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Security Token Offerings and Tokenization

by Eloisa Marchesoni

Tokens are not just an invention linked to cryptocurrencies, as is often believed. Instead, tokens can be thought of as “abstractions” based on blockchain: they can represent currencies, assets of various kinds, access rights, and so on. Tokenization is the process of transforming storage and asset management through which a digital counterpart is assigned to each asset in the portfolio.

Various types of real-world assets (company shares, real estate, art objects, intellectual property) can be converted into digital tokens stored on the blockchain. In fact, the process of tokenization of real-world assets is about to revolutionize the way in which various businesses operate, improving the speed of transactions, ensuring transparency, accountability and, above all, raising liquidity.

For a variety of reasons, traditional ways of transferring and exchanging assets end up being impractical or improper in the contemporary world. For example, some assets are difficult to physically transfer, divide or track, and other asset categories, such as real estate, involve a significant amount of documents and significant commissions for intermediaries. The result is a reduction in the speed of transactions. There are 256 trillion dollars of real-world assets and, to this day, most of these assets are still represented by paper and are highly illiquid, as well as difficult to deliver. The division of such assets can be equally problematic, in view of the assertion of specific rights. Moreover, the legal processes for the transfer of property rights are complex, thus suggesting the involvement of trusted participants, raising costs for both the seller and the buyer, both in terms of money and time.

In order solve these inefficiencies, tokenization introduces a wide range of important innovations.

First of all, the assets can be directly managed by the owner, rather than by issuing orders. Instead of using a bank account, through which the customer identifies himself via login and password and sends an instruction to the bank, when using the blockchain, the promoter of the transaction uses its own digital signature, which is itself a sufficient condition for the execution of the transaction. In terms of security, tokenization allows transparent verification in real time, with access to results for all parties, as well as guaranteed data synchronization among participants in the negotiation processes. In terms of management, a new opportunity for joint administration of goods that do not require trust opens up to the public. As for speed, the calculations can be done in a few seconds, and days-long waiting will no longer be necessary.

In other words, tokenization promotes the speed, security and convenience of operations, reducing the need for intermediaries.

Additionally, tokenization brings along the possibility to link non-connatural characteristics to an asset, which can thus be divided into smaller fractions, also allowing the integration of administration principles into the same asset (for example, the involvement of more owners of an asset in matters of its repair). In particular, greater fractional ownership reduces entry barriers for new investors.

From a purely financial point of view, any tokenized asset will have greater value than its physical equivalent. The valorization derives both from the opportunity to obtain more information on a tokenized good, through the blockchain, and from the fact that tokenization makes illiquid assets liquid, where liquidity is the ability to transform an asset into money. Blockchain and tokens create liquidity, making trade economically profitable, as they reduce administrative burdens and eliminate intermediaries.

Tokenization introduces "programmability" into the tokenized asset, thanks to smart contracts, which are comprehensive of functions for automatic transactions, formulas for calculating asset prices and other specific features. In such way, planned business logic can be automatically initiated, reducing the need for manual settlement, and are guaranteed by the "immutable" structure (hardly mutable) of the blockchain, helping to ensure investors that nobody can manipulate any transaction after it has been confirmed. Compliance can be ensured as well, since all participants to operations carried out via smart contracts usually have a digital identity that has passed the corresponding KYC and AML compliance checks, accordingly to procedures arranged by the business.

Programmability must match interoperability. An interoperable ecosystem for global assets is one in which it is be possible to hold property rights in a commercial building, holdings in startups, corporate bonds, bonds, etc. on a decentralized network on the same platform. Different assets can refer to each other contractually and interact automatically, bringing to an increase in liquidity for all categories of tokenized assets.

By now, it should be clear that one of the most important revolutions brought by the blockchain technology will be the digitalization of the world: transforming assets into tokens that represent the ownership of financial instruments and property rights worth trillions of dollars. However, there are several pending issues, for which clear answers have not yet been found, that hinder the adoption of the tokenization process.

One problem is that it is yet hard to make sure that the digital token remains connected to the good of the real world and to guarantee the value of a token linked to a specific property. Another problem is related to centralization, in the sense that, even though one of the main advantages of blockchain technology, compared to traditional systems, is its decentralization, physical assets usually have a single owner or a small group of owners. Furthermore, existing laws around the world do not take digital assets into account. Regulatory adjustments must be introduced before the tokenized assets can be treated in the same way as traditional ones. There is also a need for homogenization, or at least harmonization of regulations in the world, to promote an effective trade of assets on a global scale.

No matter these yet unsolved issues, the World Economic Forum predicts that, in the next ten years, 10% of global GDP will converge into cryptographic assets, totaling 10 trillion dollars. This will mainly be due to the growth in fractional ownership and the release of liquidity premiums for illiquid investments.

At this point in time, security tokens are still nascent, but in a few years they could become the ordinary tool to raise capital. More and more major players – including governments - intend to enter the security token field. A growing list of stakeholders is determined to make security tokens the bridge between cryptographic assets and the larger financial system. New markets will emerge for under-utilized and illiquid assets, which were previously inaccessible. Cross-border trade will increase. Technology funding will be further decentralized and Security Token Offerings (STOs) will become established as a standard.

In short, one may say that, if ICOs have been the trend of the last couple years, giving us a taste of what is about to come, the spread of STOs will take on unforeseen orders of magnitude in 2019.

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