Tokenization explained

Over the past years “tokenization” has become a recurring buzzword in many blockchain-related news articles. While tokenization may seem to many like a new concept, in fact, digital tokenization predates blockchain by several years. So what is tokenization? Simply put, tokenization is the process of substituting an important and sensitive piece of data with a non-sensitive equivalent. In other words, the new non-sensitive data now being used instead of the sensitive data’s place is the “token”. Let us use an oversimplified example, imagine a thief breaking into a Casino and stealing a bag full of poker chips. It would be absolutely pointless because the tokens stolen are worthless outside of the casino establishment and cannot be used to purchase goods or services anywhere else. Physical tokens have long been in place to replace real money for which the casino ships were one such example, which denotes a legal right of ownership of the underlying currency.

The origin of tokenization

Tokenization is the process of converting any rights or assets into a digital token that can then be used, owned, and transferred by the holder through a blockchain, without the need for a third-party intermediary. Such an asset may be precious metals, company shares/debt, real estate, and other financial instruments. Tokenization makes investing in these assets more accessible by breaking large items into small fractions that are cheaper and can be purchased conveniently. Historically, tokenization was first introduced by Trust Commerce in 2001 as a means of protecting credit card information. Prior to this, merchants would store Credit Card data on their own servers which carried a risk for potentially sensitive information. The system was developed by Trust Commerce to replace the PAN, primary account number, with a randomized number called a token. So when the merchant needed to process a payment, they could simply reference the token for their payments to be processed by Trust Commerce.

What are security tokens

For this blog, I will focus mainly on security tokens starting with different types. An equity token represents ownership of an underlying asset such as company stock. An equity token holder may be entitled to voting rights, dividends, and buybacks. Debt tokens are tokens that accrue interest. They represent the debt owed by the token holder. Asset-backed tokens can be anything from real estate to company shares, commodities, art paintings, and even diamonds. They simply give ownership rights of valuable tangibles or intangibles, in digital form. Last year, as you may know, Azimut – the asset manager under which Beewise operates, introduced the world’s first security token investing in the real economy, the Azimut Token that is issued through a Security Token Offering (STO) with ID Identification AZIM, with a collaboration with Sygnum Bank. Azimut Token opens a new frontier in the real economy where through the tokenization process, even illiquid investments, such as private markets, can become liquid and transferrable thanks to blockchain technology. This new process, which Azimut is the first in Europe to implement on loans to small and medium-sized companies, will also bring direct benefits to capital markets, making them fairer and more efficient, and in the diversification of assets. Now let us spend some time on Security Token Offerings (STOs), what they are and why they may present unique opportunities for businesses.

Why security tokens are becoming more popular

Security tokens are not cryptocurrencies or tokens from unregulated initial coin offerings (ICOs). Security tokens are traditional securities that have been digitized. If you’ve ever invested in securities (stocks, bonds, real estate, private equity, venture capital, and so on), you’re probably familiar with what holding a security entails. A security token, for example, would convert stock certificates into a digital equivalent. Trading is available 24 hours a day, 7 days a week, and there are no geographical boundaries. Smart contracts are used to create security tokens. A smart contract is a simple software that automatically executes once a given criterion is met and establishes how the token can be purchased, traded, and sold in a legal and compliant manner. Because they are based on blockchain, the transactions are immutable, traceable, and fully transparent. The entire procedure is known as whitelisting, and it makes the Security Token’s ownership more secure than other types of tokens. The most valuable feature of security tokens is certainly their worldwide liquidity. Security tokens can represent fractional ownership of an asset and can be traded on global security token exchanges, which are both things that conventional securities cannot do (A sculpture worth $8 million, for example, might be tokenized into 8,000 parts and sold at $1,000 each). Security tokens are the holy grail of the traditional financial industry because settlement and clearing usually take a long time when transferring assets. On a blockchain, however, processes are automated. This means that reassigning ownership can be done almost instantly.

Companies use security tokens to raise funds or fund new business endeavors. Due to the difficulty and limits of obtaining investment from traditional venture capitalists, other methods of obtaining funds, such as STOs, quickly became popular. STOs are legal and regulated, making them a safe option for businesses to raise capital.

How will tokenization continue to grow?

According to independent strategy consultancy Quinlan & Associates’ report released in September last year, the global issuance volumes for security tokens could reach US$4.1 trillion by 2030 from an estimated US$100 billion in 2022. The continuously growing demand for STOs is proof that while the token digital assets still need to comply and register with the SEC (Securities and Exchange Commission) to be considered a security, they are able to do that without a colossal amount of paperwork and certifications associated with traditional securities. Plus, the STOs bring a number of improvements to traditional finance products by removing the intermediary from investment transactions. Removing intermediaries leads to lower fees, faster execution, exposure to the open market, a larger base of investors, automated service functions, and lack of manipulation.

It is clear that the future of financial markets will require an investment paradigm shift and despite the optimistic projections, market participants should be cautioned that mainstream adoption of security tokens will take time.

As a final tidbit, the security token market is still in its early stages, but the future is looking bright. It is important to say that the basic overview shared here only scratches the surface of this topic, so if you are interested in exploring the STOs and blockchain technology further please be sure to research credible sources such as European Regulation, the Markets in Crypto Asset Framework MiCA, SEC websites, or whitepapers from Deloitte and PwC to help you educate yourself more on the technological approach behind the STOs.

_{Disclaimer: This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.}