Introduction to financial instrument tokenization
It seems that everyone is talking about tokenization, but only a few understand its essence. As tokenization is a relatively new phenomenon, there is no generally accepted and established definition for this term. For the purposes of this article, we define tokenization as the digitized process of issuing tokens, containing some right, via blockchain.
But first, a primer. A token is a digital file embodying a certain right. In other words, a token represents some value or opportunity. Blockchain is a distributed immutable database in which transactions within a certain network are recorded. Simply, it is the place where ownership of tokens and transactions involving them are recorded. Blockchain is used because it is decentralized (it is not in any one place) and cannot be wrongly changed.
The right associated with a particular token can be ownership of movable or immovable property, a company´s share, intellectual property, a financial instrument, profit sharing (dividend), interest, a right to require the performance of a certain act, etc.
When it comes to the classification of tokens depending on what rights they embody, there is a generally accepted division into 4 large groups:
- Payment tokens. Payment tokens are used as a substitute to legal tender for completing transactions. The most famous examples of these are Bitcoin and Monero;
- Security tokens. They can represent a company´s share, a dividend, interest, a financial instrument, etc. These tokens derive their value from the rights contained in them. Like traditional securities, Security tokens can be traded and may be subject to the existing capital market regulation;
- Utility tokens. Their primary purpose is to serve as a tool for raising corporate capital. In return for cash infusions, issuing undertakings offer investors these tokens as representation of a right to goods and services. They are often issued to circumvent the regulations related to security tokens, which may be onerous. Other forms of Utility tokens can be vouchers, loyalty programs, etc.;
- Other tokens. Also called hybrid tokens, they have characteristics of two or more of the listed token categories. There may also be tokens that contain some intellectual property rights, such as a patent.
What advantages does tokenization bring to the financial market? Speed is the most important. Normal transactions involving purchase or sale of securities may take up to a week. Because of the dynamic nature of today´s business environment, this can be too long to wait. For some opportunities, cash may be needed urgently. Four or five days is too long to wait. In addition, price changes over that time can be devastating.
The solution security tokens offer is their ability to be traded 24/7 on the global market, and not being limited to a particular jurisdiction. As another bonus, blockchain technology enables transactions to be settled in just a few seconds, with the certainty that no fraud can be committed.
Another advantage of security tokens is their program ability. Simply put, this means that any given token can be given any value or represent anything. What does this mean? Security tokens can represent a certain value (i.e. 50 EUR), or a corporate share, or even something more complicated such as a key for causing certain acts to occur when the security token is redeemed.
Interoperability is the third important feature. In the future, various token forms will have to be compatible. As with the internet, which runs numerous protocols (TCP / IP, SMTP, FTP, SSH, HTTP), the future of security tokens will make various types and forms interoperable.