Technical Analysis of Tokenization Mechanisms for Real-World Assets

Tokenization of real-world assets refers to digital tokens on the blockchain that represent ownership or legal rights to tangible or intangible assets. This encompasses a wide range of asset classes, including real estate, commodities, artworks, intellectual property, and financial instruments.

Tokenization enhances asset liquidity by enabling fractional ownership, allowing more people to participate in investment. The immutable nature of blockchain ensures the transparency of ownership records, reducing the risk of fraud. At the same time, tokenized assets traded on decentralized exchanges bring unprecedented market accessibility and efficiency.

It is estimated that by 2030, the total market value of various tokenized assets will reach approximately $20 trillion, with a pessimistic scenario of $10 trillion and an optimistic scenario of $40 trillion. These estimates do not include stablecoins to avoid double counting.

Current System

The tokenization of real-world assets is the representation of off-chain asset ownership in the form of digital tokens through blockchain or distributed ledger technology. This process links the attributes, ownership, and value of the asset to its digital form. Tokens serve as digital holding instruments, allowing holders to claim ownership of the underlying asset.

Historically, physical certificates were used to prove asset ownership, but they were vulnerable to threats such as theft and loss. In the 1980s, digital holding tools began to emerge, but they were limited by the technology of the time. The financial industry shifted to centralized electronic registration systems, but this introduced new costs and inefficiencies.

System Based on Distributed Ledger Technology

The development of distributed ledger technology ( DLT ) makes it possible to re-examine digital securities or tokens. DLT consists of a series of protocols and frameworks that enable computers to propose and verify transactions across the network while keeping records synchronized. This decentralization reduces administrative burdens and minimizes the risk of system failures caused by reliance on central entities.

Decentralized Solutions

Blockchain is a distributed ledger technology that operates through a decentralized network of computers. Tokens can be issued on private permissioned chains and public permissionless chains. Private permissioned chains are controlled by a central entity, restricting access to specific users. Public permissionless chains are open to all users.

The choice of blockchain determines the level of control that the token issuer can maintain. Public permissionless chains grant the issuer less control. The choice of blockchain architecture should align with the issuer's goals and the expected functions of the token.

A key advantage of asset tokenization is automation through smart contracts. Smart contracts are programs on the blockchain that execute when both parties meet specific conditions. This automation makes operations more efficient and secure, enabling faster and lower-cost transfers.

Tokenization Methods

The tokenization of real-world assets can be analyzed through two key attributes: the representation of the asset and ownership. The representation includes the economic characteristics of the asset, while ownership verification requires off-chain or on-chain ledgers.

The four methods of tokenization include:

1. Direct ownership: Digital tokens themselves serve as official ownership records.

2. 1:1 asset-backed Token: The custodian holds the assets and issues tokens that represent direct rights to the underlying assets.

3. Over-collateralized Token: Issuing tokens by using assets that are different from the expected representation of the assets as collateral.

4. Under-collateralized Token: A token issued to track the value of a certain asset but not fully backed by collateral.

Advantages of tokenization

Tokenization of real-world assets is primarily achieved through DLT to enhance efficiency. The main advantages include:

• Atomic settlement: Two phases of executing transactions simultaneously, eliminating counterparty risk.

• Liquidity enhancement: Improve the transferability of assets, making non-tradable assets tradable.

• Reduce intermediaries: Smart contracts replace traditional intermediaries to verify data.

• Achieve automation: Automatically execute tasks under predetermined conditions through smart contracts.

• Promote compliance: Directly encode requirements such as KYC and AML into the blockchain.

• Automated Market Maker: An asset pool managed by smart contracts that automatically matches buyers and sellers.

Risks and Challenges

The adoption of tokenized assets faces challenges in technology and regulation. Technical risks include cybersecurity vulnerabilities and system scalability limitations. Regulatory issues involve anti-money laundering compliance and governance frameworks.

In addition, investor behavior and market dynamics introduce additional complexities. Achieving widespread adoption requires a significant amount of educational work. Market risks include the possibility of assets being overvalued and increased price volatility.

The transition to a tokenized financial system involves significant costs, primarily stemming from infrastructure changes, system integration, and employee training.

To fully realize the advantages of tokenization in the financial sector, it is essential to comprehensively address these multifaceted challenges.