Rethinking the Rethinking of Tokenization
Exploring the complex interplay between technology, law, and finance in the world of asset tokenization is the subject of a recent report by VC firm Outlier Venture. Let's venture right into it.
Dear Reader,
I must apologise for what follows my short introduction: a long and sometimes endless tirade of technical commentary and questions, some minor, some less so, based on a recent research report titled "Rethinking Asset Tokenization: Beyond the Hype to Practical Realities" produced by a company that has graced its front page with super cool artwork and a clever name. So let’s dive in and rethink its content.
Why am I so bothered about sharing comments on a industry report? Well, I believe we will struggle to achieve anything significant without more precision in problem statements and defining the required action. I'm not implying the company doesn't know their business; rather, I'm suggesting that the industry as a whole is not yet detailed enough and needs to delve much deeper into the subject matter.
I encourage feedback or challenges where I may be wrong and have made my own mistakes, because I am asking a simple question: Am I right or am I right?
Or asked in a different way: is there sufficient understanding between the tech firms and financial communities on what constitutes a real-world asset (RWA) and how this thing called tokenization can take off?
Appendix overview
Discussion on the confusion between real and intangible assets like equities and intellectual property in the context of tokenization.
Analysis of how accounting and legal classifications of assets differ, affecting their categorization and treatment in financial statements.
Commentary on the variability of asset classification across jurisdictions and its impact on the legal transfer of ownership.
Consideration of tokenization ease for intangible RWAs and their digital twin existence in databases.
Addressing the legal complexities surrounding intellectual property and the limitations of property law in the context of tokenization.
The Oracle Problem in blockchain technology as a critical challenge for tokenized RWA, affecting the deterministic nature of blockchain systems.
Mention of innovative solutions with game theory to align stakeholder incentives in tokenized RWAs.
Discussion on the impact of digital transformation on the nature of assets, highlighting the confusion around the shift from tangible to intangible assets due to tokenization.
Exploration of potential consequences in scenarios like a complete blockchain network shutdown on property rights.
Analysis of renewed interest in tokenization in the institutional market based on a BNY Mellon Survey and the comparison of enthusiasm levels for crypto and tokenized securities.
Assessment of the role of major financial market infrastructures in exploring tokenization and their potential obsolescence due to blockchain technology.
Critique of reports driving narratives and conversations with regulatory authorities about tokenization, including anticipated growth in tokenized securities.
Evaluation of key blockchain features unlocked by tokenization and their practical implications.
Skepticism towards bearer asset regulation and its relevance in the context of tokenization and financial markets.
Consideration of the computable economy concept in relation to historical debates on computability in computer science and its application in blockchain technology.
Reflections on the intrinsic value of assets in the context of tokenization and its impact on market valuation.
Discussion on the segregation of asset rights, like carbon certificate rights, and the confusion around digital property rights.
Analysis of new token standards with decentralized identity frameworks and their potential impact on traditional issuers.
Observations on the demand-side bottleneck in tokenization and the move towards a multi-chain reality in financial services.
Consideration of how tokenization can unify practices across different asset classes in financial markets.
Discussion on the potential of tokenization to create markets for assets previously traded over-the-counter (OTC) and its implications for market liquidity.
Evaluation of the efficiency of financial markets and the role of tokenization in making market processes homogeneous across asset classes.
and a few more till 29.
The detailed commentary
"Converting physical or intangible assets into digital tokens that can be traded on a blockchain can enhance the liquidity, accessibility, and efficiency of multiple asset types."
Traded on a blockchain? I suppose everything is technically possible, but various factors, including speed and lacking almost all relevant functionalities from quote request or order book or whatever trading model is considered, seem to suggest to me that nobody is considering "trading on blockchain." It points to a problem though: how to get liquid secondary markets.
"Unrecognized potential [...] Also, tokenization can segregate an asset into different elements, creating separate, liquid markets for these elements, leading to further price discovery."
That I 100% agree with in terms of unrecognised potential, although it is I think ‘the’ potential but not necessarily for trading. Details will be forthcoming once the Digital Asset Creator work is completed.
"Through tokenization, off-chain or real-world assets are brought into the realm of smart contract capabilities, extending the computational capacities of the economy. This movement is called the computational economy and is a new economic paradigm where web3 technologies facilitate the development of a ‘computable economy,’ which enables a significant increase in economic complexity and, from this, wealth."
Computational capacity typically refers to the processing power of a computer system. In the context of blockchain and tokenization, it's more appropriate to talk about increasing "economic complexity" or maybe “economic reach” rather than computational capacity.
Can this work for real-world assets, and can the tokenization community and the Basel community agree on who should be allowed to call a very important aspect in finance RWA? So confusing.
"Turning any asset into a financial instrument. Tokenization examples - Data, intellectual property, in-game assets,..." "Real assets: copyrights, trademarks vs. Intangible assets: equities? (p.7)
It goes without saying that just because people establish a market for something doesn't make it a financial instrument. But the overview is a bit confusing, at least to me. There are apparently real assets in the form of trademarks and intangible assets in the form of equities? Really? And why does it matter? Unfortunately, the authors skip that part of the analysis.
This tangible vs. intangible discussion is generally misleading, and it's not a question of simply asking: is the thing we are talking about a real object I can touch, like a printing machine to produce fancy VC research pamphlets. I have said it many times before, but it needs to be said again: As always, the correct answer is ‘it depends’.
Accounting-wise, a financial instrument is not an intangible asset, although it's often portrayed as such even in scholarly articles. Take IFRS, for example, a financial instrument such as equities are ‘financial’ assets; in other words, they form a different category since intangible assets are non-monetary. In other words, I cannot physically touch the cash I hold in a bank account, but that doesn’t mean it is subject to the rules for intangible assets but to their own unique set of rules. And this is where it gets interesting: why would anyone care about these definitions? It is because of the differences in recognizing their value in financial statements that differ from tangible or intangible assets.
Then there is the property law, and unfortunately, this being one of many examples, accountants and lawyers use similar vernacular but mean to describe different things. The law also knows tangible and intangible assets. For example, English law generally speaking distinguishes between two categories of property rights: things in possession (tangible things), and rights relating to things in action (legal rights or claims enforceable). Intermediated securities, an equities position held at a bank, are generally regarded as intangible assets due to their dematerialized nature and the manner in which they are held and transacted. And lawyers can never agree on anything; certain jurisdictions like Germany would treat such ‘intangible’ securities holding as a thing you can touch as far as the applicable law is concerned (which of course is a legal fiction). And some countries have created a unique legal framework for financial instruments. Why am I writing all of this? There are different consequences to how a thing is being categorized under the law, for instance, in terms of how ownership is transferred.
So, the financial accounting asset, therefore not intangible, becomes an intangible asset in London but becomes a tangible asset 500 km south in Frankfurt, and at a given moment in time, this may also change subject to new laws or new accounting concepts that could be developed. So, while both accounting and the law aim for rules that reflect reality (one would hope), they are an abstraction of reality, which sometimes requires accountants and lawyers to become writers of fiction. And as a result, we require precision in language beyond the colloquial meaning of a word when discussing such things. And since we are interested in tokenization to record ownership and ownership transfers correctly, which is a function of the law since ownership is only interesting if you can enforce it, one would hope research like this would reflect more on the relevance of such terms as tangible or intangible and they differ from how financial assets are treated.
And it matters potentially how easy or difficult it is to tokenize an asset, and this is reflected much later in the report “intangible RWAs are easier to tokenize. In financial assets specifically, there’s the additional factor that many of these assets already have a ‘digital twin’ sitting in a database.” Yup, 100% agree! Although I would add, it’s more like an untrustworthy non-digital twin.
Two more thoughts, though: I do think that this term has some relevance but not with respect to tangible and intangible, but with respect to digital vs. non-digital. So to speak, intangible assets that only exist in digital form are significantly more appealing to be tokenized than anything else because of the potentially higher ability to test their existence through digital means. But that is something I will address another time, potentially in the Digital Asset Creator white paper (see link).
PS: Everything I wrote so far is basically wrong or incomplete because the law knows other things. Intellectual Property, but this property right is an IP right and therefore not a so-called absolute right (in rem), which is what we want for financial instruments. And property law on its own is not comprehensive enough to cover what is needed, e.g., using an asset as collateral may be governed by specific and different sets of rules. Tokenization is not simply a question of which token standard on which protocol.
“The Oracle Problem is the most critical challenge for tokenized RWA. It relates to blockchain's inability to access external data securely, hindering their decentralized nature.”
Agreed, although this hindrance is also the reason blockchain can do some cool magic in the form of being a deterministic system, and that works only on a narrow data layer since the data needs to be of a certain quality which is ‘digital’ data. How much that boundary can be shifted without compromising the deterministic quality remains to be seen. I personally think there is a way, but that would require something entirely different from the presently available data oracle solutions.
“Innovation & Game Theory - We see evidence that innovative solutions with embedded game theory can align incentives between stakeholders to incentivize updated & correctly reflected tokenized RWAs.”
That sounds intriguing, I do agree, and has been the starting point for the Digital Asset Creator as well. Innovation!
“Digitalization - We see digital transformation driving the shift from tangible to intangible assets. We believe over time, more and more tangible assets will be represented as intangible assets.”
Not again! Please kindly refer to my earlier comments plus a slight addition: The statement about the shift from tangible to intangible assets due to digital transformation is also puzzling. While digitalization can change how assets are represented and managed, it doesn't inherently alter their fundamental nature from tangible to intangible. The tokenized gold bar remains still an object one can touch, I would think, even if somebody creates some computer code somewhere.
“In the search for more efficiency, assets are becoming digital, and intangible, in nature as the process of tokenization unlocks more benefits that come with being represented in token format on the blockchain. Intangible assets can also still benefit from digitalization when moving to a different database or infrastructure.”
Hmm?! “Assets are becoming digital in nature.” This is a bit strange insofar that, if I may say so, ‘the nature’ of the asset to begin with determines how the ownership in it is evidenced as required under the law. There are examples of legal regimes creating new frameworks to capture more effectively how new innovations operate, which would then also bring a new and distinct form of ownership rights and/or new means to evidence it. Does that change the nature of the asset. Not sure. And that is very important here: the quality of the right. One good example is the discussion in the UK (Law Commission report) leading to a new legal paradigm to define stuff one can own as ‘2+1’.
2 being things in possession and things in action + new 1 being third category stuff in the form of digital objects
It's a cool, detailed and sharp document leaving very few questions out of its documented deliberations. And it also says what cannot be answered right now. For example, the legal recognition of actions within blockchain networks, like staking and the resulting penalties (e.g., slashing), may vary depending on jurisdiction and the specific legal framework in place. The document implies that these issues are subject to ongoing legal debate and interpretation. But that’s true today as well.
There are also certain scenarios that I think are not considered yet, or I missed finding it. For instance, what would happen in the scenario of a complete shutdown of a blockchain network and the consequent implications for property rights? I suppose they are gone. Such a situation would be unprecedented and would likely require legal and technical analysis specific to the circumstances and the nature of the blockchain involved. I suppose the answer is simply “res perit (domino)” - the digital asset thing perished (and that risk is on the owner of the asset).
“There was an initial buzz of interest in the tokenization of RWAs in 2017 and 2018. So, why do we now see a renewed interest in the tokenization of RWAs?”
I read this section with great interest, suggesting there is a significant movement in the institutional market to adopt tokenization. I hope they are right. The paper quotes a BNY Mellon Survey result of 271 institutional investors, indicating 76% of institutional investors are investing in crypto or are exploring it, versus only 53% investing in tokenized securities, or thinking about it.
Exploring the possibility of visiting Antarctica, so that I can say I have set foot on all continents of this planet, using a travel website and actually going there is not the same thing. Just saying. And I think the much higher level of enthusiasm for crypto than for tokenized instruments should give pause for thought. Unfortunately, the report does not provide a year with no title of publication. That would make it too easy! I like the attitude. I suppose it refers to the bank’s Digital Asset Survey from 2022, but the link is broken.
“Notably, major financial market infrastructures like DTCC, Clearstream, and Euroclear are launching tokenization pilot projects. While blockchain and RWA tokenization could potentially make these central counterparties obsolete through atomic securities settlement, they are still exploring opportunities.”
This is a good one. I better ping this to a friend at Euroclear to rub it in. How shall I say this, CSDs invented the atomic settlement long before blockchain came around, and it's called ‘delivery vs. payment’. I do have my own views around the subject, and it got more to do with chiseling off the ‘c’ for centralization in a tokenized economy. But it doesn’t necessarily mean the existing business impact as we may see a more realistic short term impact in new asset classes nor that the expertise, regulatory status, and distribution capabilities of such firms become irrelevant. There is value that can be created by orchestrating networks and insourcing stuff an investor would have to do themselves. I am buying milk in a bottle, not a cow.
“Besides infrastructure, these large incumbents are also driving the narrative and conversations with the regulatory authorities.” And the report contains a link to aDTCC Euroclear Clearstream white paper aptly named “Advancing [..] Together!”
Ok, that is a bit mean and sounds like the school bully. “Hey you over there, yes you, you are obsolete, but nice job done with the school report.” And since I am on a mission, the CSD report also shows anticipated growth in tokenized securities over the next 15 years to around $16 trillion, citing Bank of America. That’s odd. This very report cited doesn’t say this at all. The website where the report is hosted mentions 15 years but no USD number either. 16 Trillion! Sounds familiar? This seems to be the exact ominous BCG figure which is based on the more ominous WEF figure (see my comments on the 10 percent enigma in the linked article).
Good try, gotcha! All this research quoting from the same report that reads to me like it was meant as a parody. What the Bank of America report says though is interesting indeed: ‘Blockchains record ownership of the 26k+ tokens that exist within the digital asset ecosystem, but BofA Global Research expects 99% of those in existence today to essentially disappear over the next 10 years.” Bleak!
“Through tokenization, we believe there are key blockchain features that RWAs unlock by being represented through a digital token on the blockchain. These key features are: Transparent -[..] all participants can verify transactions, Tradable, Immutable, Divisible (fractions), Programmable.”
Blockchains are not fully transparent since the involvement of smart contracts and sidechains, etc., can make it very difficult to understand the transaction volume of an asset. Immutable, no, they are highly tamper-resistant. Fractionalization, this is not so simple; how you can slice and dice a property right that the law doesn’t recognize. Programmable. Yes, principally, I absolutely agree, but it is also not so easy. Because if you want to do banking, you need to ensure to be able to control or mitigate risk from this. And a provider coming along saying, "I got a cool solution," is nice, but that’s not yet a scalable solution given the many providers there are.
“Bearer ownership, where possession of a tokenized asset signifies ownership, is reemerging in blockchain. Bearer asset regulation is a framework governing the ownership of an asset. This regulation was used in the past for financial assets (bonds, equity, etc.) but became irrelevant when financial markets adopted a custodianship structure.”
I hear this all the time at tokenization conferences, but this is pseudo-lawyering.
Hey Research AI:
Is there such a thing as bearer asset regulation? List all academic journals!
The search for the specific term "bearer asset regulation" did not yield any direct results in academic or research papers. This suggests that the exact expression "bearer asset regulation" may not be commonly used or recognized as a standard term in the context of financial regulation or securities law.
Bearer instruments would remove some complexity from tokenization, I think, which would be a more correct statement. And it's important to keep in mind that bearer instruments are very common in many markets, and even with a registered share, the person registered may not be the investor but a custodian bank, and again, there can be differences across jurisdictions about what the consequences could be. Possession of colloquially speaking ‘intangible’ things - back to the beginning.
“The computable economy is a new economic paradigm where web3 technologies facilitate the development of a ‘computable economy’,”
Ok! Since I am not so sure what is exactly meant here, I would only say that the debate in math and later computer science about what is computable goes back to even before the computer and didn’t start with web3. Key contributors include mathematicians and logicians such as Kurt Gödel and Alan Turing in the 1930s. Gödel, in fact, is a name I run into often when looking at certain specific aspects of blockchain, even though he obviously didn’t know about it. And the debate on how to apply this idea from computer science to economic theory is also decades old. There is a research paper referenced, maybe it has the potential to require a blog response. We shall see.
It then references something that is indeed extremely important: examples of general-purpose solutions to the physical asset oracle problem. I think that could be a new subtitle to my whitepaper:
Digital Asset Creator - Genesis Story - A General-Purpose Solution To The Physical Asset Oracle Problem
Or how about: The Solution to All Non-Digital Asset Oracle Problems.
Much better!
“The value of an asset is defined by a combination of intrinsic value (based on future financial cash flows) and market value (what buyers are willing to pay for it).”
I love this new take on financial theory because on the next page we read:
“Tokenization of RWAs facilitates liquidity [...] leading to an uplift of its intrinsic value.”
By issuing a token, do we increase the cash flows, revenues of the actual business? That is an intriguing thought which I will pretend was never made. Personally, I am always a bit uneasy reading these oversimplified narratives. Why is it a good idea that we drive up prices for financial assets by changing the tech stack? The report says: because now people that want the asset most can get it. Why can’t they do this now? Is the combined purchasing power of fractional investors outbidding Blackrock? And then what? Sell it back to Blackrock at a loss?
We do not have perfect markets, and ideally we want markets that produce prices which are the fair value of assets adjusted for the time value of money that immediately and correctly processes all information without transaction costs and at a depth that larger transactions can be executed without suppressing the fair value or lead to price volatility at execution. And since we don’t have it, more efficient and liquid markets would mean that the risk of investing is lower (because you can get out more easily) and that’s why there could be an uplift because value is created that an efficient market should compensate for. But this has nothing to do with the intrinsic value of a corporation. At least in my view, but what do I know?
“Split up their assets into sub-categories of their assets (for example, separating the carbon certificate rights from a forest and trading these as two separate assets).”
I was not aware that a carbon credit includes the purchase of forest land. I better check it out before all the forest land is sold out.
“Example - digital property rights - separating the digital property rights from overall property rights. [...] We are excited about the trend of segregation and the value it unlocks within assets... they anticipate a 2% increase in the valuation of global property value as a result of proper segregation of property rights.”
Oh? Yeah, this made me confused as well. The so-called digital property right here concerns the right, if I get this correctly, to display some ads in a virtual reality if some virtual person walks down the virtual road and looks at said virtual ad. I am not aware that this is a property right, maybe a commercial contract with some gaming company. If we play Monopoly and I possess the card for Atlantic Avenue, it does not mean I have a property right in some neighbourhood in New Jersey. I am not discounting revenue opportunities in a virtual world. But we do things like this (‘separating’) in financial markets today. Coupon stripping for example. And whether this virtual house ownership is the killer app, I remain to be convinced.
The text continues by briefly mentioning a new token standard with a built-in decentralized identity framework championed by Tokeny (very nice people actually although this is no endorsement or marketing for or against their products) and a bunch of law firms. Admittedly, I only read the whitepaper but no technical documentation. This sounds about right insofar that we need an interplay between identity claim, permissions or entitlements they have, and deciding where the respective info comes from. It still leaves the question open how to make that determination and why any of this should concern the classical issuer. Whether it is really beneficial to blur decisions that are a function of a company’s internal risk framework with questions of the technical aspects of how to instruct a movement of funds in the market, I am a bit more ambivalent.
“We continue to see a bottleneck on the demand side of tokenization. While there are plenty of opportunities to tokenize and fractionalize asset classes, we see many verticals struggling to make a liquid market around these tokenized assets, even for assets that already have an existing liquid market. We believe the opportunity for founders now lies in building out infrastructure to onboard buyers.”
“We are of the view that we are moving towards a multi-chain reality as blockchains are going from monolithic, general-purpose ledgers towards modular and vertical- or app-specific builds. This is especially true in financial services.”
I think this is very interesting to contemplate, and since these opinions are made at a moment in time, it's not so important whether one agrees or disagrees (and I agree with a lot here) but what is required to affect this outcome, etc.
Ok, there are a few opinions which are quite close to pretending to be factual statements such as this one:
“Financial markets - infrastructure and processes of financial markets are completely different across asset classes. Tokenization can unify practices across asset classes.”
This is interesting. I do think certain infrastructure has cross-asset class usefulness, but whether this unifies ‘practice’... Ok, I am also not completely sure what is meant by this term, but equity has different lifecycle events to a futures contract, so there are some natural limits to this idea.
“Tradability - Tokenization has the potential to create a market for assets which were previously ‘over-the-counter’ (OTC).”
And the examples given are carbon and collectibles.
OTC markets are also markets. But let's assume all carbon credit trading takes place through some super-duper blockchain-powered global and transparent system; this still leaves the issue of how this would make such carbon credit negotiable instruments (general terms, not specific legal definitions). Because if not, as an investor, you would need to look at each issuance to understand what you are buying and what terms and credit standing (a ’selection problem’ in economic terms). And this is the case today for many bonds, hence why there is often limited secondary market liquidity. And all that is reflected on later in the report. But I would wish there would be a critical assessment of how this impacts the outlook. How can both statements be true?
“A key feature of financial assets is that they are the assets used in financial markets.”
Oh? I can’t wait to see where this is going.
“Looking at market infrastructure across different asset classes, it’s hard to call financial markets efficient. There are different trading, clearing, custody, regulatory,... requirements across asset classes. Tokenization and blockchain-based financial markets can make these processes homogeneous across asset classes, unlocking synergies and efficiencies, adding value to all stakeholders.”
Bang. Sorted! Oh, this is it? How, why, when—that’s a walk in the park now.
"The trend we call 'financialization of real assets' is brewing under the surface. Tokenization allows the reengineering of cash flows, ownership, and investment opportunities associated with the ownership of assets.”
I do like that idea. There could be something to it.
“Particularly in real assets, where financial returns and cash flows traditionally played a lesser role in the value proposition. [...] We see tokenization bringing liquidity and decentralization to the cash flows associated with these real assets. While previously it was hard to disassociate these cash flows from the real asset due to transparency and efficiency issues, tokenization offers a technological solution, opening up real assets to financialization.”
I have been trying to imagine what this could possibly mean that is not totally outrageous, but I can’t.
“Tokenizing IP enables the division of patent ownership into smaller parts, facilitating its distribution among multiple parties in the open market. By allowing companies that generate R&D to sell it down to recuperate investments and generate working capital, etc.”
It’s possible to 'sell' IP rights today; they get reassigned because it's a special kind of ownership. The patent office often needs to be informed not to make a 'sale' effective, but to enforce the rights. The type of IP has specific requirements for how this has to happen. What’s challenging is to assess how valid the right is, and that requires legal and market know-how. How does tokenization help? I don’t know.
"To realize the full potential of tokenization, the token must encompass all attributes of the asset, including liabilities, cash flows, terms and conditions, risks, debt obligations, and so forth, all of which should be directly embedded in the token.”
This is spot on. It’s one of those ‘told you so’ moments. Although, I would say it then needs something else in order to make all this work.
“Regulators need to address machine execution of the rules embedded in the token if we want to unlock the true value of tokenization of real-world assets (RWAs).”
I think from the perspective that a PDF is in a certain way digital data, but not the kind of ‘digital’ data we need for blockchain there is some merit here. I am not sure what rules prevent the machine execution of contractual terms directly. Indirectly, maybe, but the fundamental problem of how to transpose the ambiguity of language and human intent into clear, fair, and undisputed process steps, well, that’s not a problem regulation created.