life in early 2017 are coming to life–the promises and plans that they made in those adrenaline-filled days of fundraising rounds must be realized.

If not, the world will have ample data to make decisions about when tokenization is appropriate – and when it isn’t.

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