21.02.2023 05:20 PM

Tokenization – Basics, use cases and impact on ESG investing

Tokenization, Web3.0, Blockchain – maybe these are buzzwords you remember from 2022! But the topic of Tokenization was made popular in panel discussions of World Economic Forum in Davos with the big question if Tokenization can actually solve any real-world problems. Our article will highlight the benefits of Tokens compared to more traditional ESG investment vehicles and opportunities. However, we also show that there is much more that needs to be done, also on the regulatory side to increase the adoption speed of tokens when being active in Sustainable Finance.

Did you know that Pablo Picasso was one of the main accelerators for Tokens? Well, maybe not the artist himself, but Sygnum – the world’s first regulated digital asset bank – did something remarkable. The bank made history by teleporting Picasso’s 1964 masterpiece Fillette au béret – or, at least, its legal ownership rights – onto the blockchain. The digital asset then was divided into 4,000 tokens, which were sold to more than 50 investors at 1,000 Swiss francs ($1,040) apiece. In doing so, Sygnum gave birth to a new genre of investments. Dubbed Art Security Tokens (ASTs), it combines the technological wizardry of blockchain with the legal framework of Swiss banking. But what has this more creative application of tokens have in common with Sustainable Finance you may ask yourself! We will exactly highlight the benefits of the tokens in the next two sections.

First we briefly explain what the core concept of tokenization actually is: Tokenization is the process of converting assets, such as real estate, fine art, or even stocks, into digital tokens that can be traded on blockchain networks. The token represents ownership or a claim on the underlying asset, and the asset can be divided into smaller units, making it easier for a wider range of investors to participate. The digitization of assets through tokenization makes it easier to trade and manage investments, as well as to track the ownership and transfer of assets. In short, tokens are positioned on the same level as conventional securities. They benefit from the above-mentioned potential increases. Asset tokenization has become one of the most prominent use-cases of distributed ledger technologies (DLTs) in financial markets, for assets including securities (e.g. stocks and bonds), commodities (e.g. gold) and other non-financial assets (e.g. real estate).

Tokens do not only make the replacement of conventional securities by blockchain technology possible. Moreover, they can convert any tangible assets into tokens and make them accessible to all investor groups. That’s precisely why we will access the current tokenization market in the next section and dive deeper into three of the most common types of tokens and how they have the power to transform our economies.

What are the benefits of tokens compared to ESG-investments?

As we have already discussed, tokenization is the process of converting assets, such as real estate or art, into digital assets that can be traded on a blockchain. It is rapidly gaining popularity as a means of raising capital and creating more efficient and transparent markets. Lately, there has been growing interest in the application of tokenization to the realm of sustainable finance.

The conventional way of investing in Environmental, Social and Governance (ESG) assets has been through traditional investment vehicles such as mutual funds, exchange-traded funds (ETFs), or individual stocks. However, these investment vehicles often suffer from numerous limitations. First, they are frequently subject to high fees and administrative costs, which can eat into returns for investors. Second, these investment vehicles can be opaque and difficult to navigate, making it difficult for investors to truly understand what they are investing in. Finally, many ESG investment vehicles are subject to long lock-up periods, which can make it difficult for investors to access their capital when they need it.

Tokenization offers many advantages over traditional ESG investment vehicles. First, tokenization enables a more direct and efficient ownership structure for investors, as tokens can be bought and sold quickly and easily, without the need for intermediaries such as banks or brokers. This leads to lower fees and administrative costs, which in turn can result in higher returns for investors.

Second, tokenization creates a more transparent and accountable market, as the ownership and transfer of tokens can be tracked on a blockchain in real-time. This allows investors to see exactly what they are investing in and how their investments are performing. Additionally, the use of smart contracts allows for the automated execution of investment terms, reducing the risk of fraud or mismanagement. Additionally, we already talked about the problems with ESG ratings of companies and other investment opportunities. With tokens, the ratings are much more accurate and transparent because every bit of information about the token is publicly available.

Third, tokenization offers greater accessibility to ESG investment opportunities, as it enables a wider range of investors to participate in the market, including those who may not have access to traditional investment vehicles. This can increase the overall demand for ESG assets, which in turn can drive up their value and make them more attractive to a wider range of investors. As we have already uncovered with SPiCE, even the VC world can be opened to the typical investor, without needing large sums of capital to participate in.

Finally, tokenization allows for the creation of a more dynamic and flexible investment market, as tokens can be bought and sold in real-time and at any time, regardless of market conditions. This can give investors greater control over their investments and allow them to respond quickly to changes in market conditions. The same goes for the people and companies emitting the tokens. The creation of tokens without the need for intermediaries makes the creation of the investment vehicles more dynamic and flexible as well.

Extending the benefits of tokens to other use cases

To better illustrate the impact that tokenization of assets can have on the corporate landscape, we have collected quite some benefits and situation to better highlight the benefits. Obviously, there are many more potential use cases, we just want to highlight a couple of the ones that can create impact in the short-term and ultimately help companies in their operations.

Catalyst for ESG investments

As we have already talked about in the section above, tokenization can revolutionize ESG financing by making investment opportunities more transparent, scalable, and verifiable across the entire value chain. Tokenization allows for the issuance of securities as digital assets that can be recorded, moved, and stored on the blockchain in a transparent and cost-effective manner. It also provides a unique opportunity to package financing means and ESG data which offers transparency and decision support for investments. Thus, small ESG projects can reach a wider set of potential investors and create new ways of raising capital through tokenization. Ultimately, the tokenization of assets can bring benefits to both the investors and the issuer of the token highlighted in the graphic below.

Why didn’t tokenization take off already?

As we have already talked about in our last section about the energy industry, there are still multiple challenges for the wider adoption of tokens that need to be solved first. The OECD published a report about the challenges for tokenization and we are highlighting the biggest ones. The report makes the case that tokens can blur markets, making high-risk investments available to people who normally wouldn’t make these investments, and them taking to big of an investment risk. Furthermore, in plenty of countries and markets, we still have issues surrounding digital identities. With a broader use of tokenization, 24/7 trading and availability of the market, inherent inequality is on the rise when thinking about internet connectivity and speed. With multiple exchanges, fast internet and the right trading strategies, arbitrage opportunities are possible, but one for those who have the technical ability to use and produce them!

Besides these more B2C focused issues with tokens, there are also three conditions that need to be fulfilled for companies so that the effort put into tokenization would make sense.

At this time, not many companies have found that all three requirements are fulfilled when thinking about tokenization. As a result, the OECD made the prediction that tokens can be a complementary for established markets with more traditional ways of trading assets, but can have real impact for more niche markets with limited liquidity.

One major restriction for the adoption of tokens is the missing legal frameworks. Tokenized markets should comply with regulatory requirements that promote financial consumer and investor protection, market integrity and competition and seek to guard against build-up of systemic risks. Dr. Karl Michael Henneking from Untitled INC underlines the importance of a modern regulatory framework for tokens: “If we focus on digital securities, only a modern regulatory framework will allow us to fully unfold their potential. Overall, regulation of such assets, if transparent and geared towards utilising the benefits of digital technology, will have a positive impact. In particular, already regulated financial institutions and larger institutional investors will benefit since a significant barrier to enter digital asset markets is removed.”

The first steps toward a comprehensive regulatory framework are already underway. In September 2020, the European Commission adopted a Digital Finance Package that aims to increase the competitiveness of the Fintech sector in Europe. Digital Finance Package also introduced an extensive new legislative proposal on crypto-assets, called Markets in Crypto-assets (MiCA). MiCA is intended to close gaps in existing EU financial services legislation by establishing a harmonized set of rules for crypto-assets and related activities and services. Among other things, MiCA imposes restrictions on the issuance and use of stablecoins. The rules and regulations of MiCA will apply to similar services and assets listed under the current Markets in Financial Instruments Directive 2014/65/EU (MiFID II).

What did we learn?

Tokenization is the process of converting assets such as real estate or art into digital assets that can be traded on a blockchain, and is becoming increasingly popular as a means of raising capital and creating more efficient and transparent markets. The global tokenization market size was valued at USD 2.03 billion in 2021 and is expected to grow at a CAGR of 24.09% from 2022 to 2030, primarily driven by the increasing use of digital processes, the rise of digital payments, and the standardization of data security solutions and services.

Tokenization offers many advantages over traditional Environmental, Social and Governance investment vehicles. It enables a more direct and efficient ownership structure for investors, as tokens can be bought and sold quickly and easily, without the need for intermediaries such as banks or brokers. It also creates a more transparent and accountable market as the ownership and transfer of tokens can be tracked on a blockchain in real-time. Tokenization offers greater accessibility to ESG investment opportunities as it enables a wider range of investors to participate in the market, including those who may not have access to traditional investment vehicles, and allows the creation of new, innovative ESG investment opportunities that are not currently available through traditional investment vehicles.

If challenges, like missing legal frameworks, issues surrounding digital identities and arbitrage opportunities and missing broad use cases for a wide variety of companies can be resolved, tokenization has the potential to revolutionize ESG financing by making investment opportunities more transparent, scalable, and verifiable across the entire value chain.