There’s been a lot of noise lately about the introduction of security tokens and the potential advantages tokenised assets could have over traditional trading counterparts. So what does it mean to tokenise an asset, and what is a security token?
To tokenise an asset is to make it digitally represented by a token. When an asset is tokenised, nothing changes to the asset itself, but rather the way that ownership of the asset is recorded and managed.
A security token is a digital representation of a traditional security. It may represent shares in a company, interest in a fund, real estate, art collectables, or essentially any asset a party can own.
Blockchain makes tokenisation a superior method of recording and trading ownership claims of assets, and can deliver a number of benefits for investors, the issuers, and the regulators:
The potential for 24/7 markets
As the cryptocurrency market is borderless and unrestricted by time zones, trading is 24/7.
Currently the major US stock market opens trading at 9.30am and closes at 4.00pm Eastern Standard Time each weekday, with the exclusion of holidays. After Friday’s closing bell you cannot trade stock again on the major exchange for roughly 65 hours, and even up to 89 hours on a holiday weekend.
While the markets are closed, any number of influential events may occur. Security tokens open the door to 24/7 access. By enabling around-the-clock trading of assets, investors will have the opportunity to act on new information in a timely manner, and there is potential for the investor pool to broaden, opening up investor access across a range of time zones.
Security tokens offer an efficient path to fractionalizing a single high value asset.
As more assets are fractionalized, markets can achieve optimal asset allocation at retail investment level.
Fractional ownership is not a novel concept – the Roman Republic and the Dutch East India Company employed this idea of joint ownership.
However, in more recent times, asset classes such as real estate and fine art continue to be characterised by high unit cost buy-ins.
Typically, an investor who may not have the resources available to buy a Manhattan high rise is left with only two options; forego exposure to a Manhattan commercial real estate opportunity. Or, gain exposure through an intermediary such as a publicly traded Real Estate Investment Trust (REIT), where the property is often bundled with others of varying characteristics such as location, quality, and risk.
At scale, fractional ownership allows for eventual sophisticated investment strategies such as long-short strategies. For example, having the ability to go long in the Melbourne real estate market whilst going short in Sydney’s, thereby creating an Australian neutral real asset portfolio.
With increased trading activity of fractional ownership, price discovery will be enhanced, and markets for assets that have historically traded infrequently due to high unit costs will become more efficient.
Trades on a blockchain settle in a matter of minutes rather than days.
Settlement is the moment when the ownership of an asset actually changes hands, based on the time that the documentation around the transfer of ownership and payment between the seller and the buyer is recorded and complete.
Exchanges like the Nasdaq and NYSE can execute trades very quickly, but settling asset transfers takes time. Currently, the settlement cycles for most broker dealer transactions are T+2, meaning the ownership doesn’t change hands for two days after the execution.
It is true that there are many more parties involved in securities transactions, with complexities such as short-selling and margin buying that can complicate the process.
However, blockchain does have the potential to increase settlement speed for securities.
Advisory services around security issuance are costly, a reality that will not change in the near term.
Using blockchain technology, ownership claims are tokenised and cap tables will be reconciled in real time hardwired by code, nullifying any chance of human error after the smart contract for the issuance has been written.
Utilising blockchain incentivises companies to greatly reduce costs and put more capital to work in other operations of the business.
Traditionally post issuance, there are many administrative costs around the ownership reconciliation.
The story of Dole Foods is a prime example, where the company had 36 million shares outstanding on paper but then also had claims for payments that were filed for 49 million shares. Clearly there was a miscommunication within the company and those who issued the shares.
Liquidity and market depth
Most private assets are relatively illiquid, which means the ownership interests are costly to trade.
For private assets like an LP interest in a venture capital or private equity fund, exiting the position before fund liquidation frequently involves large discounts and requires approval from the general partners.
Blockchain company Harbor CEO Josh Stein said tokenisation provided the benefit of locking “in the capital without locking in the investors.”
Tokenised funds allow the fund managers to invest in illiquid assets without fear of redemptions, while fund investors can access liquidity in a secondary market.
As a result, more depth in the market for ownership interests and the increase in investor liquidity is expected to be accompanied by an increase in value—what investors call the liquidity premium.
Divisibility of high unit costs will also place these assets within reach of a much broader market.
Security tokens can potentially relax the frictions of trade, the most obvious being adhering to a particular country’s regulations.
When securities are tokenised, compliance can be automated, which means that regulated trade will no longer be restricted to the “walled gardens” of an exchange or a particular country.
Security tokens are programmable, so rules and regulations can be hard-coded into the architecture of the token to satisfy that of the exchanges the token will be traded.
These security tokens may then be traded anywhere where the tokens are compliant.
Interoperability is the ability of computer systems or software to exchange and make use of information.
Interoperability is one of the most important ideas in technology, however, current centralised solutions for electronic value transfer lack compatibility – they do not talk to each other.
One cannot transfer value from Paypal to Venmo, or stock with one online trading account to another without significant delays, since the layers are simply not interoperable.
Having assets that are interoperable means one will be able to hold and trade a variety of assets such as corporate bonds, T-Bills, commercial building claims, and early stage equity in a single hardware wallet on compatible blockchain platforms.
A clear example of this is the ERC-20 token standard that is built upon the Ethereum blockchain. Many tokens have been created on the same blockchain meaning anyone with an Ethereum compatible wallet may send and receive any ERC-20 token.