Distributed Ledger Technologies (DLT) and similar FinTech innovations heralded an era of dynamism in the global financial industry. DLT, for example, has created a platform to trade digital assets in the form of securities and, more recently, asset-backed digital tokens.
For a digital asset to be offered over a real-world asset (such as securities, commodities, etc.), it must be tokenized. Digital tokens are fungible digital assets representing value or a unit of ownership in a commodity or entity, which can be acquired and traded through cryptographically secured blockchain technologies.
Essentially, assets are tokenized when they are stripped in digital form. For example, ownership of a 250-story commercial estate can be tokenized by sharding the ownership into 500,000,000 digital tokens, with each token assigned an equal value of partial ownership in the actual asset. The value of each token is based on the value of the underlying asset, which is the 250 floor trading area.
The tokenization of real assets is in its infancy in global financial markets, but it presents viable investment opportunities. It has the potential to quickly mobilize large-scale liquidity from retail investors in asset classes traditionally reserved for high net worth individuals and institutional investors. The tokenization of real assets could also provide a way for private companies to raise large pools of capital through token offerings and private equity trading. But the opportunities presented by asset tokenization are most evident for tangible assets such as real estate, precious metals, minerals, arts, etc., which are largely illiquid and not currently traded electronically. .
Potential impact of asset tokenization on illiquid assets
The commodities market, with its incredibly high investment capital needs, is constantly besieged by liquidity problems, due to a lower presence of retail investors. While real estate in Nigeria currently enjoys a comfortable liquidity ratio, it offers very little inclusion for retail investors. With the tokenization of assets in the commodity and real estate markets, investment opportunities are becoming more accessible to retail investors – ordinary people. With the apparent ubiquity of blockchain technology, asset tokenization may fuel cross-border retail investment as interested individual investors subscribe to digital token offerings for these traditionally illiquid assets.
Similar to the conventional financial market, digital tokens on blockchain technology could function either as debt or capital. With Nigeria’s worrisome revenue decline and exorbitant costs being spent on servicing its debt, tokenization could therefore provide a potentially viable public finance model for federal and state governments to address their infrastructure gaps. For example, the federal government could build electronic railway systems from Lagos to Onitsha and raise billions of naira through digital token offerings. The railroad would be tokenized and domiciled on a public blockchain infrastructure, allowing investors around the world to subscribe to units of digital tokens representing a credit stake in the railroad. Thus, tokenization heralds the negotiability of illiquid assets, improving their convertibility into liquid assets.
For a digital asset to be offered on a real-world asset, it must be tokenized. For example, ownership of a 250-story commercial estate can be tokenized by sharding the ownership into 500,000,000 digital tokens, with each token assigned an equal value of partial ownership in the actual asset.
Implications of tokenization in the financial market
As with many technological innovations, the tokenization of assets is potentially disruptive to conventional financial markets. The Nigerian financial market has notably been slow to adopt blockchain technology. Its eventual foray will challenge the existing financial system and present credible opportunities to improve the liquidity of generally illiquid assets, securities trading, pricing and settlement.
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With tokenization, the existing intermediation of transactions in the current conventional financial market model will be replaced by quasi-disintermediation of transactions – without the need for intermediary players such as brokers who match call and put options. With reduced involvement of intermediaries, there is profitability in trading. Smart contracts can also lead to efficiencies by leveraging blockchain technology for transaction automation. With the adoption of smart contracts, the buying and selling of tokens in DLTs is instantly automated. A smart contract is self-enforcing and self-executing with the terms of the agreement by the parties written in lines of codes existing in the blockchain network.
Through the smart contract, digital tokens can be transferred to investors without any involvement of intermediaries once the terms of the contract (e.g. performance metrics based on value pools) are met. The contractual terms and historical data about the issuer and the underlying asset are encoded in the smart contract and this relevant (financial) data is easily accessible and visible to all participants on the blockchain.
Given the relatively nascent development of blockchain technology compared to the conventional financial model, the old market model, with its prominent intermediary players, will likely be retained for some time to come.
In the conventional financial market, there is sometimes a disparity in the information available to different participants, so that a party with more information about the market, usually the issuer, exploits this position to determine pricing; often to the detriment of the investor. Trading on blockchain technologies enables transparency and accuracy of trading information for all participants. This increased transparency in turn has an impact on the pricing and efficiency of traded securities.
Asset Tokenization Challenges
The wider adoption of asset tokenization in the Nigerian financial market is facing challenges. Foremost among these are the current limitations of technology. Competent technological capability, which is currently lacking, is required to maintain interoperability between blockchain platforms or between off-chain and on-chain market, scalability, cyber protection, data protection, network stability , the purpose of the regulations, etc.
In addition, the possible bifurcation of liquidity between off-chain and on-chain markets, with respect to assets traded on conventional financial markets as well as on the blockchain, may lead to arbitrage risk. Also, credible and trustworthy custodians are needed to connect the off-chain market to the on-chain market by holding the underlying assets.
In most developing economies, the problem of determining the existing national legal and regulatory regime governing blockchain technology persists. This presents a serious legal and governance risk to potential participants who cannot verify the legal protections they have. Cyber risks, identity and management risks, and anti-money laundering and anti-terrorist financing (AML/CFT) risks, among others, are issues that need to be addressed by relevant regulatory frameworks. Additionally, there are concerns about the applicability of smart contracts – which enable the interoperability of tokenized commerce.
There are tensions in the Nigerian blockchain industry over the Central Bank of Nigeria’s (CBN) seemingly hostile regulations prohibiting financial institutions from trading blockchain transactions. This stifling regulation poses a problem in achieving finality in the settlement of transactions; crucial for trading digital tokens on blockchain technologies.
However, the Securities & Exchange Commission (SEC) has issued commendable regulations on the issuance, offering, and custody of digital assets. This regulation to some extent allays investors’ fears of participating in digital asset transactions, as it recognizes digital asset offerings in capital markets and provides regulatory measures to ensure the integrity, sustainability and growth in asset tokenization.
In order to maintain investors’ confidence in the system, the regulations provide requirements that must be met before an asset can be tokenized, requirements for digital asset custodians, digital asset exchanges and other platforms of negotiation. While this regulatory effort is commendable, it should be noted that the regulations only apply to public company securities. Therefore, the regulation still does not cover the tokenization of real assets such as precious metals, arts, minerals, real estate, etc.
Tokenization is poised to usher in an era of profitability, disintermediation, inclusion of retail investors, and improved liquidity in financial markets. However, much remains to be done, particularly in the regulatory landscape to support full adoption. These include cybersecurity risks, proficiency of available technology, AML/CFT risk, identity risk, legal risks, etc.
The article is written by Mr. Ugochukwu Obi, the partner responsible for the Fintech and Capital Markets departments of Perchstone & Graeys LP, and Mr. Kolawole Omoyajowo, partner in the firm’s Capital Markets department.