February 17, 2022 - 9 min read
Securitization is the process by which financial instruments are crafted for illiquid assets which can be sold on secondary markets and potentially yield interest for owners. Mortgage-backed securities (MBS), for example, are commonly traded securities, and are backed by large and often illiquid home loans. Of course, the securities are tailored for various risk tolerances based on the creditworthiness of the borrowers and the time horizons of investors.
After the lender originates the mortgages, the loans are bundled into pools which are held as collateral for the loans. These mortgage notes are essentially promises of monthly mortgage payments from the borrowers. To spread the counterparty risks associated with mortgages, like borrower defaults, loan underwriters sell MBS products to investors — who then collect part of the borrower’s mortgage payments if the loans are repaid, and share in the losses if the borrower defaults.
Asset Tokenization, in Web3, refers to essentially the same process, except the securities are minted on blockchains as NFTs and recorded on digital ledgers as verifiable crypto assets. NFTs, then, could arguably be more liquid than traditional securities without accounting for the current market cap of cryptocurrencies as a whole. That is, NFTs can be traded 24/7 globally, and can be secured as immutable assets with blockchain technology. Furthermore, tokenized assets can have nested smart contracts within them, such as dividends payouts in the case of a traditional security.
Already, billions of dollars in securities and commodities have already been tokenized, with the market cap for tokenized fiat currencies (stablecoins) already in the tens of billions. Eventually, any asset could be tokenized and traded on crypto rails once certain technological, legal, and social thresholds are met.
Of course, there are hurdles to be overcome like regulatory clarifications, Web3 adoption, blockchain scalability, and issues of interoperability as well. In addition, it isn’t clear how the status quo institutions will react to decentralization efforts when the previous system has revolved around centralized, regulated intermediaries. This aims to summarize how Web3 asset tokenization will disrupt traditional securities markets by leveraging three Web3 technologies: blockchain, NFTs, and oracles.
A notable example of a tokenized physical asset is Aspen Coin, a digital security representing fractional ownership of St. Regis Aspen Resort in Colorado. By tokenizing the Aspen REIT, investors’ bar for entry is lowered since publicly listed REITs are more costly to set up and thus require larger minimum investments from investors. As such, they tend to be held longer, and remain relatively illiquid compared with the tokenized Aspen Coins.
Tokenized real estate on a blockchain reduces administrative friction regarding trading and establishes the asset on a 24/7 marketplace of global buyers. Therefore, trading the asset can be done faster and with reduced fees.
Since tokens are divisible and can be bought and sold a thousand times a day, investors can purchase a small amount of the tokenized asset, allowing for shared ownership of assets which may have previously required a tremendous amount of capital investment. That capital would also have been highly illiquid, whereas the tokenized form is highly liquid.
While this could affect real estate markets in terms of short-term price volatility, fractional ownership of tokenized real estate would establish more equitable opportunities for younger generations to take their first step into owning real estate without being priced out by huge down payments.
An example of tokenized luxury real estate is Aspen Coin, which pays dividends to token holders, providing them with a percentage of the passive income earned from the physical real estate. If more tokens like Aspen Coin become commonplace, it will level the playing field for retail investors and increase economic opportunities for millions of people around the world currently without the means to own real estate.
These smaller investors will now have access to passive income opportunities without facing insurmountable obstacles in making their initial investments. Such arrangements likewise spread counterparty risks, which encourages healthy investment attitudes and allocation strategies.
Furthermore, creative works like music, artwork, film, or video games can also be tokenized as NFTs. This may appear trivial, but creating a non-fungible, unique version of something and preserving its uniqueness and immutability in the digital world via blockchain ledgers is groundbreaking. First of all, this prevents copying and sharing of data packets, which essentially steals from the original creator by avoiding remuneration for the creator directly or through royalty schemes.
NFTs can also be financialized: original creators can be paid not only for the original sale of the asset, but also royalties for secondary sales in the future, meaning creators will be able to more effectively monetize their creativity online. Turning NFTs into interest-bearing financial instruments will therefore establish robust, trustless, and flexible financial arrangements between content creators, consumers, and investors alike.
Oracles are essential to fetch and validate external data for tokenized assets. They act as communication channels between blockchains and off-chain data sources. Since tokenized assets will often require knowledge of real-world conditions, like Aspen Resort’s occupancy rates, then oracles will play a critical role in tracking the ownership of tokenized assets and the condition of their physical counterparts.
In addition, any creative ideas which can be expressed as digital content can be represented as an NFT. Doing so provides an immutable, transparent timestamp and copyright claim upon the token on a public blockchain. More importantly, tokenized assets may engender new monetization capabilities for artists and knowledge workers alike through embedded smart contracts.
Decentralized oracles can provide secure performance analytics and content access controls so the original creator may exercise sovereignty over their content and access to it. Oracles thus help original content creators unlock latent value of their productivity using proven revenue models such as cost per impression (CMP), cost per click (CPC), cost per lead generated, time on site, subscriptions, and more.
This makes oracles important to the proper functionality of tokenized assets. If an oracle’s nodes have been compromised, the digital asset might deviate from spot prices or fail to adequately distribute dividends to tokenholders. Knowing this, we can conclude that oracles are potential single points of failure if they are not properly secured and decentralized. Deterministic smart contracts are irreversible and this requires pristine data, as fresh from the faucet as possible.
Oracles also help tokenized assets like NFTs become more productive through financialization. In fact, the majority of physical world assets may eventually be priced with the help of oracles. By applying performance-tracking metrics and pricing data to tokenized assets through oracles and onto blockchains, unproductive assets can be turned into revenue-generating digital property.
For example, dynamic NFTs can be minted by creators and sold with immutable ownership recorded on a blockchain and engender privileges which can evolve or decay over time. Financializing NFTs will also allow creators to borrow against the future revenue potential of their creations, as well as the ability to monetize through perpetual royalties models. Likewise, fans of creators can support them more directly without interference from gatekeepers.
First, blockchain technology is still in its early days, meaning it is still somewhat misunderstood, and has yet to win the confidence of traditional stakeholders. That is, early crypto adopters are aware of blockchain’s potential to facilitate human cooperation and financial inclusion.
However, there are still many who fear cyber attacks and other destabilizing or unexpected disruptions, meaning there will be resistance to adoption at first. Once data security and privacy issues have been ironed out and adoption has slowly crept upwards, this challenge becomes increasingly less insurmountable.
Though blockchains are useful for tokenizing physical and digital assets, interoperability amongst blockchains and legacy systems must be secure and seamless. Assets should be easily transferable across blockchains or redeemable in physical form without being forced into the silo of a single blockchain network.
Furthermore, tokenization of traditional assets will require clear and robust regulations before it goes mainstream. In the US, for instance, the SEC and CFTC continue to mull regulations for cryptocurrencies, DeFi entities, NFTs, and other digital assets. SEC chairman Gary Gensler signaled that for a digital asset to be considered a security will depend upon whether it’s perceived as representative of a traditional security.
Aside from this dovish tilt from the US’s SEC, as well as notably bullish signals coming from the Russian and Indian governments, it remains to be seen as to when clearer language will be rendered into law. Regulatory transparency and clarity will help balance innovation with safety and the rule of law, resulting in greater adoption by those waiting for legal safeguards to be put in place. In addition, the WEF has made calls to action to governments around the world to implement regulatory infrastructure for digital currencies and prepare to roll out central bank digital currencies of their own.
Finally, entrenched financial intermediaries will surely put up resistance in the form of lobbying and negative publicity aimed at disruptive Web3 firms. After all, 2020 global remittances totaled over $700 billion USD, which was actually a reduction from the previous year. Roughly $540 billion of that number was sent to low or middle-income countries.
That means a lot of fees were paid from low to middle income earners to massive banks and financial institutions for simply transferring their own money to either themselves or their families. In addition, moving those funds often took several business days instead of several minutes regardless of the date or time. Those third-parties collecting funds from international remittances arrangements will not happily accept that they are no longer needed, and thus will no longer collect the fees as they had previously done.
The tokenization of physical and digital assets is quickly becoming a reality, and will continue to become more commonplace in the coming years. Resulting from the fragmentation of challenges Web3 faces as a whole, it is likely that the tokenization of assets will initially be adopted incrementally for specific facets of securitization on the blockchain.
Having said that, market participants and investors are responding favorably and showing interest in NFTs and other tokenized assets. Moreover, macro forces like the increasing role of environment, social and governance (ESG) mandates and the demand for fiscal disclosure in more transparent and efficient ways should accelerate the adoption of Web3 and tokenized securities.
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