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Article:

Tokenization – the new age of digitized assets

10 January 2019

Tzvika Gross , Partner, Head of the Financial Outsourcing Services |

The world's major financial markets are storming for nearly two years around the blockchain technology and cryptographic currencies. The technology that laid the foundation, at the beginning of the decade for the presentation of the Bitcoin, soon became a favorite tool in the criminal world because of the anonymity it offered, and the ability to transfer value between parties to a transaction without leaving a trail.

 

Despite the negative reputation in those days for Bitcoin, blockchain technology was significantly upgraded with the introduction of the Ethereum network in the second half of 2015. The Ethereum added a significant component to the blockchain technology, when the possibility of smart contracts on the network was opened. These contracts enable automatic transactions between two parties, without the need for an intermediary. The first application of these contracts was the issuance of different tokens in exchange for Ether (ETHER), which is the base currency of the Ethereum network. There are many other uses for smart contracts, and many other networks offer the infrastructure for setting up such smart contracts. However, as of yet, the Ethereum network dominates the world of smart contracts and currency issues.

 

These tokens are actually a new cryptographic coin, which can be used according to the rules set up in the smart contract from which they were created. The embedded value of the currency created, and the conditions for its use, are specified in a document published by the entity issuing such coin, called a White Paper. Issuance of a token is called ICO (Initial Coin Offering) and is mainly portrayed as a fundraising tool, used to establish the venture to which these currencies can be used. These currencies become a cryptographic property, and can be traded on the various exchanges on the blockchain.

ICO became very popular, and during the year 2017 alone, ICO issuances raised an aggregate amount of $ 5.5 billion. In the first seven months of 2018 another $ 14 billion was raised. However, the second half of 2018 showed a drastic decrease in ICOs. Too many of these offerings turned out to be a flop or even a scam.

 

The huge sums raised, with the losses suffered by the public, drew the attention of the various enforcement agencies around the world. These bodies, who initially preferred to ignore the cryptographic world, understand today that crypto currencies are here to stay.

One of the most influential factors in the issue of currencies today is the securities laws in each country, and the enforcement agencies responsible for enforcing these laws. When a token is classified as a security, the issuer is subject to all legal obligations that comes along with a public offering, including the registration obligations, the disclosure and reporting obligations, and the licensing requirements for trading. Since the purpose of using blockchain for fund raising, is to reduce costs and gain flexibility, and since the trading platforms for cryptographic assets are not allowed to trade in securities, most issuances have tried to meet the various conditions that allow them to be excluded from the definition of a security. Essentially, the attempt is to present the currency as a right to purchase a future product or service rather than a security token that is expected to generate profits. However, US law enforcement agencies are very ridged and tend to classify every ICO as securities, thus subject to regulation.

 

Some legal authorities around the world are looking into several options for easements for token issuance, to enable tokens classified as securities to be issued and traded, with much lighter registration and reporting obligations. Some of the proposed easements, are based on restrictions on investment amounts, similar to the concept of Crowd Funding, and some are based on limiting investments to accredited investors only.

These proposed easements, when accepted, will open the door to a new world of financing using the blockchain technology, which will enable quick, efficient and relatively cheap capital raising to finance companies and acquire properties.

 

The possibility of issuing currencies classified as securities may create a new world, for Asset Tokenization. By linking a designated currency to a physical asset, each physical asset can be transformed into a digital asset that can be transferred from one hand to another immediately on the blockchain network (similar to the transfer of shares from one account to another). Tokenization of assets will also allow us to liquidate physical assets, trade them on the various exchanges, exit investments during the investment period, and make large assets accessible to small investors, by fractionizing the investment amount, similar to what is happening today in the stock markets.

There are already a number of blockchain projects that are intended for property tokenization, most of which turn naturally to the real estate market. Instead of investing in a property with a relatively high entry threshold, and with a lockup period of at least few years, the designated coins will allow much smaller amounts, and exit the investment within the period by selling the token to a third party. In a similar way other assets, such as art objects, and even shares of private companies can also be securitized. In addition, hedge funds can raise capital by issuing security tokens, in a more efficient and liquid manner than is currently used.

 

The tokenization of assets is highly dependent on the regulatory requirements that will be formulated in the near future, as well as in dealing with the technological challenges in implementing these requirements over the blockchain network. The implementation of regulatory restrictions within the smart contracts, the identification and classification of investors in accordance with the regulatory requirements, the prevention of money laundering, are all key to the next revolution of digitized asset, which will no doubt be disruptive for the financial markets in the near future.