Let’s talk about tokenization
If you’ve hung around the blockchain or crypto space long enough, then you’ve no doubt heard a few common sayings. Things like “Blockchain enables trustless, peer-to-peer transactions and replaces expensive intermediaries and middlemen;” or “fractionalization enables completely new understandings of ownership;” or “tokens allow single high-value items like real estate or artworks to be owned by hundreds of people at once.” In fact, we’ve even said similar things in past articles on this very blog.
Now, all of this is still technically true, but there are a couple of important caveats that really need to be discussed, and unfortunately aren’t in most cases. This has led to some pretty big misconceptions in the blockchain community and general public at large, concerning what blockchain technology is actually capable of in the real world. That’s the all important qualifier. The industry is past the point of talking about the future potential of blockchain technology, but unfortunately broad acceptance and procedural frameworks haven’t evolved to match. So in this article we’ll discuss two common points of misconception regarding tokenization — what “trustless” really means in a peer-to-peer environment, and the realities of fractionalization.
What does trustless even mean?
There’s a common misconception about blockchain that has, over the years, been left untouched. The implication is that, as a “trustless” technology, blockchain technology removes the need for 3rd parties to guarantee a reliable transaction between two parties transaction. This is technically true, but there are two issues.
First, trustless doesn’t mean there is no trust mechanism; it just means that blockchain’s distributed ledger replaces the bank or broker, by means of its decentralized network of cryptographic confirmations. So you’re actually trusting the technology to work properly, rather than a person or financial institution.
But what about the actual tokenization part that comes before the transaction is even made? How do you know that the token is truly backed by what it claims? With crypto, it’s relatively easy to confirm this by looking at the wallet. But this becomes particularly problematic when dealing with asset backed tokens. It’s similar to buying something on eBay, where you just have to trust that the pictures and description are accurate and true to the real item you’re buying, and hope that if they aren’t you’ll be able to get your money back.
However, because tokens allow for some truly high-value transactions, for example raw materials or precious metals, “hope” isn’t a satisfactory answer. So, what’s the solution to ensure you get what the token says you will? You rely on a time honored method to verify; you get a third party auditor. This means that, at least in the tokenization phase, you still need that third party to guarantee trust, there’s just no way around it.
So… Blockchain is Neither Trustless nor Removes 3rd Parties?
Not so fast. Blockchain certainly can be both, but those terms just mean slightly different things than you might have thought. Blockchain hype was/is so strong that it’s easy to mistake a simple distributed ledger system for a miracle that can solve all of our modern problems. It’s important to remember that, at the end of the day, blockchain itself should not be the focus, but rather the use cases it improves or enables.
For example, blockchain doesn’t solve for human nature. “Trust but verify,” as the saying goes, and while blockchain may enable some degree of trust that a transaction will go through, you still need a third-person to verify the asset being transacted. This isn’t a negative, but simply a reality of the hybrid physical/digital world that asset-backed tokens inhabit, and their place in a global trade system. Auditors have helped ensure quality in trade for hundreds of years, and their inclusion in a token-based system is common sense.
Tokenization and Fractional Ownership
Fractionalization is usually brought up in discussions around tokenizing assets, especially a few years ago when the ability to do this was new and exciting. All sorts of use cases were talked about; fractionalizing high-value artworks to open up the typically stuffy market to new investors was a popular example. So too was real estate; many people talked about how fractionalizing housing could enable the increasingly burdened younger generation to at least own some equity. All in all, fractionalization sounded like a technological solution to democratize and improve financial inclusion. But while all these statement are technically true and possible, basically in real life none of this is enforceable or practical.
Now, it’s important to keep in mind that, from a technological standpoint, this is all true. However, engineers shouldn’t be the ones writing media stories because, in the real world, fractionalizing ownership isn’t actually possible for reasons both legal and practical. Fractional ownership is possible with virtual items, but it is just not practical for most physical objects. Imaging working out ownership issues for a house with 100 other co-owners? And often it can’t be enforced in real life, as most jurisdictions aren’t prepared to arbitrate for something this complex, or even recognize multiple owners. That’s why, specifically when talking about fractionalization, we need to add a caveat.
Take real estate, for example. Imagine that you buy a fraction of an apartment along with 10 other people for investment purposes. Technologically speaking this number could be in the hundreds, but for the sake of argument let’s stick with 10. Now, all 10 of you have equal shares of ownership in this apartment, so you all have to be in agreement about practical matters like repairs and improvements, who can rent it, what color the curtains are, etc. Making these decisions is already complicated enough with a few roommates or even just a spouse, and that’s without the complications of wanting a return on investment.
Tokenizing for Investment
Finally, there’s the legal issue, or rather the lack of one. The vast majority of jurisdictions have no precedent for these kinds of cases of multiple ownership. If you tokenize the ownership of real-estate with the intention to distribute ownership, say an apartment with hundreds of token holders, there is no legal framework that would recognize 100 parties as owners. This is particularly important for settling inevitable disputes between the owners. How do you settle the cost of repairs and improvements? What happens if 99 of the owners want to sell and 1 does not? There is no legal precedent for this.
As an investment product, there are other legal issues too. One work around is, much like the third-party auditor above, based on an old fashioned method called usufruct. Rather than tokenize ownership, you tokenize the right to participate in revenue. A company is founded to own the property, and then two tokens are created; the first granting the token holder the right to a share of the companies revenue, and the second being that revenue itself. The first tokens, which must be bought, grants the company liquidity, while the second tokens grant the investor more flexibility, since they can sell, trade, or convert those tokens. We call this investment model revenue participation.
So with a simple workaround, courtesy of a time honored practice, all the original promises of fractionalization, like democratizing investing and improving financial inclusion, are still possible, and legal, without all the practical issues of dealing with other hundreds of co-owners.
Remembering the Limits of Technology
There are a few lessons to take away from this, first and foremost that, despite all the hype, blockchain is, at the end of the day, just a technology. A powerful one no doubt, but one that functions within strict technical, legal, and practical limits.
It’s also a reminder that in our rush to move forward and progress, there are some features of the past, (auditors, obscure procedures like usufruct) that we simply haven’t found better alternatives too. The digital, virtual future is coming, but in the meantime we still live in the ‘real world.’
At CoreLedger, we believe that blockchain is a practical technical solution to improve and solve a wide variety of issues across industries and sectors, which is why we try to cut through the hype and focus on real world applications, not just what’s technically possible.