July 14, 2020

Market News

What is tokenization?

Blockchain technology is gaining relevance in the modern economy. More and more startups are developing new business models based on blockchain technology . So far, investors have mainly focused on the purchase of cryptocurrencies as a speculation object. But new trends such as tokenization are also playing an increasingly important role. In the following, we want to analyze how revolutionary this approach is in the area of the capital market.

Tokenization – what is it actually?

Various studies by the World Economic Forum predict that around 10 percent of the gross domestic product will be tokenized by 2029. This share of global GDP would correspond to around $ 10 trillion.

The Federal Government has also become aware of this development and initiated corresponding legislative changes on November 14, 2019. The changes ensure that token assets are considered official financial instruments and are therefore subject to financial market regulation.

This step is also necessary to respond to the increasing tokenization. As part of this process, digital images of an asset including the corresponding rights and obligations are shown in the form of tokens. In addition to goods, physical objects, rights and licenses can also be tokenized. The generated tokens represent the ownership of the respective assets and are stored in a decentralized database, the blockchain.

In theory, all assets can be represented using tokens. Accordingly, government bonds, company shares, buildings or license rights can be securitized using a token. The generated tokens now regulate the ownership of the respective object.

Are tokens also securities?

According to the legislator’s definition, tokenized assets are a financial instrument. Accordingly, these assets are also subject to BaFin regulation. BaFin describes tokens as follows:

“Such tokens represent a security of their own kind, because the tokenization means that investments are traded on the financial market and must be classified as securities.”

The definition of the European Securities and Markets Authority ESMA also shows that the material components of a financial instrument are decisive and the formal form. Until the change in law in November 2019, tokens, although these represented an investment in a company, profit participation rights or registered bonds, were subject to the Asset Management Act.

In particular, the lack of tradability on the financial markets contributed to the fact that handling under the Securities Trading Act was not possible. The legislator has now closed this gap. Nonetheless, assets that are not digitized in the form of a freely tradable token remain an investment in the sense of the Asset Investment Act.

These criteria classify securities

Section 2 No. 1 of the German Securities Prospectus Act states that a security must have two basic properties:

  1. Transferability: A corresponding asset must be technically transferable to another user. The legal security and the technical nature of the transferring security must remain unchanged. Modern token standards ensure this property
  2. Tradability: The asset must also be tradable. Sufficient standardization is required for this. In contrast, the type of transfer is not relevant. Rather, a token must not convey different rights and must be quantifiable in terms of the type and number of tokens in circulation.

In addition, tokens must have securities-like rights as assets under the Securities Prospectus Act. However, legislators have defined that securitization in the form of a certificate – this applies to shares or bonds, for example – is not necessary for a token.

Furthermore, the EU-wide supervisory convergence requires a uniform interpretation of the term security at European level. Both the Securities Trading Act and the Securities Prospectus Act introduce the requirements defined in MiFID II into the national law. The laws stipulate that the rights associated with a token may only be of a membership or property.

Simply put, a token, like a share, must be proof of membership in the tokenized property, or it must represent property rights, such as a bond.

The role of tokenization in corporate finance

After throwing the theoretical view of tokenization and its classification in the previous chapters, we now focus on the practical aspect in somewhat more detail.

While currently only large companies benefit from attractive measures to raise capital, tokenization creates completely new opportunities. With the “tokenized securities”, medium-sized companies can benefit from more flexibility in the implementation of financing projects.

It is already possible today for small and medium-sized companies, so-called SMEs, to issue bonds in the form of digital securities. For reasons of simplification, this type of issue only requires a limited prospectus requirement. As a result, the issuer only has to publish a securities information sheet (WIB). In comparison to traditional bond issues in particular, such a WIB only incurs comparatively low costs.

To what extent the entire tokenization process has a lasting impact on the SME market remains to be seen. However, it is conceivable that corporations like the GmbH also use tokenization in order to make company shares more tradable. This development could have a lasting impact on the venture capital market of the future and drastically reduce the requirements for investments. The overall market could benefit from better liquidity.

The advantages of tokenization at a glance

Different studies and experts have dealt with the tokenization of assets. Almost all statements and results amount to an identical result: The market will grow in the coming years. Rather, it is a multi-billion dollar market. The digital asset model, for example, has a disruptive character that could lead to the entire financial system being turned upside down. If we look at the current financial world, it is mostly inefficient, non-transparent and national. In the future, however, we can expect more efficiency, transparency and internationality.

Overall, tokenization has numerous advantages over classic financial products. These include:

  1. Increasing efficiency by doing without intermediaries: digitized assets help to make banks, insurance companies, middlemen and intermediaries less relevant. The overall market is gaining efficiency through digital trading and the absence of additional market participants.
  2. Greater transparency: Digital traceability creates greater transparency and enables a quick and, above all, simple form of investment. Delays due to bank processing days are also a thing of the past.
  3. Open markets: If certain markets were only available to selected buyer groups in the past, this will no longer apply in the future. Rather, investors can invest directly in companies and thus overcome the disadvantages of closed-end funds. Investors and issuers benefit from more freedom.
  4. Reduction of market manipulation: In the end, tokenization can also reduce the potential of market manipulation. After all, every transaction takes place transparently, immediately, unchangeably and comprehensibly for the participants. Regulatory authorities can also access the data and thus prevent unauthorized acts.

What impact does token trading have on the financial industry?

All of the developments shown have a direct impact on the business models of traditional banks. Accordingly, these companies should already take a closer look at the different influences of tokenization on their own value chain.

Banks are particularly affected, as they accompany the first issues of company shares on the public stock exchanges. These banks will lose a profitable branch of income in the future. The overall market is still young and not sufficiently developed, but the disruptive potential does exist.

From the perspective of banks and financial service providers, a more precise analysis of the further market development is important. This is the only way for these companies to define early on what role they want to play in the financial market of the future.

If we look at the ongoing demographic change, young and digital-savvy customers are already showing a keen interest in new approaches. Accordingly, it can also be assumed that these customer groups will also accept and use tokenization. Companies that do not want to or cannot develop their own products should instead use interfaces to third-party users to prepare for the new market.

With the appropriate preparations, it is possible for financial companies to remain competitive in the future. Factors such as customer satisfaction are crucial for building and developing a healthy ecosystem.

Before these developments enter the broad market as a whole, however, the legal framework must first be further developed. The creation of modern ways of storing digital assets will have a major impact on the adaptation of the technology.

The influence of tokenization on market development

If we look at the short-term effects of tokenization, standardized emission products such as shares, bonds and profit participation rights will be particularly affected. Above all, investors benefit from the new approaches. After all, experts anticipate strong savings potential in terms of emissions and transaction costs.

Tokenization in the financial sector

In addition, the tokenization of illiquid and poorly tradable assets such as real estate or small business investments could gain momentum. In particular, the ability to trade these illiquid assets faster and more efficiently could accelerate further development.

However, even more use cases can be expected in the medium to long term. In this way, tokenization will help ensure that entire markets – for example the classic car market – gain liquidity. A corresponding example is the startup Bitcar, which specializes in the sale of luxury vehicles for the Singaporean market. Using blockchain technology, buyers can now also buy a fraction of a vehicle.

New markets may well be interesting for investors, because in the past the entry hurdles to entering a market were often too high. But in addition to the investors, the owners also benefit from the increasing liquidity in the market. So a sale now works much faster and easier. In addition, sellers can only sell a portion of your asset and thus improve their own liquidity.

Conclusion: tokenization as a new future trend

Many experts expect strong tokenization growth rates. This assumption is well founded and understandable. After all, issuing tokens to prove participation increases liquidity across the market. In addition, investors benefit from falling entry barriers.

Nevertheless, there are also some problems with tokenization. To date, it has not been determined whether blockchain technology will finally prevail. In addition, despite some tokens such as the ERC-20 token, there is still a lack of suitable solutions.

In my view, however, investors can prepare for change in the medium term. All market participants benefit from increasing transparency and falling costs. There is also greater liquidity from trading smaller assets. As a real estate investor, I’m looking forward to tokenized residential properties for sale and purchase, for example.

The Post What is Tokenization? appeared on blockchain world .