Advancements in technology have given rise to alternative approaches in various areas, including the financial market. One such new approach in the financial industry is the tokenization of securities.
While tokenized securities have been around for some time, it is now gaining popularity as a means of representing traditional securities using blockchain. This innovative approach allows for digital ownership and investment in asset classes previously only accessible through conventional methods.
Currently, the market capitalization of tokenized securities exceeds $17 billion.
One notable advantage of tokenized securities is their accessibility, as they enable everyday investors to participate in the market. Even risk-averse individuals can participate in the financial market and leverage blockchain technology without needing to invest directly in cryptocurrencies. Instead, they can invest in regulated tokenized securities within a regulated market, thus limiting their exposure to risks.
This article comprehensively explores the concept of tokenized securities and its role in the broader finance industry. So, let’s start with the basics!
What Are Tokenized Securities?
Tokenized securities(or security tokens) are traditional securities that exist as digital assets on a blockchain or distributed ledger technology (DLT) platform.
Tokenized securities can represent various financial instruments, such as debt obligations, ownership rights to an underlying asset, or dividend rights to a company.
By default, tokenized securities must adhere to existing security laws, which means they are subject to regulations regarding investor identification (know-your-customer or KYC) and measures to prevent money laundering (anti-money laundering or AML).
These forms of securities are made available to the public through a process called a security token offering (STO). The process is similar to a traditional initial public offering (IPO); tokenized securities are released to investors just as companies do their stocks for public trading.
Although cryptocurrencies do not offer direct ownership of any underlying asset or company, people still debate whether they should be considered securities. In contrast, there is no such ambiguity with tokenized securities. They have their own token standard that enables them to be represented on the blockchain and compliant with security laws at the same time.
How Do Tokenized Securities Work?
Tokenizing securities involves representing traditional securities, like stocks, bonds, or real estate, as digital tokens on a blockchain or distributed ledger technology (DLT) platform.
Although specific technical aspects are involved, the general principle of tokenizing securities remains consistent regardless of the kind of securities.
First, the issuer or an authorized entity identifies the asset to be tokenized, such as company shares, real estate property, or debt instruments.
Next, the issuer ensures that the tokenization process adheres to applicable securities laws and regulations in the relevant jurisdiction. This may involve collaborating with legal experts to structure the tokens correctly.
The asset is divided into a specific number of digital tokens, with each token representing a fractional ownership or rights associated with the underlying asset. For example, a single share of a company can be divided into multiple tokens, each representing a percentage of ownership.
In order to ensure that security tokens perform their intended functions, their features are encoded into smart contracts on the blockchain. These smart contracts may include details such as ownership rights, voting rights, dividend distributions, and other contractual terms.
Token holders can automatically receive dividends allocated to them without extra effort. In the case of shares, tokenized securities can be coded to support on-chain voting and participation in governance.
Next, the tokens are minted and issued on a blockchain or DLT platform. Each token is assigned a unique identifier and associated with the relevant smart contract.
Subsequently, these tokens can be offered to the general public through a security token offering (STO). Investors who wish to participate in the ownership of these tokenized securities must fulfill KYC/AML requirements in accordance with security regulatory standards.
Now that there’s an understanding of how tokenized securities work, let’s explore why there’s the need to create security tokens in the first place.
Why Do We Need Tokenized Securities?
Compared to traditional securities, the incentives for tokenizing securities are much higher. The following are some benefits that make tokenizing securities an attractive option for both issuers and investors in the securities market.
Improved Accessibility
Tokenized securities open up new investment opportunities by making securities accessible in a decentralized manner. The use of blockchain technology allows these securities to be available across borders, allowing a wider range of investors to trade assets that were previously inaccessible to them.
Increased Liquidity
Tokenized securities offer improved liquidity due to their broader availability to a larger audience. Additionally, the 24/7 trading model, similar to the cryptocurrency market, improves efficiency and liquidity, especially in traditionally illiquid markets like real estate. Exiting positions in such markets becomes more efficient and streamlined.
Fractional Ownership
Tokenized securities allow everyday investors to access high-value assets without the limitations imposed by stringent requirements for accredited investors. The divisibility of investment opportunities allows individuals to invest small amounts in multimillion-dollar assets easily, expanding investment possibilities.
Improved Access To Funding
Tokenized securities improve access to funding for startups; it circumvent the cumbersome processes associated with traditional funding rounds or IPOs, which pose significant challenges for startups in raising capital.
Tokenizing securities allows emerging companies to readily distribute ownership to the public and generate funds while adhering to regulatory frameworks. This approach reduces costs and facilitates expedited funding opportunities.
Automation
Tokenized securities leverage smart contracts to automate processes and eliminate manual efforts associated with traditional investments. Tasks such as paperwork and administrative procedures are replaced with automated workflows powered by smart contracts. Even KYC/AML processes can be completed on-chain, streamlining compliance requirements.
Smart contracts can also facilitate the automatic distribution of dividends to investors, eliminating the need for cumbersome paperwork.
Transparency
Tokenized securities introduce the concept of real-time monitoring to the securities markets. Because the financial assets are hosted on a blockchain, the details of transactions on the securities can be tracked by anyone who has access to the network.
This feature helps reduce investors’ vulnerability to securities fraud and allows regulatory bodies to access trading data more easily.
Challenges of Tokenized Securities
Although tokenized securities are a new and exciting idea, they do have some limitations and drawbacks. Some of which are explained below:
Hacks and Frauds
The frameworks for tokenized securities are coded within its smart contracts, similar to other cryptocurrencies. However, smart contracts have demonstrated vulnerabilities in the past, and since blockchain developments are open-source, anyone can access these smart contracts, creating opportunities for malicious individuals to exploit any weaknesses.
This presents a potential risk to investor funds and raises concerns regarding the extent of investor protection offered when investing in security tokens.
Lack of Interoperability with Existing Traditional Systems
The integration of blockchain technology with existing traditional systems, such as APIs, has not yet reached full success. This lack of interoperability poses limitations on the applicability of blockchain for creating security tokens, as it may not seamlessly meet the requirements of certain asset classes or markets.
The Future Of Tokenized Securities
As a groundbreaking innovation at the intersection of finance and technology, tokenized securities hold tremendous promise for every stakeholder in both industries and the general public.
Tokenized securities not only improve accessibility and efficiency for investors but also provide issuers with improved profit-making opportunities.
Regulators can benefit from real-time access to data and automated processes, eliminating the need for time-consuming back-and-forth interactions. By reducing the risks associated with trading securities, tokenized securities contribute to safer investment opportunities
Tokenized securities, however, face challenges arising from the relatively new nature of blockchain technology, smart contract vulnerabilities, and difficulties in achieving interoperability with traditional systems, hindering widespread adoption.
Despite these challenges, the current landscape shows increasing interest and potential for tokenized securities. As blockchain technology matures and regulations evolve, we can expect further progress in this field. Tokenized securities have the potential to revolutionize finance, reshaping perceptions, trading, and regulations around securities ownership.
Disclaimer: This article is intended solely for informational purposes and should not be considered trading or investment advice. Nothing herein should be construed as financial, legal, or tax advice. Trading or investing in cryptocurrencies carries a considerable risk of financial loss. Always conduct due diligence.
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