What Is Tokenization in Blockchain?

Security Tokens, Utility Tokens, and Cryptocurrencies

Generally speaking, a token is a representation of a particular asset or utility. Within the context of blockchain technology, tokenization is the process of converting something of value into a digital token that’s usable on a blockchain application. Assets tokenized on the blockchain come in two forms. They can represent tangible assets like gold, real estate, and art, or intangible assets like voting rights, ownership rights, or content licensing. Practically anything can be tokenized if it is considered an asset that can be owned and has value to someone, and can be incorporated into a larger asset market.

The concept of tokenization precedes blockchain technology. The financial services industry has implemented some form of tokenization to protect clients’ confidential information since the 1970s. This process has typically involved the conversion of sensitive information such as credit card numbers, social security numbers, and other personally identifiable information into a string of alphanumeric characters, which are then processed through a cryptographic function to create a unique token.

To some extent, this method bears some resemblance to the tokenization process enabled by blockchain technology. However, while past tokenization mechanisms were primarily designed to protect sensitive data, blockchain-enabled tokenization allows for a more secure yet flexible tokenization of assets that has significantly broadened the potential applications of digital tokens across a wide array of industries.

The Benefits of Tokenization

Crypto tokens provide several user benefits that can be generalized into three main categories:

More Liquidity: Once tokenized, assets can be made available to a much larger audience, which increases market liquidity and removes the “liquidity premium” associated with investments that are traditionally more difficult or time-consuming to sell, like fine art or real estate. Tokenized assets can be designed to be freely exchangeable online and allow investors to acquire fractional ownership of a token’s underlying asset. As a result, crypto tokens can both contribute to the liquidity of existing markets and provide a broader range of investment opportunities to more investors.

Faster, Cheaper Transactions: Crypto tokens allow investors to bypass market intermediaries and other middlemen who are typically involved in the traditional asset management process. This effectively reduces the transaction costs and processing time of each exchange, allowing for a more streamlined, cost-efficient method of transferring value. Additionally, since crypto tokens exist on the blockchain, they can be traded and sold 24/7 around the globe.

Transparency and Provability: Because crypto tokens live on the blockchain, users can easily trace their provenance and transaction history in a way that is cryptographically verifiable. Transactions can be automatically recorded on the blockchain, and the immutability and transparency enabled by blockchain technology helps guarantee the authenticity of each token’s stated history. These qualities enable crypto tokens to achieve a level of reliability that most other digital assets cannot match.

Crypto tokens enable both information and value to be transferred, stored, and verified in a way that is both efficient and secure. And while asset tokenization has massive implications within the financial services sector, this technology is equally valuable for smaller investors and other individuals who can benefit from more market access and more effective ways to leverage their existing assets.

What Does Crypto Tokenization Look Like?

There are four main categories of crypto tokens, although the delineations can blur depending on the specificities of a particular token or the platform with which it is tokenized.

Security tokens: Security tokens embody a particular investment, such as a share in a company, a voting right in a company or other centralized organization, or some tangible or digital thing of value. In addition to serving as a digital representation of an underlying asset or utility, security tokens can be programmed with an inexhaustible array of unique characteristics and ownership rights. As such, these tokens constitute an entirely new type of digital asset.

Tokenized securities: It’s important to note that security tokens are not the same as “tokenized securities.” While the two terms are often conflated, a tokenized security serves as a straightforward digital stand-in for its underlying security, and is typically designed to be easily exchanged, aggregated, or used. In other words, tokenized securities mainly exist to broaden the market accessibility or liquidity of the security being tokenized, without the addition of unique programmed or cryptographic characteristics such as those found in security tokens.

Utility tokens: Utility tokens represent access to a given product or service, usually on a specific blockchain network. Utility tokens may be used to power a blockchain network’s consensus mechanism, furnish the operations of a decentralized market, pay transaction fees, or grant holders the right to submit and vote on new developments within a decentralized autonomous organization (DAO) or other decentralized network. While security tokens are primarily used to establish ownership rights, utility tokens are more focused on practical use. Many of the crypto tokens launched via an Initial Coin Offering (ICO) on the Ethereum platform are intended to function as utility tokens.

Currency tokens: Currency tokens are designed to be traded and spent. Some are based on underlying assets — as is the case with asset-backed stablecoins such as MakerDAO’s DAI and Gemini’s GUSD. However, many others are not based on any underlying assets. Instead, their value is directly linked to their distribution mechanism and underlying blockchain network.

It’s important to note that just because a crypto token is designed for a specific purpose doesn’t mean that users will only use the token for that intended purpose. For instance, while utility tokens are not explicitly designed to be speculative investments, many people buy these tokens in hopes that their value will increase as demand for the company’s products or services grows.

In addition to the above classifications, tokens can also be designed to be either fungible or non-fungible, depending on their intended use. Fungible tokens are identical and can seamlessly replace one another. On the other hand, non-fungible tokens (NFTs) are unique and provably scarce, meaning their histories can be traced down to the individual level. Examples of NFTs include Ethereum’s Cryptokitties and the digital art and collectibles available for purchase on NFT marketplaces such as Nifty Gateway, OpenSea, and NBA Top Shot. As such, fungible tokens are typically used in environments where individual traceability is not a concern (such as in providing market liquidity), whereas NFTs are used in instances where uniqueness and provable scarcity is valued (such as in digital art and collectables).

Challenges to Tokenization

Blockchain projects that use crypto tokens can encounter regulatory hurdles as governments around the world scramble to react to the unprecedented nature of this new technology. These tokens can often involve characteristics common in financial securities but are often not subject to the same regulations as traditional securities. This presents a challenge to both government authorities and blockchain projects trying to balance innovation and compliance.

While an increasing number of countries have implemented crypto regulations in order to encourage growth, other nations are taking a stricter approach in order to front-run potential issues down the road. For example, in the U.S. the Securities and Exchange Commission is considering officially classifying certain tokens as securities, which would subject those projects to a heightened level of external scrutiny.

Another central concern for regulators is how security tokens will remain tethered to their underlying assets. If thousands of anonymous investors collectively own a tokenized hotel, how will they determine who is responsible for the hotel’s maintenance and operations? Or what happens if the gold reserves underpinning an asset-backed token go missing? In other words, while tokenizing digital assets allows for decentralized, trustless value transfers, physical asset tokenization will likely still require some degree of centralization and third-party involvement.

As a result, a more mature regulatory environment will likely be necessary in order to achieve the mass adoption of crypto tokens across a broader range of industries; courts need defined rules to arbitrate cases in which the blockchain environment and traditional world overlap. Many investors want specified protections and the ability to seek recourse in situations that cannot yet be fully codified in smart contracts.

The Future of Crypto Tokenization

Tokenization — from asset tokenization to real estate tokenization —  is radically transforming the way we interact with assets of value. Blockchain technology enables any asset or service to be represented and stored on a blockchain, thereby democratizing access to assets while providing an unprecedented level of online transparency and security. However, with the rules governing the sale, distribution, and management of crypto tokens continuing to vary from country to country, it will take a large-scale, multilateral effort to build the global, borderless value transfer systems that crypto tokens may one day enable. As more and more people and governments around the world come to terms with the incredible power and utility of blockchain, the tokenized future is very quickly becoming a reality.