Money, shares in a company or a piece of real estate could all be represented by tokens recorded on a blockchain.
It’s called tokenization, and it’s one of the most significant aspects in the development of blockchain technology and many say it could affect the economy as much as the development of the Internet.
Uses for tokenization
Dan Nossa, an attorney at Steptoe & Johnson’s Houston office who has studied blockchain technology, says a token on a blockchain can represent either a digital or real-world asset.
But tokenization can have much broader applications. “There are different kinds of tokens for different purposes,” Nossa says. He sees three general categories for blockchain tokens:
- Payment tokens like bitcoin, which was started to be a payment token over the Internet, and other cryptocurrencies.
- Utility tokens, which are intended to allow owners of those tokens access to the services of a particular blockchain platform or blockchain-enabled application. “Utility tokens are analogous to an arcade token which you’re required to use to play games at the arcade and like arcade tokens, utility tokens can only be used within the confines of the venue or within that blockchain application,” says Nossa.
- Asset-backed tokens, which are tokens representing real-world or digital assets. They can represent ownership interests in real estate, personal property, and equity in businesses. “I find this last category of tokens extremely compelling. It has the most immediate use cases given the current state of blockchain technology as well as the current state of business and regulation,” Nossa says.
Securities tokens, a subgroup within asset tokens, is the most likely candidate for adoption in the near future, Nossa says. Specifically, he expects tokens representing ownership shares in private companies to become part of the landscape.
Such a development, he says, would bring major benefits, including:
- Increased liquidity in the market for private company equities. Currently, the market for private company securities is illiquid. “It takes time for the buyers and sellers to find each other and once they do find each other, it takes time to vet each other and the assets that they’re buying and selling from each other,” Nossa says. “They have to conduct due diligence and once they do agree to do business with each other, they have to hire lawyers, accountants and other service providers who prepare the contracts to execute the transaction.” Tokenization could eliminate much of that friction. Participants in a blockchain platform where tokens represent private company securities are sold would be pre-vetted in such areas as whether they are accredited investors with sufficient capital to take on the risk of private company investment. The companies themselves could also be pre-vetted. Private equity and hedge funds could benefit a great deal from a more liquid private company securities market, Nossa says, because investors who want to exit such funds early would be able to sell tokens representing their investment on a secondary market rather than forcing an early redemption which is costly to both funds and investors. A more liquid market could also expand participation in private company investments. “The market for tokenized private securities will also be much larger because it would not be limited to accredited investors within a small investment network but could be open to high net worth individuals and institutions from around the world. It could really create a more global market for these private securities.”
- Automated compliance. Since blockchain tokens are programmable, they could be embedded with smart contracts that only allow their purchase by accredited investors. They could also build in requirements that a buyer of the security hold it for a certain period of time. They could even lead to automated reporting of transactions to regulators. “You can embed compliance into the token itself in order to avoid an investing free-for-all where you have widows and orphans investing in things they shouldn’t be investing in,” Nossa says.
- Cost savings. The tokenization of securities could bring considerable cost-savings. Because counterparties would be pre-vetted, the process of buying and selling would take less time and cost less money. “On top of that, there’s the opportunity to significantly reduce legal costs as well,” Nossa says. “At a certain point in the future, we can use fewer paper contracts as a lot of the contractual provisions will be embedded in the token.”
Over the longer haul
“The payment and utility tokens will thrive at some point. But I believe their mainstream adoption will follow asset-backed tokens,” Nossa says.
And of the asset-based tokens, he says he expects those representing paper assets such as securities to come into use more quickly than those representing ownership of physical assets such as commodities.
Further, technological and regulatory issues will influence how quickly tokenization is adopted.
“Blockchains, on which the tokens are utilized, are still relatively slow and can only handle so many transactions per second. Software developers are working to increase the speed and volume of transactions without sacrificing the all-important cybersecurity feature of blockchains,” Nossa says.
Further, regulators and lawmakers are clarifying how to deal with the various issues associated with blockchains and their related digital assets. The Securities and Exchange Commission has made it very clear that tokens that fit the statutory definition of a security will be regulated as such. This means that in order to be regulatory compliant security tokens will either have to be registered with state and federal securities regulators or be subject to an exemption from registration. And the digital platforms on which security tokens are traded need to be registered with the SEC as national securities exchanges, alternative trading systems or broker-dealers.
“Adoption of tokenization will depend in large part on increased scalability on secure blockchain layers and the development of regulatory compliant infrastructure,” Nossa says.
To learn how blockchain technology can affect your business, contact Daniel Nossa.
Steptoe & Johnson PLLC is a U.S. law firm with core strengths in energy, labor and employment, litigation and transactional law, serving clients from its 13 strategic locations across the nation.
Kent Bernhard is a freelance writer for The Business Journals.
Sponsored Event