Tokenization – Basics, use cases and impact on ESG investing

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. The growth of the market is due to the increasing use of digital processes and the handling of sensitive data. The rise of digital payments and the implementation of data security solutions and services is also contributing to the growth of the market. The COVID-19 pandemic has accelerated the digitization of processes in various industries, and as a result, the demand for tokenization has increased. This technology is widely used in the information technology, banking, financial services, and insurance industries, and it has helped banks and payment applications to improve their digital payment infrastructure. Tokenization makes processes more efficient by making a number of intermediaries obsolete.

The banking, financial services, and insurance industry is leading the market due to the standardization of digital services. The entry-level application and execution of the market have become more accessible globally, and this has allowed the industry to thrive. The popularity of tokenization is growing in developing countries such as India and Brazil, as these countries are adopting digitization at an exponential rate, and the regulatory push by governments and authorities is also supporting the growth of the industry. Especially in developing countries, a fast diffusion of digital assets can be recognized. With a lack of traditional banking infrastructure, the inhabitants of these countries often have no traditional alternative and the digital assets can easily jump the hurdles more traditional banking infrastructure is struggling with.

The growth of the tokenization market is driven by the increasing use of digital processes, the rise of digital payments, and the standardization of data security solutions and services. The technology is being adopted by various industries, and it is becoming more accessible globally, which is expected to contribute to the growth of the market in the future. To understand more about tokens and how they can impact ESG investments, we will take a look at three of the most common types of tokens and their practical applications.

Utility tokens

Utility tokens are digital tokens that grant holders access to a specific product or service, such as access to a decentralised platform or a specific use case. An example of a utility token is the Golem Network Token (GNT), which grants users access to the Golem network, a decentralised platform for sharing computing power. GNT advertises with “Lightweight protocol for building unstoppable applications, anonymous and censorship-resistant” to make the development of cutting-edge software tools easier and more accessible. While still giving the providers of the computational power a financial kickback. Another example is the Basic Attention Token (BAT), which is used to access the Brave browser, a privacy-focused web browser. 55 million monthly active users, 16 million daily active users, 1.5 million verified creators accepting BAT, millions of wallets created, thousands of advertising campaigns with leading brands highlight the potential of utility tokens.

Security tokens

Security tokens are digital tokens that represent ownership in an underlying asset, such as stocks, bonds, or real estate. Security tokens are subject to securities regulations, and their value is tied to the performance of the underlying asset. An example of a security token is the tZERO token, which represents ownership in the tZERO platform, a security token trading platform. tZERO can help companies raise capital on their terms without intermediaries through a variety of offering structures. Another example is the SPiCE VC token, which represents ownership in a venture capital fund. SPiCE itself invests globally in leading Blockchain and tokenization companies who are building the ecosystem of a digital future.

Under security token, often the buzzword of asset-backed tokens are mentioned as well. These are digital tokens that represent ownership in a specific asset, such as real estate, fine art, or commodities. The value of the token is tied to the performance of the underlying asset, and the token provides a claim on the asset. An example of an asset-backed token is the Art Token, which represents ownership in a specific piece of fine art. Another example is the Metal Pay token, which represents ownership in a basket of precious metals, such as gold and silver. Most investments in sustainable hard- and software would fall in this category. Take the example of tokenizing the next big wind turbine project. The ownership in the wind turbines is recorded on the blockchain and the token represents a fractional ownership in the asset. This allows for fractional ownership in the wind turbines, which can increase access and affordability for investors. These tokens can also offer a more efficient and secure way of tracking ownership and can increase transparency in the investment process. A visual representation of the tokenization process can be found here:

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.

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.

One downside of using blockchain technology for ESG or sustainable activities was energy consumption. But also here, immense progress has been made last year! Earlier versions of blockchain used to consume high levels of energy since computers had to solve complex mathematical problems to verify transactions. However, Ethereum’s latest update cuts 99.9%+ of energy consumption, while the carbon footprint of third-generation blockchain protocol Tezos is equivalent to the average annual energy footprint of 17 global citizens. The decrease in energy consumption has helped blockchains to become more sustainable and align better with ESG principles.

Bringing liquidity to the green bond markets

Tokenization offers several benefits for green bonds, which suffer from low liquidity and high entry barriers. Tokenizing green bonds through smart contracts on a distributed ledger enables automated, compliant, verifiable, and tamper-proof financing, democratizing the green-investment market and bringing liquidity to a closed market. The benefits of tokenizing green funds include compliance enforcement, increased liquidity, cost-effectiveness, and 24/7 near real-time settlement. Digital securities that exist as tokens on a distributed ledger do not require intermediaries, and fractional ownership of assets further lowers the entry barrier for investors and creates liquidity in less liquid markets.

The tokenization of green bonds allows institutional and private investors to participate in green projects, while the decentralized nature of blockchain technology eliminates the need for a third-party intermediary to validate and approve transactions, making near real-time automated settlements a reality. The credibility of green bonds can be enhanced with the Green Bond Principles (GBP) guidelines for green investing vehicles, which provide clarity on what green is and how to measure environmental impact. As the whole process of tokenizing bonds is still a rather complex system, please take a look at the next integrated link to find a detailed description of every step of the way.

Tokenization and the benefits for CSRD and LkSG

As the world continues to focus on sustainability and the impact of business on the environment, German companies are facing new regulations in the form of The Corporate Sustainability Reporting Directive. This regulation will require companies to disclose information about their environmental and social performance on an annual base. Ten subject matter-specific standards that cover 84 discrete disclosure requirements respecting 1,144 quantitative and qualitative data points need to be considered in the reporting. In the focus are all ESG-connected KPIs, especially the value and supply chain. Besides the CSRD, German companies also face tighter regulation about the assessment of their supply chain nonetheless.

Due to the low level of implementation and the increasing social pressure for more transparent supply chains, the Supply Chain Due Diligence Act, LkSG for short, was finally passed in June 2021. The aim of this law is the mandatory monitoring of compliance with minimum standards in the supply chain. The LkSG will take effect from January 2023 and will gradually affect around 4,800 companies in Germany directly. Non-fungible tokens (NFTs) can create a solution for better data tracking, supply chain management and transparency, while simultaneously creating a more customer-centric approach and making reporting and compliance with the CSRD and LkSG easier. Each NFT is unique and uniquely identifiable, which makes it essentially different from “normal” tokens and therefore incredibly useful for reporting and tracking purposes.

NFTs have the potential to revolutionize supply chain management by enabling traceability of products, data sharing, and improving production, transportation, and warehousing. NFTs provide a transparent platform for customers to know the source of the product, and it can help companies identify the owner of the asset by quick scans. With real-time data and location tracking, inventory management is enhanced with fewer stock-outs, stock checks, and replenishment data is more accurate. NFTs can eradicate malpractices such as counterfeit products and ensure the viability of products while making it easier for the seller to track and trace the carbon footprint and making the assessment of players inside the value chain more transparent.

NFTs also improve data sharing by creating a transparent platform between companies and consumers, creating trust between parties. It can be used to build better supply chain collaborations by providing a sole source of truth. This promotes trust among supply chain partners, and companies can take collaborative advantage by sharing resources and data. NFTs can help reduce inventory runs, improve decision-making, increase profit margins, and create a more customer-centric approach. All of this will help to improve on ESG and CSR KPIs which play a vital role in the compliance with CSRD and LkSG.

In production, transportation, and warehousing, NFTs can help create a digital identity for every part included in a system. This can help identify defects faster and reduce recalls, saving companies millions. In the trucking sector, NFTs can provide details of every repair made to the truck and have a lookout for future breakouts, reducing the total landed cost. NFTW, or NFT Warehouse, allows multiple parties to execute an order at a single time and provides better tracking, transparency, and movement of goods, making data collection and reporting way easier! A great use case of how tokens could have helped in the identification of the whole value chain is an example from the COVID-19 pandemic. Based on a report by ABC Australia, there was a mix-up between a harmless saline injection instead of COVID-19 Pfizer vaccine in Melbourne. If every little vaccine dosage had a unique NFT, it would have been easy to identity which contained the COVID-19 vaccine and which did not. The NFT technology can help eradicate malpractices and mishaps carried out worldwide as the customers have visibility of the entire supply chain journey, the name of the producer, storage locations, and the product’s viability.

Prosumers and the energy industry

The global solar energy market is set to reach $2tn as the green economy continues to grow, and this can be facilitated by peer-to-peer (P2P) energy exchange. However, current energy consumers and traders have difficulty distinguishing between green and fossil fuel energy, which is where blockchain technology can help. The technology allows for secure and reliable ways to transfer valuables through digital tokens. The tamper-proof properties of blockchain can be used to store market-clearing results while the representation of assets of monetary value in digital tokens can be leveraged. The blockchain can be used to securely transfer digital tokens when energy is traded. P2P exchange can incentivize prosumers to invest in local distributed energy resources and consumers to purchase green energy certificates to consume only green energy. A more detailed look into the P2P energy exchanges can be found here.

However, challenges exist, including designing a decentralised P2P market that keeps a fair balance between economic efficiency, information privacy and stakeholder fairness, accounting for inter-temporal dependencies and inefficiencies, and practical implementation. Legal and operational barriers must be leveraged to reach the full potential of P2P energy trading, and energy companies will need to develop new value-added services around smart homes, e-mobility and smart buildings. The Tokenization of Energy use case is being explored by 2Tokens Foundation, supported by organizations including IBM and Rabobank.

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).

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.