Distributed Ledger Technologies (DLT) and similar FinTech innovations have ushered in an era of dynamism in the global financial industry. For example, DLT has created a platform for trading digital assets as securities and, more recently, asset-backed digital tokens.
For a digital asset to be offered over a real asset (such as securities, commodities, etc.), it must be subscribed. Digital tokens are variable digital assets that represent a value or unit of ownership in a commodity or entity, and are capable of being acquired and traded through cryptographically secured blockchain technologies.
Essentially, assets are signed when they are decommissioned in digital form. For example, the ownership of a 250-story commercial estate can be tokenized by fragmenting the ownership into 500,000,000 digital tokens with each token attributed with an equal value of part ownership in the real asset. The value of each token is based on the value of the underlying asset, which is the 250-story commercial estate.
The tokenization of real assets is in its nascent stages across global financial markets, but it presents viable investment opportunities. It has the potential to rapidly mobilize large-scale liquidity from retail investors in asset classes traditionally reserved for high-net-worth individuals and institutional investors. The tokenization of real assets can also provide a vehicle for private companies to raise large pools of capital through token offerings and private equity trading. But the opportunities presented by asset tokenization are most obvious for tangible assets such as real estate, precious metals, minerals, art, etc., which are largely illiquid and not currently traded electronically.
Potential impact of asset tokenization on illiquid assets
The commodity market, with its incredibly high investment capital requirements, is constantly besieged by liquidity issues, due to a lower presence of retail investors. While real estate in Nigeria currently enjoys a comfortable liquidity ratio, it offers very little inclusion for retail investors. With the tokenization of assets in the commodity and real estate markets, investment opportunities are becoming more accessible to retail investors – everyday people. With the seeming ubiquity of blockchain technology, asset tokenization could drive cross-border retail investment as interested individual investors subscribe to digital token offerings for these traditionally illiquid assets.
Similar to the conventional financial market, digital tokens on blockchain technology can function either as debt or as shares. With the alarming decline in Nigeria’s revenue and exorbitant costs spent on servicing her debt, tokenization can therefore provide a potentially viable public finance model for both federal and state governments to bridge their infrastructure deficits. For example, the federal government can build electronic railway systems from Lagos to Onitsha and raise billions of naira through digital token offerings. The railway will be subscribed and domiciled on a public blockchain infrastructure, enabling investors around the world to subscribe to units of digital tokens that represent a credit interest in the railway. Consequently, tokenization ushers in the tradability of illiquid assets by enhancing their convertibility to liquid assets.
For a digital asset to be offered over a real asset, it must be signed. For example, the ownership of a 250-story commercial estate can be tokenized by fragmenting the ownership into 500,000,000 digital tokens with each token attributed with an equal value of part ownership in the real asset.
Implications of tokenization on the financial market
As with many technology-driven innovations, asset tokenization is potentially disruptive to conventional financial markets. The Nigerian financial market has been particularly slow to adopt blockchain technology. Its eventual invasion will challenge the existing financial system and provide credible opportunities to improve the liquidity of typically illiquid assets, trading, pricing and settlement of securities.
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With tokenization, the existing intermediation of trades in the current conventional financial market model will be replaced with almost disintermediation of trade – without the need for intermediary actors such as brokers who match buy and sell options. With reduced intermediary involvement there are cost efficiencies in trade. Smart contracts can also lead to efficiency gains in leveraging blockchain technology for automating trades. With the adoption of smart contracts, the buying and selling of tokens in the DLTs is instantly automated. A smart contract is self-enforcing and self-executing with the terms of the agreement written by the parties in lines of code that exist within the blockchain network.
Through the smart contract, digital tokens can be transferred to investors without any intervention from intermediaries once contract terms (e.g. performance metrics based on the value pools) have been met. The contractual terms and historical data about the issuer and the underlying asset are encoded in the smart contract and this relevant (financial) data is easily accessible and visible to all participants in the blockchain.
Given the relatively nascent development of blockchain technology compared to the conventional financial model, the old market model, with its prominent intermediaries, is likely to be preserved for some time to come.
In the conventional financial market, there is sometimes inequality in the information available to the various participants, such that a party with more market information, usually the issuer, takes advantage of that position to determine the pricing; often to the detriment of the investor. Trading on blockchain technology allows for transparency and accuracy of trading information to all participants. This increased transparency, in turn, affects the prices and efficiency of traded securities.
Challenges of Asset Tokenization
There are challenges facing the wider adoption of asset tokenization in the Nigerian financial market. Chief among these are the current limitations of technology. Competent technological capacity, which is currently lacking, is needed to ensure interoperability between blockchain platforms or between the off-chain market and on-chain market, scalability, cyber protection, data protection, network stability, settlement finality, etc.
Moreover, the possible split of liquidity between the off-chain and on-chain markets, as it concerns assets traded in the conventional financial markets as well as on blockchain, can lead to the risk of arbitrage. Credible and trustworthy custodians are also required to link the off-chain market to the on-chain market by holding the underlying assets.
In most developing economies, the problem remains of ascertaining the existing domestic legal and regulatory regime governing blockchain technology. This poses a serious legal and governance risk to potential participants who cannot determine what legal protections are available to them. Cyber risks, identity and governance risks, and anti-money laundering/countering the financing of terrorism (AML/CFT) risks are among other issues that need to be addressed by relevant regulatory frameworks. Additionally, there are concerns about the enforceability of smart contracts – which enable the interoperability of tokenized commerce.
There is tension in the Nigerian blockchain industry regarding the Central Bank of Nigeria’s (CBN) seemingly unfriendly regulations, which prohibit financial institutions from dealing in blockchain transactions. This stifling regulation poses a problem in achieving finality in transaction settlement; crucial for the trading of digital tokens on blockchain technologies.
However, the Securities & Exchange Commission (SEC) has commendably issued a regulation on the issuance, offering and custody of digital assets. This regulation to some extent allays investors’ fears of participating in digital asset transactions, as it recognizes digital asset offerings in the capital markets and provides regulatory measures to ensure the integrity, sustainability and growth of asset tokenization.
In order to protect the confidence of investors in the system, the regulation provides for requirements that must be met before an asset can be subscribed, the requirements for digital asset custodians, digital asset exchanges and other trading platforms. While this regulatory effort is laudable, it is worth noting that the regulation only applies to securities of public companies. As a result, the regulation still does not cover the tokenization of real assets such as precious metals, art, minerals, real estate, etc.
Tokenization is poised to usher in an era of cost efficiency, disintermediation, the inclusion of retail investors and improved liquidity in the financial markets. However, much needs to be addressed, particularly within the regulatory landscape to support full adoption. These include cyber-related risks, the competence of available technology, AML/CFT risk, identity risk, legal risks, etc.
The article was written by Mr. Ugochukwu Obi, the partner responsible for the Fintech and capital markets divisions of Perchstone & Graeys LP, and Mr. Kolawole Omoyajowo, an associate in the capital markets division of the firm.