Tokenization: what does it mean and how to structure a project in 4 steps

The growth of the tokenization market

One of the most important and recently growing trends in the Web3 world is the tokenization of assets. These can represent different types of assets (e.g., Real World Assets both movable and immovable, financial instruments, other digital assets, etc.), which are made available to a capital market.

Although this is a process that has been known to practitioners for years, it has gained more fame in the last 2 to 3 years and is expected to grow even more in the years to come.

Among the assets subject to tokenization, financial instruments are in fact one of the assets that attract the most attention, given their special nature and stringent regulation. For this reason, the European Union wanted to allow operators to experiment by taking advantage of the framework of Regulation (EU) 2022/858, which introduces a pilot scheme market infrastructures based on distributed ledger technology ("DLT Regulation").Regolamento DLT”).

What does token mean?

To better understand what will be discussed below, it is important to be clear in mind what token means. This consists of a digital representation of an asset or right, recorded on a blockchain.

Thus, the token acts similar to a physical token representing an underlying asset and can be programmed to perform certain functions or conditions through so-called smart contracts.

Depending on the inherent characteristics, a distinction is then made between different examples of tokens (utility token, stablecoin, non-fungible token, security token, etc.).

Tokenization: The meaning and procedure

Tokenization refers to the process of representing a physical or virtual asset on a blockchain by issuing tokens.

1 - Planification phase

This process typically begins with the identification of the object to be tokenized (be it a right or an asset), the determination of the relevant technological process (e.g., choice of blockhain, type of token, its characteristics, etc.), and the definition of the legal and regulatory framework (e.g., the case of real estate tokenization will be different from that of participatory financial instruments, which will be different from that of intellectual property rights).

2 - Creation phase

This phase first includes the management of the assets that are the subject of the tokenization process. For example, if physical assets are involved, it will be necessary to set up a custodial mechanism (neutral to the seller or buyer of the tokens) or in the context of real estate tokenization it may be necessary to define a mechanism involving the notary public.

Then, tokens are actually generated on the blockchain. It is important that these reflect the characteristics identified in Step 1 and comply with any limitations imposed by regulation. For example, in the context of data sharing, EU Regulation 2023/2394 ("Data Act") requires that there be a mechanism to cease executing transactions via smart contracts (so-called kill switch). Differently, in the context of the of financial instruments, it is required that the registry manager ensures that the blockchain complies with the technical characteristics stipulated in the regulations.

3 - Distribution phase

Having created the tokens, it is necessary for them to be made available to investors. This is an important phase for several reasons.

First, investors may not be Web3 experts, so it may be necessary to structure as simple a mechanism as possible to facilitate the purchase of the tokens (e.g., by creating wallets for investors). This step is not always trivial because it could also have legal consequences (e.g., if the project sponsor decides to guard the cryptographic keys of investors' wallets, regulations regarding custodial services could apply).

A second step of great importance is the establishment of the secondary market. This represents a key element because it allows an asset to be effectively made liquid.

4 - Management phase

Once the tokenization project has been launched, it will be necessary to carry out management and maintenance activities. This involves the technical part of the project (e.g., bug fixing, implementation of new features, cybersecurity, etc.), the classic business development and marketing functions, and the fiscal and legal part (the activities of the latter vary depending on what is actually tokenized).

The new approach of the lawmaker

One of the reasons behind the recent growth of the tokenization market is the increased interest from institutional players (e.g., banks, investment funds, etc.) and regulation of this sector.

Indeed, it is known that increased legal certainty leads to increased investor confidence, especially institutional investors, leading to the emergence of projects and increased experimentation.

From this point of view, Europe has chosen to support the growth of this market precisely through regulation. Regulation (EU) 1114/2023 on cryptocurrency markets (so-called MiCA) defines a uniform regulatory regime for token issuers and service providers.

The European Union has also made a pilot scheme available to operators for tokenization trials of financial instruments through the DLT Regulation.

If the subject matter were data instead then it would be necessary to at least consider the GDPR regulation and the legislation provided in the Data Act.

The new opportunities

The question that is often asked is: but why do you want to tokenize?

As much as this is often a non-trivial question, there are some typical benefits associated with this process that are enabled by the blockchain.

The first is certainly the creation of a liquid marketplace. Think, for example, of real estate tokenization or at any Real World Asset tokenization.

The democratization of asset investment is certainly an additional benefit. Here, too, the real estate sector can provide an excellent example: how many people would like to invest in real estate but do not have sufficient capital? With fractional tokenization though tokens, investor can purchase token representing only a portion of the entire asset (e.g., a portion of the value of the property), so that even smaller amounts can be invested.

Tokenization also results in reduced execution time of transactions (since they take place 24/7 and directly on the blockchain) and reduced operational costs (think here of the world of financial instruments).

Thanks to the typical features of blockchains (which are basically public ledgers), transparency of transactions is also guaranteed. In fact, anyone can see the transactions that have been executed on the blockchain. Beware, however, the blockchain only guarantees the transparency of the transactions and information stored on the blockchain itself. On the other hand, it does not guarantee the correctness of information that is provided to the blockchain by an external party (so-called oracle).