What Is Tokenization?

It is increasingly apparent that while cryptocurrencies and the blockchain share a common heritage, they are headed down different paths into the future. The 2022 crypto partial collapse and prosecution of crypto kingpins has made tough and continued regulation a likelihood a likelihood. Fraudulent dealings in the crypto world have made the financial community doubly cautious about crypto while the blockchain itself, prospects for Web3 and tokenization of assets are seen as practical and useful things. So, what is tokenization and how does it work?

Digital Representation of Assets on the Blockchain

Representing an asset in digital form on the blockchain is tokenization. NFTs or non-fungible tokens are one form of tokenization but artwork featuring funny looking apes is not the end of the tokenization story. Real estate can be tokenized as can bonds, commodities, or other equities like stablecoins. We wrote recently about uranium backed crypto tokens which are part of this picture. Estimates range as high as $5 trillion for the near term value of tokenized assets.

The Benefits of Tokenization

Tokenization depends on blockchain decentralized and distributed ledgers. Data is added and new blocks are created with all nodes being updated. Thus, there is not a single control point where a failure can occur. Smart contracts in decentralized finance can use tokenization for doing business across the world. The potential benefits of tokenization include twenty-four hours a day and seven days a week access to data. Transaction settlement is faster than the typical two days required in traditional finance. With interest rates having gone up, every day counts when money is tied up.

Smart contracts with tokenization promise to reduce hands-on activities, speed up financial processes, reduce errors, and make transactions more transparent. All of this also promises to make financial services available to more people who are currently not served by traditional finance.

How Tokenization Happens

The process of tokenization starts with deciding if a financial asset is to be treated as a commodity or like a security. This has to do with regulatory issues that will apply. Then custody needs to be arranged for physical assets to be tokenized. Such custody needs to be acceptable to all parties involved. At that point compliance functions need to be instituted, a blockchain network setup, and a final digital representation of the asset in question created. And the digital asset itself needs to be securely stored prior to distribution.

Investors in tokenized assets will need to set up digital wallets and either an official exchange or a secondary trading venue needs to be set up. Maintenance of a tokenized asset system will include dealing with taxes, accounting, abiding by appropriate regulations, and providing notice of corporate or business actions to those involved.

Is Tokenization Risky?

So, do you want to own tokenized assets or real, tangible assets? Tokenization promises lower transaction costs, better liquidity, and even greater access to certain assets. It also comes with risks of cyber hacking and a host of potential regulatory issues as this new financial asset or sector gets sorted out. Aside from risks inherent to tokenizing an asset, tokenization does not remove risks inherent to the asset itself. For example, we wrote about tokens backed by uranium. This is a commodity and commodity prices go up and down with supply and demand. Tokenizing them does not remove such a risk.