What Is Tokenization? How Does Tokenization Work?

A deed can represent ownership in a house. A share certificate can represent an interest in a company. A contract can represent a claim on future payments. In all these cases, the document or record representing the claim is not the asset itself, but it can give the holder a right tied to it.

Tokenization adapts this practice to the blockchain age. The question then becomes what exactly is tokenization changing, and how does this technology work?

1What Is Tokenization?

In the context of blockchain and finance, tokenization is the process of creating a blockchain-based token representing an underlying asset. This can be a real-world asset, like real estate or gold; or a financial asset, like a bond or a share in a company.

Tokenization is the process of creating a blockchain-based token that represents an underlying asset.

Notably, the token itself does not contain or replace the underlying asset, as the asset still remains off-chain. The token represents only the rights related to this asset on the blockchain, and that's it.

Evidently, creating such a connection involves more than just creating a token. The asset, the rights related to it, and the rules of the token need to be defined before the token can fulfill its purpose. So, how does tokenization work?

2How Does Tokenization Work?

Tokenization involves more than issuing a digital token: it requires a clear connection between the asset, the investor’s rights, and the rules governing the token. The process unfolds in three main phases, from establishing that connection to managing the token throughout its lifecycle.

Phase 1: Establish the Asset and Investor Rights

The process always begins with the underlying asset, which the issuer (the person or organization that creates the token) needs to define. In other words, the issuer needs to determine what can actually be offered to investors.

This begins with establishing that the asset exists, who owns or possesses the asset, and if any details of the asset might impact the proposed tokenization structure. As such, the issuer might need to review relevant records, assess the asset, and identify any existing obligations before moving forward.

Having evaluated the asset, the issuer can define what rights the investors will receive in relation to the token, which can take a variety of different forms. These include rights to ownership, income, debt, redemption, or other contractual rights.

Tokenization begins by identifying the underlying asset and defining what rights the token gives investors.

Phase 2: Create and Issue the Token

The next step involves defining and issuing the token, a process that involves defining the rules that will apply to the token. Specifically, the issuer will define how many of the token units will be issued, if these units can be further split, who can own or transfer the token, and so on.

These rules are then programmed into a smart contract deployed on the relevant blockchain. This smart contract will be what controls the creation and transfer of the token, as well as records relevant events like the issuance to a new wallet.

At this point, the issuer can begin distributing the token to the relevant investors. These buyers may need to satisfy any Know Your Customer (KYC) and Anti-Money Laundering (AML) requirements the issuer has set before their wallet can receive the token.

This initial issuance of the token to an investor is also known as the primary issuance. Any subsequent transfer of the token between investors will be part of the token's secondary-market lifecycle.

In the issuance phase, the issuer defines token rules such as supply.

Phase 3: Operate, Transfer, and Redeem the Token

Finally, the token moves into its operational lifetime, during which any payments or other actions promised under the token take place.

If the investor wishes to exit before the rights attached to the token expire, they can transfer the token to another eligible investor, provided that transfers are allowed. The ownership record will change on the blockchain, but the underlying asset does not need to be transferred.

The token then reaches the end of its life when the rights to it terminate, for instance, when a bond matures or when the property represented by the token is sold. At this point, the investor will receive the amount due under the arrangement, and the redeemed token may be burned or otherwise retired.

The above process largely applies to any tokenized assets; however, they will function differently depending on the underlying asset in question.

After issuance, a tokenized asset enters its operational phase.

3How Tokenization Differs Across Assets

The same tokenization process can produce different investment arrangements depending on the asset involved. Real estate, stocks, bonds, and gold illustrate how the underlying asset shapes what token holders can receive and how they can exit.

Tokenization works differently depending on the asset.

Real Estate

Instead of giving investors direct ownership of a property, a token may take the form of an interest in a separate legal entity that owns the property, such as a Special Purpose Vehicle (SPV). As a result, the investor's rights will be defined by the SPV and relevant legal agreements behind the token.

Meanwhile, the property itself will still rely on off-chain mechanisms, like title registration, valuation, and property management. If the property generates rental income, this may be distributed to token holders. Investors may then exit the investment by selling the token or when the property is sold.

Stocks

Stocks differ in that the stock itself is a financial instrument. As a result, a token may represent a share directly, or a claim on shares held on the investor’s behalf. In the latter case, a custodian would hold the shares and keep the official records of who is entitled to them.

If the shares pay dividends, the investor may receive the dividend proceeds. They may also exit the investment by selling the token or redeeming it with the issuer, if applicable.

Bonds

The token in the case of bonds will represent the debt obligation, either directly or via an interest in a structure holding the bonds. As a result, the token holder will be entitled to receive the interest and principal payments on the bonds. Investors will generally exit this type of investment by selling the token or holding it until maturity.

Gold

A token can represent a claim on a quantity of gold held in a vault or custodian, rather than a specific bar of gold. For instance, holding tokens worth 10 grams of gold may give an investor rights to 10 grams of the gold held in custody, without assigning a particular bar to that investor. Depending on the arrangement, that right may allow the investor to sell the token or redeem it for cash or physical gold.

4Tokenization in Practice: A Property Example

To demonstrate, you can imagine the owner of a $4.85 million building wanting to raise money from this property. Under a traditional setup, the owner would need to find a single buyer willing to purchase the whole property for $4.85 million (or more). This undoubtedly limits the pool of potential buyers, as few investors will be able or willing to commit that amount of money to a single investment.

The owner could, instead, fractionalize the property using tokenization and effectively raise the same amount of money from a larger number of investors. For instance, they could issue 48,500 tokens, with a price per token of $100 each. Under this setup, an investor who wants to invest $10,000 would be able to purchase 100 tokens rather than having to spend sleepless nights considering whether it would be a good idea to buy the entire property.

To clarify, the 100 tokens do not represent ownership of 100 pieces of the property. Instead, the 100 tokens will only represent the rights defined by the investment structure (e.g. a share of the income generated by the property).  If transfers are allowed, the investor could later sell the tokens to another eligible investor.

Tokenization can fractionalize a large asset into smaller investment units.

5A Final Word on What Tokenization Is and How It Works

Coinminutes' final goal when writing this article is not to convince you to invest in or avoid tokenized assets. Rather, we hope to equip you with the knowledge to make an informed decision on the matter.

Having grasped some of the key concepts of what tokenization is and how it works, perhaps a closer look at tokenized assets is in order. Or perhaps following the latest news around tokenized real-world assets is more your cup of tea?

If those are the types of crypto coverage you are looking for, check out our website at https://coinminutes.com/ for more updates.