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Tokenization for Illiquid Assets – The Basics

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Cryptocurrency… blockchain… tokenization… Ready or not, here I come.

Recently, more and more I seem to be surrounded by seminars and events discussing these new asset classes and their underlying technologies. In March 2019, I attended the ALTSHK Conference, an alternative investments industry event held in Hong Kong, where the most popular round table discussion topics included cryptocurrencies and tokenization. Even at Colliers, the discussion around tokenization is gaining traction, as we routinely host events aimed at educating and connecting industry participants interested in these topics.

Personally, having witnessed bitcoin’s price shot up to USD 17,000 in December 2017, before crashing down to less than USD 4,000 one year later, I still have my reservations on cryptocurrencies. Nevertheless, I do believe the technology created for bitcoin – blockchain, is a fundamentally sound technology with many potential applications around the concept of Internet of Value – an online space where people can instantly transfer value between each other. Which we’ve seen through the quick adaptation of blockchain technology in the tokenization of illiquid assets.

As a life-long finance professional who’s interested in new technologies but wouldn’t consider herself tech savvy, I struggled to grasp the concept of the technology and its applications. Still, after hours of researching online and talking to industry experts I got the gist of it. So, I wanted to share with my fellow non-tech savvy financiers and clients what I’ve learned in a simplified version, easy for a layman to understand.

First, the underlying technology – Blockchain and smart contracts

Simply speaking, blockchain is a decentralized digital ledger system that validates transaction history.

All transaction records are called blocks. Each block contains a digital record of the previous block and a current transaction, and each new block is linked (or chained) to the previous block. The blockchain is managed by a peer-to-peer (P2P) network, which is a decentralized network composed of many computers around the world. When a new transaction happens, the transaction record request is sent to the P2P network for verification, and once verified, the record is created as a new block and added to the previous block. All the computers on the network will keep the most updated blockchain.

smart contract is a digitalized pre-defined contract built in the blockchain.

Blockchain is considered extremely secure due to its inherent structure and decentralized verification system. Smart contracts, which are built into the blockchain, can be cost effective when conducting financial transactions (since no third-parties or middle men are required), and can be programmed to be executed automatically at a specific time or when certain requirements are fulfilled.

Tokenization with blockchain technology

Tokenization has many meanings, however, when referring to tokenization with blockchain technology, we are talking about a secured transaction mechanism that uses blockchain technology. Blockchain has the benefit of providing security, transparency, liquidity, and cost efficiency around the buying and selling of units of value (tokens e.g. a bitcoin).

Simply put, asset tokenization is the digital securitization of an asset.

Tokenization can be applied to many types of assets – real estate and property, famous art-work, a business or brand, an investment portfolio, etc. The values of these assets are divided into small units called tokens, and each token represents a unit of economic value. Tokens can be stored and managed on a blockchain network, in which smart contracts can be deployed to execute services and checks that include compliance review, registration, payment, ownership transfers, and even trading if listed on an exchange. All for which the cost will be significantly lower than a traditional securitization process.

Tokenization of illiquid assets

The most promising application of tokenization is for large illiquid assets such as real estate, private equity funds, or private companies. By tokenizing such an asset, the owner will have a means to sell partial ownership of an illiquid asset in a relatively easy and economical manner. An investor would be able to purchase a piece of an asset that would otherwise be too expensive or too illiquid for her to gain access to exclusively.

The setup cost of tokenization normally runs in the range of couple of hundred thousand US dollars, and therefore, it’s not suitable for a very small asset.

Tokenization becomes more economical when an asset’s value goes above USD 10 million. Private equity or venture capital funds can particularly benefit from their tokenization, as they normally have high asset values, are very illiquid, and have a long life with many transactions which require significant administrative effort.

Hopefully this all makes sense, but how would all this look in practice? How does one go about tokenizing a large commercial building? The tokenization of assets is still in its initial stages and the regulatory environment surrounding it is still being discussed, however, there are real life examples of this happening. Next week I’ll release the second part to this article, where I’ll share some examples and explain, through a series of steps, how one could tokenize a large commercial building.