November 15, 2018 article

Tokenised Assets: The Next Evolution in Capital Markets

The capital markets structure of today is firmly rooted in modus operandi that have existed for decades. Although technology has transformed how firms actually trade financial markets and manage their investments, the basic processes remain broadly unchanged – particularly when it comes to raising capital.

However, this is all changing as the advent of tokenisation, fractional ownership and the creation of new secondary markets provides revolutionary new ways of leveraging the value of assets, raising funds and trading.

Yes, some of this has existed for short while in the crypto world with ICOs (Initial Coin Offerings), but only really with early adopters. As the technology behind all of this evolves and becomes adopted by the mainstream – as it surely will – significant change and opportunity will come with it.

Asset tokenisation

Tokenising an asset basically means breaking it up into a number of parts, each with the same value and each linked to the underlying asset’s value. These tokens can then be traded and the ‘ownership’ and ‘value’ associated with each token transferred accordingly. This kind of fractional ownership is nothing new – it’s basically the same as buying and selling shares in a company. But Distributed Ledger Technology (DLT), like blockchain, has transformed how this can take place and extends the process to other types of assets.

From a technical standpoint, tokenisation refers to the process of embedding enforceable rights linked to an underlying asset into a digital token on a blockchain, where its movements and authenticity can then be reliably and securely tracked and verified. The rules that embed and enforce these rights for the asset are coded into the distributed ledger in the form of ‘smart contracts’ – reducing the need for teams of lawyers and reams of paperwork.

Moving something of value, whether it be a unit of Bitcoin or a unit representing ownership in an asset, is made safer, easier, cheaper and more frictionless by using technology like blockchain. The act of transferring an asset from seller to buyer is simplified. Transactions on a distributed ledger lessen or remove the roles of the intermediaries historically used to facilitate the transaction. It reduces costs, increases transactional velocity and helps price discovery on assets that may have historically suffered from liquidity discounts. Put simply, as an issuer, this technology should drive down the cost of capital and reduce liquidity discount.

Leveraging new asset classes

As well as revolutionising the way familiar financial assets are handled and traded, tokenisation opens the possibility of trading and leveraging the value of illiquid and hard to trade assets too.

A good example of this is in the world of art. Trading in works of art is notoriously difficult, and only really available to the privileged and wealthy few. What is more, intermediaries and galleries take hefty percentages, so it is an expensive activity also. Tokenising a piece of art effectively democratises ownership and parcels it up into small enough chunks to make it available to many more people globally.

The Andy Warhol painting ‘14 Small Electric Chairs’ recently had 49% of its value tokenised and sold. People purchasing those tokens now own their own piece of this iconic painting, whilst the owner has realised a significant part of its value – although retaining overall ownership. If the whole painting ever gets sold outright, the fractional owners would get their share of its value. In the meantime, tokens can be traded on a secondary market.

Another example is property. There are a number of firms setting up funds that take ownership of buildings – e.g. an apartment block or office building – and tokenise the asset. This allows investors to get direct exposure to say Manhattan real estate that in normal circumstances would be difficult. They get to share in the rental income from the building and, once again, their capital is not tied up as tokens can be freely traded on a secondary market.

Raising capital

The process of raising capital can take advantage of this new paradigm too. Businesses who want to raise funds in the traditional world look to the likes of venture capital firms or IPOs (Initial Public Offerings) on stock exchanges. These methods can be long, complex, drawn out affairs that can be very expensive. Issuing tokens as a way of raising capital reduces a lot of these costs and can be much quicker and more frictionless.

ICOs have been doing this for the last couple of years, but mainstream adoption has not really taken place as the pure utility nature of these tokens means they have no real intrinsic value – just a potential promise of some value at some point in the future. Understandably this, along with the fact they are generally unregulated, has put many people off – particularly institutions who struggle with valuations – and created a rather tarnished reputation, as many of these schemes have failed to deliver.

STOs (Security Token Offerings) are the latest evolution in the crypto space and, by contrast, are tied to some underlying real-world asset – e.g. shares or revenue. They may still have a utility value too (e.g. a discount against the products or services that the business offers) but they also have intrinsic value and so also generally fall under existing regulation. STOs are attractive to investment firms as well as fundraisers, as investing in them allows realisation of investment when required on the secondary market. In contrast, traditional venture capital investments are often locked up for extended periods of time.

Key benefits of tokenisation

Revolutionise capital markets: The universe of assets that can be tokenised and represented by a digital smart contract will greatly expand as this technology matures. Royalty streams, IP claims, multi-asset underliers pointed to single contracts, are all potential use cases. The routes to slice and dice all types of assets and capital raise are going to be transformed.

Bring down barriers: Appropriately permissioned smart contracts backed by different asset classes, issued by entities from different jurisdictions, will be able to be purchased on a global scale. The creation of a global investor pool in this space will promote new and exciting competition for assets, improving pricing accuracy and the ability for investors to create diverse portfolios of assets more efficiently.

Regulatory efficiency: Assets issued on transparent and immutable ledgers, with regulatory permissions embedded in the token are an attractive proposition to regulators. Their ability to track flows, manipulation or fraud is improved with less effort.

In conclusion

Understandably regulators do not want the maturation of this space to happen with no oversight, and the same securities laws that have been successfully applied to date can apply to security tokens. Smart contracts can take care of some regulatory functions, such as AML/KYC verification, in real time, reducing the compliance cost and burden historically applied by third parties on buyer and seller.

A compliant digital asset exchange that lists and trades security tokens needs to have systems and processes that are constructed to perform to the high standards a regulator and institutions expect. It needs to have the internal compliance, risk and monitoring all traditional regulated exchanges employ. Trade surveillance, AML/KYC of all exchange participants and segregation of customer assets are all essential building blocks to any legitimate venue.

The opportunity is huge for early adopters of tokenisation. In a World Economic Forum study, the majority of respondents believed that 10% of Global GDP would be on blockchains by 2024. The visionary businesses that see change coming and adapt to leverage it are the ones that will truly benefit and succeed

The author, Matthew Pollard, is a co-founder and CFO of Archax, an institutional digital asset exchange launching in 2019 (www.archax.com).

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