In this article, we will discuss the process of tokenisation, what it means, and how it can be effectively implemented. We also discuss various factors that need to be considered before tokenisation can be applied.
Factors to consider can vary depending on the application, but we will look at it from a broad perspective. One of the most important things to consider is the design of the token economy, which we discuss in greater detail below. We also look at one instance where tokenisation is applied today.
Tokenisation, in the context of Distributed Ledger Technology (DLT) and blockchain, refers to the process of representing ownership of real assets in digital form.
I first studied tokenisation when Red Skies considered the application of blockchain and tokenisation of assets in the insurance industry; specifically, in the areas of reinsurance and Insurance-Linked Securities (ILS). Tokenisation of assets could change the face of several industries and sectors like insurance, capital markets and real estate in a very profound way.
Buildings, securities and exotic derivatives, which have traditionally had difficulty accessing liquidity, could potentially get very cheap access to capital, instantly through the use of blockchain/DLT. This is because having a digital representation of an asset allows solving for information asymmetry problems prevalent in traditional processes. This is why tokenisation can have many different applications across platforms currently underutilized, because of lack of capital, lack of liquidity, information asymmetry, and lack of participants (Forbes, 2018).
Red Skies’s initial project on tokenisation was to identify areas that stand to benefit from fractionalization of value. The process could add additional liquidity to asset classes that were previously deemed illiquid and untradeable. It is similar to the traditional securitization of assets, which is prevalent in the financial services industry. Some examples of securitization include mortgage-backed securities, asset-backed securities and collateralized debt obligations (Loutskina, 2009).
Tokenisation has been applied in industries like wine, real estate, gemstones and art. Artists are now conducting ICOs for the ultra-expensive projects which would previously be more challenging to fund. Infrastructure projects and project finance collaborations could also become cheaper, simpler to manage and easier to execute through tokenisation. These are just a few examples of sectors that stand to benefit.
In the insurance industry, tokenisation can help automate several steps in the life-cycle of an insurance contract. If we were to imagine a simple insurance contract, in it’s purest form it would consist of these three steps;
- - Issuance of contract
- - Trigger (occurrence of a specific event)
- - Settlement of contract
These steps above can be automated to a great extent, using smart contracts and oracles. This can therefore, shorten settlement times, improve liquidity and reduce costs associated with the steps mentioned above. Of course, when we look at more complicated contracts like catastrophe bonds and Insurance-Linked Securities, the number of steps and complexity of DLT implementation increases.
‘Tokenomics’ or ‘token economics’ is an integral part of tokenisation because each token represents a unit of value for the asset being held in collateral. Therefore, it is imperative for companies to consider the design of the token economy if it decides to offer services related to tokenisation or implement it (Nesbitt, 2018).
Current literature on tokenomics is dominated by simplistic representations of the token economy based on models that have been used in traditional macro and microeconomics. These models which have been used in the real world, are being applied in the token economy without enough consideration to factors unique to the token economy.
Equations like MV=PQ which relate to the demand and supply of money are being simplistically applied, on a stand-alone basis, with the assumption that it is the best tool regardless of the use case and design of the token economy. This can lead to a flawed model of a token-based economy, and one should be aware and prepared to deal with problems stemming from any assumptions.
A token economy needs to be modelled very carefully, keeping the function and the purpose of the ecosystem in mind (Neng Wang, 208). A token economy for a digital asset like a Bitcoin or Ethereum crypto-token would look very different from the token for an ecosystem developed to provide a service or for a special function such as securitization.
Expertise in tokenomics is difficult to find since the industry is fairly young, and the skills and frameworks available in other disciplines don’t yet exist. We conducted interviews with notable academics and researchers from Imperial College London and University College London, and it became clear that this was still a developing discipline that lacked universally accepted standards.
Initial Coin Offerings (ICOs)
Blockchain and cryptocurrencies rocked the world of finance by introducing a new system and infrastructure for businesses to utilize and participate in. They provided a platform for companies looking to raise additional funds for the product and ecosystem growth and development.
This was all made possible by the application of tokenisation. Investment in blockchain and similar disruptive technologies has grown steadily. VCs and other private equity companies have started to use these digital assets as a part of their portfolios. VCs invested just over $ 1 billion into blockchain in 2017 (Statista, 2018).
ICOs, which are also known as initial coin offerings, raised billions of dollars per year over the past 3–4 years. In 2017 alone, ICOs were able to raise $ 5.6 billion. Despite this unusually high amount raised, the ICO market was rampant with fraud and regulatory challenges. This is because ICOs in their current form can create a conflict of interest among stakeholders of a company, which the blockchain & DLT community is yet to resolve.
The main consideration is that tokenisation is a powerful concept that can be applied to various industries, sectors and sub-sectors making it easier for businesses to solve problems and deal with issues emerging in a new digital world.