Talk about the tokenization of everything seems to be everywhere, from financial products to real estate, islands, sports cars, and of course, your favorite collectible digital cats.Token use of the word tokenization is a symptom of having reached peak blockchain mania, but buried in the noise, the digital transformation of real-world assets through security tokens has immense future value. It holds the promise of freer, fairer, more equal and efficient markets.
But how can we see what this might tangibly look like today? This post gives a brief background on token sales, a practical experiment in creating a security token, and a look at what we might learn from this.
The boom inInitial Coin Offerings (ICOs) during late 2017 and early 2018 predominantly saw the sale of utility tokens — typically a cryptocurrency or digital token required to use or fuel some product or blockchain-based software. Companies pre-sold utility tokens in order to fund development needed to deliver their product — no equity, no shares, or financial entitlements for investors. Most utility tokens were created to access software products, therefore managing (especially in the early days) to tiptoe around financial regulations.
A security token, on the other hand, is a digital representation of some financial product or real-world asset with intrinsic underlying value (equities, debt, commodities, real estate, etc.).Most Security Token Offerings (STOs) aim to comply with financial regulations upfront because they are actually seeking to be financial products. The potential benefits of tokenizing financial products are wide ranging: increased liquidity, automation of compliance processes, more transparent auditability, and greater financial inclusion through lower minimum investment barriers.
I’ve recently been reminded of the concept of ‘Genchi Genbutsu’ while reading about the history of Toyota’s car manufacturing dominance. Roughly translated to‘Go-and-See’, genchi genbutsu means going directly to the place where work is done in order to truly understand the situation. It is one of the ways Toyota massively improved production line efficiencies and continues to solve problems today (aka their secret car making sauce).
With this in mind, I set out on my own genchi genbutsu expedition to go and see how the tokenization of financial assets could be practically achieved today. First, I needed to find an asset to tokenize, and fortunately, the answer was in plain sight. As well as being a blockchain technology firm, shares in our company DigitalX are publicly listed on the Australian Stock Exchange. What better asset to experiment with combining the old and new worlds of finance than with our own company’s stock? Let the tokenization begin.
Next, I need a way to create the token. Groups like Polymath,Harbour, and MyStake are building issuance platforms and new standards for security tokens, similar to what the ERC-20 standard did to enable new utility tokens to be created on top of the Ethereum blockchain. These standards are basically a set of rules about what information the token needs to contain and store on a blockchain, like how they can be traded or which regulatory and compliance rules are enforced and baked directly into the code. For example, there may be a maximum ownership limit for any given holder or a minimum amount of time required to hold securities before they can be traded.
I chose Polymath for this tokenization experiment simply because 1) at the time of writing it seems to have the greatest public awareness and 2) it provides an easy way to test out the STO creation process using the Ethereum test net (plus a very handy tutorial). Though the three platforms mentioned above share many similarities in their approaches, there are meaningful differences between them that may be covered in a follow-up post.
1. Polymath is a distributed app (or dApp) built on the Ethereum blockchain.
2. The Polymath dApp creates smart contracts according to their ST-20 standard.
3. The ST-20 contract issues security tokens to Ethereum wallet addresses.
4. All fees on the Polymath dApp are paid using Polymath’s own cryptocurrency token, POLY.
5. We will usePolymath to create our own DigitalX ST-20 contract to issue security tokens representing DigitalX shares.
Rather than listing all the token creation steps through Polymath, here are the highlights following Polymath’s own documentation.
Much like a stock market ticker symbol, a token symbol must be created. The fee for this is, of course, paid for using POLY tokens, though at a cost of 250 POLY this will only set you back about $22 US (at the time of updating).
Executing a full STO requires a lot more than just simply creating tokens. Polymath offers contact information for a range of service provider partners to facilitate identity checks, fulfill KYC/AML requirements, obtain legal advice, corporate advisory services, PR and marketing and more. For simplicity, DigitalX will be the sole service provider for this offering, so we advanced to the next stage.
This is one of the key differences between a utility token and a security token. One way to think about the current state of security tokens is that they are simply utility tokens, except with a restricted list of wallet addresses that are authorized to hold and transfer them. Performing adequate investor checks ensures that the real world identity of each wallet owner is known, therefore restricting access to the token based on relevant financial securities regulation.
With a list of qualified and vetted investors, each wallet address is added to the STO whitelist. For this experiment, I went around the office and collected each of my colleagues’ wallet addresses. This would be an employee-only token, in what might be one of the first tokenized employee share scheme trials.
At 25,000POLY (~$2,2000 at time of update), the launch of the STO is the most expensive step in the Polymath process, though we are using the testnet version where POLY tokens can be acquired for free. The number of tokens issued to each wallet address should replicate the capital structure of the security. For this experiment, we simply issued tokens on a notional basis of 1 token =1 DigitalX share. Other required basic information establishes:
1. The total number of tokens
2. The number of tokens to issue to each address
3. The number of tokens to be sold in the STO
4. The STO price per token in either ETH or POLY
The open and close dates for the sale of tokens in the STO are also then set. During this time any whitelisted address can send ETH or POLY to the STO address and automatically receive back the security tokens according to the set price.
And with this, we’re done! Our finished security token contract can be viewed here.
1. The technology has already arrived.
While only hypothetical, the whole process of tokenizing DigitalX employee shares took just under an hour to complete on a first run-through. It's amazing to think that this kind of functionality is already available and that security tokens can be issued today with relatively minimal fuss. The real barrier to widespread mainstream adoption is not technical but human — incentivizing behavior change, updating existing laws, and making products and services that are as easy as possible for people to use is always the real challenge.
2. Many areas of financial securities administration will become more automated.
In the future, blockchain ownership records are set to become the technology serving traditional share registry functions such as maintaining a list of shareholders, proxies and voting, management of rights issues, and payment of dividends etc.Automation of these tasks will both replace some businesses and result in cost-saving efficiencies for others, but eventually, the continued minimisation of required trusted third parties will completely revolutionise the financial services industry as we know it.
3. But the need for associated financial services providers won’t quickly vanish.
Currently, most tokenization of securities (like our DigitalX experiment) creates a digital representation of real-world securities, storing a duplicate copy of the security’s ownership details on a blockchain. In other words, the token register is a copy of the share register, so the central share register still exists. The emergence of security tokens will usher in some exciting changes, but for the foreseeable future will still require quality service providers across the entire ecosystem, from corporate advisory to identity verification, investor marketing, legal guidance and a range of other professional services continuing to adapt and change.
I expect this duplicate model to persist at least for the medium term, especially in instances where the token is backed by physical assets, given the need for some real-world entity to validate their physical existence (a form of what’s known as the oracle problem). But the longer term prospect of a more fully decentralized financial system, where the security token is the security itself, offers a tantalizing step towards realizing the full benefits of truly programmable money.
Visit www.digitalx.com for more information.
The information in this article is general in nature. Any advice it contains is general advice only and has been prepared without taking into account the objectives, financial situation or needs of any particular person. The article content is not intended to be a substitute for professional advice and readers are urged to seek their own appropriate advice before making decisions. Any reference to a particular investment is not a recommendation to buy, sell or hold the investment.