Tokenization and the Repackaging of Illiquid Assets

Thanks to modern investment vehicles and tools, consumers can invest in almost anything even if they cannot afford to purchase an entire unit.  Most consumers are familiar with shares of stock, which allow investors to purchase ownership shares in a corporation - for as low as a few dollars apiece - rather than having to buy the entire company.  Almost as many may be aware of bonds, which allow investors to lend relatively small amounts of money to corporations or governments and receive fixed interest payments in return.  This breaking down of historically large investments, such as buying a company or lending all the money needed for a project, into small enough pieces for common investors to purchase them is known as securitization.

From Securitization to Tokenization

History of Modern Securities

During the 20th century, common citizens began purchasing securities (stocks and bonds) in large amounts.  During the Roaring Twenties, stocks became so popular that many investors recklessly borrowed money to purchase more shares, incorrectly assuming that share value would always rise and guarantee profit.  While the infamous stock market crash of 1929 was devastating, it led to government regulation and oversight of stock trading.  When the economy recovered, many investors learned to diversify their portfolios, for which came an increasing array of investment vehicles.

The Market Efficiency Hypothesis, which says investors should diversify to mirror the market rather than try to “beat the market” with individual stocks, led to the creation of mutual funds and exchange traded funds (ETFs).  Modern technology allows virtually anyone to enjoy the benefits of these investment vehicles - you can now trade stocks, bonds, and even cryptocurrency through apps on your smartphone.  Securitization now extends to microshares, where people can invest small dollar amounts to purchase fractions of a share.  This opens up the benefits of investing to low income individuals who cannot purchase whole shares (which, for some stocks, can be more than a few hundred dollars).

Rise of Tokenization

Tokenization emerged in 2009 with the birth of cryptocurrency, which consists of digital tokens that are publicly coded on blockchains to record transfers and ownership.  The use of blockchain technology makes it very difficult to “hack” or “steal” cryptocurrency, providing security for crypto owners.  Thus, converting assets into cryptocurrency can be seen as providing another layer of security against fraud and theft.  Similar to securitization, it can also allow high-value assets to be divided into much smaller amounts for trade and exchange, opening up investment and consumption opportunities to common citizens.

Economics of Tokenization

Similar to securitization, the rise of tokenization has increased investment and spending in the economy (both components of aggregate demand) by allowing smaller-dollar spending by common citizens.  Previously, consumers had money that remained unspent on investments because the money was insufficient to purchase whole units of investment, limiting the investment in endeavors that could be generated.  Thus, tokenization has increased both aggregate demand and the rate of capital formation by allowing previous non-investors to become investors.

Reduced Transaction Costs

By using cryptocurrency, investors can enjoy reduced transaction costs compared to previous whole-unit purchases, which may have required lengthy contracts.  An example is real estate, where contracts are time-consuming and require substantial transaction costs through legal fees.  Previously, those who wished to invest in real estate had to “buy in” to the property through traditional contacts, which may require surveys and inspections from third parties that had to be paid separately.  Now, thanks to cryptocurrency and tokenization, the value of a property can be converted into thousands of digital tokens that most consumers can afford.

By eliminating the need to “buy in” to properties through lengthy processes, more people are likely to invest and thus generate economic activity.  When transaction costs decrease, spending increases.

Increased Pricing Efficiency

Instead of one singular price, such as a real estate property in the millions of dollars, an illiquid (difficult to spend) asset is converted by tokenization into thousands of easily-purchased units.  These small units can be bought and sold on the free market.  Thanks to their lower price and higher volume, these crypto tokens are far more responsive to changes in supply and demand compared to a singular expensive unit.  This increased responsiveness to market forces leads to greater market efficiency and more total spending.  Buyers and investors benefit when price falls and tokens become more affordable, and sellers benefit by no longer having to access an illiquidity discount.

Increased Information Asymmetry

Unfortunately, tokenization runs into the same risks that faced securitization prior to the mid-1930s: information asymmetry, lack of regulation, and high risk.  During the Roaring Twenties, many common citizens invested heavily in low-priced stocks without much understanding of these corporations’ financial standings.  Corporations were under little government regulation to accurately report their finances, resulting in considerable fraud.  Many investors were misled into investing large sums into stocks that were not backed by real revenue.

The reduced barriers to entry in the markets for real estate and heavy assets caused by tokenization can lead to fraud and abuse as unwary investors purchase digital tokens without doing much research.  Fueled by a misconception that crypto and other digital tokens will only ever increase in value, unwary investors may buy them recklessly.  Currently, the regulatory framework does not exist to ensure accurate information reporting for tokenization of assets versus securitization.

Depreciation Risk and Information Asymmetry

While stocks and bonds are backed by revenue, digital tokens representing physical assets like real estate and equipment may not be.  Therefore, the value of most tokenized assets will decline over time due to depreciation.  Many casual investors may not understand this difference and be surprised to discover that the value of their investment declines over time.  There may also be incomplete or false reporting of the condition of physical assets that have been tokenized, such as a building, tractor trailer, or computer server.  While a corporation is making money to actively repair and upgrade its facilities and equipment, a physical asset that is not revenue-generating may not do and simply degrade over time.  Eventually, the tokens become worthless because they represent an asset that has fully depreciated.