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Guide to tokens and NFTs: what is ‘tokenization’ and how does it work?

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Image: Envato Elements

Buying into and managing assets — whether it’s real estate, bonds, art or other collectibles — traditionally was a difficult endeavor. With several go-betweens and time-consuming steps, investing in and managing assets also historically required a large outlay of money upfront. For the majority of the world’s population for most of history, because of the high cost, entrance into this world was near impossible.

Tokenization offers a new way of digitizing ownership rights and doing business. The increasing popularity of non-fungible tokens (NFTs) — epitomized by digital artist Beeple’s recent US$6.6 million sale of a Donald Trump NFT and the National Basketball Association allowing fans to buy NFT video clips of their favorite stars — has also opened new markets and has made blockchain-managed ownership of collectibles and other unique assets possible. 

Below, we explore: 

  1. What is tokenization
  2. How tokenization works
  3. Different kinds of tokens
    • Fungible tokens
    • Non-fungible tokens
  4. Benefits of blockchain-based tokenization
  5. The technology underlying tokenization
  6. Remaining challenges, and
  7. The future of tokenization  

1. What is tokenization

In its simplest sense, tokenization is the conversion of physical or virtual assets into digital units that can be bought and sold. Tokenization eliminates territorial barriers and intermediaries while enabling fractional ownership of assets — which opens the market to small investors. Almost any asset can be tokenized nowadays, from artwork to gold to real estate

Tokenization is disrupting the way we invest in assets, and companies are increasingly seeing the token economy as a way to create new markets and increase sales. The global tokenization market is projected to surge to US$4.8 billion by 2025, up from US$1.9 billion in 2020, with a compound annual growth rate of 19.5%. 

Tokenization is now a fixture in the virtual gaming industry. The National Basketball Association famously went all-in on NBA Top Shot, a crypto collectibles venture that allows fans to trade numbered versions of specific, officially-licensed and tokenized video highlights. An NFT of LeBron James doing a dunk recently sold for over US$200,000

Tokenization is increasingly prominent in the precious metals space. Royal Mint Gold (RMG) is a gold tokenization project with backing from the Royal Mint of Great Britain. 

There is also currency tokenization, with stablecoins now available that provide the benefits of cryptocurrencies with the stability that comes with being backed by a fiat currency. 

2. How tokenization works

Tokenization has been on the rise in the blockchain sector, in particular in 2021. But the concept of tokenization has been around for a while. As far back as the 1970s, tokenization was seen as a data security mechanism popularized by financial companies. 

These firms used a combination of letters and numbers to replace sensitive customer info. Financial firms used tokenization to protect their customers’ confidential details such as credit card numbers, personal data, financial statements, and more. 

Take Apple Pay, for example. Apple receives customer card details and replaces them with a token. Everything happens under the hood so fast; you don’t even notice it.  Other areas where tokenization is widely used are for hospital records and voter registration.

In the payment sector, tokenization involves using tokens to replace cloud sensitive data. In the blockchain space, tokens are used to represent physical and digital assets as well as a unit of value in a particular system, such as an ownership stake or a voting right.

Imagine you have a farm worth US$10 million. Tokenization would allow you to fractionize the farm’s ownership and open up the asset to a broader investor group. But instead of dividing the farm’s ownership shares the traditional way, you can create a digital token — let’s call it “FARM.” Say each FARM is worth 0.1%of the farm itself – or US$10,000 a token. You can now sell your FARM tokens — each one representing a small chunk of ownership — to investors. Elevated Returns’ sale of US$18 million worth of tokens in St. Regis Aspen Resort is a real-world example of how asset tokenization works.

3. Types of tokens

Generally, there are two main types of crypto tokens — utility tokens, and security tokens.

Utility tokens are also known as user tokens or app coins. They are the tokens given out during a crowd sale of a project. Utility tokens represent a form of value that can be redeemed in the future. These tokens do not derive their value from any external asset. Companies create them for a specific purpose. You can’t trade them on an exchange. Examples of utility tokens are Filecoin and Brave’s Basic Attention Token (BAT).   

Security tokens are digital assets representing legal ownership of an asset that can be bought and resold. They are typically distributed to investors through a security token offering (STO). Security tokens could represent a share in a company, or the ability to vote on critical company decisions, such as in the case of governance tokens.

In our farm example, the FARM tokens would be security tokens. People purchase them in exchange for a share in your farm. An example of popular security tokens is tZero. 

A different way to classify tokens is whether they are fungible or not.

Fungibility refers to the ability to exchange an asset for another of the same kind of equal value. Fiat currencies are fungible assets. Say you borrow $100 from a friend and want to pay him back. You don’t have to pay that exact note you borrowed back. You could give him a different $100 note — or even 10 separate $10 notes, or two $50 notes. As long as they all have the same value, your debt is paid. 

Fungible tokens essentially are tokens you could easily exchange for one another. They hold inherent value, and you can easily swap one token for another in the open market without running into a dispute over their value. Most cryptocurrencies — bitcoin, ether, XRP, etc. are fungible tokens in this sense.

On the flip side, non-fungible tokens (NFTs) are designed to hold special value. Each NFT — similar to a painting — is cryptographically unique, has a unique value, is not divisible and is not mutually interchangeable. 

An example of a non-fungible item in the real world is a used car. If you borrow a car from the same friend who lent you $100, your friend generally will want you to return the same car. The car you return also has to be in one piece. The used car, in this case, is indivisible and cannot be easily exchanged for another car. Your friend’s used car has a unique value and is non-fungible.

Non-fungible tokens first gained public attention through CryptoKitties — collectible digital cats that are cryptographically unique and whose authenticity, provenance and ownership are recorded on a blockchain. It would be difficult to divide a CryptoKitty into smaller parts or trade it for other CryptoKitties as each one has a unique look and value. One CryptoKitty — a lavender creature with buck teeth — reportedly once sold for over US$170,000. But there are many more CryptoKitties that sell for under $US10.

Aside from CryptoKitties, NFTs are also now increasingly being used in art, sports, music and fashion. Even billionaires like Twitter CEO Jack Dorsey are cashing in on the NFT mania by tokenizing his first ever tweet and auctioning it off. 

4. Benefits of blockchain-based tokenization

Aside from NFT’s money-making potential for artists and other content creators, here are some other benefits of tokenizing assets: 

a. Reduced intermediaries

Consider selling your company’s shares on the stock market. You need underwriters and other intermediaries, including securities custodians, brokers, registrars, and others. Each intermediary increases the transaction’s complexity and cost.

Tokenization cuts off the intermediaries — making it faster and cheaper for the owners to raise capital. The token issuance is swift; the assets are inexpensive. Also, because real assets back tokens, they are a far less risky endeavor than initial coin offerings (ICOs).

b. Faster transactions

Tokenization is completed with smart contracts integrated into the blockchain. This means certain aspects of the buying and selling of assets that would have taken days or weeks in the traditional space can be executed quicker and cheaper.

c. Divisibility — and lower barriers to entry for investors

Even though NFTs are not divisible, tokenization of other assets makes it possible to split ownership rights into smaller bits, with each bit represented by a token. This feature creates liquidity in the market, which transforms the asset into a lucrative investment option. 

Non-NFT artworks are great use cases for tokenization. Imagine tokenizing a US$200 million painting by Picasso with 10 million tokens. This means the entry threshold for investing in this artwork drops to US$20 per token. This opens up Picasso’s art — previously only accessible to museums and superrich collectors — to a much larger network of buyers. Blockchain lowers the barriers for entry and provides more opportunities for the asset’s owner to make sales. 

d. Immutability

Unlike a traditional database, anything recorded on a blockchain is permanent. A blockchain record immutable — meaning, it can’t be altered, changed or faked.

For tokenization, immutability is critical because it makes it possible to track the asset’s history or provenance. You can trace the token’s origin, issuance date, ownership changes and prices that it was bought and sold for over time. This feature greatly lowers the possibility of investment fraud or theft from the system.

5. The technology underlying tokenization 

Tokenization relies on the use of smart contracts. These contracts act as agreements between parties on a blockchain. In the case of tokenization, a smart contract enables a person to purchase your token and receive shares of your property by eliminating intermediaries and other go-betweens. 

Currently, the most prominent blockchain platform used for tokenization is Ethereum. Powering the second most valuable cryptocurrency, the Ethereum blockchain is the most widely-used in the token industry. Last year, data from crypto research firm Messari showed that the Ethereum blockchain handles more transactions daily than even the Bitcoin blockchain, thanks to the rise of the decentralized finance (DeFi) sector and ERC-20 tokens.

However, the popularity of Ethereum blockchain has also led to congestion and high gas fees, and alternatives to Ethereum for tokenization — such as Polkadot, Hedera Hashgraph, Cardano and Flow — have been gaining users as a result. 

a. ERC-20 tokens: crypto industry standard in token issuance 

The ERC-20 token is the gold standard for Ethereum-based tokens. it is a technical standard that is used for all smart contracts on the Ethereum blockchain for seamless token implementation, and it provides specific rules for assets to follow. 

In some respects, ERC-20 is similar to assets like Litecoin and Bitcoin. It is a blockchain asset with value that can be sent, received and traded. However, instead of running on their own blockchain, these tokens are issued via the Ethereum network. Examples of cryptocurrencies running the ERC-20 standard are Basic Attention Token (BAT) and OmiseGo (OMG).

The ERC-20 token has six functions that make it operational. These include: 

There are additional token standards that run on the Ethereum standard. These include: 

b. ERC-223 Tokens 

ERC-223 tokens were designed to solve a significant problem with ERC-20 tokens, which is token losses during a transfer. ERC-223 is a standard proposal that treats each transaction the same way as an Ether transaction — as an event. The ERC-223 standard also improves on the security concern on the ERC-20, as it’s same transfer function can be used for both wallet address and smart contracts. This transfer function effectively prevents invalid transfers and loss of funds. By providing the same function for funds to be sent to wallets and smart contracts, the ERC-223 standard addresses this problem effectively. 

c. ERC-721 Tokens 

The ERC-721 tokens first broke into the limelight thanks to the popularity of CryptoKitties, an Ethereum-based NFT collectible. 

The primary difference between these tokens and other ERC standards is that ERC-721 allows developers to easily create NFTs. Essentially, one token can be worth a separate value than another, while still being exchangeable within the same ecosystem or platform.

d. ERC-777 and ERC-820 Tokens 

ERC-777 tokens were also built to improve on the ERC-20 token standard. It also addresses the asset transfer flaw that ERC-223 tokens improve on, although it differs in terms of transaction handling. 

To fully understand the ERC-777 standard, you need to start with the ERC-820 standard. In the latter, a central smart contract registry is established on the Ethereum network. The registry ensures that anyone can “examine” a smart contract address and check the functions it supports. 

ERC-777 uses the same registry as ERC-820 to increase the ease of verifications for smart contract functions. it also establishes a new set of functions, instead of using the same “transfer” and “approve” functions in the ERC-20 standard. As a substitute, it uses the “send” function to transfer ETH itself.

ERC-777 also uses a standard for burning and minting tokens — something that can come in handy based on a project’s token economics.  

6. Issues and challenges of tokenization

Some unresolved issues and potentially problematic areas to tokenization remain. The most prominent are:

a. Regulatory uncertainty

There’s regulatory uncertainty concerning asset tokenization on blockchains. Given that blockchain technology is borderless, there is a need for collaboration at various government levels. This would allow regulators to define the legal framework to cover all aspects of tokenization.

Today, different countries have varying laws and standards that guide security compliance. So, an asset classified as a security in one country could be classified as a utility token in another. These varying classification creates confusion for token holders and makes compliance difficult.

b. Operational uncertainty

There are no common standards for creating and managing digital tokens. There must be connectivity between market and interoperability between networks for tokens to be widely accepted, useful, and easily bought and sold. Ultimately, input from the government and cooperation within the blockchain industry may be required to fix this challenge if tokenization is to move into the mainstream.

c. Hacks and scams

The token economy is susceptible to scams. For one, token storage platforms could be hacked as they continue to develop and hackers get more sophisticated in their operations. 

Then, there is the fraud problem. Recently, several users of Rarible and OpenSea — two popular NFT marketplaces — noticed a trader named “Pest Supply” selling NFTs with the signature of world-famous artist Banksy. Given the real Banksy’s penchant for pop-up sales, many flocked to the trader’s wares and bought some. It was later discovered that the trader had been a fake. By then, the individual had made off with over US$1 million in profits, receiving 453 ETH in its main wallet address and another 430 ETH in a secondary address.

d. Heightened risk to small investors

NFTs are still relatively new despite the recent surge in sales. While the NFT form of Twitter CEO Jack Dorsey’s first ever tweet sold for US$2.5 million to a wealthy buyer, many more NFTs — such as NBA’s Top Shot NFT video clips of pro basketball stars — are being sold at under US$100, likely to smaller buyers. Some may be buying NFTs purely as hobbyists or collectors might have done in the past with baseball trading cards. But others may be hopping on the NFT bandwagon in the hope of cashing in on the craze. But things could change in the future. There’s a possibility prices could crash once the hype dies down, leaving investors with huge losses.

7. What a future ‘token economy’ might look like

A “token economy” could open up the financial industry to typical illiquid assets and enable much faster volumes of trades. The transactions are cheaper and quicker to execute. 

Tokenization provides lower-income individuals greater access to investing in markets they were previously excluded from. But investment risks remain.

For real estate, tokenization provides an opportunity to improve liquidity in the market. By their very nature, buildings are illiquid. Real estate investment trusts (REITs) were introduced to provide some liquidity to the market, but they are rife with fraudulent activity as well. With tokenization, real estate asset trading can be better, more transparent, and easier to implement. But the returns to digital fractional ownership — if it is anything like buying a timeshare in the real world — are questionable.

Digital art is another aspect that is expected to see more  tokenization. Physical art is primarily valuable when you can prove your ownership and the authenticity of an art piece. Tokenization is making it easier for artists like Beeple — formerly just a graphic designer in Wisconsin — to showcase their works and, in many cases, get paid for their work. The global art market was worth about US$67.4 billion in 2018, with the bulk of the market in the hands of a small group of affluent individuals. But, notwithstanding the involvement of powerful auction houses like Christie’s now getting into the digital art space, their influence is shrinking, and tokenization may reduce the power of art gatekeepers like galleries and big collectors further. 

We’ve also witnessed an expansion in blockchain-native virtual worlds, which sell land and other in-world assets to participants. In 2018, Decentraland, a multiplayer role-playing game, began selling plots of land in its virtual world. The firm’s LAND NFTs eventually saw more trading than any other NFT in the entire year. 

For now, regulatory uncertainty is the most significant hurdle facing the growth of blockchain-based tokenization. However, with the entire crypto market growing, especially with NFTs, the governments and industry may be pressured into working out the issues sooner rather than later.