Tokenization is a way to record ownership or rights to assets using digital tokens on a distributed ledger, also known as a blockchain technology. Before you invest, it’s important to understand what the token represents, what rights you have and whether the people or firms involved are properly registered. Find out more.
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What is tokenization?
A tokenized system is a record-keeping system where assets and their ownership or rights to the asset are represented on a distributed ledger, also known as a blockchain. Tokenization is the process of converting or representing the rights to an asset as tokens on a distributed ledger. The asset could be a share in a company, government bond, real estate interest, artwork, or another type of financial asset. Through the tokenization process, rights to such assets are contained in a digital record, known as a token.
The token or digital record specifies the rights the person has to the asset and details such as how it can be sold or redeemed. The distributed ledger serves as a record about a token, such as ownership and transfers (for example, token A is sold to buyer B).
Some issuers use smart contracts. Smart contracts can be built into a token’s code to handle certain functions such as receipt of dividends or other distributions, transfers, or redemptions. Smart contracts are not contractual agreements. They are computer programs (or “code”) that automatically perform certain functions when predetermined conditions are met. They can also be used for more complex financial transactions involving several tokenized assets or multiple conditions.
A tokenized asset may be a digital representation of a traditional security that already exists. In other cases, the security may be issued only in digital form. Depending on how a tokenized arrangement is structured, the ledger may serve as the official record of ownership or may operate alongside traditional records that are kept by someone else such as an issuer, transfer agent, custodian or other intermediary.
Today, tokenization is being explored and adopted across a range of assets, including investment funds, bonds, private markets securities, real estate interests, and other financial assets.
Tokenization is playing an evolving role in global capital markets. Financial institutions are testing and launching tokenized products, while regulators and policy makers are considering how existing regulatory frameworks apply and whether additional safeguards may be needed.
Some believe tokenization could make some capital markets processes more efficient. Potential benefits may include more streamlined recordkeeping, reduced reliance on manual processes, with faster settlement in some cases, and greater transparency. However, the extent of these benefits depends on the design of the system, operational arrangements, and applicable legal and regulatory requirements.
What are the risks of tokenization?
Like any investment, there are risks that can come with tokenization. The risks include:
- Legal and ownership risks – The legal rights associated with tokenized products can vary. Investors should understand how ownership is documented, who maintains ownership records, and how their rights will be enforced if there is a dispute, insolvency, technology failure, or other problem.
- Technology and operational risks –Tokenized assets rely on digital infrastructure. Technology failures, cybersecurity incidents, coding errors, governance changes and operational disruptions could affect ability to access assets, transfer, or complete transactions.
- Third-party risks –Investors may depend on third parties such as custodians, transfer agents, trading platforms or other service providers. If one of these organizations fails to perform its role properly, investors could face delays, losses or difficulties accessing their assets.
- Liquidity risks –Tokenization does not ensure that an active market will develop or be maintained for buying and selling an investment. Some tokenized products may trade infrequently or only on limited platforms. As a result, you may not be able to sell your investment when you want or at the price you expect. This is known as the degree of liquidity an asset has.
- Fraud and investor protection risks –As with any emerging technology, tokenization can attract misleading promotions or fraudulent schemes. Claims of high returns, low risk or exclusive access should be treated with caution. Always check before you invest to verify whether the investment and person or firms offering it are appropriately registered.
What should investors know about tokenization?
There are things you should keep in mind if you are considering investing in a digital token, including:
- Focus on the underlying investment – A token is still an investment. The digital technology used to record ownership does not automatically make the investment safer, more profitable, or easier to sell. Before investing, consider the quality of the underlying asset, the risks involved, and whether the investment is appropriate in your circumstances.
- Understand what the token represents and your rights to the asset – Before investing, understand what the token represents and what legal rights come with it. A token may represent direct ownership of an asset, a beneficial interest in an asset held by someone else, a contractual claim, or exposure to the value of an asset. The structure can affect your rights, including what happens if the issuer, platform, custodian, or another service provider encounters financial or operational difficulties.
- Check who is involved in issuing the token – Tokenized products can often involve multiple parties, such as issuers, custodians, trading platforms, technology providers and other service providers. Understand who is responsible for issuing the product, maintaining ownership records, safeguarding assets, and operating technology used by the product. You should understand who controls or governs the system. For example, are decisions made by a single organization, a group of participants or an automated process? Knowing who is responsible can help you understand your rights and who to contact if a problem arises.
What should investors know about tokenization regulation?
Just because an investment is tokenized does not mean securities laws stop applying. Tokenization does not determine whether securities laws apply. Depending on the structure of the product and the rights in provides, a tokenized product may be a security and may be subject to securities law requirements. Other laws and regulatory requirements may also apply.
The Canadian Securities Administrators’ (CSA) Project Tokenization initiative is looking at how tokenized financial products intersect with Canadian securities laws and what regulatory responses may be needed as the market develops.
What should you ask before investing in a tokenized product?
Before investing in a tokenized product, consider asking:
- Is the person or company offering the investment registered?
- What asset does the token represent?
- What rights do you have as the token holder?
- Who issued the token?
- Who maintains ownership records?
- Is there an underlying asset and, if so, who holds or safeguards it?
- How can you sell, transfer, or redeem the investment?
- Are there restrictions on when or to whom you can sell it?
- What fees apply?
- What happens if the technology or service provider fails or something goes wrong such as a cybersecurity breach or hack? Will you have any recourse?
- Why do you want to own the tokenized version of the asset? What are the advantages, if any, to you?
Summary
Tokenization is the process of converting or representing rights to an asset on a distributed ledger, often called blockchain technology.
- A tokenized asset could be a share, bond, real estate interest, artwork, or another type of financial asset. The digital record, known as a token, represents the rights associated with that asset.
- Like any investment, there are risks that can come with tokenization, including legal and ownership risks, technology and operational risks, third-party risks and liquidity risks.
- If you are thinking of investing in a digital token, focus on the underlying investment, understand what the token represents and your rights to the asset, and check who is involved in issuing the token.
- Before investing in a tokenized product, check to make sure that the person or company offering the investment is registered.
