With ongoing talks of Central Bank Digital Currencies and now even a possible digital dollar, tokenization continues to be a hot topic both in the crypto world and in traditional finance. It’s been a buzzword in the financial industry for a while now, and the concept is being explored by startups, established institutions and governments alike, through centralized and decentralized blockchain technology.

As the world of tokenization marches on, some questions have been raised from technological, financial and regulatory standpoints. Here is a deep look into tokenization, how it will impact the financial markets, and what challenges it currently faces on its way to mainstream adoption.

What is tokenization?

Tokenization is a process, through which assets are made digitally available on a distributed ledger. The concept has been made possible by the creation of blockchain technology which in turn, ensures that transaction and balance records cannot be tampered with or retroactively altered.

This process can take many different forms depending on what is being tokenized, the technology used, and the purpose of the token. Centralized or decentralized blockchain technology can be utilized depending on the aforementioned variables. Tokenization on a decentralized ledger allows ownership to be verified in a quick and trustless manner but also poses a challenge when it comes to performance and compatibility.

Related: Tokenization, Explained

Digital tokens are mainly a way of representing ownership of the asset they are backed by and can be very useful when it comes to transferring or exchanging it fully or partially, improving liquidity and allowing for increased access to these assets.

From company or real estate ownership to art and video game items, tokenization reaches beyond financial applications and has the potential to transform and improve countless industries. Although tokenization is a fairly new concept, it’s already gaining ground in the fintech world.

Tokenization is here

Cryptocurrency advocates often exaggerate the current capabilities of cryptocurrencies and blockchain technology. While blockchain has enormous potential, crypto assets are still in their infancy and are nothing more than a blip in a vast universe of established financial markets.

Moreover, while the prospect of replacing the fiat currency system with Bitcoin (BTC) is one that excites many enthusiasts, Bitcoin would simply not be able to handle adoption on such a large scale due to technological constraints when it comes to processing transactions.

While crypto as a currency or global payment system is still very much a dream, tokenization has crossed that bridge. It has gone from theory to reality in just a few years. Not only can it be applied privately on a small scale but it also does not require a high throughput capacity. Assets can exist on separate blockchains — centralized or otherwise — unlike the concept of a national or global cryptocurrency-based monetary system.

Although prior iterations of tokenization already existed in projects like Counterparty (XCP) and Nxt (NXT), the Ethereum blockchain brought the concept to light. Nowadays, many platforms like EOS, Tron, Neo and Waves also allow assets to be tokenized. Centralized blockchain technology is also used, especially by large scale private and public institutions.

Nonfungible tokens: From CryptoKitties to real estate

One of the most popular applications of tokenizations is what is known as nonfungible tokens, or NFTs. In NFT systems, each token or set of tokens are different from one another and therefore hold a different value. NFTs have gained a lot of visibility in the crypto industry with the emergence of collectible games like CryptoKitties. Virtual land is also becoming big in the industry.

NFTs are also used as a way of retaining ownership of in-game items. This allows the item to be exchanged outside of the game and even through smart contracts — which ensures that once the item is passed in-game, funds are released, and fraud, which is rampant in secondary gaming markets, is eliminated. Another interesting application comes in ensuring in-game ownership is assured even if game servers malfunction or get hacked.

While NFTs are popular in the crypto and gaming community, the concept is now extending to traditional finance and has become a way to bring liquidity to nonliquid asset classes like real estate. It allows people to easily raise funds for property investments using the tokenized asset as collateral for a loan.

Stablecoins

Another application of tokenization is stablecoins. Different iterations of tokenized fiat currencies exist, including Tether (USDT) — which was first issued on the Bitcoin blockchain through the Omni Layer protocol. Since then, other examples like USD Coin (USDC), StableUSD (USDS) and WUSD (WUSD) — and even ones backed by gold like PAX Gold (PAXG) — have been issued by different entities.

Stablecoins aim to leverage the benefits of blockchain technology without exposing users to the volatility often associated with cryptocurrencies. They are usually backed by an equivalent amount of the currency or commodity they represent and can be redeemed at a one to one ratio. There are also stablecoin projects like Saga’s SGA coin and Celo that aim to bring further stability by issuing custom tokens that are backed by a basket of different fiat currencies, reducing exposure to just one economy. Keren Orian Nadel, Saga's Managing Director, told Cointelegraph:

“The SGA model starts by being fully reliant on the value of a trusted basket of currencies — replicating the configuration of the IMF’s SDR (Special Drawing Rights) but unlike all other stablecoins, SGA aims to eventually separate from the SDR and become an independent currency with its own value.”

Security tokens

In 2018, cryptocurrencies took the spotlight and became synonymous with volatility and speculation in part due to initial coin offerings. Similar to initial public offerings — the traditional finance counterpart — ICOs are a fund raising mechanism.

ICOs have opened up the doors of equity investment to a wider audience and paved the way for projects like Ethereum and EOS. However, the returns of early projects have led to a flood of low-quality projects and scams. Regulators in the United States have stepped in, and ICOs have since lost their popularity, making way for security token offerings.

Security tokens are basically tokenized company shares. Examples of popular STOs include Nexo are Robinhood. Antoni Trenchev, a managing partner and co-founder at Nexo, told Cointelegraph:

“Opting for a blockchain-based STO has some advantages as listing on a traditional exchange would be harder and more expensive, but it also allows a wider range of people to participate and to acquire the tokens after the STO, including those without access to traditional financial services. It also allows for instant settlement, which, in a time of crisis like this, can prove to be essential for those seeking liquidity.”

DeFi, DApps and crypto synthetic assets

Tokenization has led to the emergence of smart contracts and has brought many advantages to the field. By allowing contracts to be agreed upon and executed automatically, smart contracts remove the need for third-party intermediaries and make new concepts like decentralized finance and decentralized applications possible. The aforementioned NFTs, for example, can be traded in a trustless environment thanks to smart contracts.

Cryptocurrency-based synthetic assets, which expose users to a variety of different assets like commodities and stocks without leaving the crypto sphere, are also a concept that has been gaining popularity. A recent report by DappRadar shows that Synthetix, an exchange that allows users to trade in these assets, was the second most popular DeFi application during March 2020. Jon Jordan, the communications director of DappRadar, told Cointelegraph:

“Synthetix is still small, but the user base has been growing steadily and is pretty active during periods of high crypto price volatility, which is what you’d expect in a trading product.”

Tokenization hits traditional finance: Tokenized securities and CBDCs

Tokenization has gained some ground when it comes to institutional use. Recent projects, such as the first Swiss Franc-backed stablecoin to be issued by a regulated Swiss bank or the first covered bonds issued as a tokenized security on a public blockchain by Societe Generale, have demonstrated how popular the concept is becoming.

While Societe Generale’s efforts have shown that securities can be tokenized on a decentralized blockchain and still be fully compliant, private blockchain tech is still a trend when it comes to security tokenization. Nevertheless, examples are becoming vast and they include efforts like The World Bank and the Commonwealth Bank of Australia, which have issued a blockchain-based security token called Bond-i. The Central Bank of China has also recently tokenized 20 billion Chinese yuan ($2.8 billion) worth of bonds using blockchain technology.

CBDCs have also been making headlines. From the digital dollar advocated by the former CFTC Chairman J. Christopher Giancarlo to the recent experiment program by the Bank of France, CBDCs are becoming extremely popular. China, for example, has been working with the concept since 2005 in the hopes of launching its own digital yuan.

Stablecoins are also becoming popular among commercial banks, as they can facilitate transactions and payment settlements as demonstrated by projects like JPMorgan’s JPM Coin, Signet and Wells Fargo’s Digital Cash. While decentralization is one of the key components of blockchain technology, most financial institutions work with centralized and permissioned technology although according to Guido Santos, founder and chief technology officer of Genesis Studio, a Portugal-based provider of blockchain-focused consulting, the trend may change with time. He told Cointelegraph:

“There will be an initial adoption of permissioned blockchain technology and then a transition to permissionless. A few examples like Santander have been working with Ethereum for example, but the focus is still very much, at least for now, in Hyperledger and Corda.”

The good, the bad and the law

The advantages of tokenization speak for themselves, and the interest in the concept further cements this. There are many potential upsides to tokenization: It can facilitate international financial activity; allow for increased liquidity and shared ownership; and reduce costs and risks in settlements as tokenization may make escrows theoretically obsolete. As Juergen Hoebarth, a blockchain tokenization specialist, told Cointelegraph:

“Tokenization will break down ‘financial market borders’ and democratize access to global retail capital.”

While tokenization is, in theory, a swiss army knife of benefits, it’s not without its flaws and challenges, especially when it comes to fully decentralized platforms, and its success may depend on how well the technology interacts with traditional account-based systems. For now, decentralized blockchains remain at a disadvantage as Santos explained:

“When it comes to selling the concept to companies, enterprise adoption, the 100% decentralized model simply doesn’t work. Removing control and adding higher transaction fees. The conversation usually ends there.”

Moreover, there are still regulations to take into account. While some countries have been working on legislating blockchain technology and tokenization, especially in connection with securities and stablecoins, others may fall behind and pose some regulatory incompatibilities.

However, as the technology explores uncharted financial territory, progress may be delayed as seen with the U.S. Securities and Exchange Commission’s latest decision to postpone the approval of Overstock’s Boston Security Token Exchange. Nevertheless, progress ensues and regulatory entities have shown their willingness to understand this new concept.