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Digital token: A viable investment vehicle in illiquid assets

Digital token: A viable investment vehicle in illiquid assets

Distributed Ledger Technologies (DLT) and similar FinTech innovations have heralded an era of dynamism in the global financial industry. DLT has for instance created a platform for trading digital assets as 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 a value or unit of ownership in a commodity or entity, and which are capable of being acquired and traded through blockchain technologies that are cryptographically secured.

Essentially, assets are tokenized when they are dismembered in digital form. For example, the ownership of a 250-storey commercial estate can be tokenized by fragmentizing the ownership into 500,000,000 digital tokens with each token being ascribed with an equal value of part ownership in the real asset. The value of each token is predicated on the value of the underlying asset, which is the 250-storey commercial estate.

The tokenization of real assets is at its nascent stages across 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 vehicle for private companies to raise large capital pools through token offerings, and trading of private equities. But the opportunities presented by tokenization of assets are most apparent 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 commodity market, with its incredibly high investment capital requirements, is constantly besieged by liquidity issues, due to a lower presence of retail investors. While real estate in Nigeria currently enjoys a comfortable liquidity ratio, it affords very little inclusion for retail investors. With the tokenization of assets in the commodity and real estate markets, investment opportunities become more accessible to retail investors – everyday people. With the seeming ubiquity of blockchain technology, tokenization of assets can power cross-border retail investing 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 equity. With the worrisome decline in Nigeria’s revenues and exorbitant costs spent servicing her debt, tokenization could therefore provide a potentially viable public finance model for both Federal and State governments to bridge their infrastructural deficits. For instance, the Federal Government could construct electronic railway systems from Lagos to Onitsha and raise billions of naira through digital token offerings. The railway would be tokenized and domiciled on a public blockchain infrastructure, enabling investors across the globe to subscribe to units of digital tokens representing a credit stake in the railway. Hence, tokenization heralds the tradability of illiquid assets, by enhancing their convertibility to liquid assets.

For a digital asset to be offered over a real-world asset, it must be tokenized. For example, the ownership of a 250-storey commercial estate can be tokenized by fragmentizing the ownership into 500,000,000 digital tokens with each token being ascribed with an equal value of part ownership in the real asset.

Implications of tokenization on the financial market
As with many technologically driven innovations, asset tokenization is potentially disruptive to conventional financial markets. The Nigerian financial market has notably been slow to adopt blockchain technology. Its eventual incursion will challenge the existing financial system and present credible opportunities to enhance the liquidity of typically illiquid assets, trading, pricing, and settlement of securities.

Read also: Redefining token burn systems, Uniglo (GLO) could force Ethereum (ETH) and Solana (SOL) to adapt their Tokenomics

With tokenization, the extant intermediation of trades in the current conventional financial market model will be replaced with near disintermediation of trading – without the need for intermediating actors like brokers who match buying and selling options. With reduced intermediary involvement, there is cost efficiency in trading. Smart contracts can also lead to efficiency gains in leveraging blockchain technology for the automation of trades. With the adoption of smart contracts, the buying and selling of tokens in the DLTs are instantly automated. A smart contract is self-enforcing and self-executing with the terms of the agreement by the parties written into lines of codes existing within the blockchain network.

Through the smart contract, digital tokens can be transferred to investors without any intervention of intermediaries once contract terms (e.g. performance metrics based on the value pools) are met. The contractual terms and historical data about the issuer and the underlying asset are encoded in the smart contract and these relevant (financial) data are 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 actors, will likely be retained for some time to come.

In the conventional financial market, there is sometimes disparity in the information available to the different participants, such that a party with more market information, usually the issuer, leverages that position to determine the pricing; often to the detriment of the investor. Trading on blockchain technologies allows for transparency and accuracy of trading information to all participants. This increased transparency in turn impacts the pricing and efficiency of traded securities.

Challenges of asset tokenization
There are challenges confronting the wider adoption of asset tokenization in the Nigerian financial market. Foremost among these are the current limitations of technology. Competent technological capacity, currently lacking, is required to sustain interoperability among blockchain platforms or between the off-chain market and on-chain market, scalability, cyber-protection, data protection, network stability, settlements finality, etc.

Moreover, the possible bifurcation of liquidity between the off-chain and on-chain markets, as it concerns assets traded in the conventional financial markets as well as on blockchain, can lead to the risk of arbitrage. Also, credible and trustworthy custodians are required to connect the off-chain market to the on-chain market by holding the underlying assets.

In most developing economies, the problem of ascertaining the extant domestic legal and regulatory regime governing blockchain technology lingers. This presents a serious legal and governance risk for potential participants who cannot ascertain the legal protections available to them. Cyber risks, identity & management risks, and Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) risks, among others, are issues to be addressed by relevant regulatory frameworks. Additionally, there are concerns as to the enforceability of smart contracts – which enable the interoperability of tokenized trading.

There are tensions in the Nigerian blockchain industry regarding the Central Bank of Nigeria’s (CBN’s) seemingly unfriendly regulations, prohibiting financial institutions from dealing in blockchain transactions. This stifling regulation poses a problem to attaining finality in transaction settlement; crucial to the trading of digital tokens on blockchain technologies.

However, the Securities & Exchange Commission (SEC) has commendably issued a regulation 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 the capital markets and provides regulatory measures to ensure the integrity, sustainability, and growth of asset tokenization.

In order to safeguard the confidence of investors in the system, the regulation provides for requirements that must be satisfied before an asset can be tokenized, the requirements for digital asset custodians, digital asset exchanges, and other trading platforms. While this regulatory effort is commendable, it is noteworthy that the regulation only applies to securities of public companies. Hence, the regulation still does not cover the tokenization of real assets such as precious metals, arts, minerals, real estate, etc.

Conclusion
Tokenization is poised to usher in an era of cost efficiency, disintermediation, the inclusion of retail investors, and improved liquidity in the financial markets. Much however remains to be addressed, especially within the regulatory landscape to support full adoption. These include cyber-related risks, the competence 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 Market Departments of Perchstone & Graeys LP, and Mr. Kolawole Omoyajowo, an Associate in the Capital Market Department of the Firm.