Dr Pavel Kravchenko holds a PhD in technical sciences and is the founder of Distributed Lab.
In this opinion piece, the first of a two-part series, Kravchenko argues that tokenization of assets using blockchains will have more profound effects on the world’s markets than simply reducing back-office record-keeping costs.
Would you swallow a random pill that you saw on the counter in the pharmacy? Of course not. You don’t know anything about it!
But what if this pill came in a package with details from the manufacturer? And you had a prescription from your doctor? Further, what if you could independently test the pill’s chemical composition and make sure it matches the label and prescription? Or (flash forward to 2049), suppose you could verify that the chemical composition of the tablet is suitable for your DNA and confirmed by clinical studies.
Would that pill be more valuable to you? Undeniably. Its value increases depending on how much reliable information about it you have, even though the properties of the pill did not change.
Today, financial assets are too much like that loose pill on the counter. You don’t know enough about where it’s been, what’s in it, or what it will do to you.
But the process we call tokenization is going to make many assets a lot more attractive to a lot more investors, in part by providing an unprecedented level of information.
Why crypto took off
Stepping back, let’s consider the legacy financial system. Quite apart from information asymmetry, there are other forms of friction that discourage investment.
Even though we tend to think the global financial markets are as liquid as possible, that is only actually true for people and organizations already in the “system” – i.e. brokers and financial institutions. The end client is forced to go through all the levels of hell in the form of know-your-customer (KYC) and compliance checks at each and every opening of an account, signing of contracts, paying of commissions, etc. This also applies to investments into growing enterprises, access to which is only granted to accredited investors.
Strict regulation of the market for end users has led to demand for alternatives, which has unexpectedly let off steam through the cryptocurrency market. As soon as people started to believe that this market let them not only enter, but also withdraw freely, liquidity surged, cryptocurrency grew by factors of 10, and the number of initial coin offerings (ICOs) rose by more than hundreds per month.
Despite the hype and inevitable disappointment in investing in totally unregulated assets (where the level of fraud constitutes 90 percent, according to the People’s Bank of China), it is clear that the democratization of trade leads to a sharp increase in the attractiveness of assets. Every business or nation would, or should, like this to happen in its economy.
Barriers to exchange
As someone who, for a couple of years, was involved in the equities market, I can say red tape is the main reason why a client can change their mind about opening an account.
A secondary issue is by a low usability of trading software – it is necessary either to study up or to entrust the work to a third party.
More fundamental problems – such as the need for trust in intermediaries, poor infrastructure integration, and the speed of settlements – are in third place.
Indirectly, tokenization has created a fashion for extremely simple, convenient systems, where within 20 minutes you can get money on the exchange, trade, and withdraw capital. Of course, there is a risk that it will never be possible to withdraw money, but it is sometimes easier to accept such risk than the infinite dragging-on of undergoing compliance procedures.
The age of tokenization
One way or another, a term appeared in the blockchain space that had been coined, as it were, in the security management process. Balances of accounts on blockchains began to be called “tokens,” due to the fact that they were items to be simply and safely transmitted. In essence, tokenization is the process of transforming the storage and management of an asset, when each asset is assigned a digital counterpart.
Ideally, everything that happens in a digital accounting system should have legal implications, just as changes in a real estate register lead to a change in ownership of land. The age of tokenization introduces the important innovation that assets are managed directly by the owner instead of managing assets through issuing orders to a middleman.
The difference in approaches is easily explained by the example of the difference between the banking system and bitcoin. With a bank account, the client sends an instruction to a bank where it is executed by someone, and the client identifies themselves through their login and password. In the case of bitcoin, the transaction initiator uses their digital signature, which in itself is a sufficient condition for the transaction to be executed.
Nothing prevents the use of the same mechanism for traditional asset management. Certainly, this will require a change in infrastructure, but will bring many benefits. It will reduce costs, and increase the speed and security of trades.
Every trading infrastructure includes a depository, an exchange, a clearing house and client software. Tokenization assumes that all these components will be far more integrated. And blockchain technology will allow decentralizing the entire infrastructure, distributing the storage and processing functions between all the parties involved. This decentralization will make the system more resilient, since there will be no single point of failure; it will reduce the need for trust in a central provider; and it will allow instant audits, since multiple parties have real-time access to the ledger.
Unexpected results
In addition to the most obvious benefits from the transition to a digital domain – increased speed, security and convenience of operations, as well as less need for intermediaries – tokenization allows unexpected results.
Among them is the addition of properties of assets that are not initially inherent: the ability to prove the history of ownership, the opportunity to divide assets into the smallest fractions (bitcoin, for example, is divisible to the eighth decimal), and the ability to integrate principles of management into the asset itself. For example, suppose there are several partners in a real estate development who need to vote on a proposed renovation. With a wallet that holds their tokenized property, they can take the vote more efficiently, without having to meet face-to-face or trust a proxy to represent their wishes.
All these things will make a tokenized asset more valuable than a non-tokenized asset with the same fundamentals, just as easy access to reliable information about a pill would give you more confidence to take it.
In the next article of this series: What stands in the way of tokenization.
Pills image via Shutterstock