Facilitating the Trading of Illiquid Assets through Tokenization

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Tokenization is potentially the largest use case of blockchain and distributed ledger technology, whose value could exceed $24 trillion by 2027 [...] Christian Dick and Christian Pohle analyzed the value proposition of tokenization for customers, financial intermediaries, and regulators, including fractional ownership, the ability to take a stake in previously illiquid assets such as art objects or real estate with only small amounts (Dick & Pohle, 2021). Regulators around the world are currently working to create the regulatory framework to tokenize debt and equity instruments; the current non-fungible token (NFT) hype is just another example of tokenization. This also shows: Tokenization is becoming relevant for almost all industries and will create new business models. However, understanding the concept and navigating the world of tokens is not easy.

[Heines, R. Industry Insights: “The Tokenization of Everything”. (Accessed September 13, 2022)].

"A large chunk of the world’s wealth today is locked in illiquid
assets. In a survey conducted in the U.S. in 1997, 56%+ of
assets held by taxpayers with a net-worth of between
$600,000 and $1 million were illiquid. All else being equal,
illiquid assets typically trade at a discount vs. liquid assets,
and are characterized by a high stock-to-flow ratio, lower
trading volumes and imperfect price discovery vs liquid
assets". [Kumar, S., Suresh, R., Liu, D., Kronfellner, B., and Kaul, A. Relevance of on-chain asset tokenization in ‘crypto winter’. (Accessed September 13, 2022)].

Some prime examples of assets which are considered illiquid are: "real estate (incl. home equity), natural resources, land, commodities, public infrastructure like mines/ports, fine art, computing infrastructure, private equity etc. On top of that, there are multiple other asset classes which are only accessible to limited wealthy investors/institutions due to constraints on ticket size, e.g., pre-IPO stocks, hedge funds, infrastructure projects, commodities and alternate investment instruments, private credit. The total size of illiquid asset tokenization globally would be $16 trillion by 2030" [Id].

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The main growth is expected in the tokenization of financial assets (such as insurance policies, pensions, and alternative investments), home equity, and other tokenizable assets, such as infrastructure projects, car fleets, and patents [...] The promising market surpassed $2.3 billion in 2021 and is expected to reach $5.6 billion by 2026, states the report [...] [T]he current growth of the global digital asset daily trading volume is only the tip of the iceberg of the total potential of illiquid tokenizable assets. It is notable since the tokenized asset trading soared from 30 billion euros in 2020 to 150 billion euros in 2022.

[PaySpace Magazine. Tokenization of illiquid assets to reach $16T by 2030 — BCG Report. (Accessed September 13, 2022)].

"Reasons for this asset illiquidity are attributed to factors such as limited affordability for mass investors, lack of wealth manager expertise, limited access such as when assets are restricted to elite cliques (in the case of fine art and vintage cars), regulatory hurdles and other scenarios in which users have difficulty acquiring or trading an asset" [Pereira, A. Tokenization of illiquid assets to reach $16T by 2030: Report. (September 13, 2022)].

This interesting and illuminative report goes on to state:

On-chain asset tokenization presents an opportunity to
obviate many of these barriers of asset illiquidity as well as
the current modality of traditional fractionalization. Onchain asset tokenization helps reimagine the end-to-end process of finding and matching investors with investment opportunities, and the subsequent secondary market opportunities once an investment has been made [...] [T]here is an impending shift from traditional fractionalization to on-chain tokenization, which expands the scope of asset classes, stakeholder groups and regulatory scope for tokenization. Therefore, it is crucial to understand and appreciate the incremental benefit from fractionalizing assets on blockchain-based platforms.

[Kumar, et.al., supra]

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There are five key steps for end-to-end asset tokenization online. which for informational purposes are:

1. Assemble the ecosystem
2. Register underlying asset & configure token
3. Set compliance rules
4. Store, manage & distribute the token
5. Execute corporate actions

[See, Kumar, et. al., supra].

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But more importantly there are six distinct benefits of on-chain asset tokenization over the traditional forms of fractionalization, to wit:

● Improves affordability by enabling investments in divisible, fractional asset values of high-ticket instruments (e.g., hedge funds, alternatives)

● Enables borderless accessibility by enabling listing of hitherto illiquid assets (e.g., natural resources, land, vintage paintings) subject to local regulations in each jurisdiction, and enabling seamless trading in the secondary market

● Unlocks liquidity and enhances flexibility by enabling trading of assets before maturity (e.g., future earnings from agricultural land)

● Enforces immutable transparency and accountability by offering a clear historical and current transaction record and immutable assignment/ recording of ownership rights governed by smart contracts, in a shared ledger on distributed P2P network nodes (e.g., tokenization of government’s infra projects as public ownership rights, improved tax recovery)

● Streamlines transaction efficiency by a) enabling higher transaction speeds at lower price due to enhanced cost efficiency in asset transfer with smart contract to allow for automation of exchange, b) reducing friction by ensuring a single KYC suffices across all investments / platforms by linking users’ wallets to the blockchain, c) gaining from asset servicing, i.e. the ability to distribute to tokenholders without having to go via transfer agents/3rd party custodians and depositories over the life of the asset, and d) reducing the settlement times with blockchain overcoming DvP inefficiencies.

● Ensures better price discovery of illiquid assets as blockchain enabled platform disintermediates the process by helping reduce/lower ‘rent-seeking’ by intermediaries (e.g., auction houses, asset management companies).

[Id].

One of the key challenges impeding the growth in usage of on-chain asset tokenization is the "[i]ncreasing regulatory scrutiny, geographical variance and associated uncertainty in governance" [Id] which have the effect of lengthening the path to cross-border scalability. A look at the variance existing among 14 individual countries in this regard clearly illustrates this point:

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"While demand is growing for tokenized assets, it is still not strong enough yet among some investors (esp. corporate investors), which stems often from their own internal policies where digital assets are often not mentioned" [Id].

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