What Tokenization Is and How It Can Unlock Illiquid and Opaque Markets

“The next generation for markets, the next generation for securities, will be tokenization of securities,” said Larry Fink, the CEO of BlackRock, the world largest asset manager, with $10 trillion assets under management, at a December 2022 New York Times DealBook event.

BlackRock is not the only prominent financial institution that has expressed this sentiment about tokenization. JPMorgan has also promoted the benefits of tokenization in one of its whitepapers, saying that tokenization could potentially enable financial services to be delivered “in a more open manner.” JPMorgan not only writes about it but also, and most importantly, has been experimenting with blockchain technology and tokenization for several years.

One of its latest experiments was in November 2022, facilitated by the Monetary Authority of Singapore’s (MAS) Project Guardian, which was established as part of a pilot program to explore potential decentralized finance (DeFi) applications in wholesale funding markets. JPMorgan successfully executed its first-ever cross-border transaction using decentralized finance (DeFi) on a public blockchain.

The trade was executed on Ethereum layer-2 network Polygon, using a modified version of the Aave protocol’s smart contract code. The live cross-currency transaction involved tokenized Singaporean dollar and Japanese yen deposits, along with a simulated exercise of buying and selling tokenized government bonds. The tokenized Singapore dollar deposits were the first issuance of tokenized deposits by a bank. 

In addition, JPMorgan developed JPM Coin, a version of a United States dollar stablecoin. JPM Coin is currently in its prototype stage and is being trialed and tested for money transfer across JPMorgan’s institutional customers. JPM Coin may be launched in other currencies should the dollar prototype prove successful.

Why are these leading financial institutions so excited about the potential of tokenization? What are the benefits that tokenization could bring to financial and economic markets? And how could it shape the way financial markets operate on a global scale? Before we dive into the benefits of tokenization, let’s first understand what tokenization is.

What is Tokenization?

Simply put, in the financial context, tokenization of assets refers to the process of issuing a digital token that runs on a blockchain. This token is a digital representation of an asset – tangible or intangible – and its value is based on the value of the asset it represents, like the process of traditional securitization, but with a digital twist.

Tangible assets could be real estate, stocks, or artwork, which could be tokenized. Similarly, intangible assets could be voting rights, loyalty points or patents. Avios, a global currency of travel, which turns everyday spending into travel and leisure rewards for almost 8 million customers around the world, is an example of tokenized loyalty points. IPwe, an IP transaction platform, is an example of tokenized Intellectual Property, and specifically patents.

So why bother with tokenizing anything? How does this make sense for institutions like JPMorgan?

The Benefits of Tokenization

Liquidity

Among the highest reasons to tokenize assets is liquidity. Increased liquidity comes from several features: removing the liquidity premium associated with illiquid assets, fractionalization, and globalization.

The liquidity premium is often associated with illiquid assets such as real estate or fine art, which can be harder to transact given their scarcity, or tricky to handle and transport (imagine trying to safely transport a Jeff Koons balloon dog, for example – in this case it might be even beneficial to create a “digital twin” of this fragile artwork, via a non-fungible token (NFT), which then the NFT can be tokenized as a fungible token to provide liquidity and fractionalized owenship). Introducing liquidity, therefore, helps to introduce fairer prices.

Tokenized assets also enable fractionalization of assets, which is infeasible when using traditional instruments (for example, rather than owning the Mona Lisa, you could own a portion of the Mona Lisa if it was tokenized ). Once investments are fractionalized, their liquidity is increased, as more investors will be able to afford fractions of them rather than paying for the entire asset. 

Public blockchains are inherently global in their nature, opening markets to a broader audience of investors. Increased liquidity enables investors to quickly enter and exit positions without lock-up periods or big slippage – the difference between the expected price and the executed price – upon sale. 

For example, real estate is one of the most illiquid asset classes. When a property is worth a few million dollars, buying and selling the property can take a long time just because there are only so many people who can afford such a property.

Now imagine that a $1 million home is tokenized, issuing one million tokens, where each token represents property ownership. When these tokens are available for purchase in the market, anyone can participate based on how much they can afford -- in this particular example, it'd be as little as $1. In fact, it could even be much less than $1, since each token is infinitely fractionalized. Bitcoin is fractionalized, and you can purchase a fraction of a bitcoin.

All of this is to say that fractionalization naturally increases the ease with which illiquid assets can be bought and sold.

All illiquid asset classes, like private equity and venture capital, can benefit from tokenization. In September 2022, KKR tokenized its Health Care Strategic Growth Fund II (“HCSG II”) on the Avalanche public blockchain, which made institutional private market strategies more accessible to individual investors.

From a property owner’s perspective, this opens options of selling merely part of the property through tokens instead of selling the entire property – e.g., you can tokenize only 20% of the property or only a particular apartment in an apartment building.

From an investor perspective, someone in Brazil with $1,000 can invest in property in Manhattan. This isn't an imaginary scenario; this is already happening. Realt offers investors tokenized properties. While the properties listed on their platform cost from several hundred thousand dollars to a few million, they are tokenized, and each token can be valued at less than $50. This makes it extremely affordable for interested investors in most places in the world.

In late 2022, Boston Consulting Group (BCG) released a report noting that “a large chunk of the world’s wealth today is locked in illiquid assets.” BCG predicts that the total size of tokenized illiquid assets, including real estate and natural resources could reach $16.1 trillion by 2030.

There is already evidence of the benefits of tokenization. In a case study, IPwe generated a 25% increase in ROl for Crown Electrokinetics’ IP portfolio.

Transaction speed and reduced costs

When assets are tokenized, many processes that previously required intermediaries for transactions and transfers can be automated. This leads to more cost-efficient transactions and faster processing, benefiting investors and traders.

Tokenized assets also enable near instant settlement. In traditional finance, settlement and clearing are complicated processes, which require various intermediaries to complete. With tokenization, anyone can easily start transferring their tokens, leading to an automatic reassignment of ownership rights. 

Token issuers benefit from reliance on the public internet and a reduction in costs for insurance. It’s estimated that tokenization could reduce the issuance cost of bonds by 80%. A report by Roland Berger suggests that if tokenization adoption was high, the entire cost saving could reach 4.6 billion Euros (4.83 billion US dollar as of this writing) by 2030. 

Transparency 

With public blockchains, every transaction is stored on a publicly available ledger. The immutable nature of the underlying technology prevents tampering and helps mitigate counter-party risk by giving everyone access to the transaction history of their counterparties. This benefits investors as they have more insights into who they are trading with than in traditional systems. 

Tokenization of assets can potentially even help fight corruption and tax evasion by making revenue streams visible. With regards to corporate social initiatives, tokenization can enhance compliance through transparency and give shareholders easier ways to vote through governance. 

In a recent report, IPwe demonstrated how their Patent Valuation Methodology provides a solution to undervalued and underutilized patents by bringing transparency to the market and measuring and boosting patent utilization rates.

Liquidity risk management

Liquidity risk management within financial services organizations can also benefit from tokenization. The collapse of FTX can clarify this benefit. The FTX collapse had several underlying issues, one of them relating to the liquidity gap. If there were checks and balances in place that were transparent for customers to see, mitigating actions could have been taken in time.

At no point did FTX create transparency around how much liquid assets they had to service their liabilities. Thus, FTX managed to repurpose user funds (liabilities) for their investments (illiquid assets). Tokenizing both assets and liabilities would have shown a liquidity gap in real-time and cautioned the market of the looming crisis.

After the FTX collapse, there has been a rushed effort to provide proof of reserves from several centralized crypto exchanges. Proof of reserves only shows that a company has some assets to service its debts; it does not provide any information on the organization’s liabilities. If a company can transparently demonstrate that it has $1 billion in reserves/assets, but its liabilities, which could be $10 billion, are not clear for everyone to see, its solvency is under question.

Therefore, it would be more useful to show proof of A Going Concern. If both assets and liabilities of an organization can be tokenized, on-chain analytics can be used to understand if the organization has enough assets to service its liabilities. In other words, it answers and verifies whether an organization is a going concern – i.e., whether it will meet its financial obligations when they become due.

Democratization and financial inclusion

The tokenization of assets makes them more accessible to retail investors. In the example given earlier, an investor with $100 could own a portion of a million-dollar property in a prime location and benefit from a rise in its value. Without tokenization, they wouldn’t be able to participate in big-ticket assets that offer good returns.

This is particularly true with high-net-worth individuals who want access to products that are only available for private banking clients. Products with attractive return profiles are offered exclusively to institutional investors. Even high-net-worth and sophisticated investors would struggle to get access to these assets. 

Since tokenized transactions run on a blockchain, they do not require that the user has a bank account or a broker account, making it accessible for anyone from anywhere. Accessibility and fractionalization enable financial inclusion to those who need financial services the most, meaning that unserved communities will be served.

Challenges

There are some challenges that should be resolved if tokenization ever scale to become mainstream. The following are some of the main challenges, that yet to be resolved:

• loss of private keys if the asset still exists;
• the underlying asset is lost, but its tokenized representation still exists;
• scalability;
• regulation – in a global framework how can we achieve unified regulation to facilitate global compliant transactions.

Tokenization has great potential to open markets, democratize access, and enhance efficiency and transparency meaningfully. As technology and regulation evolve, tokenized assets will play an ever-increasing role in financial markets and beyond.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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