Every person who has taken an interest in cryptocurrencies and blockchain has heard about the term token and tokenization at least once. Tokenization is a process that allows individuals, businesses, and fintech organizations to represent their assets with a digital placeholder representation. A token is a mere symbol or invoice for a real asset or security.
With the help of tokens, the consumers can purchase the deed or a contract that shows their ownership. A token is not the actual asset or data or a cryptocurrency but rather its digital representations in the form of a legal contract or a digitally tokenized object. Ethereum co-founder Joseph Lubin claims that tokens are ideas, symbols, or even a piece of paper that represent another asset class.
What is Tokenization?
In addition to being the first-ever cryptocurrency, Bitcoin is also considered the first-ever token that allows users to exchange value on P2P, trustless, and decentralized networks. Since tokenization has branched from blockchain, it is at its base a digital product. A digital token can contain some strings of data that make up the real security or cryptocurrency.
However, it does not contain the entire information of the real asset class that it intends to represent. A good example of a token can be gambling chips at a casino. These chips denote real money, but they cannot be used as a real currency unless they are redeemed with the proper authority first. It is important to note that tokens don’t have an intrinsic value, but they represent something valuable like PAN or Primary Account Number for Credit Cards or Social Security Number or SSN.
What is the Difference Between Tokenization and Encryption?
Tokenization is a process that takes a small percentage or a few data strings from the real asset class to act as its placeholder or representative. However, Encryption is a method that converts the entire asset class data and protects it with an encryption code using algorithms and mathematical equations. The tokens do not need to get decoded or hacked to extract important information about the underlying assets that it represents.
On the other hand, encrypted assets can be hacked or broken into with the help of malware or any other forced techniques. The encrypted assets must possess a private key to make sure that the owners can decode them at their discretion. In case the owner of an encrypted asset loses their keys, they can lose the information forever, or it can also be stolen by threat actors.
What is Detokenization?
Detokenization is a process that is used to reverse the tokenization and use it to redeem or replace it with the real asset class that it represents. The presence of an authorized and specified tokenization system is necessary for commencing the process of Detokenization. Since tokens do not contain the complete details of the assets that they represent, it is impossible to use the information present in a token to detokenize.
In terms of Detokenization, a token can be a low or high-value type. A low-value token is usually created for single use. This type of token does not need to retain a lot of information like a quick Debi card transaction. The low-value tokens cannot be used more than once. On the other hand, a high-value token can be used many times, and it can retain a large stream of data, such as Credit Card transactions history.
Types of Tokens
Depending on their use cases, styles, modus operandi, functionality, and even place of origin, there are several types of tokens already operational in different fintech ventures. It is worth noting that the concept of tokenization is fairly new to the world, and the experts are coming up with a better way to find more use cases that can result in a wide array of token types in the future. At present, here are some of the most popular types of tokens:
- Utility Tokens
- Security Tokens
- Tokenized Securities
- Vault Tokens
- Vault-less Tokens
- Currency Tokens
- Fungible Tokens
- Equity Tokens
As denoted by their name, Utility tokens are the type that is issued by companies or corporations to indicate their services or goods. The users of a Utility token can use it to qualify for a particular service or product that is provided by the issuer, or they can also represent some type of special offer or discount that has been offered by the issuers.
In some cases, utility tokens are useful for securing future deals, services, or goods for its holder. There are many companies in the gaming and IT sector that are issuing Utility tokens to allow their users to rent out personal computers, cast their votes, or even place digital bets on sports. The Basic Attention Token or BAT issued by Brave Browser is a good example of UT that allows them to engage more users by incentivizing browsing time.
Security tokens are a form of asset representation that is meant to be used as an investment. Security tokens can be denoted as equity, share, or even bond. In some cases, Security Tokens can provide a voting right to the holder in important company matters. In some cases, Security Tokens can also act as placeholders for commodities like gold or classic cars and music royalty.
It is important to note that there is still a considerable lack of regulatory clarity around Security Tokens. Some organizations offer consultation services for companies that are trying to issue Security Tokens. Companies like Securitize that are backed by Coinbase exchange are also working in the fintech sector to help businesses remain in compliance with the legislative jurisdiction for their Security Tokens.
It is important to note that in many cases, Tokenized Securities are confused with Security Tokens. Security Tokens are mere placeholders for an investment option like stock etc. However, Tokenized Security is the whole digital form of a stock or a share issued by an enterprise. All Tokenized Securities are subjected to the same regulatory requirements as regular stocks and bonds.
Like many people have transitioned to the use of digital money applications rather than the paper currency used in the 21st century. In the same manner, many companies have shifted their attention toward converting their securities and other stock options into a digital form. Tokenized Securities also do not possess any cryptographic aspect like Security Tokens.
Vault tokens have a centralized or main database network that is called a vault. All the sensitive information about the Vault tokens is stored within the main server or database. The Vault is the place where the sensitive information about the asset class is placed, while the Vault tokens can remain in circulation using only non-sensitive strings of data in them. Vault tokens are easier to detokenize, but they pose a higher security risk.
A vault-less token does not have any centralized database at its core. The vault-less tokens are considered more cost-effective, secure, and efficient in comparison to Vault Tokens. Most Vault-less tokens use cryptographic components to function. For the Detokenization process, VLTs need original data integration.
Non-fungible tokens have become one of the most famous types of tokenized products. By design, it is impossible to duplicate or replicate an NFT once it has been mint. NFTs are considered a good way representation of digital ownership of the real estate, an in-game purchase, an artwork, or a piece of media, among other things. According to data from Technavio, the NFT marketplace is estimated to become a $147.24 billion space between 2021 and 2026.
Currency tokens are created for trading and making purchases. It is worth noting that Currency tokens are mostly created by companies to allow in-app purchases as they are not legal tenders. Some Currency tokens like Gemini Exchange’s GUSD and MakerDAO’s DAI tokens are placeholders for underlying cryptocurrencies.
Unlike NFTs, fungible tokens can replace each other and do not record information about the original ownership or history of sales. All the types of tokens that can be used interchangeably can qualify as fungible tokens. Fungible tokens are useful in sectors where precise traceability does not need to be defined exclusively.
Just like with stocks and bonds, many organizations have started to explore blockchain technology for tokenization of their equity or capital. The main reason for the issuance of an Equity Token is to raise capital for a firm or a startup. The ETs can also help a company collect funds from all parts of the world by issuing them during an IPO or Initial Public Offering event. At present, the legislative distinction between Equity Tokens and Tokenized securities is not very visible and distinctive.
Advantages of Tokenization
Tokenization is still in its nascent phase. Over time, the investors, financial strategists, and corporations are coming up with better uses for this option that allows converting and presenting any valuable entity in a digital form without disclosing a lot of information. Keeping in view the current presence and adoption of tokenization, here are some of its benefits listed as under:
Tokenization allows its users to realize the principles of Zero-Trust systems from the blockchain sector. Companies that need to safeguard their data can issue tokens using a fragment of useful information to create a digitized placeholder. In this manner, their users would not have to depend on a centralized issuer; the traders can simply purchase or sell the token in question from the open markets that can be verified.
Even the best type of cyber-security protocols are bound to get broken at one point or the other. It is worth noting that even blockchains like the Ethereum network were hacked in 2015. Therefore, companies are always looking for better ways to increase their security quotient, and tokenization provides them with the perfect alternative to securing their real database in a remote and secure location.
Tokenization has opened up a new avenue of opportunities for both issuers and investors of the product. A person hailing from any part of the world can earn and use tokens on their mobile application, browsers, or gaming platforms. However, it is worth noting that different sovereign nations have different laws about the use of tokens. Therefore, many businesses need to hire legal experts or consulting firms to help them make global distribution possible.
Data masking is a technical term that entails that the issuer of a security or a digital product can hide its underlying data string or replaces it with blank values. Data masking closely resembles Redaction, where the sensitive information from a legal document is edited or concealed. Tokenization allows corporations to create a redacted form of data-based tokens that works as a source for the real data rather than the actual asset class.
Pseudonymized data distribution is possible with the help of tokenization. It means that the real data can be replaced with alternative monikers or values that cannot be traced back to the real source. However, corporations must ensure that their pseudonymous tokens are compliant with the GDPR and CCPA regulations.
Illiquid Assets Reach for Investors
Illiquid assets are entities that do not have a lot of transaction or exchange options available in the marketplace. However, with the help of tokenization, the corporations have gained the ability to tokenize just about every asset or commodity that holds some value into a digital form and distribute it on a mass scale. With tokenization, options like being able to own a small fraction of a stock or 1/3 part of a fixed asset have become possible.
Reduction of Settlement Duration
Due to the absence of a centralized authentication or supervisory network, tokenization increases the speed of every trade settlement by many folds. The verification of a transaction is confirmed almost instantaneously, and it is also a great option for making big trade deals.
With tokenization, the need for submitting hefty forms and going through the tiring and demanding paperwork is removed entirely. Since the verification process is conducted with the help of smart contracts, the investors only need to provide their information once, and then they can keep trading without facing any obstacles. However, due to the introduction of new regulations, KYC-compliant checks have become more stringent.
In the corporate world, being innovative is deemed not a good quality that adds to the value of an organization, but it is also considered a crucial aspect for the survival of any enterprise in the long run. Therefore, fintech experts are trying to adopt the tokenization standard to keep up with the changing financial sector and treat it as a digital upgrade for their organizations.
One highly useful quality of the tokenization process is that it offers the ability to the issuer to save costs on several fronts. Traditional stock traders invest a considerable amount of money in conducting financial audits and reconciliations. The presence of tokenization as a secondary market works as a net-asset-value scale for investors. Due to the inherent design of the Tokenized assets, the need for reconciliation is either removed or automated.
Over time, the regulatory clarity around the tokenization sector is improving. With the introduction of regularity infrastructure that has been tailored for the tokenization products, the financial risks for the investors can be mitigated.
Due to rapid transaction settlements and verification processes, tokenization makes liability management much more efficient for investors.
Using tokenization, companies are at liberty to distribute their investment products to a broader market and enable borderless trading without worrying about increasing costs, performance, scalability, and data protection issues. Therefore, within a little amount of time, it is possible to generate viable liquidity that can warrant an additional interest among the digital currency traders.
Since most tokenized products depend on the Distributed Ledger Technology or DLT, it makes the entire investment vehicle more transparent for the individual traders. The traders are at liberty to follow the transaction history and examine the logs to learn about the stakeholder dynamics and other useful information at their discretion.
Fractional shares mean that a company can distribute a single stock unit into several smaller components that investors can purchase. With the current traditional financial infrastructure, it is not possible. However, with the help of tokenization, companies can offer investment options to a greater diameter of interest investors.
With the help of fractional trading, tokenization can increase the possible qualifiers for collateral offerings. Rather than just making do with the traditional asset class like money, gold, real estate, etc. The people in the new century would have the option to offer their fractional token investments as collateral to draw out loans.
While traditional stock markets have limited operational timings, the tokenization markets are open for business 24/7. Despite the unfavorable economic and social conditions, tokenized securities can remain operational since they are inherently automated.
Additional Use Cases
The tokens that are created as a result of tokenization are used in a wide variety of use cases. In many cases, a token can be seen in use on several different projects that were not its underlying or intended function. Rather than limiting itself to securities, tokenization is also allowing consumers to convert equity, commodities, and other valuable assets into investment options.
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