Tokenization: The New Frontier for Capital Markets

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There is tremendous value in the world of crypto. Given some of our recent opinions (linked below), you probably did not expect to hear those words from us. Digital tokenization of assets, made possible by the crypto-blockchain construct, can boost efficiency in the capital markets, thus greasing the wheels that drive the economy.

Our views on cryptocurrencies and meme coins haven't changed, but digital asset tokenization is different and could drastically redesign financial markets for the benefit of the capital markets and the economy.

What is tokenization?

Asset tokenization is the act of digitizing the ownership of an asset. At a very high level, it is not that different from the way your bank manages your checking account. Your bank doesn't have a vault stuffed with your cash in it. Instead, it has a computer with a series of 1s and 0s representing your cash balance. Banks essentially digitize our money.

Digital asset tokens represent real-world assets, just as the banks' 1s and 0s represent your cash. The range of assets that can be tokenized is limitless. Before we get into the details of tokenizing assets, it's worth sharing some unique examples of how tokenizing assets benefits the sellers and buyers of the tokens. Consider the following possibilities.

Movie property rights

A movie producer may issue tokens to fund the production of a movie. Not only would this finance the movie creation, it might allow the producer more artistic freedom by avoiding the large studio companies that often dictate budgets and many aspects of the movie.

In exchange for their funding, the token owners might receive a percentage of future revenue from the film and the rights or partial rights to the film. Furthermore, they might also receive free premiere tickets as a bonus.

Drug development

A scientist or pharmaceutical company may source capital to research a new cancer drug via tokens. In exchange for funding, token owners could receive the rights and future revenue from the drug. Not only would this provide a new source of funding for the pharmaceutical industry, it's also a new way for individuals to donate to a cause they care about and possibly benefit financially.

Art

A painting might be tokenized to share ownership of one painting or a collection of art. Token holders, for their part, could receive revenue if the art is leased to museums. Further, art enthusiast token holders can own a fraction of a prized piece of art. While revenue may or may not benefit the token holder, some ascribe much nonfinancial value to owning such works of art.

Future earnings of an athlete

A college athlete with exceptional baseball skills but little money could tokenize his future baseball income. Token holders who can scout athletes at a young age can provide some income for the young man today and share in his revenue if he makes it to the big leagues.

Hotel rooms

An investor or company could buy a hotel and fund its purchase with room tokens. The holder of the tokens may receive future revenue whenever the room is rented. Moreover, tokens may give the investor a discount for that room or other rooms owned by the hotel owner.

Here are a few more ideas to highlight just how distinctive and vast the potential to raise and invest capital is:

Shipwreck treasure exploration
Podcast rights
Carbon offset values
Vineyards
Poker player winnings
Patents/copyrights
Food trucks
Arcade/vending machines
Sports teams

We get into the tokenization weeds a bit in the following sections. However, whether you stop reading here or at the end, what we hope you take away from this article is that the tokenization process opens many new doors for those looking for capital funding. Equally, it significantly increases the number of unique and diversified investment opportunities for investors.

More simply, it makes capital markets more effective.

How it works

The following is a step-by-step summary of the tokenization process:

Identify the asset: Select a tangible or nontangible asset to tokenize.
Verify ownership and legal compliance: Confirm the asset's rightful owner, and legal and regulatory compliance with the asset's sale.
Define the structure: Choose the token's properties, such as its value, divisibility, and the number of tokens to be issued.
Create a smart contract: Develop a blockchain-based smart contract to govern the token's issuance, rules, and transferability rights.
Mint the tokens: Make the smart contract live on the blockchain and generate the digital tokens.
Sell the tokens: Market and sell the tokens. Numerous ways exist to accomplish this, including an initial coin offering, security token offering, private sale, or direct issuance to specific investors or stakeholders. All investor accreditation and qualification rules apply to tokens.
Manage and trade: Enable the token holders to trade and possibly redeem tokens while maintaining complete transparency of all trading activity on the blockchain.

Token platforms and exchanges

The platform and exchanges take the digital token from an idea to a funding mechanism and tradable asset.

The token platform is like the factory for the product. The platform includes the lawyers, technical analysts, and back offices responsible for creating the digital security. It is where the tokens are created, hosted, and managed. This comprises regulatory compliance, initiation of smart contracts, and token creation. Ethereum, Binance Smart Chain, Polygon, and Solana are a few of the larger platforms. The token issuer is mainly responsible for managing platform-related tasks.

Token exchanges, like the stock exchanges, are where the tokens are traded after they are created on the platform. Some examples include Coinbase, Binance, and Kraken. Traders, investors, and broker/dealers are the primary users of the exchanges.

Some companies like tZero offer both platform and exchange services. (Additionally, tZero is an SEC-registered special-purpose broker-dealer for digital tokens.)

The importance of blockchain is that it provides much more transparency than the current financial system. A token's ownership and its entire transaction history are available for anyone to see.

Furthermore, the platforms and exchanges ensure that the tokens are tied to an asset and verified by external data sources to ensure the value and veracity of the assets backing the tokens.

Lastly, any payments to the investors or the issuer can occur instantly. This avoids the multiple-day settlement process, and weeks and months of legal paperwork that many asset transactions currently incur.

Summary

The key benefits of digital tokenization are as follows:

Better liquidity
More transparency
Around-the-clock market access
Cost-effectiveness
Fractionalization
It makes capital markets more inclusive for funders and investors
Enlarges the pool of investable assets

As judged by those benefits, digital tokenization is a significant upgrade from the current financial system. However, despite the promising outlook, the adaptation process is slow. For the token market to compete against traditional capital markets, more explicit regulations, and a greater understanding and trust of the blockchain among retail and institutional investors and the government are required. It will be incumbent on the government, financial industry, and investor alliances to form guidelines, regulations, and governance to help create a solid and trustworthy foundation.

The economic benefits of tokenization are massive. Financial markets for liquid and illiquid assets will be more efficient, cheaper to fund and transact in, and less exclusive. If tokenization takes off as we think it can, the benefits could be substantial for capital markets, but much more importantly, for the economy and the nation's populace.

Michael Lebowitz is a portfolio manager with RIA Avisors and author for Real Investment Advice. For more information, contact him at [email protected] or 301.466.1204.

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