Tokenization: from material to digital

Tokenization in a nutshell
Tokenization is the term used to describe the creation of a digital replication of a tangible asset (e.g. machinery, equipment) or an intangible asset (e.g. software programmes, licences). In other words, the specific asset is securitized with the help of blockchain technology and represented as a digital asset by a token.

Three key benefits of tokenization

1. Tokenization offers a number of crucial advantages over conventional securitization approaches that involve financial intermediaries such as banks, insurers and law firms. The involvement of these parties can be reduced thanks to digital securitization and redirection (disintermediation), which in turn leads to a significant increase in efficiency in the trading of digital assets. Trading hours are also greatly extended, as trading via blockchain can essentially be undertaken 24/7. Moreover, the costs of such transactions are substantially reduced. Another benefit is the low susceptibility to error, as human error is almost entirely eliminated.
2. Tokenization lowers the hurdles for investors wanting to participate in the financial markets. As digital tokens can be designed in very small denominations, investors can now gain exposure to exclusive asset classes with levels of capital that would previously have been far too low. For example, it is now possible to purchase 0.01 percent of an expensive painting via blockchain.
3. Over the last few years, asset categories such as real estate, fine art and exotic vehicles have generated impressive returns, making them highly promising alternatives to traditional asset classes such as equities and bonds. The aspect of disintermediation in the trading of digital assets also offers significant advantages for the issuer: the high fees traditionally incurred when collaborating with investment banks and other institutions on the issuance of conventional securities can be avoided. 

Issuing equities and bonds is therefore becoming just as easy as agreeing a loan with a bank. Tokenization therefore also makes it easier for small and medium-sized companies or start-ups to raise the necessary financial resources. This can be illustrated with the following example: a bakery requires a new kneading machine at a cost of CHF 25,000. By tokenizing this need, the bakery can sell tokens to its customers along with its baked goods. With the money it raises, the bakery can then purchase the costly machine in question. However, where is the benefit for the capital providers here? They receive – as envisaged by the bakery's issuance terms – a regular payout equating to a proportion of the income earned with the new kneading machine.

How does tokenization work?
The process of tokenization is based on blockchain technology. It is complex from a technical standpoint, but can be easily understood as follows:

Let’s assume that John Smith owns a Bugatti Veyron worth CHF 2 million. Then there is Bob Jones, who wants to invest CHF 2,000 in exotic vehicles. Until very recently, the latter would not have been able to invest in this asset class due to his insufficient level of capital. Thanks to tokenization, John Smith can “break up” his vehicle from an ownership perspective and sell the individual “pieces” to numerous individual investors. Therefore, Bob Jones now can acquire exposure to the value of a Bugatti Veyron after all.

Nevertheless, a key question arises here: does Bob Jones suddenly gain direct access to the Bugatti Veyron?

What rights does the investor have?
It is advisable to scrutinize the rights associated with the acquired token closely. In many cases, acquisition of the token does not give the holder any direct access to the valuable object in question – such as in the case of the above-mentioned Bugatti Veyron or an expensive property. In other words, the investor takes the risk of trusting the issuer to actually meet the promises associated with the token in question.

Fruit as a new asset class?
Almost any asset you can think of can be made accessible to investors through tokenization. Obviously, it is reasonable to ask whether it makes sense to subject things such as fruit to this process, for example. However, it is nonetheless clear that all sorts of interesting possibilities and any number of new asset classes can be realized through tokenization.

Areas currently being developed in this sphere include real estate, commodities, diamonds, gold, fine art and luxury goods such as exotic sports cars.

Tokens – an alternative investment?
The above-mentioned advantages of tokenized assets are likely to lead to a rise in both interest and demand, and a significant increase in the trading volumes of tokens. Higher liquidity in turn leads to an appreciation of the underlying assets. Why?

An asset gains in value if it can be traded easily – and at a competitive price – at all times. This can lead to wider acceptance of an entire asset class, which is then reflected in greater supply and greater demand. The greater liquidity is additionally strengthened by the fact that almost anyone with internet access can participate in almost any investment opportunity (subject to the relevant statutory restrictions), irrespective of their geographical location.  Low transaction costs and the possibility of acquiring fractional shares also allows people with limited financial resources to acquire tokens.
 
The secondary market challenge
In order to ensure high liquidity and the associated ease of trading, it is crucial to maintain a functioning secondary market for digital assets. In the absence of such a market, the token loses one of its key purposes, namely to facilitate the trading of intangible assets. This will inevitably result in the asset losing some of its appeal, as selling will either be restricted or in some cases impossible. Indeed, many tokenization projects have fallen at precisely this hurdle.

This publication is intended for information and marketing purposes only, and does not constitute investment advice or a specific individual investment recommendation. It is not a sales prospectus and does not constitute a request or an offer or a recommendation to buy or sell investment instruments or investment services, or to engage in any other transaction. Maerki Baumann & Co. AG does not provide legal or tax advice. Investors are therefore advised to obtain independent legal or tax advice concerning the suitability of such investments, since their tax treatment depends on the personal circumstances of the investor in question and is subject to change at any time. Maerki Baumann & Co. AG holds a Swiss banking license issued by the Financial Market Supervisory Authority (FINMA).