Asset Tokens & Fractional Ownership - Token-Economy-Book/EnglishOriginal GitHub Wiki

Asset tokens allow the creation of a digital representative for any physical asset or securities and could introduce a range of new use cases that might not have been feasible before. They are the next step in the automation of the securities and asset markets, replacing entire back offices with smart contracts.

The tokenization of an existing asset refers to the process of creating a tokenized digital twin for any physical object or financial asset. The token hereby represents the physical counterpart, collectively managed by a distributed ledger. “Asset token” is a general term that can include any assets, such as commodities, artwork, real estate, or securities. “Security tokens” are a specific type of asset tokens that are classified as securities under financial market regulations. The interpretation of what constitutes a security, however, is subject to local legislation.

From a legal perspective, tokenization of (rights to) a physical asset and other (virtual) rights seems important. Tools that aim to represent virtual assets (such as paper certificates and other digital certificates) are likely to be substituted by tokens soon; for physical assets, possession seems likely to remain the most important link. Depending on the regulatory environment and how the smart contract is set up, asset tokens may be eligible for global trading. An investor in France could easily buy equity tokens in a restaurant in Canada with a few clicks. An investor in Mexico could fund an apartment building in India. Opening up global markets adds even more liquidity and provides new opportunities for entrepreneurs and investors alike. This trend might make it feasible to buy shares of assets in foreign countries that were previously much more difficult to obtain.

Any physical good or share in a small- or medium-sized enterprise can be tokenized at a fraction of what it would cost in the client-server world and divided into representative tokens, which could be traded on an open market. In order to tokenize a real asset like an apartment, one generates a token with a smart contract, and associates a value of the real asset with that token. The ownership right in such an asset and its corresponding digital representation can be divided into parts and sold to several (co-)owners. Even if a token represents a physical asset that is not divisible, like a piece of art or real estate, the token itself is divisible. Asset markets, such as fine art or real estate, that usually have high economic buy-ins can be tokenized and fractionalized, potentially generating new use cases that were not feasible before. Instead of investing millions of Euros for an art piece, one can now buy a fraction of a painting. This allows for increased market depth and liquidity.

Tokenizing real-world assets could lead to a market capitalization of trillions of EUR, but it needs a few prerequisites: (i) online exchanges specialized in asset tokens, (ii) trusted custodians of wallets that can manage multiple assets and ideally also grant self-custodianship to the token holders, and (iii) a well-defined regulatory environment for different types of asset tokens.

The risks and ramifications of asset tokens are harder to predict than those of security tokens, and pose a challenge for investors, entrepreneurs, and regulators alike. Security tokens can be compared to the early days of the Web, when publishers started to post their content online as if it were a printed paper. At first, the Internet only provided a new distribution channel but did not change the type and format of content. It took years until the first comment sections were added to websites, where readers could interactively discuss the topics. It also took a while until publishers understood that they could add new types of content that would normally not make it into the paper or the magazine. It wasn’t until the emergence of social media that the publishing industry was truly disrupted, by the introduction of more fragmented and dynamic distribution channels, when any individual could become an “influencer.” Asset tokens are to financial markets what social media was to the publishing industry. They are much more likely to revolutionize our economy, and security tokens are the gateway drug to get there.

Use Case 1: Security Tokens

Security tokens provide a new form of representation, management, and distribution of existing securities. Paying out dividends could be conducted with a smart contract and on the fly, which is an upgrade for state-of-the-art financial settlement systems. From a regulator’s point of view, these tokens are traditional securities that are simply represented and managed by a new technology. They are not a new product, and therefore are fairly easy to regulate. Financial conduct authorities and similar regulatory bodies worldwide have concluded that any token that might be considered a security token is subject to regulatory bodies worldwide, like the Securities and Exchange Commision (USA), FMA (Austria), Monetary Authority of Singapore (MAS), BaFin (Germany), and FCA - Financial Conduct Authority (UK), just to name a few examples.

There is no common global understanding of what constitutes a security token; regulation differs from country to country. In some jurisdictions, the term “security token” applies to any token that represents a recognized asset or investment concept, and other jurisdictions have a more narrow definition of what constitutes a security. The Securities and Exchange Commission (SEC) in the US, for example, defines a token as a security if one invests money with the idea to profit from the efforts of someone else. More specifically, a token would be considered a security if there is: (i) an investment of money; (ii) an expectation of profits; (iii) that money is held by a common enterprise; and (iv) profits are a result of third-party efforts. In contrast, the European definition of securities includes standardized assets that are transferable and negotiable on capital markets, have no instrument of payment, and are comparable to equity or debt instruments.

In the current financial system, securities and other financial products take a long time to settle. In spite of the fact that the processes have improved with the advent of computers and then the Internet, the settlement is still far from real time. Transactions can take a minimum of two work days to settle. While operational twenty-four-hour markets exist already today, they are rarely P2P. Security tokens can facilitate frictionless settlement processes, without sacrificing legal protection.[^1] The smart contract replaces the intermediary and executes the settlement process between sellers and buyers, minimizing brokerage fees. Fully operational 24/7 markets could reduce settlement time to a few minutes or less.

Compliance comes inbuilt with the smart contract. The self-enforcing code is an efficient answer to a complex aspect of trading securities, where regulation can vary depending on asset type or investor type, taking into account that all stakeholders—the buyer, the seller, and the issuer—might be subject to varying jurisdiction. Today, a complex document-handling process is performed by a series of separate ledgers, where data is managed behind the walled gardens of the servers of each stakeholder involved. This document-management nightmare creates many inefficiencies and time lags. The programmable nature of tokens also makes it cheaper and easier to formalize special conditions, which could introduce more personalized asset types that were not feasible before. However, any system for trading security tokens needs to incorporate a myriad of legal contracts. The implementation of security tokens is a complex techno-legal question and depends on network effects. Third-party service providers have started to provide token standards designed to allow transparent issuance of asset tokens and security tokens, including processes for KYC and AML requirements.

More and more market players are announcing services around security tokens. Some established companies have announced specialized trading platforms, including NYSE founders who are investing in relevant startups. The Swiss Exchange is also planning to build a regulated exchange for security tokens. Other players active in this field: “Bakkt,” “Securitize,” “OTCXN,” “tZERO,” “Polymath,” “Neufund,” “Binance” partnering with Malta Stock Exchange, “Cezex,” Gibraltar Blockchain Exchange, “Templum,” “Coinbase,” and London Stock Exchange (Bancor).

Use Case 2: Tokenizing Real Estate

Real estate is one of the largest asset classes worldwide in terms of market capitalization, however, real estate ownership is not open to all members of society. Many low-income households can never afford to buy real estate. To receive a loan, buyers must have a positive credit score, a steady and well-paid job, or a collateral of other assets. Furthermore, the real estate market is highly fragmented and centralized. Data is managed by a series of third parties like banks, attorneys, notaries, and land registries who all use their own proprietary and costly software that, for the most part, is not interoperable. Smart contracts have the potential to facilitate rights management in the real estate industry, including the whole settlement process. Once real estate ownership is tokenized, it can be easily registered and managed on a public infrastructure and traded P2P, if it complies with regulation. The hashed data of each property could be recorded on a distributed ledger to provide a universally shared data set on all real estate–related activities, such as previous owner, repairs conducted, and amenities.

Real estate is an illiquid asset, which means that buying and selling the asset is a lengthy and bureaucratic process; ownership does not swap hands quickly. Research shows that using Web3-based land registries could minimize bureaucracy and reduce market friction and the considerable costs involved in the transfer of ownership. The tokens could be easily fractionalized, which means that real estate owners could sell off fractional shares of their apartments. While selling shares of a property is not a new concept, tokenizing real estate would be the next step in the automation process, making it more efficient to issue and sell these assets at a fraction of the costs that were needed before.

Tokens could either be issued for existing real estate or for a real estate project under development. Private homeowners could issue fractional tokens of an apartment they want to buy, which would allow them to raise funds without needing to go through a bank or take out a private loan. The token holders would be co-investors and could collect fractional rent in proportion to the amount of shares they hold. People who were previously excluded from such investments for economic reasons could now invest in only a fraction of a whole unit, which would make the market more inclusive to those who have less economic means. Rent collection is administered by the smart contract and ownership is more easily transferred. If, for example, another person buys 5 percent of the tokenized value of your apartment, proportional rent could be paid out on a monthly basis automatically by the smart contract. In the case of a sale of the apartment at a future date, fractional token holders of that apartment could get their money back, which might also be automatically managed and enforced by the smart contract.

With fractional tokens, it is important to distinguish the type of rights that are granted with the token acquired: ownership (as an investment, I can sell and monetize any time) and access right (I can access that property). Ownership rights also need to be detached from the management of that real good. The governance rules of the token will need to regulate who gets to decide on selling the apartment. In most cases, it would only be feasible to grant profit sharing rights, but not voting rights. However, there would need to be a regulation in place to specify the rights of token holders, in the case that the issuer of the tokens fails to pay rent to the fractional token holder. Details of such business cases would need to comply with regulatory standards and have a meaningful way to be executed. There is a variety of established legal options for conflict solutions in fractional ownership situations, like so-called “drag along” and “tag along” rights[^2] or “Dutch auctions,”[^3] which could all be modeled in a smart contract to arrive at a solution fit for the purpose of a given situation.

The current process of taking out a loan for home ownership comes with a lot of regulatory oversight and due diligence from the bank side to make sure that the person taking out the loan will also be able to pay the loan, including interest, back. If they can’t, the bank is co-registered in the land titles. If the homeowner fails to pay back the loan, the bank can claim the property, sell it, and liquidate the apartment on the market to get back the credit they gave out. In the case of fractional ownership, how will such a case be managed? By trusted third parties and liquidators? Maintenance processes also need to be covered by the smart contract; otherwise, it would be a regulatory nightmare to try and force litigation against hundreds, if not thousands, of owners of an office building who don’t take care of maintenance.

While tokenizing real estate has a lot of potential, this use case comes with many practical challenges, most of which concern legal and regulatory questions, which vary from country to country, or state to state. One prerequisite for tokenizing real estate would be that the legal process of the real estate market is made Web3 compatible, from the land registry process to the general regulatory environment accepting smart contract processes. In some countries, land ownership is barely tracked at all; in most countries, the process is still predominantly paper-based, requiring a myriad of intermediaries. All involved stakeholders of the real estate market, from developers and brokers to banks, real estate funds, and facility managers, also need to be distributed-ledger compatible before such a use case can become feasible.

Tokenizing and fractionalizing real estate could also have potentially negative ramifications that would require regulatory oversight. There is much learning to incorporate from the housing market collapse in the United States that led to the financial crisis of 2008.[^4] When many people do not understand what they’re buying into, fractional ownership of real estate can become a dangerous investment game and result in the same “magical thinking” by uninformed investors who have little understanding of the big picture of the market dynamics when making investment decisions.

Many countries are already looking into registering land titles on some kind of distributed ledger, and many more are following. A fast-growing ecosystem of service providers offering fractional ownership solutions and other tokenized real estate services is evolving, such as “Atlant,” “IHT Real Estate Protocol,” “LATOKEN,” “Max Property Group,” “Meridio,” “BitRent,” “Etherty,” “Caviar,” “Propy,” “PropertyShare,” “Rentberry,” “Treehouse,” or “Trust.”

Use Case 3: Tokenizing Art

From an investment perspective, fine art is an asset class that makes up an integral part of the investment portfolios of many high–net worth individuals. However, investors with less economic means have no access to this type of asset class, as the most attractive investment objects are very expensive and the prices are dictated by auction houses and galleries that usually have very limited market participants, which all results in low market liquidity. To complicate matters further, the maintenance of fine art is expensive and conducted in bunkers, not in the living rooms of people who have invested in them. Furthermore, the buying and selling of fine art is currently accompanied by a heavy documentation process, to guarantee the authenticity and provenance of an art piece, which is a prerequisite of guaranteeing value. The current system relies on trusted third parties managing a patchwork of databases across the art supply chain, managing those digital certificates that guarantee value. The same is true for the music industry, film industry, and publishing industry when it comes to settlement of royalties for artists by publishers, music labels, film studios, or online streaming services. Royalty settlement happens with a considerable time lag of several months to sometimes years. The process is inefficient and highly intransparent. Tokenizing the art and entertainment market could, potentially, resolve many of the inefficiencies of the current systems, from fractional ownership, provenance, digital rights management, and settlement to crowdfunding. Tokens could also enable new derivative artworks. Selected examples of projects that are already involved in the tokenization of art are: “Artex,” “Artory,” “Ara,” “ArtWook,” “Audius,” “BitSong,” “Blockchain Art Collective,” “Blockgraph,” “Braid,” “Custos,” “Comcast,” “Curio,” “Cards,” “Dada.nyc,” “Feedbands,” “Filmchain,” “Livepeer,” “Looklateral,” “Maecenas,” “Musicoin,” “Plantoid,” “re8tor,” “RNDR,” “Snark.art,” “SOUNDACC,” “Tatatu,” “The Art Token,” “Ujo,” “Verisart,” “VooGlue,” “Vezt,” “Viberate,” “Vevue,” and “White Rabbit.”

  • Fractional Ownership: Low–net worth individuals, who would usually be excluded from this investment opportunity, would be able to buy a fraction of an expensive work of art. This could lead to an increased demand for art investments, potentially increasing overall art prices and the production of new types of art, democratizing and diversifying the market. The main question that arises in this context is how collective ownership of a piece of art can be managed. The artwork itself could, for example, be maintained by a custodian who has the experience to maintain an art collection, the cost of which would be borne by all of the piece’s token holders. The payments would be managed and enforced by the smart contract. An early example is Andy Warhol’s painting, “14 Small Electric Chairs,” which was tokenized and sold on “Maecenas” in 2018. The painting was tokenized and fractionalized on the Ethereum network, the ownership certificates were managed by a smart contract and became publicly verifiable, and could thus be traded on the Maecenas platform.

  • Provenance: Tokenizing art could pave the way for a more transparent market, where potential investors have access to verified artworks. Assigning provenance using tokens managed by a public infrastructure could resolve the challenges of conventional systems, like corruption, counterfeiting, and hacking. The current system relies on trusted third parties managing a fragmented patchwork of databases, where these digital certificates are stored. Conversely, tokenized systems would use hashes and cryptography to publicly verify the provenance of artworks. Management of ownership transfers would be conducted by smart contracts, at drastically lower costs, allowing for real-time settlement.

  • Rights management: Smart contracts are rights management tools. Tokenization allows for more transparent and disintermediated management of intellectual property rights and subsequent real-time settlement of royalties. Artworks could easily be rented out to a gallery, musicians could collect their royalties faster, and general revenue sharing between platform providers and artists could be managed by the smart contract on the fly as a song/movie/book was streamed or downloaded. The royalty fees could be settled directly, without publishers, film studios, or streaming services acting as intermediaries, which often compensate the artists and contributors with a significant time lag. Royalties could be settled in the form of tokens that are sent to the artist in real time, based on the number of people who viewed their art, streamed their movie or audiotrack, or read their post.

  • Crowdfunding/investing: Tokens can also be used to crowdfund future art projects, which their investors could own as a fraction or as a whole. Anyone who contributes to the funding of an art project could receive a proportional share of the tokenized value of that project, accepting the terms laid out in a smart contract. The artist could define the smart contract in such a way that the artist maintains a share of the artwork produced, while other token holders are free to sell their tokens on the open market, or alternatively cash out, should the piece be collectively sold. In such a setup, an artist can receive funding before production, while maintaining partial ownership of the art. Tokens could also enable galleries to pre-fund purchases of artworks.

  • Derivative artworks: The emergence of new derivative artworks could be another application of tokenized art. One could create convoluted smart contracts that give access rights to derivative artworks with the purchase of a real painting. One could add extra features, such as linking a digital file into the physical artwork, like integrating augmented reality features into the token. For example, a video documenting the process of producing the art piece. Tokens can permanently connect physical artwork to its digital file, such that the digital file becomes part of the physical artwork and increases its value. Art tokens also open up new forms of artistic expression and value creation, like gamification, and could lead to the fusion of art, virtual reality, and gaming.

Use Case 4: Collective Fractional Ownership

The exact business logic of a smart contract that manages fractional collective ownership depends on the use case. An office building, for example, could be collectively bought by members of a co-working space, in which case the decision making could also be collectively managed. The tokens would grant voting rights. The co-working space could be tokenized based on usage rights, where members would have a right to use a certain share of the space. Collective ownership could also be useful for many NGOs or grassroots efforts. A community of neighbors could buy and collectively operate a renewable energy–powered micro-grid, as it is more feasible for a collective of neighbors to cover the cost than for an individual. The smart contract would send monthly revenues from the excess energy produced and sold to all members of the collective, in proportion to the shares they owned (read more: Part 2 - Institutional Economics of DAOs).

Such a setup could also be attractive for taxi drivers. Many drivers lack the money to invest in their own car, and thus work for a company to provide the infrastructure, sharing their revenues or paying a fixed rent to the vehicle’s owner. Fractional collective ownership tokens would allow several taxi drivers to collectively purchase a car, instead of renting it from someone, and split up the shifts as well as the costs and revenues involved with buying and maintaining the car for their rides. A smart contract could collect a portion of everyone’s revenues, allocated for the expenses involved.

Collective fractional ownership tokens could furthermore manage the commons of a larger community, and settle the right of an individual to the benefits from community-owned assets. The state of Alaska in the United States and Norway have already passed their residents a share of their oil sales, either directly or in the form of wealth funds. Such a process could be tokenized to reduce settlement costs, while increasing transparency and accountability.

Chapter Summary

Asset tokens allow the creation of a digital representative for physical assets or securities. They are the next step in the automation of the securities and asset markets, replacing entire back offices with smart contracts.

The tokenization of an existing asset refers to the process of creating a tokenized digital twin for any physical object or financial asset. The token hereby represents the physical counterpart, collectively managed by a distributed ledger.

“Asset token” is a general term that can include any assets, such as commodities, artwork, real estate, or securities. “Security tokens” are a specific type of asset tokens that are classified as securities under financial market regulations. The interpretation of what constitutes a security, however, is subject to local legislation.

Security tokens provide a new form of representation, management, and distribution of existing securities. Paying out dividends could be conducted with a smart contract and on the fly, which is an upgrade for state-of-the-art financial settlement systems. From a regulator’s point of view, these tokens are traditional securities that are simply represented and managed by a new technology. They are not a new product, and therefore are fairly easy to regulate.

Asset tokens are to financial markets what social media was to the publishing industry. They are much more likely to revolutionize our economy, and security tokens are the gateway drug to get there.

From a legal perspective, tokenization of (rights to) a physical asset and other (virtual) rights seems important. Tools that aim to represent virtual assets (such as paper certificates and other digital certificates) are likely to be substituted by tokens soon; for physical assets, possession seems likely to remain the most important link.

Depending on the regulatory environment and how the smart contract is set up, asset tokens may be eligible for global trading. Opening up global markets adds even more liquidity and provides new opportunities for entrepreneurs and investors alike. This trend might make it feasible to buy shares of assets in foreign countries that were previously much more difficult to obtain.

Smart contracts have the potential to facilitate rights management in the real estate industry, including the whole settlement process. Once real estate ownership is tokenized, it can be easily registered and managed on a public infrastructure and traded P2P, if it complies with regulation. The hashed data of each property could be recorded on a distributed ledger to provide a universally shared data set on all real estate–related activities, such as previous owner, repairs conducted, and amenities. Tokens could either be issued for existing real estate or for a real estate project under development.

In order to tokenize a real asset like an apartment, one generates a token with a smart contract, and associates a value of the real asset with that token. The ownership right in such an asset and its corresponding digital representation can be divided into parts and sold to several (co-)owners. Even if a token represents a physical asset that is not divisible, like a piece of art or real estate, the token itself is divisible.

One prerequisite for tokenizing real estate would be that the legal process of the real estate market is made Web3 compatible, from the land registry process to the general regulatory environment accepting smart contract processes.

Tokenizing the art and entertainment market could, potentially, resolve many of the inefficiencies of the current systems, from fractional ownership, provenance, digital rights management, and settlement to crowdfunding. Tokens could also enable new derivative artworks.

Asset markets, such as fine art or real estate, that usually have high economic buy-ins can be tokenized and fractionalized, potentially generating new use cases that were not feasible before. Instead of investing millions of Euros for an art piece, one can now buy a fraction of a painting. This allows for increased market depth and liquidity.

Any physical good or share in a small- or medium-sized enterprise can also be tokenized at a fraction of what it would cost in the client-server world and divided into representative tokens, which could be traded on an open market.

Chapter References & Further Reading

Footnotes

[^1]: While there seems to be at least broad consensus on the applicability of regulatory regimes among the regulators, the situation is different with regard to many countries’ civil law and thus the token holders “protection.” The qualification in regulatory law seems easier, because it aims to address certain risks (protection of markets and investors) and therefore allows for a “substance over form” approach. In civil law, legal protection of securities (such as bona fide acquisition) is typically connected to either paper certificates or book entries by regulated intermediaries. Legislative amendments will be necessary to achieve legal certainty (see consultations in Liechtenstein, Switzerland, Germany).

[^2]: In a shareholders’ agreement, a"drag along” clause requires minority shareholders to sell their shares, while the “tag along” clause requires majority shareholders to allow the minority to join in on a sale.

[^3]: In a Dutch auction, investors bid for the amount they are willing to buy a token. The token price is determined after all bids have been conducted, to determine the highest price at which the total offering can be sold.

[^4]: “The housing bubble preceding the crisis was financed with mortgage-backed securities (MBSes) and collateralized debt obligations (CDOs), which initially offered higher interest rates (i.e. better returns) than government securities, along with attractive risk ratings from rating agencies.” The collapse of the housing bubble led to the devaluation of housing-related securities which were mostly unregulated. https://en.wikipedia.org/wiki/Subprime_mortgage_crisis

Token Economy: How the Web3 reinvents the Internet.
Second edition, first amended printing, Nov 2020. The first edition was published by BlockchainHub Berlin https://blockchainhub.net in June 2019 under the title “Token Economy: How Blockchain & Smart contracts revolutionize the Economy” and had two amended editions.

Author: Shermin Voshmgir
BibTeX: @book{voshmgir2020token, title={Token Economy: How the Web3 reinvents the Internet}, author={Voshmgir, Shermin}, year={2020}, publisher={Token Kitchen} }

LICENCE: Copyleft 2020, Shermin Voshmgir:Creative Commons CC-BY-NC-SA This license allows reusers to distribute, remix, adapt, and build upon the material in any medium or format for noncommercial purposes only, and only so long as attribution is given to the creator. If you remix, adapt, or build upon the material, you must license the modified material under identical terms.
For commercial permissions contact: [email protected]

Comments: There are various possibilities of forking the text of the book: You could add code contributions to the theoretical examples mentioned in this book, create future iterations with new /modified chapters or translate this book into another language, and distribute it non-commercially (for free). To do this you can fork the wiki and start translating the texts under your own Github account anytime and publish the modified/translated book on Github directly. I can send you the original AI files for creating translated version of the graphics. Please not that with this licence you are not allowed to sell the book or use it for other commercial projects, but I can try and support you get funding with a Gitcoin Grant or any other crowdfunding campaign, so you get money for the work you put in. 

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